Working Through an Employer’s Failure to File Form W-2 or 1099 with the IRS

We welcome guest blogger Omeed Firouzi to PT. Omeed is a Christine A. Brunswick public service fellow with Philadelphia Legal Assistance’s low-income taxpayer clinic, and he is an alum of the Villanova Law Clinical Program. His fellowship project focuses on worker classification. In this post, Omeed examines a recent case where the taxpayer unsuccessfully sought relief under section 7434 for her employer’s failure to report her compensation to the government at all. Litigation in this area is likely to continue. Christine

Tax season is upon us so I would be remiss if I did not cite fellow Philadelphian Ben Franklin’s famous maxim that “in this world nothing can be said to be certain, except death and taxes.” But whether you are filing your return as soon as possible or at 11:59 PM on April 15, there is one thing that is uncertain for many taxpayers: whether your employer filed an information return.

As we have seen in our clinic at Philadelphia Legal Assistance and more broadly, employers are increasingly not filing income reporting information returns with the Social Security Administration (SSA) and the Internal Revenue Service (IRS). The Internal Revenue Manual, at IRM 21.3.6.4.7.1, describes the proper procedure for IRS employees to follow should a taxpayer not receive an information return. The IRS website also provides tips and tools for how taxpayers should proceed in such situations.

Under the Internal Revenue Code and regulations promulgated under the Code, employers could be held liable – and subject to penalties – for failure to file correct information returns. However, the IRC and its accompanying regulations lack a clearly defined legal recourse for individual taxpayers when the employer fails to file any information return at all. No explicit cause of action exists for workers in this predicament. Recently, a taxpayer in New York unsuccessfully tried to make the case that 26 U.S.C. Section 7434 encompasses this situation.

read more...

The statute states, in part:

If any person willfully files a fraudulent information return with respect to payments purported to be made to any other person, such other person may bring a civil action for damages against the person so filing such return.

This statute has been the subject of several previous Procedurally Taxing posts. As these posts described in detail, courts are in consensus that the statute at least encompasses an employer’s willful misstatement on an information return of the amount of money paid to a worker. The legislative history of Section 7434 reveals that when Congress drafted the legislation in 1996, its authors were concerned with the prospect of “taxpayers suffer[ing] significant personal loss and inconvenience as the result of the IRS receiving fraudulent information returns, which have been filed by persons intent on either defrauding the IRS or harassing taxpayers.” 

The case law is split on whether misclassified taxpayers can use Section 7434 to file suit against their employers for fraudulently filing a 1099-MISC rather than a W-2, if the dollar amount reported is correct. No circuit court has ruled on the issue but most courts have followed the lead of the U.S. District Court for the Eastern District of Virginia and its Liverett decision that found that Section 7434 does not apply to misclassification.

However, one aspect of Section 7434 where there is judicial consensus is that the statute does not encompass the non-filing of an information return.

The U.S. District Court for the Eastern District of New York recently joined the chorus of courts on this issue. In Francisco v. Nytex Care, Inc., the aforementioned New York taxpayer argued that her former employer, NYTex Care, Inc., violated Section 7434 by “failing to report payments made” to the taxpayer and other workers. The facts of the case are straightforward. Taxpayer Herlinda Francisco alleged NYTex Care, a dry cleaning business, “fail[ed] to identify [her] and other employees as employees” by failing to file information returns for tax years 2010, 2011, 2012, 2013, 2014, 2015, and 2016. Francisco filed suit under Section 7434 alleging that NYTex “willfully and fraudulently filed false returns…by failing to report” employees’ income.

The court principally cited Second Circuit precedent, set in Katzman v. Essex Waterfront Owners LLC, 660 F.3d 565 [108 AFTR 2d 2011-7039] (2d Cir. 2011) (per curiam), in dismissing the case. Katzman established that Section 7434 “plainly does not encompass an alleged failure to file a required information return.” In Nytex, the employer “did not report payments made” to the taxpayer and other employees but the court found that Section 7434 was not the appropriate remedy.

More broadly, the Nytex court examined the plain language of Section 7434, its legislative history, and other relevant case law in foreclosing this claim. The plain text of the statute, the court noted, necessitates a filing by definition; there must be a filed information return in order for it to be fraudulent. The court also looked to Katzman’s parsing of congressional intent for guidance; in Katzman, the Second Circuit ruled explicitly that “nothing in the legislative history suggests that Congress wished to extend the private right of action it created to circumstances where the defendant allegedly failed to file an information return.”

Further, the court even relied upon another case the same plaintiffs’ attorney brought in the Southern District of New York. In Pacheco v. Chickpea at 14th Street, Inc., the plaintiff there also brought suit under Section 7434 on the basis of the failure of their employer to file information returns but the Southern District “found [that situation] was not covered by the statute.” Ultimately, the Nytex court granted the Defendants’ motion to dismiss for failure to state a claim upon which relief can be granted because the court found no cognizable claim for alleged failure to file an information return under Section 7434.

The result in Nytex leaves it frustratingly unclear what remedies exist for workers who find themselves in this taxpayer’s predicament. Had the employer here actually filed a 1099-MISC with the IRS, a potential argument could’ve been made about misclassification and whether that is encompassed by Section 7434. There is more division in the courts about that issue as opposed to the question posed in Nytex. Had the employer willfully overstated the amount the taxpayer was paid, the court could’ve found a clear Section 7434 violation, based on the reporting of a fraudulent amount.

Of course, neither of those things happened here. Instead, there is an aggrieved taxpayer ultimately unable to rely on a statute that is both ambiguous and seemingly limiting all at once. Practically, she is left with no clear way to sort out her own tax filing obligations when no information returns were filed. The court interestingly does not identify an alternative course of action, or judicial remedy, the taxpayer could seek.

In relying on congressional intent, the court leaves the reader wondering if Congress ever envisioned that an employer’s failure to file an information return could cause “significant personal loss and inconvenience” to the worker. If it means a frozen refund check as part of an IRS examination, there is certainly loss and inconvenience there. As Stephen Olsen described at length previously, courts have deeply examined the statutory language in terms of whether the phrase “with respect to payments made” only modifies “fraudulent” or if the information return itself could be fraudulent even if the payment amount is correct.

That discussion raises an interesting question as it relates to Nytex: if a court found an actionable claim for non-filing under section 7434, how would it determine whether the failure to file was fraudulent or whether there was willfulness in the non-filing? Since there would be no information return, would the court be forced to look at what kind of regular pay the taxpayer got to ascertain what the information return likely would’ve been?

Then, the court would have to find that there was “willfulness” on the part of the employer, not merely an inadvertent oversight. To make matters more complex, the court would have to likely wrestle with how there could be a willful act in a case where the employer did not even act at all. If a court found willfulness, a potential argument could be that a non-filing is analogous to filing an information return with all zeroes on it thus leading the court to say it is, in effect, fraudulent in the amount.

For now though: what can a taxpayer do in such a situation? When employers fail to provide or file information returns, the IRS recommends that workers attempt to get information returns from their employers. If that fails, the IRS advises workers to request letters on their employer’s letterhead describing the pay and withholding. Should an employer not comply with these requests, the IRS can seek this information from an employer while taxpayers can file Substitute W-2s attaching other proof of income and withholding – such as bank statements, paychecks, and paystubs. If a taxpayer got an information return but the employer never filed it with the government, that might ease the burden on the taxpayer but the IRS will still seek additional verification.

