Rejecting Returns That Meet Beard

The IRS rejects a lot of e-filed returns for reasons that seemingly have nothing to do with whether the taxpayer filed a valid return. (see these posts) It has done this for years, decades even.  This disparity between the way it treats e-filed returns and the way it treats returns mailed by snail mail catches up with it in Fowler v. Commissioner, 155 T.C. No. 7 (2020) a fully reviewed opinion with no concurrences or dissents (see also Bryan Camp’s informative post on Fowler from a different perspective). I don’t know if the Fowler case will serve as a wake-up call to the IRS to change its practices of rejecting returns with issues having nothing to do with whether the taxpayer actually filed a return, but it should.  The opinion seems so clearly correct that I wonder if, even given the administrative importance of the issue, the IRS will bother to appeal.  It would be interesting to be a fly on the wall in the Room of Lies when the IRS tries to sell this case to DOJ to appeal, if it does.

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Mr. Fowler requested an automatic extension to file his 2013 return extending the due date from April 15 to October 15, 2014.  Pursuant to the extension, Mr. Fowler timely e-filed his 2013 return; however, the IRS rejected his return because he failed to attach an IP-PIN, something the IRS wants some taxpayers who have had issues with identity theft to file with their return.  When the e-filed return rejected, Mr. Fowler’s preparer created a paper return which Mr. Fowler signed using DocuSign and filed on October 28.  Although the preparer received a signed certified mail slip indicating that the IRS received the paper return, in December, 2014, the IRS notified Mr. Fowler that he had not filed a return.

A third attempt to file the return occurred in April of 2015 and this attempt succeeded.  For some reason, the IRS waited to send Mr. Fowler a statutory notice of deficiency until April of 2018.  The notice date fell within three years of the third return but outside the three years of the first two documents Mr. Fowler sent in as returns for 2013.  He filed a summary judgment motion arguing that the IRS blew the statute of limitations by not sending the notice with three years of the originally filed or the second return.  The IRS filed a cross motion for summary judgment on the statute of limitations issue, arguing that the failure to include the IP PIN with the original return caused it to fail the Beard test.  Similarly, it argued that signing the paper return via DocuSign caused the second return to fail the Beard test, making the third return the original filing of a return for 2013 and the timing of the notice of deficiency appropriate.

To get to the bottom of the case the Tax Court analyzed the facts using the Beard test – a test developed in the 1980s before e-filing existed.  The problem the IRS has stems from its effort to shoehorn a post-Beard practice into the language of Beard.  As it developed and refined e-filing, it let programmers define acceptable e-filing, but the programmers did not keep their eye on the Beard test because it has rather elegant simplicity designed to provide guidance in a different time.  Either by statute, regulation or an updated version of Beard, the IRS must change the underlying law if it wants to stick with the tests it seeks to impose on e-filing that go well beyond Beard’s requirements.  The Tax Court judges unanimously, and correctly, determine that IRS practices in rejecting e-filed returns for matters not covered by Beard’s test fail. 

The Tax Court said it was not going to bother looking at the second return because it could decide the case based on the first one. Let’s look at the Beard test and how it lines up with rejecting a return for failure to include an IP PIN. The Court noted “We first consider whether the October 15 submission was a “required return” and “properly filed”.”

It looked at the concept of required return and explained what the Beard test requires:

The Beard test requires that: (1) the document purport to be a return and provide sufficient data to calculate tax liability, (2) the taxpayer make an honest and reasonable attempt to satisfy the requirements of the tax law, and (3) the taxpayer execute the document under penalties of perjury.

Here, the original 1040 purported to be a return and provided sufficient data to calculate the liability. The IRS did not object to this conclusion.

Having determined that the document met the first test, the Court moved on to the second test which it described as follows:

We next consider whether petitioner made an honest and reasonable attempt to comply with the tax law. A taxpayer need not file a perfect return to start the limitations period.

The Court determined that Mr. Fowler’s document met this test because he did try to file a correct return that complied with the tax law. The Court notes that the only difference between the original return and the one filed in April was the addition of the IP PIN on the April return. It further noted that the IRS did not file any response that would lead the Court to the conclusion that the original return did not provide an honest and reasonable attempt to comply with tax law.

Having concluded the taxpayer met the first two tests it moved onto the test involving the need to sign the return under penalties of perjury. On this point the IRS strenuously objected that Mr. Fowler complied. To win, the IRS had to argue that including the IP PIN constituted an integral part of his signature. The problem with this argument, or at least a major problem with this argument, is that even the IRS own descriptions don’t say that. Here’s what the Court says on this subject:

Under the heading “IRS e-file: Electronic Return Signatures!”, the instructions state that the taxpayer “must sign the return electronically using a personal identification number (PIN)”, either a Self-Select PIN or a Practitioner PIN. 2013 Form 1040 Instructions, at 73 (emphasis added). Here, Mr. Call included a Practitioner PIN on petitioner’s efiled return in accordance with the instructions.
Notwithstanding the foregoing instructions, respondent now argues that the IP PIN is part of the signature requirement. Because we find no IRS guidance characterizing an IP PIN as a signature, we disagree.

The IRS instructions for electronic filing explicitly required Mr. Fowler to use a PIN and his practitioner to use a PIN but did not require that he use the IP PIN. Because the programmers at the IRS decided that certain individuals must submit an IP PIN so the IRS can satisfy itself that the person is who they say they are, the programmers added the additional requirement regarding the IP PIN just as they have added other requirements which do not conform to the Beard test. The Court noted that the IRS regularly rejects returns that meet the Beard test:

the Modernized e-File (MeF) system, which the IRS uses to process
efiled returns, see infra Part II.B, rejects returns for numerous errors that may not cause a return to fail the Beard test.

In a footnote to this sentence the Court also noted that although the Internal Revenue Manual says that the IRS should reject e-filed returns failing to contain a IP PIN when the IRS had sent one to the taxpayer, the same provision does not provide for the IRS to return the paper filed return with the same problem. Because the IRS provided no authority for the fact that its programmers injected into the system a requirement that the taxpayer must attach the IP PIN, the Court found that the original return Mr. Fowler filed constituted a valid return, making the notice of deficiency one sent after the statute of limitations had expired.

The Court went on to explain why an IP PIN did not need to serve as the only line of defense here to avoid a problem of validating Mr. Fowler’s identity. It also provided some history on e-filing to show that his return went into the IRS system the way it should.

Assuming Fowler stands, what does it mean? It can mean that the IRS completely loses a case. as in this situation where the notice of deficiency bears a date more than three years after the valid initial filing. The Fowler case will not stand alone in reaching this result for certain taxpayers, but the more common situation will involve penalties. The IRS will seek to impose late filing penalties on electronic filers like Mr. Fowler, whose electronically filed returns fail to meet the rules created by the IRS programmers. We discussed the issue of the disconnect between the electronic filing rules and paper rules in this regard several times in the last few years, and the ABA Tax Section tried to get the IRS to react to the problem at that time.

The problem here results from the IRS using different rules for electronically filed returns than the case law allows. It deserved to lose. It needs to take a hard look at how to treat taxpayers equally in the electronic and paper context. If it persists in wanting more protection or more tests for a valid electronic return than Beard requires, it needs to find some authority for that. The Tax Court got it right that the emperor has no clothes on this issue.

