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.

read more...

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.

read more...

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.

read more...

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.

read more...

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.

read more...

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.

 

 

 

 

Update on the Substitute for Return Issue

On October 16 TIGTA issued the press release copied below. The release includes a link to the full report. The release and the report make clear that putting the Substitute for Return program on hold represents a significant compliance hole in the IRS system. Persons who do not file their returns, of whom there are many, may now receive a pass because of the lack of resources at the IRS.

read more...

October 16, 2017
TIGTA-2017-27
Contact: Karen Kraushaar, Director of Communications
Karen.Kraushaar@tigta.treas.gov
(202) 622-6500

A Significantly Reduced Automated Substitute for Return Program Negatively Affected Collection and Filing Compliance

WASHINGTON — Due to resource considerations, the Internal Revenue Service (IRS) has significantly curtailed the Automated Substitute for Return Program (ASFR), which it uses to address taxpayers who have failed to file a tax return, according to an audit report that the Treasury Inspector General for Tax Administration (TIGTA) issued today.

From June 2010 through July 2011, the ASFR program collected over $3 billion, whereas from June 2015 through July 2016 the program’s collections were down to approximately $430 million.  IRS management has mainly used the ASFR program to focus on “Refund Hold” cases where the IRS holds a refund on one tax year to secure an unfiled return in another year.  If the IRS refocused priorities away from small Refund Hold cases and focused on high net tax due cases, the IRS could collect $843 million over the next five years.  If the IRS worked Refund Hold cases differently, it could have collected $45 million in unpaid taxes by applying refunds to amounts owed from prior years in which no tax return was filed.

When a taxpayer who has a tax filing requirement fails to file a tax return, the IRS is authorized to use third-party information to determine and assess a tax liability.  The IRS handles these cases primarily through the ASFR Program, which enforces filing compliance on taxpayers who have not filed individual income tax returns but appear to owe a significant tax liability.  TIGTA initiated this review to evaluate the effect of the ASFR Program on enforcement yield and nonfiler compliance and determine whether the program effectively processed its workload.

Refund Hold inventory includes income tax refunds that are withheld from taxpayers to cover any potential tax liability on an unfiled return.  Refund Hold cases are considered the highest priority work for the ASFR Program, because refunds are held for only six months.  High net tax due cases in the ASFR Program are those in which the potential tax liability from an unfiled return is $100,000 or more.

TIGTA’s analysis of 21,533 Refund Hold cases worked in the ASFR Program between June 2011 and November 2016 identified 12,872 cases (60 percent) that were not resolved within six months, and a refund was released to the taxpayer in 8,115 cases.  If the IRS held these refunds until the ASFR process was completed, it could have potentially applied $45 million to the taxpayers’ accounts.

However, TIGTA also estimates that if the IRS had worked the same number of high net tax due cases it closed in the period July 2010 through June 2011 in the most current period, July 2015 through June 2016, it would have potentially increased revenue by about $169 million dollars, which is approximately $843 million over the next five years.  Specifically, replacing nine percent of the Refund Hold cases the ASFR Program closed during FY 2016 with high net tax due cases would achieve these results.

In addition, TIGTA’s analysis of 103 randomly sampled ASFR cases determined that nine percent of ASFR inventory could be eliminated if previously filed tax return and other information was considered during the inventory selection process.  Finally, ASFR Program performance measures are generally limited to the amount of direct time employees spend on the Program, types and numbers of closures, and closure rates.  Additional comparative measures such as the rates of reduction in tax assessments after taxpayers file their own returns and collection of tax dollars for ASFR cases would provide management with information to make informed strategic decisions.

“The IRS needs to bring noncompliant taxpayers into compliance to ensure fairness and reduce the burden on the vast majority of taxpayers who fully pay their taxes on time,” said J. Russell George, the Treasury Inspector General for Tax Administration.  “An effective Automated Substitute for Return Program is an important part of its efforts to bring those who do not file tax returns into compliance,” he added.