Even then, taxpayers could get mired in lengthy audits and examinations all while waiting for a critical refund check they rely on to make ends meet every year. We have seen this pattern play out in our own clinic and I suspect as it befalls more taxpayers, there may be either a congressional or judicial reexamination of Section 7434 or another effort to address the problem of non-filing of information returns.

Problems Facing Taxpayers with Foreign Information Return Penalties and Recommendations for Improving the System (Part 3)

We welcome back Megan Brackney for part three in her three-part series discussing penalties imposed on foreign information returns.  Today, she brings of stories of clients who have faced these penalties demonstrating the problems caused by the manner in which the penalties are being imposed and she brings suggestions of how to improve the system.  Keith

The Gifts That Keep on Giving

Two young people moved to the U.S. as students.  They met in graduate school and married.  After graduation, they were offered jobs and were sponsored by their employers so that they could stay in the U.S.  While they were students, their parents from their home country sent them money to help pay for their expenses in the U.S.  After they became U.S. taxpayers, they received a few more gifts, totaling more than $100,000.  They told their CPA about these gifts, and even showed him copies of their bank statements so that he could see the wire transfers from their parents’ non-U.S. accounts.  The CPA told them that because these were gifts and not subject to taxation, they did not need to be reported.  The CPA did not advise them of the Form 3520 filing requirement for gifts from foreign persons that exceed $100,000 in the aggregate during the tax year.  Neither of the taxpayers had any knowledge of the Form 3520, and genuinely believed that they were filing their returns correctly.

read more...

A few years later, the taxpayers switched to a new CPA and again mentioned the gift issue, and she told them that they should have been filing Forms 3520 after they became U.S. taxpayers.  She prepared three Forms 3520 with statements explaining their reasonable cause, and the taxpayers filed them.  There was no audit or inquiry by the IRS and no tax due as a result of the error, and other than this understandable omission, they have a perfect compliance history.  The CPA was not aware of the Delinquent International Information Return Submission Procedures, but the taxpayers’ submission nevertheless substantially complied with the requirements for that procedure. 

Soon after their good faith attempt to self-correct, the IRS assessed the maximum amount of penalties on both taxpayers pursuant to I.R.C. § 6039F – 25% of the amount of the gifts they had received.  The IRS issued separate notices for the three years so that there were three different deadlines for the appeals, and thus three separate appeals.       

These notices were entitled “Notice of Penalty Charge.”  The Notices stated merely that “you have been charged a penalty under Section 6039F of the Internal Revenue Code for Failure to File Form 3520 to Report Receipt of Certain Gifts” and did not provide any other information or explanation.  As the word “charge” does not appear in the Code or Regulations, a lay person would not know from this notice whether there has actually been an assessment of the penalty. 

The only information provided about how to challenge the penalty was to state that the taxpayer could submit a written request for appeal within 30 days from the date of the notice which, “should reflect all facts that you contend are reasonable cause for not asserting this penalty.” 

The notice does not contain any information about collection while the appeal is pending but contains the following statement: “If you do not wish to appeal this penalty, there is nothing you need to do at this time.  You may later dispute the penalty by paying the penalty and then filing a claim.”  A reasonable layperson could interpret this to mean that the taxpayer does not have to pay the penalty until after his or her appeal.  And, indeed, as noted in the previous column, Internal Revenue Manual 8.11.5.1 states that taxpayers are afforded pre-payment appeals.  The notice does not explain any of this, however, and yet the IRS will only suspend collection activity if the taxpayer separately notifies Collections that he or she has filed an appeal (and frequently not even then).

Moreover, from the notice, there is no indication that the IRS obtained managerial approval of the penalty, as is required by I.R.C. § 6751(b), and no indication that the IRS considered the reasonable cause defense submitted along with the Forms 3520. 

The taxpayers timely submitted an appeal to each penalty, explaining again that they had reasonable cause for failure to file foreign information returns, i.e., that that they retained a competent CPA to prepare their returns, that they gave him full and complete information, and they reasonably relied on his advice that nothing needed to be done to report the gifts from their parents.

Despite the timely appeals, the IRS has continued sending collection notices.  In response to Notice CP504, the taxpayers requested that the IRS place a hold on collection pending the appeal.  The IRS did not respond, but moved forward with issuing the notice of intent to levy on one tax year.  The taxpayers were forced to file a CDP request to prevent enforced collection while Appeals considers their reasonable cause defense.  The taxpayers are frightened that the IRS will file a notice of federal tax lien, which would be devastating as they are trying to buy a house right now.  

In the meantime, for one of the tax years, the IRS sent the taxpayers a notice stating that it was rerouting the taxpayers’ correspondence (the timely filed appeal) to the Frivolous Correspondence Department.  The taxpayers promptly responded with a letter explaining that their appeal was not frivolous, and that they had a right to Appeals review, and that the IRS cannot refuse to forward their protest to Appeals.  They have received no further communications regarding the appeal. 

For another tax year, the taxpayers received a cryptic letter from the Service Center, responding to their correspondence (with the same date as the appeal for that year), by stating “We reviewed the information you provided and determined that no action is necessary on your account.”      

The taxpayers have not received any further communications from Appeals.  We have tried to find someone at the IRS who has this file, but have had no luck.  Although the Service Center told me that their case is assigned to the field, no one at that office has specific responsibility over it.  As of the date of publication of this column, the taxpayers have been waiting for over a year for an Appeals conference.  Meanwhile, the IRS collection machinery rolls on, without regard to the fact that the taxpayers have never had any Appeals review of the assessments. 

Welcome to the Machine

This taxpayer is a non-U.S. Person who is the sole shareholder of several U.S. real estate holding companies.  Due to some serious health issues, including dementia and loss of hearing, he fell behind on filing returns.  His son began taking over the business, discovered that returns had not been filed, and starting filing Forms 1120, which included Forms 5472, and a reasonable cause statement explaining his father’s health problems and his inability to file returns on time.  The entities filed the Forms 5472 for years which there was no tax due and owing pursuant to the Delinquent International Information Return Submission Procedures.  For the years in which tax was due, the entities filed the returns in the ordinary course but attached reasonable cause statements.

The IRS’s response to these various filings has been haphazard.  For many of the Forms 5472, no penalties were imposed at all.  There is no discernible pattern – sometimes tax was due, sometimes it was not; sometimes the year at issue was the first year of correction, sometimes it was a later year.  The taxpayers have no complaints about not getting penalties on these years, but it does make one wonder whether the IRS just failed to catch them, or if someone evaluated the reasonable cause defense and agreed that penalties would not be appropriate, and if this is the case, why penalties were imposed for other tax years with identical facts.

For the rest of the Forms 5472, the IRS sent out notices assessing penalties for $10,000 per form for each of late-filed Forms 5472.  The Tax Cuts and Jobs Act of 2017 (“TCJA”) increased this penalty to $25,000 for each late-filed or incomplete Form 5472.  On almost all of the notices, the tax year was mistakenly stated.  The entities are fiscal year taxpayers, with their tax years ending on different dates, such as June 30, or September 31.  The U.S. companies’ fiscal year, was, of course, stated on the front of the Forms 1120, and thus that information was available to the IRS.  However, the IRS identified the penalty period for all years as ending on December 31.

In any event, the notices of penalty were on a different form than those issued to the taxpayers described above.  These notices had a heading stating, “We Charged You A Penalty.”  This notice provided thirty days to notify the IRS if “you don’t agree with the penalty assessment,” and provided instructions on presenting a reasonable cause statement under penalties of perjury.  The notice does not explain whether this submission would be an appeal or a request for abatement.  Like the notice to the other taxpayers, this notice does not provide any information about collection or indicate whether managerial approval has been obtained or acknowledge that the taxpayer had already submitted a statement of reasonable cause under penalty of perjury.  And again, there is no concept of a “charge” under the Internal Revenue Code, and it would not be clear to a lay person trying to interpret this notice what this meant. 