For 2020, IRS Offers Spanish Speakers a “Diez Cuarenta”

We welcome back frequent commenter and occasional guest blogger Bob Kamman with a glimpse of a new Spanish language version of Form 1040 the IRS has tested before as Bob tells us from his research into the history of the form.  He also refers to the music the IRS might add to its call line and that reminded me of a post I wrote in the second year of the blog.  Keith

The idea was rejected by IRS in 1971 and tested with little success in 1994.  But IRS has announced an “aggressive step” that for the next tax season, Form 1040 will be available in Spanish.   According to the IRS press release:

“As part of a larger effort to reach underserved communities, the Internal Revenue Service is taking a number of aggressive steps to expand information and assistance available to taxpayers in additional languages, including providing the Form 1040 in Spanish for the first time.”

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Will the numerous schedules and forms that must be attached to some Ten Forty (Diez Cuarenta) returns also be available in Spanish?  How about the 1040 instructions?  IRS does not tell us.  But the press release notes:

“Other changes include Publication 1, Your Rights as a Taxpayer, is now available in 20 languages. The 2020 version of Publication 17, Your Federal Income Tax, will be available early next year in seven languages – English, Spanish, Vietnamese, Russian, Korean and Chinese (Simplified and Traditional).”

It’s accurate for IRS to claim that this is the first time for Form 1040 to have an official translation, although the Form 1040-PR is in Spanish.  (That form is used by some residents of Puerto Rico to report self-employment income and to claim the additional child tax credit.)

However, in 1994 IRS tested Spanish versions of Form 1040A in Southern California and Florida.  That “simplified” IRS form no longer exists.   The purpose was described then as “aimed at increasing tax revenue.”

An IRS spokesperson in California told the Los Angeles Times, in an article published January 28, 1994:

“Most people want to comply but they don’t know how to and can’t understand the forms.  The IRS isn’t concerned about [which language a person speaks or] legal or illegal status . . . We just want the taxes.”

A spokesperson for the Mexican American Legal Defense and Education Fund (MALDEF) of Orange County, California, saw the Spanish forms as a way to decrease tax-preparer fraud.  “It may minimize the exploitation of the immigrant community by those who file their taxes,” he said.  The Times article reported that “it will also give immigrants, who are often accused of feeding off the public welfare system, a chance to ‘pay their fair share of taxes,’ [the MALDEF spokesperson] said.”

Two members of Congress from Orange County objected, however. Representative Ron Packard, who served from 1983 to 2001, criticized the $100,000 cost of the test, claiming the forms were a waste of money that would just make tax collection more confusing.  “Will the United States government print forms . . . for all of the thousands of different languages spoken and written by people in this country?” he asked.  “At a time when the federal government faces unprecedented fiscal constraints, this does not represent a prudent use of taxpayer funds.” 

Meanwhile, a spokesperson for Representative Dana Rohrabacher, who retired in 2019 after 20 years,  said the Congressman  believed   all government business should be conducted in English and all forms should be printed in English.

What conclusions did IRS draw from the 1994 trial of Spanish tax returns?  A July 27, 1994 article in the South Florida (Fort Lauderdale) Sun Sentinel reported that the program cost taxpayers about $157 per completed return:

“The IRS printed about 500,000 Spanish-language 1040A forms and distributed them in districts in South Florida and the Los Angeles area.  The translation, printing and distribution of the forms cost about $113,000.  As of the middle of May, a total of 718 Americans had filed their tax returns on the forms, called 1040A Espanol, the IRS said.”

Well, at least they tried.  In 1971, Representative Henry B. Gonzalez of Texas, ten years into his 38-year career in Congress, asked IRS to provide a Spanish translation of Form 1040.  IRS wrote him back that “practical difficulties” prevented this.  James N. Kinsel, described as “IRS tax forms chairman,” wrote that “one of these difficulties is the number of different languages which might have to be given this treatment.  Another difficulty stems from our processing and audit activities, and the possible need to employ large numbers of bilingual technicians.” 

Instead, Rep. Gonzalez was told that IRS puts Spanish-speaking workers in income tax assistance offices in areas of the country with high Mexican-American population, and was working on a Spanish-language pamphlet concerning income tax.

Of course, in the Internet era, most of the printing and distribution costs of translated forms are gone.  But as IRS becomes increasingly dependent on private enterprise, will software providers like TurboTax and the coalition that sponsors Free File make it easier for taxpayers to prepare returns in a language other than English?  And how many states will translate their income tax forms and instructions?

Optimistically, IRS tells us that it will allow taxpayers to indicate their choice of language when IRS contacts them.  As the press release notes:

“In addition to being available in English and Spanish, the 2020 Form 1040 will also give taxpayers the opportunity to indicate whether they wish to be contacted in a language other than English. This is a new feature available for the first time this coming filing season.”

It might be more useful if taxpayers were given a choice of music for listening on hold.  Mariachi, Salsa or K-pop?

By the way, the Taxpayer Advocate is called the “Defensor” in Spanish, which translates to “Defender.”  This may remind some of the 1961-65 television series starring E.G. Marshall and Robert Reed, and others of the recent Netflix series starring the Marvel Comics heroes Daredevil, Jessica Jones, Luke Cage, and Iron Fist.

Senate Investigation Concludes IRS Free File Program is Not Meeting Eligible Taxpayers’ Needs

Today we welcome first time guest blogger Evan Phoenix. Evan is an ABA Tax Section Christine Brunswick Public Service Fellow with Bet Tzedek in Los Angeles. In this post Evan describes a recent senate subcommittee memo on the IRS Free File program. The memo and this post are quite critical of the IRS’s oversight of the program and of certain program members. Needless to say, the Free File Alliance (FFA) and its members likely have a different take. Intuit, for example, points out that the memo “acknowledges Intuit’s voluntary investment in paid advertising of Free File, our email communication with customers beyond what is required, and reiterates findings by the previously published MITRE report and recommendations Intuit has supported, many of which are already enacted in the new MOU between FFA and IRS.” Christine

A recent memorandum by staff of the Senate’s Permanent Subcommittee on Investigations (“PSI Memo”) concludes that deficient IRS oversight of the Free File Program has resulted in the program struggling to meet its mission to provide free tax preparation and e-filing services to economically disadvantaged populations. 

The IRS Free File program has been discussed in previous posts here and here.

The PSI Memo highlights the fact that multiple independent entities have reviewed the Free File program since 2018 and provided clear recommendations for improvement with respect to observed issues. For example, the PSI memo notes that in 2018 the Internal Revenue Service Advisory Council (IRSAC) concluded that “the IRS’s deficient oversight and performance standards for the Free File program put vulnerable taxpayers at risk, and make it difficult to ensure that FFA members are upholding their obligation …”

The need to ameliorate deficiencies in the Free File Program has been exacerbated by the COVID pandemic as many private tax prep businesses and VITA sites have been closed during the tax filing season. Given the uncertainty of the situation, it is incumbent on the IRS to concentrate on protecting economically disadvantaged taxpayers by future-proofing the Free File Program to meet the needs of the vulnerable in our communities. Delays in filing taxes means delays in receiving desperately needed refunds—such as the refundable EITC, which is the largest anti-poverty initiative  in the country—for economically disadvantaged taxpayers fighting to survive the devastating effects of COVID-19. The EITC and the Child Tax Credit greatly reduce poverty for working families. These working family credits lifted an estimated 8.9 million people out of poverty in 2017, more than half of whom were children. However, “paid tax preparer fees are diminishing the EITC” with fees between 12% to 22%, and as high as 25% of the EITC.    

The PSI Memo covers five topics—a brief history of the Free File Program, a summary of IRS oversight of the program, a discussion of the importance of online search engines in taxpayers’ selection of tax preparation software, the IRS’s Free File Program marketing strategy, and recent IRS changes to strengthen the program. I will discuss these issues under three headings—(1) Brief History, (2) Recent Improvements to Free File Program, and (3) Future-Proofing Free File Program Benefits.  

