Discharge of Late Filed Return Takes a Turn in Taxpayer’s Favor – Has the Objective Test of Colson Migrated Out of the 8th Circuit?

In the case of In re Starling, 125 AFTR2d 2020-2587 (Bankr. S.D.N.Y 2020) the bankruptcy court holds against the IRS in a case involving the filing of a Form 1040 after an assessment based on a substitute for return.  The case runs contrary to lots of case law but none at the Second Circuit level.  I anticipate the IRS will appeal this aspect of the case and maybe others.  Thanks to Christine Speidel for bringing the case to my attention and Ken Weil for providing me with background research as we discussed the case.  I have posted many times on this issue but not since the beginning of 2020.  Look here for a collection of the posts.

The case also involved a claim for damages under IRC 7433.  The bankruptcy court determined that the debtor could not obtain damages from the IRS because he failed to exhaust administrative remedies; however, it determined that the private debt collector who sent notices to the debtor after a referral of the debt from the IRS did owe damages, since it lacked the immunity available to the IRS on this issue.

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Mr. Starling failed to file his 2002 individual income tax return despite notices from the IRS requesting that he do so.  Eventually, the IRS prepared a substitute for return and made an assessment of tax for 2002 in 2005.  Two years later, the taxpayer filed a Form 1040.  Six years after filing the Form 1040, Mr. Starling filed a chapter 13 bankruptcy petition.  After completion of the plan payments Mr. Starling received a discharge in May 2016.  Although he had paid the priority claim of the IRS through his plan, Mr. Starling found that the IRS did not consider the 2002 year discharged.  In the chapter 13 case the 2002 taxes would have been classified as general unsecured claims because of their age and as general unsecured claims would generally have been eliminated when Mr. Starling received his discharge.  This seems to have been his expectation.

The IRS did not believe the 2002 taxes were discharged because it made its assessment based on an SFR.  I am almost certain that the IRS instructions coded into its computer and given to its bankruptcy employees would treat the 2002 debt in this manner everywhere in the country except in the 8th Circuit.  Because it believed that the 2002 debt survived the bankruptcy discharge and because it remained unpaid, the IRS referred the debt to one of the private debt collectors (PDC) with whom it has a contract, and the PDC sent Mr. Starling letters seeking payment on the outstanding liability.  Sending those types of collection demand letters regarding a discharged debt would violate the discharge injunction in BC 524.

Because Mr. Starling felt that his chapter 13 discharge eliminated the 2002 liability, he brought a contested matter seeking a determination regarding discharge and seeking contempt against the IRS for violating the discharge injunction.  The IRS defended the action arguing that the exception to discharge in BC 523(a)(1)(B)(ii) applied to the 2002 liability because Mr. Starling filed the Form 1040 for 2002 after the IRS had processed a substitute for return and made an assessment based on the substitute.  Since the IRS had already processed a return for Mr. Starling for 2002, it argued that the subsequent submission of the Form 1040 for that year failed the Beard test and, therefore, did not trigger the late filed exception in B.C. 523(a)((1)(B).

The issue here has existed for over 20 years since the 6th Circuit’s decision in the Hindenlang case.  In that case the court decided that the filing of a Form 1040 after the assessment of the liability could serve to trigger a discharge but the late return must have been filed prior to an IRC 6020(b) assessment triggered by the IRS.  Most courts look at the issue agreed with Hindenlang but the 8th Circuit in Colson did not.  The split in authority and the uncertainty resulting from the split caused the IRS to push for and Congress to adopt an amendment to B.C. 523 in 2005 intended to resolve this situation.  Unfortunately, the 2005 amendment did not resolve the uncertainty but injected more uncertainty into the situation.  Instead of two theories regarding what should happen in this situation, the amendment created a third without resolving the original dispute.

The three possible outcomes, in order of likelihood from least likely to most likely, are 1) the debtor’s objective filing of the Form 1040 after the IRS makes the SFR assessment begins the two year period described in B.C. 523(a)(1)(B) allowing debtor to obtain a discharge by waiting two years after filing the delinquent Form 1040 before filing a bankruptcy petition – the Colson view which is the prevailing view in the 8th Circuit; 2) the debtor’s filing a return late, even one day late, prevents the debtor from ever obtaining a discharge for the taxes related to the late return based on an interpretation of the flush language of the 2005 amendment to BC 523(a) in the unnumbered paragraph at the end of that provision – the one day late rule which is the prevailing view in the 1st, 5th and 10th Circuits and most recently repudiated by the 11th Circuit in In re Shek, 937 F.3d 770, 776 (11th Cir. 2020) (providing a definition of applicable to overcome the one day rule).; and 3) the debtor can file a late return and discharge it by waiting two years before filing bankruptcy after the filing of the late return but the late return must be filed prior to an IRC 6020(b) assessment triggered by the IRS – the Hindenlang view.