In response to these notices, the entities requested abatement of penalties on the ground of reasonable cause, and the IRS granted several of these requests, with no explanation.  It is possible that for some of these penalties, the IRS was applying a concept of First Time Abatement, since they were the first tax years with non-compliance.  The First Time Abatement provisions of the Internal Revenue Manual do not refer to foreign information return penalties, but I suspect that this relief may have been granted for these entities, and I have heard, anecdotally, from other practitioners, that their clients have received this relief. 

For the penalties on which the IRS denied the request for abatement, the IRS provided an explanation for the denial and obtained proper managerial approval under I.R.C. § 6751(b).  In the letter denying the abatements, the IRS stated that the taxpayer could appeal the decision.  It is unclear why these taxpayers were provided with a two-step procedure – request abatement, and then appeal of the denial of the abatement request — while the taxpayers described above were told to go directly to Appeals.  In any event, the IRS provided these entities with 60 days in which to submit an appeal, and the entities have done so, but several months later, they still have not heard from Appeals.

In the meantime, on all of the remaining penalties, the IRS has sent collection notices, and each time, the entity responded with a request a hold on collection pending its appeal.  The IRS did not directly respond to any of this correspondence, but for some of the entities, the IRS seems to have stopped sending notices.  For other entities, the IRS issued final notices of intent to levy.  Despite already having one appeal pending, these entities were forced to submit CDP requests to avoid levy. 

In addition, for several of the penalty assessments, the IRS filed notices of federal tax lien.  As noted, the Code section that authorizes the penalty for failure to file the Form 5472 is I.R.C. § 6038A.  However, on several of the notices, the IRS stated that the penalty had been assessed under I.R.C. § 6038.  This is close, but not quite right – this is the penalty for failure to file Form 5471.  On one of the notices of federal tax lien, the IRS did not even get close, but identified the penalty as being assessed pursuant to I.R.C. § 6721 (trust fund recovery penalties).  And, as noted above, the IRS assessed the penalties for tax years ending December 31, even though the entities’ tax years do not end on December 31, but at the close of their fiscal year.  As these notices were improper and inaccurate, and the taxpayer’s Appeals had not been heard, the entities had to file CDP requests challenging the federal tax lien filings. 

The entities have not received any response to their appeals, many of which have been pending for more than a year.

Perfection is the Enemy of Good

The next taxpayer is a high net worth individual who is the grantor of a foreign trust with significant assets.  Since the formation of the trust, he has always timely filed Forms 3520 and Forms 3520-A and reported all income related to the trust.  At some point, the country codes stating where the trust was administered and what law applied were not included on the Form 3520, although that information is included in other parts of the form.  The IRS caught this error on the Form 3520 for one year and assessed a multimillion-dollar penalty pursuant to I.R.C. § 6677.  There was no tax non-compliance related to this error – it was a minor and inconsequential technical error on a timely filed return.  The taxpayer did not notice this minor error during his review of his returns and he certainly did not instruct his CPA not to fill out these items on the form.  Other than this minor foot-fault, the taxpayer has an excellent compliance history.

The notice was entitled “Notice of Penalty” charge, and provided for 30 days to appeal or request abatement and directed the taxpayer to correct the errors within 90 days or be subjected to additional penalties.  The language of the notice was unclear as to whether the taxpayer would be able to appeal if the request for abatement was denied.  To be on the safe side, the taxpayer submitted an appeal to the IRS explaining that the taxpayer had reasonable cause for the error based on reliance on his CPA, and that penalties were not appropriate because he substantially complied with the Form 3520 filing requirement. 

There is no indication from the notice that the IRS obtained managerial approval under I.R.C. § 6751, and the notice did not provide any information about suspending collection.  Before the 30-day deadline for the appeal, the IRS sent Notice CP504, taking the first steps toward enforced collection action, despite the fact that the taxpayer’s time to appeal had not yet elapsed.  The Appeal is pending, unless the IRS changes its practices, despite the timely appeal, which should be successful, the taxpayer may have a federal tax lien filed against him and may receive a notice of intent to levy and be forced to submit a second appeal through CDP.    

Suggestions for Improving Penalty Enforcement Procedures

Below are a few simple suggestions for the IRS that would go a long way toward fair and efficient administration of the Internal Revenue Code penalty provisions.

1.          Stop systematically assessing these penalties.  These are significant penalties and it is important that they only be assessed in appropriate cases.   

2.         Consider that a taxpayer voluntarily self-corrected.  Instead of encouraging voluntary compliance, the IRS is severely penalizing taxpayers without any proper purpose.  The message that the IRS is sending to taxpayers is not to attempt to resolve issues voluntarily and self-correct, as the IRS treats taxpayers who come forward to correct past non-compliance in the same manner – as harshly as possible – as those whom the IRS identifies as non-compliant. 

3.         Apply concepts of substantial compliance.  Missing a line on a form should not warrant the highest level of penalty assessment where there is no tax due or other harm to the government.

4.         Formally adopt a First Time Abatement policy for foreign information return penalties that is applied consistently among taxpayers. 

5.         Find a way to follow the Internal Revenue Manual.  Wait until the time has elapsed for filing an appeal before commencing collection action, and upon receipt of the appeal, immediately stop collection.  If there is no system in place to cause this to happen automatically, create one, or, at a minimum, add a line to the notice telling the taxpayer that if they receive a collection notice, they should notify the office that sent the notice that they have timely filed an appeal of the penalty.  Then, instruct Collections to suspend collection activity once they receive notification that an appeal has been filed.

6.         Train IRS personnel in the Service Center and Collection about these penalties, so that they know what they are and how the procedures are different than those that may apply to the usual situations they see with taxpayers who have income tax liabilities so that they are able to respond to taxpayers who call for assistance. 

7.         Use consistent language in the penalty notices.  There is no reason for there to be different versions of the notices that taxpayers receive when foreign information penalties are assessed. 

8.         Use language that tracks the statute.  There is no such thing as a penalty “charge” in the Internal Revenue Code or Treasury Regulations.  It is an assessment, and it is misleading to call it something else.

9.         Clearly describe how the taxpayers may submit their reasonable cause defenses to the IRS, and state that if the IRS denies abatement, they may request an appeal.

10.       Notify taxpayers that they can request additional time to appeal and explain the process for doing so, or provide a longer time period and make it consistent for all taxpayers. 

At this point, there have been very few court decisions addressing reasonable cause and other defenses to foreign information return penalties, and none addressing the IRS’s procedures.  This may be because the increase in systematic assessments is fairly recent, and it also may be because for Forms 5471, 8938, and Forms 5472 (until the TCJA increased it), the penalty of $10,000 per form did not warrant the cost of federal litigation.  The IRS should not take advantage of the fact that most people will not go to court to challenge these penalties, but should take immediate action to ensure that they are being applied in an appropriate manner, and that taxpayer’s right to challenge the IRS’s position and be heard, the right to appeal an IRS decision in an independent forum, and the right to a fair and just tax system are being honored and protected.  As can be seen by the cases discussed in today’s post, the IRS is not taking steps to protect these rights. 