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BRIEF HISTORY

Topic one of the PSI Memo discusses the Free File Program history. In 1998, Congress directed the IRS to work with the tax preparation industry to ensure at least 80% of all federal tax returns were electronically filed by 2007. In 2002, the IRS entered into the Free Online Electronic Tax Filing Agreement with several electronic tax prep companies that had banded together as the Free File Alliance (“FFA”).  Under this agreement, FFA members committed to offering free online tax prep and filing services, known as Free File. The IRS and FFA also agreed to coordinate for the marketing of these free offerings to “provide uniformity and maximize public awareness.” In 2005, the IRS and FFA also developed a Memorandum of Understanding (“MOU”) to identify the service standards for Free File members and the procedures for resolving disputes.  The most recent version of the MOU runs through October 31, 2021.

Pursuant to the FFA agreement, private-sector tax prep providers agree to provide tax prep and e-filing services to vulnerable taxpayers at no cost to the taxpayer or the government; in exchange, the government agrees to not compete with FFA members by refraining from offering free online tax prep or e-filing services. Since its inception in 2002, the IRS reports the Free File Program has produced “more than 53 million free returns e-filed and an estimated $1.6 billion in savings to taxpayers.” Despite each stakeholder’s vested interest in the success of the Free File Program, the PSI Memo highlights that the program has come under scrutiny repeatedly for falling short of its objectives. The PSI Memo finds that “[u]ntil recently, the IRS conducted little oversight of the Free File program.”

Topic two of the PSI Memo provides a summary of IRS oversight of the Free File Program in the last decade. The PSI Memo highlights the fact that “[t]hree different independent entities have reviewed the Free File program since 2018 and provided recommendations for improvement, but the program continues to struggle to serve eligible taxpayers.” The PSI Memo reports that TIGTA’s 2007 review of “the effectiveness of the Free File program […] found that the IRS could improve its efforts to evaluate, promote, and administer the Free File program.”

RECENT IRS IMPROVEMENTS TO FREE FILE

Next, I’ll discuss topic five and three of the PSI Memo together. Topic five is an analysis of recent changes the IRS has made to strengthen the Free File program, and topic three discusses the importance of online search engine results in helping taxpayers choose a tax preparation software.

Prior reports revealed that some FFA members had taken deliberate actions to reduce access to the Free File Program by using coding to prevent the program from being populated in organic online web searches, a practice known as de-indexing. This is particularly troublesome because, as the MITRE 2019 assessment report (“MITRE 2019 Report”) of the program revealed, “[m]ost taxpayers find their preferred tax preparation product through online searches using an online search engine.”

The PSI Memo found:

[f]or the first 15 years of the Free File program, the IRS declined to take a position on whether FFA companies should index Free File websites to appear in online search engines, nor did FFA companies seek guidance from the IRS on whether their indexing practices complied with the MOU. As a result, participating FFA companies took different approaches in deciding whether to code their Free File program.

MITRE found that five of the twelve FFA members engaged in non-indexing their Free File websites. Upon questioning by MITRE, “most [FFA] members” stated that they “believed” this practice complied with the MOU terms. The PSI Memo emphasizes that TIGTA agreed with the IRS that the MOU did not explicitly prohibit de-indexing, but stated “it was against the spirit of the Free File program.” Indeed, this practice seems inconsistent with the FFA’s clear mission of providing low-income taxpayers with tax prep services for free, and its agreement with the IRS to “provide uniformity and maximize public awareness.”

Following public reports exposing the FFA members for using coding in this way, in December 2019, the IRS and FFA members agreed to an addendum to the Free File MOU prohibiting any practice that would exclude Free File websites from organic searches and standardizes the naming of Free File offerings to “IRS Free File program delivered by (Member company name or product name).” The PSI memo notes that FFA executives said that they “discover more program violations than the IRS and believe [the FFA] is tougher on their members than the IRS [… and] added that members do “a lot of self-policing” and report violations by other members.”

Recent news of the departure of one of the FFA members has raised many questions. After being a 20-year member, H&R Block recently announced its withdrawal from the FFA. H&R Block was one of the FFA members that engaged in the de-coding practice aimed at steering taxpayers away from the Free File Program. H&R Block will continue to offer its own free-filing options on its website, but it will remove its return filing software from the IRS’s Free File website after the extended filing season ends on October 15, 2020. Nina Olson, executive director of the Center for Taxpayer Rights, told Tax Notes (subscription required) that the withdrawal “is a perfect storm of things—the cumulative effect of the negative articles, the TFA, the [IRS] nonfiler portal, etc.”  Perhaps H&R Block’s performance of MOU requirements or stated position regarding certain requirements foreshadowed its recent announcement to exit the program.  Specifically, the PSI Memo highlights H&R Block’s position regarding marketing, stating it does not believe it should be marketing the program “in any manner;” therefore, it does not engage in any efforts to market the Free File program. H&R Block sends one reminder email, as required by the MOU, to individuals who used the company’s Free File product the prior year. Whereas, Intuit sends six to eight reminder emails each year to previous Fee File users.  

Although H&R Block will withdraw from the FFA, it will continue to benefit from the collective bargaining benefits of the agreement with the remaining eleven members because the IRS will continue to honor its commitment to not compete against the FFA members. H&R Block will have all of the benefits and none of the oversight or accountability. What is to stop other members from following suit?

The MOU addendum is a great step in the right direction, however, as the PSI memo highlights, there is still much more that needs to be done to ensure the program meets the needs of taxpayers.

FUTURE-PROOFING FREE FILE BENEFITS

The PSI Memo notes that,

[d]espite these challenges, the Free File program continues to provide a valuable service for millions of Americans. To support Free File, the IRS should increase its oversight of FFA members and dedicate funding—including increased funding from Congress, if necessary—to market the Free File program. The IRS should ensure FFA members comply with new guidance that attempts to avoid similarities between Free File branding and branding for commercial tax preparation products that could confuse taxpayers.

These recommendations echo those made previously by TIGTA, MITRE, and the National Taxpayer Advocate.

Increase Member Oversight and Accountability

A February 2020 Treasury Inspector General For Tax Administration Report (TIGTA 2020 Report) concluded that complexity, confusion, and a lack of taxpayer awareness about the Free File program led to low levels of eligible taxpayer participation, and that this was partially due to the IRS’s insufficient oversight of the Free File Program. These findings are consistent with those in the NTA 2019 Annual Report to Congress (“2019 ARC”), presented in a section titled, “Substantial Free File Program Changes Are Necessary to Meet the Needs of Eligible Taxpayers.” 

Among other things, TIGTA recommended that IRS management update its testing review guide to ensure adherence to the MOU by FFA members. Increasing member oversight and accountability will help ensure consistency to the FFA mission that will benefit the program. The IRS partially agreed with this recommendation.

Dedicate Funds to Marketing

Topic four in the PSI Memo is a discussion of the IRS marketing strategy for the Free File program. The PSI Memo finds that “[a] lack of investment in marketing by the IRS likely led to a lack of consumer awareness that hampered participation in the Free File program.” The TIGTA 2020 Report explains that in addition to deterring effects of the confusion of the Free File Program, the lack of taxpayer awareness about the operation and requirements contributes to lack of participation by eligible taxpayers.  The TIGTA Report explains that insufficient actions have been taken to educate taxpayers that the only way to participate in the Free File Program is through the IRS website.  “To participate in the Program, taxpayers must access the IRS.gov Free File web page and select a link on this web page directing them to a Free File Inc. member’s website. However, this provision is not in the […] MOU and most taxpayers are unaware of this requirement.” The PSI memo also highlights that the lack of taxpayer awareness is directly related to the fact that the IRS has no budget for marketing the Free File program, and Congress has not appropriated funds for it. 