The bankruptcy court in Starling chooses the path less travelled and essentially follows Colson.  This potentially presents large problems for the IRS if it stands because it requires the IRS to reprogram its computers and issue supplemental instructions to its bankruptcy staff for all bankruptcies in the Southern District of New York.  For that reason and for the reason that the Colson theory has not caught on elsewhere, I expect an appeal to the district court on this issue.  Because the IRS does not agree with the one-day rule, it will appeal arguing that a subjective test should apply and that Mr. Starling knew when he filed the Form 1040 that the IRS had already assessed his taxes for 2002, causing his Form 1040 not to meet the Beard test based on his knowledge of the circumstances. 

So far, there may only be one case applying the subjective test in which a debtor has prevailed on the Beard test that has not been reversed on appeal.  That case is Briggs, Sr. v. United States (In re Briggs, Sr.), 511 B.R. 707 (Bankr. N.D. Ga. 2014).  At trial, the tax was found dischargeable.  The District Court affirmed.  Briggs, Sr. v. United States (In re Briggs, Sr.), N.D. GA. No. 15-2427 (June 7, 2017).  In Briggs, the debtor thought his business partner had filed his return.  Their custom was for the business partner to prepare the return, the debtor to sign it, and the business partner to file it.  The business partner did not file the return.  The IRS’s notice of deficiency was mailed to the business partner’s address and not the debtor’s, so the debtor did not know the return was nonfiled.  As part of a lawsuit, the debtor had done a forensic accounting to determine revenue and expenses.  Upon learning of the nonfiling and SFR assessment, taxpayer filed a return, which was found to be a valid return.

I previously wrote a post on Shek here.  Although Shek is an 11th Circuit case it involves state income taxes owed to Massachusetts.  Massachusetts convinced the 1st Circuit in the Fahey case that the flush language added to the end of BC 523 in 2005 means that a return filed one day late prevents it from ever receiving a discharge.  Shek did not involve an intervening substitute for return but a clean question of the application of the one-day rule.  Thanks to an amicus brief by University of Michigan law professor John Pottow, the 11th Circuit rejected the one day rule argument, finding that the language added in 2005 did not require this result.  

The Massachusetts Department of Revenue wisely, in my opinion, chose not to seek cert from the Supreme Court based on the direct split between the 1st (and 5th and 10th) Circuits and the 11th Circuit.  Because almost all of the Massachusetts Department of Revenue cases exist in the 1st Circuit, it had much to lose by taking the case to the Supreme Court and little to gain.  So, we must wait for another circuit decision before the Supreme Court will have the opportunity to fix the problem.  Of course, Congress could step in and try again to fix the problem without creating a fourth split in possible outcomes.  I know there are some debtor’s attorneys in the 1st Circuit looking for another chance to take on the Fahey decision.  Maybe the 1st Circuit will take another look at this issue and the next split will come there.

In addition to the issue of discharge, the bankruptcy court in Starling also addressed the issue of damages.  Mr. Starling sought damages from the IRS for seeking to collect the tax liability after discharge.  The bankruptcy court found that he could not obtain damages from the IRS, because he did not exhaust administrative remedies by making a request to the IRS before bringing the action.  If he had made a request to the IRS, he likely could have recovered damages, because the IRS would have told him his position on the discharge issues was wrong.

Although the bankruptcy court could not award damages against the IRS because the waiver of sovereign immunity required exhaustion of administrative remedies, it decided that it could award damages against the PDC, which lacked the same sovereign immunity protection cloaking the IRS.  While I am not a fan of PDCs, I expect this aspect of the decision will also be appealed, both because of the argument regarding the applicability of the exception to discharge and the argument of the PDC’s relationship to the IRS and reliance on the IRS.

Procedure Grab Bag – Foreign Tax Credits

Two cases dealing with foreign tax credits, with very different litigation records; one being denied cert by SCOTUS (Albemarle, which we’ve covered before) and one tossed on summary judgement in the District Court (Estate of Herrick) with the taxpayer prevailing on making a late election where no late election was permissible.  The second case has pretty interesting regulatory interpretation.