Problems Facing Taxpayers with Foreign Information Return Penalties and Recommendations for Improving the System (Part 2)

We welcome back Megan Brackney for part two in her three-part series discussing penalties imposed on foreign information returns.  Keith

Reasonable Cause

For all of the foreign information return penalties, reasonable cause is a defense.  See I.R.C. §§ 6038, 6038A(d)(3), 6038D(g), 6039F(c)(2), 6677(d); Treas. Reg. § 1.6038-2(k)(3)(ii).   The IRS applies the same standards for reasonable cause for failure to file income tax returns under I.R.C. § 6651 to failure to file foreign information returns, i.e., the exercise of ordinary business care and prudence.   See e.g., Chief Counsel Advisory 200748006

read more...

In determining whether taxpayers satisfy the reasonable cause standard, the IRS also applies the holding of United States v. Estate of Boyle, 469 U.S. 241 (1985), to the failure to file foreign information returns.  Boyle articulates a non-delegable duty to file tax returns.  In that case, the executor of an estate relied on a tax advisor to file the estate tax return, but the advisor missed the deadline.  The Supreme Court explained that determining the due date and ensuring that the return was filed did not require any special tax expertise, and that taxpayers have a non-delegable duty to make sure that their returns are timely filed.  Any other rule, according to the Supreme Court, would not be administrable.  Id. at 249.       

However, the Supreme Court specifically contemplated that a taxpayer can rely on a tax professional’s advice as to whether to file a particular return.  As stated by the Supreme Court, “Courts have frequently held that ‘reasonable cause’ is established when a taxpayer shows that he reasonably relied on the advice of an accountant or attorney that it was unnecessary to file a return, even when such advice turned out to have been mistaken.”  Id. at 250.  Other courts have reached similar conclusions.  See e.g., Estate of Liftin v. United States, 101 Fed. Cl. 604, 608 (2011) (an expert’s advice concerning a substantive question of tax law as to whether a return was required to be filed was reasonable cause).  Accordingly, a taxpayer should be able to rely on the advice of a tax professional as to whether a foreign information return is required (as opposed to merely meeting a known deadline). 

 Challenging Foreign Information Return Penalties

Foreign information return penalties are “assessable penalties,” meaning that they are “paid upon notice and demand” and are not subject to the deficiency procedures, and thus cannot be challenged in Tax Court (with one narrow exception discussed below).  I.R.C. § 6671(a). 

The Internal Manual states that the taxpayer is entitled to post-assessment, but pre- payment, Appeals review of the penalty.  See Internal Revenue Manual 8.11.5.1.  As we will see, the IRS does not automatically suspend collection activity in order to provide taxpayers with this pre-payment right to appeal, and routinely fails to respond to taxpayers’ requests to suspend collection during their appeals.  I have recently learned that the IRS’s failure to suspend collection may be due to an error in inputting the right code.  In one case, the Service Center told me that the collection hold had mistakenly been put on the 1040 account, rather than the civil penalty account.  I do not know how often this occurs, but it is concerning that a taxpayer could be subject to levy because of this type of an error.   

In any event, as we will see below, the notice of the right to appeal is cryptic, provides a short time to submit the appeal, and does not provide the taxpayer with information on whether or how to extend this deadline if the taxpayer needs more time.  

If the appeal is unsuccessful, the taxpayer’s only option for judicial review is to pay the penalty in full and file a refund claim, and if the refund claim is not granted (or acted upon within six months of receipt by the IRS), the taxpayer could then file a refund action in federal district court or the court of claims.  See I.R.C. § 7422; 28 U.S.C. § 1346(a)(1).

If the IRS does not offer Appeals rights before issuing a final notice of intent to levy, the taxpayer can file a CDP request with IRS Appeals, and at that point, should be able to raise defenses to the penalties, such as he or she acted with reasonable cause.  I.R.C. § 6330(c)(2)(B); Treas. Reg. § 601.103(c)(1); Interior Glass Systems, Inc. v. United States, 927 F.3d 1081, 1087 (9th Cir. 2019).  If Appeals does not grant relief during the CDP hearing, the taxpayer could file a Petition for Lien or Levy Action Under I.R.C. § 6330(d), in the United States Tax Court. 

Procedures to Get Into Compliance

The IRS has established the Delinquent International Information Return Submission Procedures, which may be helpful for some taxpayers in avoiding penalties, but there is no guarantee.  A taxpayer is eligible to use these procedures if he or she has reasonable cause for not timely filing the information returns, is not under a civil examination or a criminal investigation by the IRS, and has not already been contacted by the IRS about the delinquent information returns.  Under this procedure, the taxpayer sends in the delinquent return as directed by the IRS, along with a statement of facts establishing reasonable cause for the failure to file.

The IRS makes no express promises on the outcome under these procedures, but it is generally understood by tax practitioners that the IRS will not assess penalties if there is no tax liability related to the failure to file and the taxpayer has reasonable cause.  Nevertheless, we have seen the IRS assess penalties against taxpayers who have submitted their foreign information returns under these procedures, but as the IRS provides no acknowledgement that the taxpayer attempted to use the procedure, it is unclear if this is due to mistakes in processing or is intentional. 

The Delinquent International Information Return Submission Procedures are not difficult to locate if you already know to look for them.  However, there is no reference to these procedures or links to them on the other pages of the IRS’s website that discuss the foreign information return penalties themselves.  The average layperson, and even many tax practitioners, are not aware of the procedures.  On several occasions, clients have come to us after they have received notices of penalty assessments for late filing of Form 5471 or 3520, when no tax was due and they had a reasonable cause defense to late-filing, because their CPA’s filed the forms without a reasonable cause statement in the form required by the Delinquent International Information Return Submission Procedures. 

For individuals who made non-willful errors in their foreign information reporting, the Streamlined Voluntary Filing Compliance Procedures, may provide some relief.  Also, for taxpayers who acted willfully, or are concerned that that the IRS will view their non-compliance as willful, the IRS’s voluntary disclosure practice may be an option.

Even though these procedures are available to allow certain taxpayers to limit their penalty exposure, they are not a substitute for the IRS applying the penalty provisions as required by the Internal Revenue Code and following its own administrative procedures. 

Part III will explore some examples of foreign information return horror stories.  Unlike other genres of horror, these stories do not derive from rare events, but represent the day to day conduct of the IRS in this area. These are not isolated examples, and I could have described numerous other cases of my own clients, and on an almost daily basis, I hear similar stories from other attorneys and CPA’s who are seeing the systematic assessment of significant and, sometimes life altering, penalties against taxpayers for negligible errors and delinquencies. 

Problems Facing Taxpayers with Foreign Information Return Penalties and Recommendations for Improving the System (Part 1)

We welcome guest blogger Megan L. Brackney who is a partner at Kostelanetz & Fink, LLP in New York City, and focuses her practice in civil and criminal tax controversies. Over the past couple of years, she and her colleagues have seen a significant influx in foreign information reporting penalties and have represented hundreds of taxpayers against the IRS on these issues.  She provides us with the wisdom gained from her experience.  Megan and I serve together as vice chairs of the ABA Tax Section.  I can tell from the experience of working with her what a great lawyer and counselor she is.  Keith

The IRS has been assessing more and more foreign information return penalties on taxpayers.  It is difficult to find statistics on this point, as the IRS’s reports on tax penalties lump all “nonreturn” penalties into one category, which includes failure to file Forms 1099, 8300, and other information returns, along with foreign information return penalties.  Even without the statistics, tax controversy practitioners know this to be true, as we have clients coming in with these assessments every day.  Many of these penalties are being systematically assessed, meaning that a penalty is automatically issued whenever there is a late-filed form or a form is missing information, without regard to the individual circumstances of the taxpayer.  In many cases, the penalties are wildly disproportionate to the taxpayer’s mistake, and serve no purpose other than to discourage taxpayers from voluntary compliance.

read more...