TIGTA made several recommendations connected to marketing and taxpayer education. First, TIGTA recommended that the IRS “develop and implement a comprehensive outreach and advertising plan to inform eligible taxpayers about the Free File program and how to participate.” (Recommendation 1) The IRS agreed with this recommendation. Second, TIGTA recommended that the IRS.gov Free File page contain comprehensive eligibility criteria for each product. (Recommendation 2) The IRS agreed, but stated this was already the case. Importantly, TIGTA also recommended that the IRS inform taxpayers of their right to be free from cross-marketing or upselling of fee-based services on Free File program software. (Recommendation 7) This practice confuses taxpayers and gives the specious impression of IRS endorsement. The IRS agreed with this recommendation, and in response created a new webpage, Know Your Protections Under the IRS Free File Program. Whether taxpayers will find this information without additional marketing seems doubtful. We will hopefully see the new comprehensive outreach and advertising plan by the next filing season.

CONCLUSION

I personally have used Free File software, and I definitely saw how certain parts can be confusing. Thanks to my experience as a VITA volunteer and coordinator, I was able to work through it, but it is unlikely that most eligible taxpayers have VITA training and experience.

One example of a confusing surprise that confronts taxpayers is the fee for a state tax return. Free File allows eligible taxpayers to file their federal tax return for free, but there can be a fee ranging from $14.99 to $54.95 to prepare your state tax return for some taxpayers. When the payment request popped up for my state return, I backtracked to the first page to double check if there were any disclosures about payments associated with state tax returns or if I had unknowingly navigated away from the Free File program. The main page says “free state return options are available,” but nothing about payments. The payment is disclosed once you choose a product to use. The products generally break down into two groups—the first group says “No free state tax preparation in any states,” and the second group says “Free state return, for some states.” California is not on the list of states eligible for free state tax preparation.

However, I recommend checking the website of your state taxing authority for free state tax preparation software if your state is not eligible for free state tax preparation services. California, for example, provides CalFile to e-file your state tax return directly to the Franchise Tax Board for free. Realistically, I think most eligible taxpayers will eat the costs to avoid going through the daunting task of preparing their state tax return from scratch when the federal tax software can transfer the information over to the state if they pay.

Another point of confusion is the constant upselling gimmicks promising a better refund gives the impression that the Free File program may be inferior to the paid software, giving me cause to think that my refund could be higher if I paid for another product. Thankfully, I know better, but these gimmicks are likely to successfully steer vulnerable taxpayers with little or no understanding of tax preparation away from the beneficial Free File program that will save them a substantial sum of money.

Given the enormous potential of the Free File Program to meet its mission of best serving vulnerable taxpayers’ needs, one can only hope the IRS heeds the constructive criticism outlined in the PSI Memo, which echoes previously reported issues. The IRS has risen to the challenge of meeting taxpayers’ needs many times before, e.g., the implementation of IRS Settlement days and the commendable rapid mobilization and implementation of the EIP initiative in response to COVID-19. I’m confident the IRS can rise to the challenge of making the necessary improvements to the Free File Program to meet the needs of eligible taxpayers. The question is, when?

Third-Party Production of Tax Returns

When must a third party produce in litigation a federal tax return that it possesses? This question has risen to the attention of national media in recent months, as litigants in multiple ongoing lawsuits currently seek the production of President Trump’s tax returns. For example:

  • See Trump v. Vance, ___ F.3d ___, 2019 WL 5687447 (2d Cir., Nov. 4, 2019) (affirming the District Court’s refusal to enjoin enforcement of a grand jury subpoena from the Manhattan District Attorney directed to President Trump’s accounting firm)
  • See also Trump v. Mazars USA, LLP, 940 F.3d 710 (D.C. Cir., Oct. 11, 2019) (upholding as valid and enforceable a legislative subpoena issued by the House Committee on Oversight and Reform to President Trump’s accounting firm)
  • Trump v. Deutsche Bank AG, 2019 WL 2204898 (S.D.N.Y., May 22, 2019) (denying motion for preliminary injunction to prevent Deutsche Bank AG and Capital One from complying with a legislative subpoena from the House Committee on Financial Services and the Permanent Select Committee on Intelligence)
  • Committee on Ways and Means, U.S. House of Representatives v. U.S. Dep’t of the Treasury, Docket No. 1:19-cv-01974 (D.D.C.) (ongoing litigation seeking President Trump’s tax returns and related IRS administrative files from Treasury)

These cases deal with weighty issues of the separation of powers, executive privilege, and with the Vance decision, the appropriate balance of power between federal and state government.

Stripping all of those weighty issues away still leaves us with serious private concerns. Section 6103 provides that the government must keep a tax return confidential (subject to numerous exceptions). The public, writ large, generally thinks of returns as private, confidential documents. So when must a third party (for example, a tax return preparer, accounting firm, or tax attorney) produce a tax return?

In this post, Matthew Bradley, a 3L at the Notre Dame Law School, walks us through the recent (albeit less widely covered) case of Anyclo International v. Cha out of the U.S. District Court for New Jersey. His writeup nicely captures the competing privacy and informational concerns and how the District Court balances them. – Patrick

Litigation is usually driven by one thing—money. Because of this driving force, the financial situation of the defendant is frequently at issue—after all, you can’t get blood out of a turnip. One way to learn a bit more about the defendant’s financial status is to read their tax return. Since a return can be a great source of very personal information it is no surprise that litigants are not usually willing to turn over a copy of the document to their adversary. Then again, litigants are not usually willing to turn anything over to the other side. So, the question becomes when a discovery request for tax returns is permissible. The remainder of this post will look at the procedure of getting such a return and will draw on the recent case of Anyclo v. Cha, No. 18-5759, 124 AFTR 2d 2019-5203 (D.N.J. Sept. 3, 2019), for purposes of illustration.

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Anyclo International is a clothing manufacturer that markets its clothing to the United States. It hired Cha to market its products to the New York metropolitan area. Cha and Anyclo decided that Anyclo should have a branch office in the US, so they decided to form a corporation in New York that would be wholly owned by Anyclo. Anyclo wired Cha $10,000 for seed money to start the office, and Cha told Anyclo that he had successfully incorporated the business as a New York corporation. According to the complaint, Cha submitted fictitious documents to Anyclo in order to show operating costs and requested reimbursement for such expenses. Additionally, the complaint alleges that Cha skimmed (or otherwise withheld) money received from purchasers before sending the funds to Anyclo headquarters.

On March 26, 2019, Daniel Cho (the defendant’s CPA) was subpoenaed. The subpoena commanded the production of “[a]ll communications (electronic and otherwise) with [the defendants] as it relates to Anyclo USA, Inc. and/or Mojo Moto, LLC. Copies of all documents prepared for the benefit of [the same].” Counsel for the defendants moved to quash the portion of the subpoena that would require the disclosure of the personal tax returns of the individual defendants. In the motion to quash, defense counsel argued that the “court should not authorize disclosure solely because the credibility of the defendants may be impeached. A defendant’s credibility is at issue in almost any case. If the Court accepts that the tax returns could adversely affect credibility, then in almost every case a party’s tax information would be discoverable. This would . . . constitute an unreasonable intrusion into a defendant’s privacy.” Defense counsel also explained that “the Plaintiff’s own records can be the source of its prima facie proof of loss.”

In its response to the motion to quash, Plaintiff’s counsel noted that the defense’s theory is, at least partially, based on the entitlement of the Defendant to certain monies as compensation. According to the Plaintiff’s counsel: “Given that YS Cha’s entire defense in this matter is based upon an accounting of his personal income and business expenses, his tax returns are clearly relevant. . . . Indeed the individual tax returns of the Defendants will show how they classified these payments contemporaneously with the parties’ dealings. The entire crux of this matter is whether the monies received, transferred, and/or withheld by Defendants are stolen funds, rental payments, income, salary, reimbursements, or otherwise.”