No SCOTUS

The first has been covered here on PT before on at least two occasions.  SCOTUS has denied cert in Albemarle Corp. v. US.  When the Federal Circuit reviewed the case, I wrote the following in a SumOp:

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Hopping in the not-so-wayback-machine, in October of 2014, SumOp covered Albemarle Corp. v. US, where the Court of Federal Claims held that tax accruals related back to the original refund year under the “relation back doctrine” in a case dealing with the special statute of limitations for foreign tax credit cases.   As is often the case in SumOp, we did not delve too deeply into the issue, but I did link to a more robust write up.  It seems the taxpayers were not thrilled with the Court of Federal Claims and sought relief from the Federal Circuit.  Unfortunately for the taxpayer, the Fed Circuit sided with its robed brothers/sisters, and affirmed that the court lacked subject matter jurisdiction because the refund claim had not been made within the ten year limitations period under Section 6511(d)(3)(A).   This case deserves a few more lines.  The language in question states,  “the period shall be 10 years from the date prescribed  by law for filing the return for the year in which such taxes were actually paid or accrued.”   When the tax was paid or accrued is what generated the debate.

In the case, a Belgium subsidiary and its parent company, Albemarle entered into a transaction, which they erroneously thought was exempt from tax, so no Belgian tax was paid.  Years in question were ’97 through ‘01.  In 2002, Albemarle was assessed tax on aspects of the transaction in Belgium, and paid the tax that was due.   In 2009, Albemarle filed amended US returns seeking about $1.5MM in refunds due to the foreign tax credit for the Belgian tax.  Service granted for ’99 to ’01, but not ’97 or ’98 because those were outside the ten year statute for claims related to the foreign tax credit under Section 6511(d)(3)(A).  Albemarle claimed that the language “from the date…such taxes were actually…accrued” means the year in which the foreign tax liability was finalized, which would be 2002 instead of the year the tax originated.  Both the lower court and the Circuit Court found that the statute ran from the year of origin.  The Circuit Court came to this conclusion after a fairly lengthy discussion of what “accrue” and “actually” mean, plus a trip through the legislative history and various doctrines, including the “all events test”, the “contested tax doctrine”, and the “relation back” doctrine.  The Court found the “relation back” doctrine was key for this issue, which states the tax “is accruable for the taxable year to which it relates even though the taxpayer contests the liability therefor and such tax is not paid until a later year.” See Rev. Rul. 58-55.  This can result in a different accrual date for crediting the tax against US taxes under the “relation back” test and when the right to claim the credit arises, which is governed by the “contested tax” doctrine.

At that time, McDermott, Will and Emery posted some “Thought Leadership” (I’ve hated that term for a long time, but the summary is extensive and helpful), which can be found here.  The final paragraph of their advice is right on the mark, indicating there is no circuit split, so there likely would be no SCOTUS review.  It also provides great additional parting advice, stating:

Taxpayers in similar situations wishing to take positions contrary to the Federal Circuit’s decision, and without any option other than litigation, may want to file suits in local district court to avoid the negative precedent. Taxpayers may also want to consider filing protective refund claims in situations where it does not appear that a tax payment to a foreign jurisdiction will actually be made (and there will be enough time to file a formal refund claim with the IRS) within 10 years from the date the U.S. federal income tax return was filed to avoid the situation in Albemarle.

Not so late election

The second foreign tax credit case is the Estate of Herrick v. United States from the District Court for the Central District of Utah, where an estate filed late income tax returns seeking a refund for a decedent who had resided and worked in the Philippines for a number of years.  The taxpayer failed to file income tax returns during that period, under the mistaken belief that no income tax would be due because of credits for the foreign tax he was paying (not how that works).  The Service created SFRs, and assessed and collected over a $1MM in tax for the years in question.  The taxpayer sought summary judgement on its refund claim, which the IRS was contesting, arguing the taxpayer was not entitled to the credit or exclusion for foreign income taxes or that there were insufficient facts to establish that he was entitled to the same.

Under Section 911, some taxpayers living and working abroad in some circumstances can exclude a portion of the foreign earned income, and under Section 901, there is a credit for foreign tax that is paid, which can be applied against US income tax (as most of our readers know, under Section 61, the United States generally treats all income of its citizens, wherever earned, as being taxable income—these provisions help to reduce the potential for double taxation with the other jurisdictions).

As to the second claim, that insufficient evidence was available regarding the credits, the IRS position largely applied to one year.  For all other years, the taxpayer had showed copies of its returns, copies of his employer’s information related to him for the years in question, and the taxing authority in the Philippines verified all the information, including payment.  For one year, only a copy of the return and the employer’s information was available.  The Court found this was sufficient evidence to show proof of payment.

The second argument the Service made was that the taxpayer could not obtain the foreign earned income exclusion under Section 911 because the taxpayer had not made the election on a timely filed return or within one year of a timely filed return.  See Treas. Reg. 1.911-7(a)(2)(i).  Seems damning.