The increase in penalty assessments has also increased the workload of IRS Appeals and there are significant delays in resolution.  As will be discussed below, while these appeals languish without any response or action, the IRS continues to move forward with enforced collection.  This is a waste of the taxpayer’s resources to be constantly receiving notices and attempting to call and correspond with the IRS, and sometimes filing multiple appeals because they have to resort to Collection Due Process (“CDP”) to stop the IRS from levying on their assets before their appeals are heard.  This is also a waste of resources for the IRS, and further burdens Appeals, as more CDP requests come in on cases that are already assigned to Appeals. 

The IRS has caused this chaos from overreacting to taxpayers who have filed late or incomplete foreign information returns while at the same time, not allocating additional resources to Appeals to deal with the additional volume, or instructing Collections and Service Center personnel as to how to handle these cases.  There are some very simple administrative fixes to these issues, which I will recommend at the end of this column. 

To provide some context, and hopefully to bring some order to the chaos, this column tells the stories of three taxpayers who have faced assessment of devastating foreign information return penalties and have been unable to get the IRS to consider their defenses, followed by ten recommendations for improvement. 

Background on Foreign Information Return Penalties

Before talking about these three illustrative cases, below is some basic information about foreign information return penalties.

 Types and Amounts of Penalties

Foreign information return penalties include penalties for failure to file:

  • Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations)
  • Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business)
  • Form 8938 (Statement of Specified Foreign Financial Assets)
  • Form 8858 (Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs))
  • Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation); Form 8865 (Return of U.S. Persons With Respect to Certain Foreign Partnerships)
  • Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts)
  • Form 3520-A (Annual Information Return of Foreign Trust with U.S. Owner), and other forms.  (Note that Penalties for failure to file FinCen Form 114 (the “FBAR”) are not assessed under Title 26 (the Internal Revenue Code), but Title 31 (the Bank Secrecy Act).  See 31 U.S.C. § 5321.  The rules for assessment and collection of FBAR penalties are contained in 31 U.S.C. § 5321.  This column focuses only on the Title 26 foreign information return penalties and does not address the IRS’s enforcement of FBAR penalties.)    
  • See I.R.C. §§ 6038(c)(4)(B), 6038A, 6038B, 6038D(d), 6039F(c), 6677.  These penalties are related to the failure to file, or the incomplete filing, of these foreign information returns, and are not related to any tax deficiency.  Accordingly, the IRS can – and frequently does – assess these penalties even where there is no tax due as a result of the failure to file or the incomplete form.  

The penalties for not filing Forms 5471, 8938, 8858, and 8865 (to report ownership in a foreign partnership) are $10,000 for the initial failure to file the form, and an additional $10,000 for every 30-day period, or part thereof, after the IRS has notified the taxpayer of the failure to file, up to a maximum of $50,000, meaning that the IRS can assess penalties of up to $60,000 for each form.

Beginning with the 2018 tax years, the penalty for failure to file Forms 5472 have been increased to $25,000 per failure, an additional $25,000 with every 30-day period, or part thereof, after the IRS has mailed a notice of failure, with no outer limits.   

The penalty for failure to report a transfer to a foreign corporation on Form 926, or failure to report a transfer to a foreign partnership on Form 8865, is 10% of the fair market value of the transferred property, up to $100,000.

 The penalties for failure to file Form 3520-A to report a gift from a foreign person or inheritance from a foreign estate is 5% of the amount of such foreign gift/inheritance for each month for which the failure to report continues up to 25% of the foreign gift/inheritance.

 The penalty for not reporting a transaction with a foreign trust on Form 3520 is 35% of the “gross reportable amount,” increasing by $10,000 for every thirty days for which the failure to report continues up to the “gross reportable amount.”  The “gross reportable amount” is the transfer of any money or property (directly or indirectly) to a foreign trust by a U.S. person, or the aggregate amount of the distributions so received from such trust during such taxable year.  I.R.C. § 6677(c).

 As with all penalties, the IRS is supposed to obtain proper managerial approval before assessment. I.R.C. § 6751(a)(2) (“no penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”)

TIGTA’s Report on the Growing Gig Economy

Today we welcome guest blogger Joseph C. Dugan. Joseph is a 2015 graduate of Indiana University Maurer School of Law. During law school, he coordinated IU’s IRS VITA program and worked part-time at a Low-Income Taxpayer Clinic. After graduating, Joseph clerked on the U.S. District Court for the District of Maryland and the U.S. Court of Appeals for the Seventh Circuit before assuming his present position as a trial attorney with the Federal Programs Branch of the Department of Justice, Civil Division. Joseph lives in Maryland with his wife and four-month-old son. Joseph writes in his individual capacity and does not purport to represent the views of the Department of Justice or any of its components.

 This post originally appeared here on the Surly Subgroup blog. We highly recommend adding it to your regular blog reads. Christine

On February 14, 2019, the Treasury Inspector General for Tax Administration (TIGTA) released a Valentine’s Day treat: a comprehensive report following a TIGTA audit concerning self-employment tax compliance by taxpayers in the emerging “gig economy.”

read more...

As Forbes noted last year, over one-third of American workers participate in the gig economy, doing freelance or part-time work to supplement their regular incomes or stringing together a series of “gigs” to displace traditional employment. Popular gig services include ride-sharing giants Uber and Lyft; arts-and-crafts hub Etsy; food delivery services GrubHub and Postmates; and domestic support networks Care.com and TaskRabbit. Even Amazon.com, the second-largest retailer in the world and a traditional employer to many thousands of workers in Seattle and at Amazon distribution centers worldwide, has gotten in on the gig economy with its Amazon Flex service. And for those interested in more professional work experience to pad their resumes, Fiverr connects businesses with freelance copywriters, marketers, and graphic designers. The power of smartphones and social media, coupled with flat wage growth in recent years, makes the digital side hustle appealing and, for many households, necessary.

From a tax revenue perspective, the gig economy is great: it is creating billions of dollars of additional wealth and helping to replenish government coffers that the so-called Tax Cuts and Jobs Act (TCJA) has left a little emptier than usual. From a tax compliance perspective, however, the gig economy presents new challenges. Gig payers generally treat their workers as independent contractors, which means that the payers do not withhold income tax and do not pay the employer portion of FICA. Instead, the contractor is required to remit quarterly estimated income tax payments to the IRS and to pay the regressive self-employment tax, which works out to 15.3% on the first $128,400 in net earnings during TY2018, and 2.9% to 3.8% on additional net earnings. That self-employment tax applies even for low-income freelancers (i.e., it cannot be canceled out by the standard deduction or nonrefundable credits).

While the proper classification of gig workers is a legal question subject to some debate, platforms hiring these workers generally treat them as independent contractors. Taxpayers new to the gig economy and unfamiliar with Schedules C and SE may not be aware of their self-employment tax obligations. If they are aware, they may not be too eager to pay, especially if back-of-the-envelope planning during the tax year failed to account for this additional, costly tax.