This sequence of events set up the question for the United States District Court: When can production of a party’s tax return(s) be compelled under the rules of discovery?

Generally, the Federal Rules of Civil Procedure allow parties to “obtain discovery regarding any nonprivileged matter that is relevant to any party’s claim or defense and proportional to the needs of the case, considering the importance of the issues at stake in the action, the amount in controversy, the parties’ relative access to the relevant information, the parties’ resources, the importance of the discovery in resolving the issues, and whether the burden or expense of the proposed discovery outweighs its likely benefit.” FRCP 26(b)(1). The information sought does not need to be admissible to be discoverable. Id.

However, this broad discovery rule stands in stark contrast to IRC § 6103, which places limits on the disclosure of returns and return information. This section notes that such returns and return information “shall be confidential.” The section goes on to list the specific exceptions for when the government (or certain people who received the tax return from the IRS) can disclose such returns. However, of course, there is a difference between confidentiality and privilege.  Hanks v. Zenner, 2000 U.S. Dist. LEXIS 13201, *8 (W.D. La.) (“Although tax returns are not privileged documents, courts have been reluctant to order their routine disclosure as a part of discovery.”).  If tax returns were privileged, rather than merely confidential, they could not be compelled to be turned over. Moreover, IRC § 6103 proscribes only governmental disclosures of a tax return; in Anyclo, the plaintiff has requested that the taxpayer disclose his own return. 

Yet, despite the technical inapplicability of IRC § 6103 and the non-privileged nature of tax returns, courts are still reluctant to order their disclosure. The idea behind the reluctance is that unless confidentiality is guaranteed, taxpayers are less likely to accurately report all of their taxable income or to claim all legally available tax benefits. De Masi v. Weiss, 669 F.2d 114, 120 (3d Cir. 1982) (citing Payne v. Howard,75 F.R.D 465, 469 (D.D.C. 1977)).

When a court considers whether to compel disclosure of a tax return, it conducts a balancing test. On one side, the court weighs the privacy interest of the individual whose returns are in question. On the other side, the court is “required to balance a number of factors, including plaintiff’s need for the information, its materiality, and its relevance.” Id. Unfortunately, balancing tests are rarely easy to understand and generally cannot be applied in a mechanical fashion. This impediment is yet another reason why discovery costs so many resources, particularly money and time.

Because there are not many reported cases to establish the procedure when a tax return is sought, we turn to how the United States District Court for the Eastern District of Pennsylvania handled the issue. This case is not properly considered to be a seminal case with regard to the issue, but it provides a bit of guidance in the absence of well-established case law. In it, the court begins its analysis with two questions: (1) is the tax return relevant to the subject matter of the action; and (2) is there a compelling need for the return because the information is not otherwise readily obtainable. Jackson v. Unisys, Inc., 2009 U.S. Dist. LEXIS 121716, *4-5 (E.D.P.A. 2009). “The party seeking the discovery at issue bears the burden of establishing its relevance . . . while the party resisting discovery bears the burden of establishing other sources for the information.” EEOC v. Princeton Healthcare Sys., 2012 U.S. Dist. LEXIS 65115, *61-62 (D.N.J. 2012) (citing Jackson v. Unisys, Inc., 2009 U.S. Dist. LEXIS 121716 (E.D.P.A. 2009).  Even if it is demonstrated that the tax returns contain some relevant information, they “are protectable from discovery as confidential documents if the party seeking protection demonstrates good cause to uphold its expectation of confidentiality, as well as the availability of reliable financial information from other sources.” Farmers & Merchants Nat’l Bank v. San Clemente Fin. Group Sec., 174 F.R.D. 572, 585 (D.N.J. 1997). Accordingly, “[w]here the taxpayer has placed . . . financial information into dispute, the tax returns may contain relevant information. The probative value of such information must be weighed against the policy of confidentiality of tax return information, taking into account the alternative sources from which reliable financial information may be obtained.” Id. (internal citations omitted).  

Once relevancy of the tax return is established, the court will turn to the question of whether there is a compelling need for the return. “Good cause for the production of income tax returns is not shown when the movant has the information sought or can obtain it with little difficulty through other methods.” EEOC at *62 (citing Blakey v. Continental Airlines, 1997 U.S. Dist. LEXIS 22067 (D.N.J. 1997)). One way a subpoena for a tax return might be defeated on this element is by providing other documents, such as copies of W2s or 1099s, to the party seeking the subpoena. This can allow reconstruction of tax returns with less sensitive information (e.g., no social security numbers of children, no non-relevant income, etc.).

Overall, the party seeking to obtain the tax return is facing an uphill battle. Courts are quite reluctant to grant the request if there is any feasible way of obtaining the information needed that does not require the disclosure. In Anyclo, however, the Court held that “Defendants’ tax returns are relevant” because “the contemporaneous treatment of monies allegedly paid to support [Anyclo’s branch office’s] business operations on Defendants’ individual tax returns may support or undermine each parties’ contentions.” Anyclo, slip op. at 5.Further, the court found that “it does not appear . . . that the same information discoverable in Defendants’ individual tax returns is discoverable by other means.” Id. Accordingly, the court denied the defense motion to quash.

So, what is the lesson to learn from this case? In short, it is that tax returns are protected from discovery but not immune from it if one can prove (1) relevancy and (2) a compelling need. Of course, the procedural protection afforded to tax returns is given on the back side (a subpoena has to be challenged). Perhaps it would be better to provide this protection at the front end and require a motion to be made to the court beforehand (much like a request for a mental or physical examination under Rule 35). Such a requirement would help protect unsophisticated litigants from intrusive discovery. Yet, that is not the rule. If you have the resources to challenge a subpoena, you might very well win, but there is no absolute guarantee of protection. 

Debtors Still Trying to Fight Against One Day Rule

The case of In re Kriss, 2019 Bankr. LEXIS 3039, (Bankr. D. N.H. 2019) shows that debtors in the First Circuit (and undoubtedly the 5th and the 10th) still struggle with the one-day rule interpretation of their circuits.  I have not written about this issue in some time but it still haunts those living in the wrong places.

As a quick reminder of the issue for those who may have forgotten or who have not read about it previously, three circuits have interpreted the language added to the unnumbered paragraph at the end of B.C. 523(a) in 2005 to mean that if a debtor files a tax return even one day late the debtor can never discharge that liability.  The IRS does not agree with that interpretation of the bankruptcy code and the circuits looking at the issue most recently have not agreed with the issue; however, until the Supreme Court takes up the issue, Congress decides to clarify the language in the bankruptcy code or the circuits reverse themselves, taxpayers in these three circuits can obtain no relief of the tax debts through bankruptcy if they file their returns late.  For a detailed discussion of the issue, see the prior posts here, here and here.

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Mr. Kriss did not file his tax returns for 1997 and 2000 timely.  The IRS prepared substitute for returns for these years and made relatively substantial assessments.  Mr. Kriss later filed returns which the IRS treated as claims for abatement and used as a basis for reducing his liability.  Mr. Kriss also did not timely file returns for 2008 through 2011.  He filed a chapter 13 bankruptcy petition on June 19, 2012, and filed the late returns for 2008 through 2011 in July, 2012 as required by B.C. 1308(a) which provides:

Not later than the day before the date on which the meeting of the creditors is first scheduled to be held under section 341(a), if the debtor was required to file a tax return under applicable nonbankruptcy law, the debtor shall file with appropriate tax authorities all tax returns for all taxable periods ending during the 4-year period ending on the date of the filing of the petition.