The Court, however, stated that the Service was only looking to subsections (A) through (C), and not giving consideration to subsection (D) in the Regulations allowing for elections to made when:

(D) With an income tax return filed after the period described in paragraphs (a)(2)(I) (A), (B), or (C) of this section provided –

(1)  The taxpayer owes no federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached either before or after the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion; or

(2)  The taxpayer owes federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached before the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.

The Court found the first prong under (D) did not apply.  The taxpayer claimed that it did not owe any federal income tax, because the IRS had already assessed and collected an amount over the total amount outstanding.  The Court stated, however, the fact that no tax was due at the time of filing was not the question, and the determination was whether any tax was due for the year, which had been the case but the Service had already collected that amount via levy.

The Court, however, held that the second prong did apply.  The Court found the Service had not discovered the failed election.  The Court found the Service had determined the taxpayer failed to file returns for the years in question, but that was not the same as discovering the taxpayer failed to make the election (would anyone be surprised if the Service doesn’t concede this point in other jurisdictions?).  This allowed the taxpayer to make the election on the late filed returns.

The Automated Substitute for Return Procedures

Today we welcome guest blogger Michelle Drumbl.  Professor Drumbl teaches tax at Washington and Lee University School of Law and runs the low income taxpayer clinic there.  She thanks clinic student Hollie Floberg for her assistance in writing this post.  One of Professor Drumbl’s suggestions concerns the use of the substitute for return procedures to pursue returns with little collection potential.  I wrote about the IRS policy of taking collection into account in the TFRP context.  That policy may have some play here.  Keith

The automated substitute for return (ASFR) procedure, authorized by section 6020(b) of the Internal Revenue Code, provides the Internal Revenue Service with a mechanism by which to use third-party information reporting to assess a tax liability for nonfilers. This enforcement mechanism is a relatively easy way for the Service to narrow the so-called “tax gap,” defined as “the amount of true tax liability faced by taxpayers that is not paid on time.” In the context of closing the tax gap, income that is subject to information reporting is low-hanging fruit. Unsurprisingly, studies show that taxpayer compliance rates are higher when income is subject to “substantial information reporting” (and highest if subject to both information reporting and withholding).

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It is hard to refute that noncompliance undermines the tax system, or to deny the appropriateness of the Service pursuing assessment of unreported income it can easily verify. However, in her recently released 2015 Annual Report to Congress, National Taxpayer Advocate (NTA) Nina Olson identifies the selection criteria for cases in the ASFR program as Most Serious Problem #17. Olson insightfully identifies a number of ways in which the ASFR process, while easy for the Service, is imperfect for the taxpayer. Olson’s critique of the current ASFR selection criteria includes three points: 1) the IRS has a poor collection rate on these assessments; 2) the IRS has a high abatement rate on amounts assessed through ASFR; and 3) the ASFR program has a low return on investment.

I will address some of these points and the NTA’s recommended solutions from my perspective of a practitioner representing low-income taxpayers, and add some observations of my own. 

When Using its Third-Party Documentation, the IRS Should Take into Account Deductions and Credits, Not Just Income

In describing the abatement rate on ASFR assessments, Olson notes that the program could increase efficiency and return on investment if, as part of its case selection, it more carefully considered third-party documentation consistent with possible deductions and credits. She notes that selection of cases likely to result in abatement causes “rework for the IRS and potential harm for the taxpayer”. She suggests that the IRS refine its selection process by “considering third-party documentation that supports deductions or credits when determining which cases to select for the program”.

Olson’s point is well taken. The ASFR assessment process takes into account all income reported as earned by the taxpayer, but it ignores reported items that would reduce taxable income. For example, mortgage interest is reported to the IRS on Form 1098, state income tax withholding is reported on Form W-2, and student loan interest is reported on Form 1098-E. All of these reported payments potentially reduce a taxpayer’s liability.

I agree with Olson that the failure of the IRS to use or acknowledge this readily accessible information is inefficient, but the burden must remain on the taxpayer to claim these deductions. These deductions cannot be accurately calculated by the IRS during the ASFR process because the IRS has imperfect information. For example, the student loan interest deduction phases out at a certain income level, and it is possible that the taxpayer has additional income not subject to information reporting. Thus, it would be premature to propose the deduction based only on the income information reported by third parties. Accordingly, it is not unreasonable for the IRS to omit these deductions in calculating its proposed ASFR assessment. After all, the taxpayer sat on his or her rights by not filing a return; appropriately, the burden of filing and claiming deductions or credits rests with the taxpayer. But as I describe in my recommendation below, the IRS can and should communicate these possibilities to the taxpayer when known. Another issue the IRS should address more clearly in its communications is filing status.