In light of this emerging economic narrative and evidence that the portion of the Tax Gap attributable to self-employment tax underreporting is on the rise, TIGTA undertook an audit. TIGTA identified a population of 3,779,329 taxpayers who received a Form 1099-K (an information return commonly used by gig economy payers, as discussed below) from one of nine major payers between TY2012 and TY2016. The audit found that 25% of those taxpayers did not report income on either Schedule C (where self-employment income should be reported) or Form 1040 line 21 (where self-employment income is often incorrectly reported). The TIGTA audit further found that, after adjusting for taxpayers who filed Schedule C with a profit of less than $400 (who may not owe self-employment tax) and taxpayers who earned less than $400 on combined Forms 1099-K received by the IRS, 13% of taxpayers did not file a Schedule SE and did not pay self-employment taxes.

These TIGTA findings are revealing. As Leandra Lederman and I discuss in a forthcoming article, Information Matters in Tax Enforcement, there is a host of evidence that information reporting increases tax compliance. As a suggestive starting point, according to IRS statistics, the voluntary individual compliance rate for income subject to substantial information reporting is 93%, while the voluntary individual compliance rate for income subject to little or no reporting is under 37%. TIGTA’s report does not provide percentages that permit a direct comparison with overall IRS compliance estimates. However, the high rates of complete failure to report income tax and employment tax by gig workers receiving a 1099-K seem to suggest that the 1099-K requirement is not as effective as its drafters hoped. Given the transparency of the earnings to the IRS, a likely explanation for this failure is that some gig workers simply do not understand their tax obligations.

But there’s another problem: a substantial amount of gig income is not clearly subject to an information reporting requirement at all. Back in the day, if a payer hired an independent contractor and paid the contractor over $600 during the tax year, the payer was required under Code section 6041(a) and IRS guidance to file Form 1099-MISC, an information return that put both the IRS and the taxpayer on notice of the income. In 2008, however, Congress enacted Code section 6050W, which, upon its effective date in 2011, required “third-party settlement organizations” (TPSOs) to report payments on what is now Form 1099-K, subject to a generous $20,000/200 transaction threshold. A tiebreaker rule set forth in Treas. Reg. § 1.6041-1(a)(1)(iv) provides that a payer subject to reporting requirements under both Code section 6050W and Code section 6041(a) should comply with the former provision only. As a practical matter, this means that payers who consider themselves to be TPSOs (the definition of which is ambiguous and obviously drafted without reference to the emerging gig economy) can report payments for their higher-earning contractors while leaving contractors with under $20,000 or under 200 transactions invisible to the IRS. What are the chances that an Uber driver who earns a few hundred bucks a month in compensation for rides might genuinely, or conveniently, forget to report those receipts come tax time if she hasn’t received a 1099? Pretty good, if prior Tax Gap research is any indication.

My coauthor, Leandra Lederman, presaged some of the problems with Code section 6050W and Form 1099-K reporting in a 2010 article, in which she identified factors that inform the determination whether additional information reporting might be successful. As Leandra and I observe in Information Matters, Form 1099-K held little promise from the outset. And the problems inherent in the TPSO reporting regime have only worsened as the worker economy has transitioned more and more toward lean, diversified gigs.

As if all of this weren’t concerning enough, TIGTA also found serious problems with the way the IRS goes about assessing self-employment tax compliance. Due to resource constraints, the IRS’s Automated Underreporter (AUR) program, the first line of offense against noncompliant taxpayers subject to information reporting, only selects and works a fraction of returns flagged for discrepancies by the Information Reporting and Document Matching Case Inventory Selection and Analytics (IRDM CISA) system (an acronym that only a bureaucrat could love). The idea is for AUR examiners to focus on cases that may yield the highest assessments while also pursuing repeat offenders and providing balanced coverage across AUR inventories. Yet, even as the discrepancy rate involving Forms 1099-K issued by the nine gig economy companies at the center of the TIGTA study increased by 237% between 2012 and 2015, the AUR program selected just 41% of these cases for review.

That review is not necessarily robust. TIGTA found that, for TY2011 through TY2013, 57 percent of all self-employment cases selected to be worked by AUR examiners were screened out—that is, closed without further action. Yet for cases not screened out, 45% were assessed additional self-employment tax; and TIGTA estimates that about $44 million in further self-employment tax could have been assessed during TY2013 alone if the screened-out cases had been worked and resolved similarly to those that were not screened out.

TIGTA also found that, while the IRS has implemented several tiers of quality review within the AUR program, little action is being taken to identify and correct error trends, and the review processes themselves are prone to error and mismanagement due in part to a lack of centralized coordination. One unfortunate consequence of these shortcomings in the AUR program is that gig workers who are already confused about their obligations are receiving inaccurate CP 2000 notices (the standard notice that informs a taxpayer of an error detected through AUR). In fact, TIGTA estimates that the AUR program sent taxpayers 23,481 inaccurate CP 2000 notices about their self-employment taxes in FY2017. That error rate is not only bad for taxpayers, it is bad for the government: if self-employment tax is inadvertently omitted from a CP 2000 notice, as a matter of policy the IRS is generally unable to correct that omission even if the IRS later detects the mistake. That additional revenue is simply forfeited.

So, despite all its wonderful potential to increase both economic opportunity for hard-working Americans and access to valuable services for those willing to pay for them, the gig economy has created some new challenges for tax administration. Gig workers are unsure of (or noncompliant with) their self-employment tax obligations; gig payers are unsure of (or taking advantage of) their status as TPSOs; and the AUR program is not keeping up with the changing times. TIGTA proposes a host of corrective actions in the February 14 report, most of which the IRS has endorsed. Among these corrective actions, three that strike me as particularly important are Recommendation 3 (revise the Internal Revenue Manual to clarify those circumstances in which an AUR examiner should enter a note justifying a screen-out decision); Recommendation 10 (develop IRS guidance on how taxpayers should classify themselves under Code section 6050W); and Recommendation 11 (work with Treasury to pursue regulatory or legislative change regarding the Code section 6050W reporting thresholds). The IRS disagrees with Recommendation 10, asserting that the problem is better addressed through a Treasury Regulation than IRS guidance and complaining that the IRS is preoccupied with issuing guidance under the TCJA and reducing regulatory burdens pursuant to E.O. 13,789. That may well be the case, but revenues are being lost every year that gig payers and workers misunderstand, or misapply, their reporting and payment obligations. There is no reason to suppose that the gig economy will start contracting any time soon, so it would be prudent for the IRS and Treasury to allocate resources to address this problem expeditiously. (Yes, I appreciate that the IRS is chronically underfunded and forced to make very difficult choices about how to staff projects. This is a problem that Congress largely created and Congress alone can fix.)

Ultimately, the best course here might be for Congress either to tailor the definition of TPSOs to a narrower subset of payers for whom the higher thresholds actually make sense (e.g., platforms like eBay, whose casual sellers may not net any income through their online rummage sales) or to lower those thresholds to make gig earnings more transparent to the IRS. So long as we maintain the regressive self-employment tax, we ought to ensure that all taxpayers liable for the tax—even tech-savvy taxpayers Ubering their way through the emerging economy—pay their fare share.

Oral Persuasion: Taxpayer Testimony and the Burden of Proof

We welcome guest bloggers John A. Clynch, Managing Director, and Scott A. Schumacher, Faculty Director, of the University of Washington School of Law Federal Tax Clinic. John and Scott take us behind the scenes on a recent case where they successfully shifted the burden of proof and convinced the Tax Court that their client did not have income despite its appearance on a Form 1099-MISC. The facts of this case are unusual in several respects, but information return disputes are a regular issue in tax controversy practice and on this blog. Keith collected several previous PT posts here last July. Christine

Unreported income cases are a staple of low-income taxpayer clinics. Low-income individuals often have several jobs of shorter duration, move their residence more often than the general population, and may not be the most adept at recordkeeping. Handling these cases is generally straightforward – obtain the wage and income information from the IRS and match it to the return. These cases can be more challenging if the taxpayer was a victim of identity theft, and the taxpayer must prove they did not receive the income listed in the W-2 or 1099.