TIGTA made seven recommendations in the report.  IRS management plans to take corrective actions relating to five of them, but disagreed with two of them.  In one instance, they did not agree to reassess the suspension of the ASFR Program due to limited resources, and in the other instance, management disagreed with extending the refund hold period due to its view that the hold period is sufficient when the ASFR Program is operating as intended.  Read the report here

Follow up to Yesterday’s Post on Suspension of ASFR Program

Longtime reader and frequent commenter Bob Kamman provides additional history and context for the ASFR suspension Carl Smith discussed yesterday. Les

This is not the first time the ASFR program has been halted, according to the September 11, 2017 report from TIGTA, “Trends In Compliance Activities Through FY 2016.” According to the report,

“IRS management halted ASFR issuances completely from September 2015 through May 2016 due to resource constraints and the assignment of resources to other collection activities that were deemed a higher priority. Although the ASFR is one of the IRS’s primary tools used to enforce filing compliance, the IRS reported in the FY 2016 Data Book that there were $542.8 million of additional assessments in FY 2016. This represents a substantial decline compared to the $6.7 billion of additional assessments that were reported for FY 2012.”

The program seems to be more effective at assessing, rather than collecting tax. The TIGTA report’s Figure 6 on Page 14 shows that more than 28% of unpaid assessments in FY 2016 are from ASFR/Section 6020(b) returns. That compares to about 29% of unpaid assessments from returns filed with a balance due.

The decline in ASFR assessments appears to be part of a five-year strategy:

“IRS officials attributed the significant decline in the CSCO TDAs [Compliance Services Collection Operations Taxpayer Delinquent Accounts] to the decline in Automated Substitute for Return assessments that are issued as part of the nonfiler program, which have decreased 86 percent since FY 2012.”

The TIGTA report (76 pages) is here

 

 

Automated Substitute for Return (ASFR) Program Suspended

Thanks to frequent guest blogger Carl Smith for this news from a tax conference this morning. Keith

On September 26, at a New York County Lawyers Association seminar entitled “Nontraditional Tax Advocacy”, Matthew Weir, the Assistant Inspector General of the office of the Treasury Inspector General for Tax Administration (TIGTA) spoke. Among other things, he announced that the IRS had, for lack of sufficient financial resources, suspended its Automated Substitute for Return (ASFR) program. This is shocking news!

Mr. Weir said that TIGTA internally debated whether to disclose to the public the ASFR program’s suspension because, normally, TIGTA does not like to disclose information that taxpayers could use to evade enforcement. But, TIGTA decided that the suspension of the ASFR program was too important to keep from the public. He said a TIGTA report on the suspension would be issued shortly.

The ASFR program was employed for individuals who did not file an income tax return but who had enough gross income reported by third parties to the IRS on information returns (such as on Forms W-2 and 1099) to have had an obligation to file an income tax return. In the ASFR program, computers (without human involvement) (1) detected the need to file and the lack of filing, (2) prepared substitutes for returns under section 6020(b) based on the third-party gross income information, and (3) issued a letter to the taxpayer showing the proposed deficiency and balance due based on that substitute for return (essentially, a 30-day letter). The computer would automatically tack on late-filing and late-payment penalties to the tax balance due. A taxpayer who did not respond to the computer’s letter or who did respond, but did not convince the IRS that no tax or penalties were due, would later get a notice of deficiency – a ticket to the Tax Court.

Under the ASFR program, many taxpayers wrote back to the IRS and pointed out either errors in the gross income calculation or claimed entitlement to fully- or partially-offsetting deductions or credits that the IRS had no knowledge about, such as dependency exemptions and earned income tax credits. Human IRS employees needed to respond to such taxpayer letters. Although Mr. Weir did not say so, I assume that the big expense in running the ASFR program was employee time responding to the taxpayer correspondence. I also assume that, given the frequently-available offsetting deductions and credits, the ASFR program may not have generated enough enforcement revenue to justify the use of the scarce resource, human IRS employee time.