Filing Status Presents Challenges for Taxpayers beyond What the NTA Report Describes

Olson is absolutely correct that filing status matters. Married taxpayers who file a joint income tax return are entitled to a number of potential benefits that are denied to married taxpayers who file separately. Most notably for low-income individuals, the earned income tax credit is not available to married taxpayers filing separately. But because joint filing is at the taxpayers’ election, an ASFR assessment must be based upon a filing status of single or married filing separately. Olson addresses this issue, but she does not describe the limitations that section 6013(b)(2) impose on married taxpayers who wish to file a joint return after filing separate returns.

Professor Kathryn Sedo has blogged here and here about one possible “procedural trap for unrepresented taxpayers” that arises under section 6013(b)(2)(B), namely that married taxpayers cannot amend from a separate return to a joint return once either spouse has filed a petition in Tax Court with respect to such tax year.

Another limitation, set forth in section 6013(b)(2)(A), is that if one of the spouses has filed a separate return, the taxpayers are prohibited from amending to file a joint return after the expiration of three years from the due date of the return for such tax year.

As I write about in a forthcoming article, in my low-income taxpayer clinic I commonly encounter married couples in which one spouse is a wage earner subject to information reporting and withholding and the other spouse receives nonemployee compensation subject to self-employment tax and no withholding. If a low-income couple with dependent children files a joint return, it may result that the personal exemptions, the standard deduction, the earned income credit, and the child tax credit combine to offset (in part or whole) the self-employment tax and the lack of withholding. However, a couple who lacks proper information and tax advice does not realize this; fearing a tax bill because of the self-employment tax and the absence of withholding, the taxpayers make a decision to file separate returns (or, quite commonly, a decision for one to file a separate return and one not to file).

Assuming the self-employed individual receives a Form 1099-MISC, the IRS will eventually discover the nonfiler and may pursue an assessment through the ASFR procedure. But this does not necessarily happen within three years of the due date of the return; as Olson describes, ASFR criteria require, among other things, that the module be “not older than five years prior to the current processing year.” But because of section 6013(b)(2)(A), the spouse who files a separate return has a limited window in which to amend and file jointly. Thus the nonfiler who comes into compliance more than three years late (perhaps in response to a proposed ASFR assessment) will have no choice but to file as married filing separately for those years if his or her spouse filed a separate return.

The IRS should (but currently does not) advise a nonfiler receiving a proposed ASFR of the time limitations imposed by section 6013(b)(2)(A) for amending to file jointly.

My Recommendation: Advise Taxpayers More Clearly of their Rights and Options, and Do So Sooner

The IRS can and should be much clearer in its communications with the taxpayer during the ASFR assessment process. My recommendation would be for the IRS to contact nonfilers within one year of the missed deadline and to include a letter explaining their rights and responsibilities more clearly. Currently, the 30-day proposed assessment letter lists the details of income reported by others. This letter should include all information received from third parties, not just income reported; it should notify (or remind, as the case may be) the taxpayer of any information reporting it received relating to possible deductions or credits. The letter could state clearly that the reported information may or may not be relevant in determining certain deductions or credits, note explicitly that the IRS has not included any deductions or credits in its calculation of the proposed assessment, and remind the taxpayer that it is his or her responsibility to affirmatively claim any deductions or credits on the return.

Moreover, the 30-day letter should be used as a reminder that the taxpayer may be eligible to use a more favorable filing status and is entitled to claim any qualifying dependents, either of which may reduce the proposed assessment. Specifically, it should notify the taxpayer that if he or she is married, there remains the option to file jointly with a spouse; it should further provide the deadline by which the taxpayer would need to file if the taxpayer’s spouse previously filed a separate return and wishes to amend and file a joint return.

Finally, the notice should recommend that the taxpayer visit a low-income taxpayer clinic if income eligible. 

In Conclusion: A Word About Those Low Collection Rates

Olson notes that the ASFR program has poor collection rates, citing statistics that the Service collected less than one-third of the amount assessed through ASFR in fiscal years 2011-2014. She suggests that the poor collection results are evidence of inefficient selection criteria, and notes that the ASFR program has a low return on investment relative to other IRS programs.