But what if there is no dispute that the taxpayer received the money but there is no indication of what payment is for? In Park v. Commissioner, T.C. Summ Op. 2018-46, the Tax Court decided the rather unique question of not whether the amount was received or by whom, but rather what the amount paid was for and thus whether the amount was taxable.

read more...

The taxpayer, Jin Park, is an immigrant from South Korea, who served in the U.S. Army. Mr. Park purchased a home in 2008 and took out mortgages with Bank of America. He was paying both principal and interest on the mortgages in 2012 while on military deployment overseas.

In 2014, Mr. Park received a $13,508 check from BOA. Included with the check was a letter that provided, “based on a recent review of your account, we may not have provided you with the level of service that you deserve, and are providing you with this check.” The letter further stated that Mr. Park might wish to consult with someone about any possible tax consequences of receiving the funds, included a number for him to call if he had any questions. The letter concluded by thanking him for his military service. Mr. Park called the phone number provided on several occasions, but he was unable to obtain any further information. He filed his 2014 Federal income tax return without including the $13,508.

The IRS received a Form 1099-MISC from BOA, reporting other income of $12,789 and a Form 1099-INT from BOA, reporting interest income of $719. The IRS duly issued a Notice of Deficiency, and Mr. Park, now represented by the Federal Tax Clinic at the University of Washington, submitted a Tax Court Petition on his behalf.

In preparing the case for trial, the clinic first sought information from BOA by phone. After what appeared to be a successful telephone contact with BOA, all future calls were met with a brick wall. No one at BOA was able (or willing) to provide any information regarding the payments. The clinic subsequently served a subpoena for records on BOA. The bank declined to produce any records, even after being ordered by the Court. In response to the subpoena, BOA stated, “the bank is unable to locate any accounts or records requested with the information provided.” This is quite surprising, especially given that the Bank Secrecy Act requires banks to maintain records for at least five years.

The case proceeded to trial without any further information from BOA. The issue for the Tax Court to decide was whether any part of the $13,508 received by Mr. Park was income. At trial, the IRS relied on the general presumption of correctness afforded a Notice of Deficiency and on the Form 1099-MISC. At trial, Mr. Park presented testimony that he had been making payments to BOA of interest and principal and that the check received from the bank could be a non-taxable return of overpayment of principal.

The case thus, as in many cases like this, turned on the burden of proof. As readers of PT know, section 7491 places the burden of proof on the IRS, subject to several very important conditions, including the requirement that the taxpayer introduce “credible evidence” to dispute the factual issue. Section 6201(d) further provides that if a taxpayer asserts a “reasonable dispute” with respect to any item of income reported on an information return, the IRS has the burden of producing “reasonable and probative information” concerning the deficiency, over and above the information return.

The specific question before the Court was whether Mr. Park produced “credible evidence” that raised a “reasonable dispute” as to the accuracy of the Form 1099-MISC. The Court held that Mr. Park met his burden. The Court held that his testimony “was subjected to cross-examination and was both plausible and credible.” Further, the Court held that BOA’s letter admitted it was correcting a wrong it had committed regarding Mr. Park’s accounts and was returning his money and the interest that had accrued on it. The Court further noted that the IRS did not offer any argument to the contrary and appeared instead to rely on the presumption of correctness. The Court accordingly held that the $12,789 received from BOA was a nontaxable return of principal.

The facts of Park are unique and are unlikely to repeat, although with banks, one never knows. However, the larger lesson from the case is that credible testimony from the taxpayer can be effective in meeting the burden of proof or shifting it to the IRS. Oftentimes it is the only evidence.

Trials and Tribulations in the ITIN Unit

We welcome first time guest blogger Sarah Lora. Sarah is a supervising attorney in Legal Aid Services of Oregon located in Portland, Oregon. She is also a vice chair of the ABA Tax Section Pro Bono and Low Income Taxpayer Committee. She represents a high percentage of immigrant taxpayers. Today, she discusses the problems encountered by one of her clients trying to file a proper tax return. The process led to frustration and points to the need for a system that allows clients to have a further hearing when things go wrong. She cites us to the Taxpayer Bill of Rights and to administrative law in her discussion of the search for a clear answer. Julie Preciado, Willamette Law School 2L, helped edit this piece. Keith

Our clinic represents a U.S. legal permanent resident who supports his teenage daughter who resides in Mexico. Our clinic helped the client file his 2015 return tax return. The client rightfully included his daughter as a dependent on the return. The daughter qualifies as a dependent under Section 151 of the code, except that she does not have a TIN as required by Section 151(e). To satisfy that requirement, we helped prepare the W-7 application pursuant to Section 6109(i)(1) with supporting documents of an original birth certificate and school record as allowed by the W-7 instructions. A few weeks passed and we received a notice that stated that the supporting documents submitted were insufficient, without further explanation.

read more...

Regarding school records, the W-7 instructions state:

School records will be accepted only if they are for a school term ending no more than 12 months from the date of the Form W-7 application. The school record must consist of an official report card or transcript issued by the school or the equivalent of a Ministry of Education. The school record must also be signed by a school official or ministry official. The record must be dated and contain the student’s name, coursework with grades (unless under age 6), date of grading period(s) (unless under age 6), and school name and address.

I carefully reviewed the documents and the W-7 instructions and could find no problem with the birth certificate. The only discrepancy I could find with the school record is that it contained a grade point average, and not individual coursework. We submitted a detailed explanation as to why the documents substantially complied with the W-7 instructions. The rejection letter came shortly thereafter, again, without explanation. I started to feel like I had entered Dickens’ Office of Circumlocution.

I posted to the ABA listserv requesting feedback from my fellow practitioners about how to appeal a rejected W-7. All the responses were the same: you cannot. The only recourse is to file another application. However, if I do not understand why the ITIN unit rejected the original application, how can I hope to be successful in a second application? Furthermore, the education record had become stale because, according to the W-7 instructions, the records are only acceptable for 12 months from the end of the school term for which the record pertains. To file another W-7 would mean the time-consuming and arduous task of obtaining other documents from Mexico.

The Taxpayer Bill of Rights guarantees my client the right to: challenge the IRS’s position and be heard; appeal an IRS decision in an independent forum; and pay no more than the correct amount of tax. How could we appeal and where could my client be heard? Several weeks later, we received a math error notice stating that my client had erred in calculating the correct amount of tax because he was denied a dependent exemption due to lack of a valid tax identification number for his dependent. A light bulb went off. We could get to the issue of the wrongly denied ITIN by protesting the math error notice!

Section 6109(i)(1) authorizes the Secretary to issue an ITIN, “if the applicant submits an application, using such form as the Secretary may require and including the required documentation.” Section 6109(i)(2) defines required documentation to include “such documentation as the Secretary may require that proves the individual’s identity, foreign status, and residency.” The implementing regulation is found at Section 301.6109-1(b)(3) and states, in relevant part, that the applicant “must apply for [an ITIN] on form W-7.” An ITIN will be assigned to an individual on the basis of information reported on Form W-7 . . . and any such accompanying documentation that may be required by the Internal Revenue Service. An applicant for an [ITIN] must submit such documentary evidence as the Internal Revenue Service may prescribe in order to establish alien status and identity.