The timing of his bankruptcy filing made the liabilities for 2009-2011 priority claims under B.C. 507(a)(8)(A)(i) and the status of the taxes for these years as priority claims required that Mr. Kriss provide for full payment of these liabilities in his chapter 13 plan.  The older periods did not have priority status but rather were classified as general unsecured claims and did not require full payment in the plan.  As in many chapter 13 cases general unsecured claims received little or nothing.

This case picks up after Mr. Kriss has completed his plan.  As with the situation described in the recently blogged case of In re Widick, the post discharge receipt of a bill from the IRS for taxes he thought had disappeared moved Mr. Kriss into action.  In this case the post discharge action of the IRS results in three issues addressed by the bankruptcy court: 1) the one day rule discussed above; 2) the collection of post discharge interest addressed in the Widick post; and 3) damages for wrongful collection.

With respect to the one-day rule issue as it applies to the general unsecured claims for 1997 and 2000, the IRS not only sent Mr. Kriss the first notice of liability, it sent him a seriously delinquent notice (meaning the non-payment of this debt would impact his passport), and it filed suit against him to reduce the liability to judgment.  In response he admitted that:

the Late Filed Returns were untimely and does not contest that under the “one-day late rule” set forth in Fahey, the tax debts from those years are nondischargeable. Instead, the Debtor urges this Court to reconsider Fahey, reject the “one day late rule,” and adopt an alternate analysis set forth by the United States Tax Court in Beard v. Commissioner of Internal Revenue, 82 T.C. 766 (1984). The Debtor suggests that if the analysis in Beard were adopted, the Late Filed Returns may qualify as returns and, if so, any debts relating to the corresponding tax years were discharged.

Not surprisingly, Mr. Kriss does not get anywhere with the bankruptcy court on this argument.  The bankruptcy court’s hands are tied by the circuit decision.  It goes through the motions of explaining the Fahey decision and his argument before stating the obvious – that it cannot change the applicable precedent.  If he wants to make this argument, he has only just begun and must pass through the district court on his way to the First Circuit to try to pursued that court to reconsider its decision.  The bankruptcy court notes that he is not the first person to seek a reconsideration of the First Circuit’s decision in Fahey.  As I have written before, the Fahey decision does not make good sense to me (or to the IRS), but the IRS easily wins this issue.  It can continue to collect on the 1997 and 2000 liabilities and Mr. Kriss’ inability to file his returns on time will haunt him for decades once the IRS obtains a judgment.

Next, the court turns to the liability for the priority liabilities that the IRS seeks to collect after bankruptcy.  Mr. Kriss paid the priority tax claim in full during the bankruptcy case.  Because he did not timely file the returns for the three priority periods on the claim, the debt for these three years is non-dischargeable.  As discussed in the Widick post, a debtor does not pay interest during a bankruptcy case except in situations of fully secured claims.  Here, Mr. Kriss did not pay interest on the priority claims and the IRS wants that interest from him after discharge.

The problem the IRS faces stems from its form letters, which do not mention interest but state that Mr. Kriss has unpaid taxes.  Any attempt to collect taxes violates the discharge injunction while the effort to collect interest after the discharge is permitted because of his late filing of the taxes.  The bankruptcy court holds for the IRS to the extent it seeks to collect taxes but finds that it cannot rule on the summary judgment motion of either party until it has more facts regarding whether the IRS seeks only to collect interest or, as stated in its notices, it also seeks to collect tax. 

The IRS could fix this problem going forward by rewriting its form letters.  The collection of post discharge interest on priority claims arises in only a small percentage of its collection cases, but it needs to acknowledge that these cases represent a special situation and adjust its collection practices accordingly.  By sending out its normal collection letters in these situations, it causes confusion for the debtors and the courts.  The situation already confuses debtors if their bankruptcy attorneys have failed to alert them to this issue.  The IRS should not compound the confusion by using letters with inappropriate descriptors of the liability.

The last issue concerns the liability of the IRS for violating the discharge injunction.  The IRS argues that it has no liability, no matter how the second issues turns out, because Mr. Kriss did not seek to mitigate his damages.  The court quickly agrees with the IRS to the extent that he seeks damages for emotional distress but fails to grant summary judgment to the extent that Mr. Kriss has actual damages, saving the decision on that issue until further factual development occurs.  The court notes that the topic of exhaustion of administrative remedies has been the subject of much litigation stating:

[L]ess conclusive is the IRS’s argument that the Debtor is not entitled to attorney’s fees and costs, actual damages and/or sanctions resulting from the IRS’s post-discharge collection activities because he failed to comply with the exhaustion of administrative remedies requirement found in both 26 U.S.C. § 7430(b)(1) (awarding costs and certain fees) and 7433(d)(1) (governing civil damages for certain unauthorized collection actions). While the IRS admits that this issue has not been definitively decided by the First Circuit, it cites to cases such as Kuhl v. United States, 467 F.3d 145, 148 [98 AFTR 2d 2006-7379] (2d Cir. 2006), for the proposition that administrative exhaustion is jurisdictional in an adversary proceeding seeking attorney’s fees, and that failing to exhaust administrative remedies divests this Court of jurisdiction per 26 C.F.R (Treas. Reg.) § 301.7430-1.
 
Many other courts have “painstakingly” considered the issue of administrative exhaustion with repect (sic) to motions for awards of attorney fees, actual damages, and sanctions relating to discharge injunction violations, arriving at various and differing conclusions utilizing different statutory provisions and treasury regulations for their decisions. See In re Langston, 600 B.R. 817, 825 [123 AFTR 2d 2019-1262] (Bankr. E.D. Cal. 2019) (providing an extensive review of cases addressing this issue from multiple jurisdictions with varying outcomes). For example, in contrast to the Kuhl case cited by the IRS, the court in In re Graham, No. 99-26549-DHA, 2003 WL 21224773 [91 AFTR 2d 2003-2142] (Bankr. E.D. Va. Apr. 11, 2003) found that it had jurisdiction to award damages in the form of litigation costs to debtors who alleged IRS violations of § 524, even where they had not exhausted their administrative remedies, holding that: “26 U.S.C. § 7433(e)(2)(A) states that the exclusive remedy for recovering damages for violations of the Bankruptcy Code is to petition the bankruptcy court,” and within that section “there is no mention … of the need to exhaust administrative remedies.” Id. at *2. The Graham court held that 26 U.S.C. § 7433(e) was “quite clear” that the “bankruptcy court is the exclusive remedy for the violation of Bankruptcy Code provisions.” Id. (emphasis in original).

The ability to obtain damages for a stay violation is something we discuss at some length in IRS Practice and Procedure at 16.11[2].  You might look there if you face this issue.  Here, Mr. Kriss will not receive damages if he cannot show that the IRS has violated the discharge injunction and that may turn on whether the IRS seeks to collect anything more than interest in the priority claims.  Even if the IRS has tried to collect more than interest on the priority claims, he may have trouble showing actual damages the IRS has created by sending the post-discharge bill.  This will leave him seeking attorney’s fees for fending against the wrongful collection and trying to convince the court to impose sanctions.

Filing Form 1040 did not Extend Statute for Filing Form 945

Last year I wrote about the case of Quezada v. IRS. In the aspect of the case decided last summer, the bankruptcy court refused to grant summary judgment to the IRS regarding the statute of limitations for the taxpayer to file Form 945. The taxpayer argued that his Form 1040 provided the IRS with the information necessary and started the statute of limitations. The taxpayer needed the Form 1040 to serve as a surrogate Form 945 in order to discharge the liabilities it should have reported on Form 945. Now, the court has ruled on the issue and found for the IRS in Adv. Proc. No. 16-01101 (Bankr. W.D. Tex. 2018). The court provides a thoughtful analysis for its decision.