I feel strongly that the IRS should not simply choose to ignore nonfilers who represent a poor “return on investment” just because the program has “low collection rates”. Nonfilers degrade the tax system. They undermine the faith of the general public in a fair system, and they should not be given a pass because the relative dollar amounts are small or because they likely cannot afford to pay the liability. Olson speaks of the right to a fair and just tax system, but this concept cuts both ways. Compliant taxpayers expect the IRS to enforce filing requirements in an even-handed manner. Taxpayers who cannot afford to pay their tax liabilities have many avenues of relief available to them, including financial hardship status, a variety of installment agreement options, and the offer in compromise process. Taxpayers whose income exceeds the filing threshold must be expected to file a timely return and report their income, even if it is unlikely that the IRS will ever collect from them.

While the ASFR process can be modified in ways that would make it a more taxpayer-friendly (and perhaps a more efficient) procedure, it should not use collection likelihood (or the lack thereof) as part of its selection criteria.

Summary Opinions for October 19th through the 30th

Happy Thanksgiving Week! And thank you all for reading, commenting and guest posting!  SumOp this week is full of great tax procedure content that was released or published in the end of October, including updates to many items we previously covered in 2014 and 2015.  In addition, I am pretty confident that I solved all of your holiday shopping needs, so no reason to fight the Black Friday crowds.

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  • From Professor Bryan Camp, a review of Effectively Representing Your Client Before the IRS (which was edited by Keith) can be found here.  This article was originally published in Tax Notes.  I have not read the article, so I suppose he could be bashing the book; however, knowing Keith and the book, I’m pretty confident that isn’t the case (perfect holiday gift for that tax procedure nut in your life; you can pick it up here).  Completely unrelated, unless you are looking for holiday gift ideas for me, I’ve always wanted a Lubbock or Leave It t-shirt to go with my Ithaca is Gorges t-shirt.  At that point, it would become a bad pun t-shirt collection….How did I make this bad transition – Professor Camp teaches at Texas Tech, which is located in Lubbock, TX.
  • Keith forwarded this article to me from the AICPA newsletter regarding ten things to do while on hold with the IRS.  I say just sit back and enjoy the music…wait, we already discussed how that music seems to have been designed to slowly drive you insane (see Keith’s post, A Systemic Suggestion – Change the Music).  I sort of feel terrible admitting this, but I make my assistant sit on hold and then transfer the calls to me.   Wait times do not appear to be getting much better, but, since misery loves company, I would suggest checking #onholdwith.com/irs while waiting, or post your own.  Everyone loves complaining.
  • Kearney Partners Fund has generated a lot of tax procedure litigation over the last few years, which continues with the Eleventh Circuit affirming the GA District Court in Kearney Partners Fund, LLC v. United States.  At issue in this case was whether one particular participant was responsible for the accuracy related penalties.  The Eleventh Circuit agreed with the District Court that the transaction was in fact a tax shelter, but that the participant had disclosed the tax shelter in a voluntary disclosure program under Announcement 2002-2.  The Service argued that the participant only made disclosure in his individual capacity, not on behalf of the partnerships involved.  The Courts, relying on the doctrine of nolite jerkus, found it was disingenuous for the Service to attempt to collect the penalties on a shelter it was notified about through a disclosure program (I know that actually isn’t Latin, or a court doctrine).
  • In Notice 2015-73, the Service has identified additional transactions as “of interest” or as listed, including Basket Option Transactions.
  • In US v. Sabaratnam before the District Court for the Central District of California , a taxpayer lost his attempt to toss a Section 6672 TFRP assessment as untimely, which was made more than three years after the deemed filing date of the returns.  Although normally this would have not been timely as there is a three year statute for assessment, the taxpayer made a timely protest thereby tolling the time for assessment under Section 6672(b)(3).  The taxpayer actually argued his protest was not timely, thereby allowing the statute to run, and, in the alternative, that it wasn’t valid because it failed to contain the required information and because his representative did not tell him the letter was filed.  The Court disagreed, and found the filing was valid and timely.  Interestingly, in the letter, the representative stated that he did not “know personally whether the statements of fact…[were] true and correct. However…[he] believe[d] them to be true and correct,” which the taxpayer argued was damning because no one was attesting to the allegations.  The Court found that since the IRS instructions only required the representative to indicate if the facts were true, his statement was sufficient, as opposed to requiring that the representative actually state the facts were true.
  • The Senate is apparently checking up on Big IRS Brother.  In a hearing regarding the handling of the Tea Party applications, the Senate inquired about news that the Service would be using a high-tech gadget that could locate cell phones and collect certain data (couldn’t listen in on conversations though).  The Service indicated this was going to be used in criminal matters to help locate drug dealers and money launderers.  The Senate was nervous that Louis Lerner would target Republicans the Service would abuse this power (which twelve other agencies are currently using).  Don’t all drug dealers solely use burners?  And, aren’t the ones who don’t in jail already?  Looks like this will be moving forward, hopefully for tax crimes not thoughtcrimes.
  • In December, guest blogger Jeffrey Sklarz blogged about Rader v. Comm’r, a Tax Court case discussing substitutes for returns and when those have been validly issued under Section 6020(b).  In October, Mr. Rader was in court again, where the Tenth Circuit affirmed the Tax Court’s treatment of the SFRs and the imposition of sanctions by the Tax Court for frivolous arguments.
  • I’m in the process of working with Les on a rewrite of Chapter 5 of SaltzBook, which contains a discussion of the mitigation provisions for the statute of limitations.  One case dealing with those mitigation provisions that has been interesting to us over the last few years was Karagozian v. Commissioner, where the Tax Court and then Second Circuit held the mitigation provisions could not provide relief where a taxpayer overpaid employment taxes in one year, only to have income taxes imposed for that year after a worker reclassification.  SCOTUS did not find it as interesting as we did, and will not be granting cert.
  • From Jack Townsend’s incomparable Federal Tax Crimes Blog in early November was a post about nonresident aliens failing to pay US estate tax.   Jack offers some thoughts on how to start chipping away at that tax gap in his post.
  • The Eastern District of Pennsylvania in Giacchi v. United States decided another dischargeability of late returns case.   EDPA held in line with recent cases that the tax due on the late returns was not dischargeable.  Keith’s has written a fair amount on this topic, and I think the most recent was in June and can be found here.
  • Do you ever wonder if those companies claiming to give a % of their revenue to charity ever actually give the funds to charity?  I can proudly say PT will be donating 100% of its proceeds to charity, but deductibility and follow through won’t be an issue (it’s zero, we just do this for the love of the game; well maybe a hope that some publisher buys us out for millions).  Is there a watchdog group that tracks this?  Well, apparently some are actually donating the funds just out of charitable inclination, and the IRS has issued guidance on the deductibility of those payments.  In CCA 201543013, the advice concludes that the company taxpayer and not its customers are entitled to the deduction.  It also goes through the deductibility of payments to various types of entities, including exempt and non-exempt.