The regulation gives latitude to the IRS to prescribe the types of allowable documents. However, that latitude is limited by the APA. Judicial review under the APA allows a court to examine a final agency action, so long as it is not committed to agency discretion or otherwise precluded from review by statute. Section 706 requires that with respect to any agency action, a reviewing court must “hold unlawful and set aside agency action found to be,” among other things, “arbitrary, capricious, [or] an abuse of discretion.”

The arbitrary and capricious standard requires agencies to engage in reasoned decision making prior to issuing a determination. Motor Vehicle Mfr. Ass’n v. State Farm Auto Mut. Ins. Co., 463 U.S. 29, 52 (1983). Courts will invalidate agency determinations that fail to “examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choice made.” Id. at 43 (internal quotation omitted).

In this case, a reasonable person could make the argument that the denial of my client’s dependent’s ITIN application was arbitrary and capricious under State Farm because the IRS did not articulate a satisfactory explanation for its action, much less show a rational connection between a report card with “coursework and grades” and proving an applicant’s identity. Not only are the W-7 instructions raising barriers for the most vulnerable taxpayers by requiring “coursework” rather than grade point averages, a rational connection with a legitimate state interest is tangential at best. If fraud prevention in supporting documentation is the IRS’s objective, requiring report cards including “coursework with grades” is both under and over inclusive. It excludes more official government issued educational proof documents, such as the one my client submitted with a grade point average, and includes easily falsified commonplace progress reports. The ITIN unit is wrong to offer no explanation for its decisions that create confusion, frustration, and ultimately an inefficient process that wastes taxpayer resources.

Another possibly narrower argument against the ITIN unit’s actions in my case is that the ITIN unit’s interpretation of Treasury Reg. 301.6109-1(b)(3) is “plainly erroneous” as set in Auer v. Robbins, 519 U.S. 452, 461 (1997). Here the ITIN unit’s requirement for specific coursework versus a grade point average (if this is indeed the problem in my case) does not appear to be at all rationally related to the regulation’s requirement that the document show “alien status and identity.”

Creating opaque guidelines for the most vulnerable taxpayers is fundamentally unfair. Administrative agencies have a duty to the public to provide clear guidelines, tied to legitimate state interests. After all, Nina Olson has told us on many occasions that “[a]t their core, taxpayer rights are human rights.”

Fighting a Form 1099 with Which You Disagree

We have written about cases involving Form 1099 previously on several occasions including one post early last year that provides approaches both the IRS and the taxpayer might take to the problems created by a Form 1099. I also wrote a post yesterday discussing how to approach a Form 1099-C contest. An order entered in the case of Horejs v. Commissioner, Dk. No. 4035-17 shows that, no surprise, the problem continues and that at least one petitioner was pretty upset about the trouble it took to fix the problem. A bad information return is costly to the IRS and to the taxpayer as Horejs demonstrates. Just as it is critical to the system to do everything possible to get tax returns correct at the outset it is critical to get information returns correct as well. The preparer of a bad information return, however, usually does not pay the price inflicted on the taxpayer and the IRS to unwind the bad information provided.

The Horejs case also raises an interesting jurisdictional issue regarding a refund to an intervenor.

read more...

Citibank sent a Form 1099-C to Mr. Horejs, his wife Mary Baldwin and the IRS indicating that Mr. Horejs and Ms. Baldwin had income resulting from the cancellation of debt. Mr. Horejs told the IRS, presumably during the audit phase though the description of the timing is not perfectly clear, that the “Form 1099-C was incorrect, referring respondent (the IRS) to litigation between petitioner (Mr. Horejs) and Citibank.” The IRS asked for more information about the dispute which Mr. Horejs did not provide. Specifically, the IRS asked him to contact Citibank to obtain a corrected Form 1099-C and send it a copy.

While it would be nice if Citibank would oblige, in situations like this Citibank and the taxpayer usually have a broken relationship. The fact that Mr. Horejs sued Citibank about the debt suggests that he will probably struggle to convince Citibank to send him a new form. Mr. Horejs alleges in his case with the IRS that it was wrong for the IRS to ask him to do this and wrong for the IRS to rely on the Form 1099-C sent to it by Citibank. I sympathize with Mr. Horejs and I also sympathize with the IRS because it’s trying to resolve a problem it did not directly create. Because of the impasse regarding the Form 1099-C at the audit stage, the IRS issued a notice of deficiency. This is an easy way for the correspondence auditors to kick the problem upstairs.

Of course, sending the notice of deficiency not only prolongs the problems for the taxpayer and the IRS but also brings another innocent party into the situation, the Tax Court. The parties before the court and the court itself generally do not possess the information necessary to resolve the case and the system does not create a mechanism to make the issuer of the Form 1099 a party to the case over which the court would have power to issue orders and over which it could impose sanctions. Perhaps we should build a better mousetrap with respect to information return cases and make the issuer of the information return a party, get everyone in front of the court at the same time and assign “blame”, including the imposition of penalties against the issuer of a bad information return or against the taxpayer. If the information return issuer were a party to the litigation, the IRS would have almost no work to do because it would be up to the information return issuer to come forward with information to support the basis for issuing the information return and up to the taxpayer to respond when the information return issuer came forward with solid evidence to support the issuance.

But that’s not the system we have.

When the IRS sent the notice of deficiency, Mr. Horejs filed a Tax Court petition. Mary Baldwin did not. Since she did not file a petition, the IRS assessed the proposed deficiency against her. She paid the liability while Mr. Horejs’ Tax Court case was still pending. Then she filed Notice of Intervention and the Court issued an order amending the caption and allowing her to intervene. I do not recall seeing this before but maybe I just have not paid enough attention to parties trying to intervene.

Meanwhile, the IRS made contact with Citibank to request support for the information return it issued. Citibank responded by sending the IRS a corrected Form 1099-C reporting that petitioner had not received cancellation of indebtedness income in 2014. Based on this change of heart by the issuer of the information return, the IRS prepared a decision document conceding the deficiency in the case. The order indicates that Mr. Horejs and Mary Baldwin signed the decision document as did the IRS attorney; however, neither Mr. Horejs nor Ms. Baldwin were happy.

Mr. Horejs filed a motion for summary judgment asking for his $60 filing fee, $500 for time and expenses dealing with the matter, a refund of the money paid by Ms. Baldwin, a letter of apology from the IRS and damages from Citibank for issuing a false document. At the hearing on the motion, the Court explained it did not have jurisdiction to order the IRS to apologize or to order damages against Citibank. The IRS stated at the hearing that it would issue a refund to Ms. Baldwin at the conclusion of the case and the parties filed a stipulation showing her statement of account.

Steve wrote a two part post last fall on 7434 generally for anyone interested in the relief available there.

So, Mr. Horejs wins his case. Does not receive an apology, does not receive compensation for his time and effort or his outlay of funds for the filing fee, does not receive, at least in the Tax Court, a recovery of damages from Citibank and may feel pretty empty as a winner since winning in Tax Court is often not as much winning as avoiding losing. I am sure he is still unhappy and frustrated. Still, an interesting thing happens in this case in that Ms. Baldwin, who did not timely file a Tax Court petition and now comes into the case as an intervenor, gets all of her money back (plus interest). The result shows that intervenors can obtain a recovery of an overpayment in a Tax Court case and creates an interesting aspect of Tax Court jurisdiction of which I was previously unaware. Hat tip to Carl Smith for noticing this unusual wrinkle in a Tax Court case. Maybe more non-petitioning spouses will come into the Tax Court after being assessed and use this refund forum.