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Mr. Quezada operates a masonry company that builds projects for general contractors. He hires subcontractors to perform some of the work and provided to the subcontractors Forms 1099. The problem occurred because the Forms 1099 contained missing or incorrect TINs of the subcontractors. A missing or inaccurate TIN prevents the IRS from effectively using the Form 1099 to check on the reporting by the subcontractor. So, the IRS sent Mr. Quezada a notice in September 2006 that the 1099s had missing or inaccurate information and that if he did not correct the situation he had to start backup withholding. The IRS sent the same notice in 2007 and twice in 2009.

In 2008 the IRS began examining Mr. Quezada regarding his backup withholding liability for the subcontractors. This ultimately led to the recommendation of an assessment of $600,000 plus penalties of over $300,000. He eventually filed bankruptcy in which the IRS filed a claim for over $1.2 million. He brought an action to determine dischargeability arguing that the IRS waited too long to make its assessment. Mr. Quezada argued that his timely filed Forms 1040 and 1099 started the running of the statute of limitations on assessment while the IRS countered that he had an obligation to file Form 945 and his failure to file that form meant the statute never began running.

When a business pays an independent contractor, it must deduct backup withholding if the independent contractor fails to provide its TIN or if the IRS notifies the business that the TIN is incorrect. In addition to the backup withholding, the business must also file Form 945. Mr. Quezada argued that he had all of the TINs in a notebook but did not provide a record to the court and he had previously signed a sworn statement that he “did not obtain Social Security numbers (SSN) OR Taxpayer identification numbers (TIN) from all of [his] subcontractors.” The failure of proof in the trial coupled with the admission against interest caused the court to find that he had an obligation to file Forms 945.

Having found he had a duty to file the Forms 945, the court then looked at whether his failure to do so could somehow be excused. In Commissioner v. Lane-Wells, 321 U.S. 219 (1944) the Supreme Court analyzed whether a taxpayer who had filed a Form 1120 satisfied the requirement for filing a Form 1120H for holding companies. It found that Lane-Wells did not meet its statutory requirement for filing a return with respect to the holding company liability. The bankruptcy court found that Mr. Quezada, like Lane-Wells, had a separate liability requiring him to file two returns and preventing him from relying on the Form 1040 to satisfy his backup withholding liability.

The court also addressed his argument that he provided sufficient data to meet the Beard test. Beard v. Commissioner, 82 T.C. 766 (1984), aff’d 793 F.2d 139 (6th Cir. 1986) establishes the well-recognized test for what constitutes a return. Even though the bankruptcy court found that he had a responsibility to file the Form 945 return, if he could convince the court that his submissions on the Form 1040 essentially provided the information needed for the Form 945 he could meet the filing requirement. Beard has four tests: 1) sufficient data to calculate the tax liability; 2) document must purport to be a return; 3) honest and reasonable attempt to satisfy the tax law requirements; and 4) execution of the return under penalties of perjury.

The court found that he failed the second and fourth tests. He argued that missing TINs are “not relevant to his tax liability.” The court rejected this argument pointing out that the IRS needs to have the TINs in order for the Form 1099 to have meaning. The data provided did not meet the needs of the IRS and could not be considered sufficient. With respect to the third test the court explained that the IRS told him on several occasions of his failure and need to correct. His failure to correct over an extended period of time negates any argument that he acted in good faith and reasonably attempted to satisfy his tax law requirements.

This type of case provides a horrible result for a taxpayer such as Mr. Quezada if the subcontractors actually paid their taxes. Earlier this year we blogged about a case involving the misclassification of workers. We also posted a response from the National Taxpayer Advocate to our blog post. The situation faced by Mr. Quezada has similarities with the misclassification cases. The goal of backup withholding is ensuring that the third parties report their income to the IRS. If Mr. Quezada could show that his independent contractors actually reported their taxes, there should be some way to relieve him of at least a part of his liability. By failing to follow the rules, he causes the IRS to expend a fair amount of effort and for that he should be penalized. At the same time it seems he should have a path to reduce this crushing liability if he can prove that his independent contractors reported and paid the proper amount of tax. Maybe they did not pay and maybe, even if they did, he could not prove it but it seems a shame he does not have a chance to show that his failure did not result in loss to the IRS.

 

How a Credit is not the Same as a Refund

We are still working out logistics to get Christine Speidel full access to the blog site. In the meantime I introduce her most recent post which focuses on the distinction between giving a taxpayer credit and giving the taxpayer a refund. Keith

On April 4, 2018, the Eleventh Circuit ruled in Schuster v. Commissioner that a credit applied to a taxpayer’s account is not the same thing as a refund. This was bad news for the taxpayer.

Sometimes the IRS messes up when it applies payments, and mistakenly gives the taxpayer an account credit or a refund that the taxpayer did not deserve. If the error is discovered many years later, it can get complicated to figure out where the parties stand and which remedies are available to each.

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Mr. Schuster’s case stems from an IRS error in 2005, when it applied an $80,000 check meant for his mother’s taxes to Mr. Schuster’s 2004 income tax account. If Mr. Schuster had requested a refund when he filed his 2004 tax return, the case would be very different and the outcome might have changed. Instead, Mr. Schuster’s tax returns for 2004 through 2007 asked that his refunds be applied to the following year’s estimated tax. (Line 77 on the current Form 1040)

In 2011, the IRS discovered its mistake and reversed the erroneous credit. Mr. Schuster had made payments (apart from the $80,000) that satisfied his tax liabilities for 2004 and 2005, but not for 2006. So, after the credit was reversed the IRS sent Mr. Schuster a bill for his 2006 balance due. The case came before the Tax Court on a CDP appeal of a notice of intent to levy.

The government has many mechanisms it can use to collect from taxpayers who owe money to the Treasury. One of these mechanisms is an erroneous refund suit under section 7405. An erroneous refund suit must be brought within 2 years of the refund, except in cases of fraud. IRC 6532(b). Mr. Schuster argued that the $80,000 credit applied in 2005 was an erroneous refund that started the 2-year clock running. He argued that the IRS effectively created an end-run around 7405 by using its administrative collection powers, and it should not be permitted to do that. For its part, the IRS argued that the error at issue was a “credit transfer” which did not implicate section 7405 at all. In the IRS’s view, the appropriate statute of limitations is found in section 6502, providing for a 10-year collection period following assessment of tax. Both the Tax Court and the Eleventh Circuit sided with the IRS.

From a taxpayer’s perspective one can understand how unfair this feels. The $80,000 would have been refunded to the taxpayer had he not elected to have it credited to his 2005 (and then 2006) liability. I imagine Mr. Schuster thought he was doing a good deed as a taxpayer by making that election. If he had received a refund check and then sent an estimated tax payment to the IRS, section 7405 would apply. Economically the taxpayer would be in the same position. But the tax code does not run on fairness or logic. Also, there are complications beyond the distinction between a refund and a credit.