Summary Opinions for the Week Ending 8/21/15

We here at PT are huge fans of self-promotion, so I am thrilled to link Les’ recent article in The Tax Lawyer.   Les’ article, Academic Clinics: Benefitting Students, Taxpayers, and the Tax System, was published in the Tax Section’s 75th Anniversary Compendium – Role of Tax Section in Representing Underserved Taxpayers.  There are various other articles in the full publication that are worth reading (and hopefully will make you all feel guilty enough that you aren’t doing enough pro bono work to either cause you to assist some underserved folks or donate some money to those who are).

To the tax procedure:

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  • Hopping in the not-so-wayback-machine, in October of 2014, SumOp covered Albemarle Corp. v. US, where the Court of Federal Claims held that tax accruals related back to the original refund year under the “relation back doctrine” in a case dealing with the special statute of limitations for foreign tax credit cases.   As is often the case in SumOp, we did not delve too deeply into the issue, but I did link to a more robust write up.  It seems the taxpayers were not thrilled with the Court of Federal Claims and sought relief from the Federal Circuit.  Unfortunately for the taxpayer, the Fed Circuit sided with its robed brothers/sisters, and affirmed that the court lacked subject matter jurisdiction because the refund claim had not been made within the ten year limitations period under Section 6511(d)(3)(A).   This case deserves a few more lines.  The language in question states,  “the period shall be 10 years from the date prescribed  by law for filing the return for the year in which such taxes were actually paid or accrued.”   When the tax was paid or accrued is what generated the debate.

In the case, a Belgium subsidiary and its parent company, Albemarle entered into a transaction, which they erroneously thought was exempt from tax, so no Belgian tax was paid.  Years in question were ’97 through ‘01.  In 2002, Albemarle was assessed tax on aspects of the transaction in Belgium, and paid the tax that was due.   In 2009, Albemarle filed amended US returns seeking about $1.5MM in refunds due to the foreign tax credit for the Belgian tax.  Service granted for ’99 to ’01, but not ’97 or ’98 because those were outside the ten year statute for claims related to the foreign tax credit under Section 6511(d)(3)(A).  Albemarle claimed that the language “from the date…such taxes were actually…accrued” means the year in which the foreign tax liability was finalized, which would be 2002 instead of the year the tax originated.  Both the lower court and the Circuit Court found that the statute ran from the year of origin.  The Circuit Court came to this conclusion after a fairly lengthy discussion of what “accrue” and “actually” mean, plus a trip through the legislative history and various doctrines, including the “all events test”, the “contested tax doctrine”, and the “relation back” doctrine.  The Court found the “relation back” doctrine was key for this issue, which states the tax “is accruable for the taxable year to which it relates even though the taxpayer contests the liability therefor and such tax is not paid until a later year.” See Rev. Rul. 58-55.  This can result in a different accrual date for crediting the tax against US taxes under the “relation back” test and when the right to claim the credit arises, which is governed by the “contested tax” doctrine.