In the 1990s there were seven circuit court cases that addressed whether the government could treat erroneous refunds as unpaid tax, and thereby use its administrative collection powers to recover the funds. The government lost those cases. The courts of appeals held that once a taxpayer has paid their assessed taxes, a subsequent erroneous refund does not re-open the liability, and therefore the erroneous refund cannot be treated as an unpaid tax liability to be collected administratively under the original assessment. See O’Bryant v. United States, 49 F.3d 340, 346 (7th Cir. 1995); Mildred Cotler Trust v. United States, 184 F.3d 168, 171 (2d Cir. 1999); Stanley v. United States, 140 F.3d 1023, 1027-28 (Fed. Cir. 1998); Singleton v. United States, 128 F.3d 833, 837 (4th Cir. 1997); Bilzerian v. United States, 86 F.3d 1067, 1069 (11th Cir. 1996); Clark v. United States, 63 F.3d 83, 87 (1st Cir. 1995); United States v. Wilkes, 946 F.2d 1143, 1152 (5th Cir. 1991). For example, in the O’Bryant case, the taxpayers fully paid their liability but the IRS accidentally credited the payment twice, and issued a refund check. The Court held that the IRS could not use its administrative lien and levy procedures to recoup the erroneous refund.

Unfortunately for Mr. Schuster, he had not actually paid all of his assessed taxes for 2006. The Tax Court opinion (by Judge Chiechi) cites the Clark and Wilkes cases for the proposition that a tax assessment can only be extinguished by a payment tendered by the taxpayer, and not by an IRS clerical error. (Refunds resulting from clerical errors are often referred to as nonrebate refunds.) Therefore, the court holds that the 2006 assessment was not extinguished by the $80,000 credit, and the IRS could use its administrative collection powers to pursue the balance. The Court further found that the erroneous credit was not a refund for purposes of section 7405, so the two-year time limit did not apply.

The Eleventh Circuit affirmed the Tax Court, under different (though not inconsistent) reasoning. The per curiam opinion is short and to the point. The court notes that the Code distinguishes between a refund and a credit in several places, and section 7405 specifically only refers to refunds. Therefore, following basic statutory interpretation principles, the Eleventh Circuit holds that section 7405 does not apply to erroneous account credits.

Is the lesson for taxpayers to eschew line 77 and always request their refund? This does not guarantee a windfall for the taxpayer as the government may act within the 2 years or it may be able to use other mechanisms to collect the funds, but it makes the government’s task more difficult especially if the taxpayer takes care to remit legitimate payments covering their assessment.

 

 

 

 

 

 

 

 

 

 

 

Paying for but not Receiving Your Social Security Benefits – The Consequence of Filing Late

We have had many posts on the myriad of consequences of filing late tax returns. One we have not discussed results when a self-employed taxpayer files more than three years late. In that situation, the individual must still pay the self-employment tax; however, the individual receives no social security benefits as a result of those payments. As the economy drives more and more individuals into jobs in which they have independent contractor status, the importance of filing on time increases in order to preserve future benefits available to those who qualify for social security.

When a non-filer shows up, sometimes we triage their return for the year in which the refund statute of limitations will soon expire. If it appears that the taxpayer will receive a refund, a last minute push occurs to send that return in before the expiration of the statute of limitations which is generally three years from the due date of the return. If it appears that the taxpayer owes money, the same last minute push may not occur. Because filing the return before three years from the original due date could preserve for the individual the ability to get credit for self-employment earnings for purposes of calculating the amount of social security they will receive, or even whether they will qualify for social security, the practitioner who has the chance to file the return before three years from the due date of the original return should make every effort to do so.

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In order to receive social security benefits based on age, an individual must accumulate 40 quarters of earnings. To receive social security disability benefits, the individuals needs 32 quarters.   In 2017, an individual receives credit for a quarter of social security earnings if they have $1,300 of qualified earnings. Anyone earning more than $5,200 in 2017 will receive four quarters of credit – the most quarters it is possible to earn in a single year. In addition to meeting the number of quarters necessary to obtain benefits, an individual receives social security benefits based on the amount of their earnings. While the formula skews towards individuals at the lower end of the earnings spectrum by giving a higher return on those earnings in calculating the benefits, the more a person earns the higher their social security benefits.

Here are the directions from Social Security on how to calculate your projected benefit. You can find Column A and B here. I include this primarily to show how valuable the lower earnings are to someone compared to the earnings over $5,336 and how the benefit skews to provide the greatest assistance to those who will likely have the greatest need. 

Step 1: your earnings in Column B, but not more than the amount shown in Column A. If you have no earnings, enter “0.”

Step 2: Multiply the amounts in Column B by the index factors in Column C, and enter the results in Column D. This gives you your indexed earnings, or the estimated value of your earnings in current dollars.

Step 3: Choose from Column D the 35 years with the highest amounts. Add these amounts. $_________

Step 4: Divide the result from Step 3 by 420 (the number of months in 35 years). Round down to the next lowest dollar. This will give you your average indexed monthly earnings. $_________

Step 5:

  1. Multiply the first $885 in Step 4 by 90%. $_________
  2. Multiply the amount in Step 4 over $885, and less than or equal to $5,336, by 32%. $_________
  3. Multiply the amount in Step 4 over $5,336 by 15%. $_________

Step 6: Add a, b, and c from Step 5. Round down to the next lowest dollar. This is your estimated monthly retirement benefit at … your full retirement age. $_________

The aged based benefit is calculated based on the highest 35 years of earnings. Some of my earnings from the 1960s and 1970s when I worked summer jobs while going to school and a quarter of earnings could accumulate for $250 will not do much to push up my high 35 years of earnings, but these quarters did provide a benefit to me in reaching the 40 quarters because all of my earnings when working for the federal government involved no social security taxation and therefore no buildup of earnings or quarters. Federal employees hired starting in the mid-1980s do pay social security, but some state and local government employees may still be outside of the social security system from their primary earnings. Some of my clients have not yet earned enough quarters to receive any social security benefits. Making sure that they understand the importance of earning enough quarters and the link between filing their tax return and earning quarters is something we try to impart.

What can you do if your client has failed to file their return within the normal time period for having their earnings count toward social security? Several exceptions apply to individuals in these circumstances; however, the exceptions are narrow:

After the time limit has passed, earnings records can only be revised under the conditions described below and in §1425:

1. To correct an entry established through fraud;

2. To correct a mechanical, clerical, or other obvious error;

3. To correct errors in crediting earnings to the wrong person or to the wrong period;

4. To transfer items to or from the Railroad Retirement Board (if reported to the wrong agency), or to add railroad earnings to Social Security earnings records when the law permits;

5. To add wages paid in a period by an employer who made no report of any wages paid to the worker in that period, or if the employer is increasing the originally reported amount for the period;

6. To add or remove wages in accordance with a wage report filed by the employer with IRS; or, if a State or local governmental employer, with SSA if the report is filed within the time limitation specified for assessment, refund, or credit under a State’s coverage agreement;

7. To add self-employment income in a taxable year if an individual or the individual’s survivor establishes that:

(1) A self-employment tax return for that year was filed before the time limit ran out; and

(2) Either no self-employment income for that year has been recorded in the individual’s earnings record, or the recorded self-employment income for that year is less than the amount reported on the self-employment tax return; or

8. To add self-employment income for any taxable year up to the amount of earnings that were wrongly recorded as wages and later deleted. This can be done only if a tax return reporting such self-employment income is filed within three years, three months, and 15 days after the taxable year in which the earnings wrongly recorded as wages were deleted. The self-employment income must:

(1) Be for the same taxable year as the year in which the wages were removed; and

(2) Have already been included on the individual’s Social Security record.

9. Prior to the expiration of the time limit the worker or the worker’s survivor has:

(1) Applied for benefits and stated that the earnings for a year(s) were incorrect; or

(2) Requested a revision of his or her earnings record for a year(s).

The time limit can also be extended if an investigation was in progress. Because of the manner in which social security benefits work, it may not be the taxpayer who wants or needs to correct the social security records. It could be a spouse or a child or someone else who can obtain benefits derivatively from the individual with the earnings.

Some sources for correcting the social security statement can be found here, here and here.