  • Prof. Andy Grewal, a past PT guest poster, has uploaded an article on SSRN entitled “King v. Burwell:  Where Were the Tax Professors?”  The post discusses possible reasons why tax professors largely did not enter the public debate on the merits of the legal arguments in King v. Burwell, and encourages them to be more active in future similar cases.
  • Another fairly technical issue was addressed in PMTA 2015-009, where the Service discussed interest netting when it is later determined that there was no original overpayment.  Under Section 6621(d), interest is wiped out if there equivalent overpayments to the taxpayer and underpayment to the Service.  The PMTA has a fair amount of analysis, but the issue and conclusion are a sufficient summary for our purposes.  Issues are:

(1) Whether an underpayment applied against an equivalent overlapping overpayment to obtain a net interest rate of zero pursuant to Section 6621(d) is available for netting against another equivalent overlapping overpayment if the Service determines the first overpayment was erroneous, (2) Whether the same is true for an overpayment netted against an erroneous underpayment, and (3) Whether the cause of the error affects these answers.

And concludes:

(1)  An underpayment that was previously netted against an equivalent overlapping overpayment is not available to net against another equivalent overpayment if the taxpayer has retained the benefit of the original interest netting (the interest differential amount paid or credited to the taxpayer). If, however, the taxpayer did not retain the benefit of the original netting, then the underpayment is available for netting against another overpayment. (2) The same analysis applies to an overpayment netted against an erroneous underpayment. (3) We are unaware of any circumstance where the cause of the error would change our answers.

  • I haven’t highlighted Prof. Jim Maule’s blog, MauledAgain, in a while, which is a failing on my part.    Here you will find Prof. Maule’s post on tax fraud in the People’s Court and if you scroll down on this page you will find an update to the case.  Two schmohawks agreed to commit tax fraud by transferring the value of a child tax credit.  The plan fell apart, and one sued the other in People’s Court to enforce the “contract” between the co-conspirators.  The Judge dismissed the case because fraudulent contracts are not enforced.  Prof. Maule quotes from the show, where the plaintiff said, “What about pain and suffering?”  Stole my line.
  • TIGTA has released a report about Appeals penalty abatement decisions, and it isn’t great.  First, it isn’t great because, as the report concludes, Appeals is not adequately explaining its abatement decisions.  I agree Appeals should indicate why it is abating penalties, but I do not agree with the second conclusion, which is that Appeals is leaving money on the table.  Meaning, it should not be waiving those penalties.  TIGTA reports that an additional $34MM could have been collected on the abated penalties.  It also reported that many cases were inappropriately considered by Appeals because Compliance had not reviewed the abatement.  Given that penalties are essentially applied to every underpayment, with no consideration to whether the taxpayer reasonably attempted to comply, it seems inappropriate to assume those penalties are all collectible (or to encourage Appeals to abate less).
  • On Jack Townsend’s Federal Tax Procedure Blog is a discussion of the tax perjury case, US v. Boitano (What would Brian Boitano do?  Not perjure himself in a tax filing, that is for darn sure.  This is Steve Boitano- presumably not related to the super hero/figure skater).  Questions presented in the case were whether filing a document was required under Section 7206(1) for perjury, and what constituted filing.  In Boitano, the taxpayer provided returns to an agent who was not authorized to accept filed returns.  Agent realized the returns were questionable and never forwarded to appropriate Service employee for filing.  The 9th Circuit held filing was required (not stated in statute), and giving the return to the agent did not constitute filing.  Therefore, no crime under Section 7206(1).
  • Like Thor’s mighty hammer, the IRS has slammed down the tax law upon Marvel, and not even its super team of Avenger like lawyers could provide a  Shield (select from Captain America’s, or Agents of) from the consequences.  The Tax Court has decided the hulking consolidated group of the Marvel universe was required to offset its net operating loss by the cancellation of debt  income, and could be applied against the NOL of one member of the consolidated group.   I’ll touch on the holding below in broad strokes and I’ll stop trying to incorporate Marvel superheroes, but what I found most interesting about this case is that it arose out of the 1996 Chapter 11 Bankruptcy of Marvel, which seems to just print money with its movies now.  I had completely forgotten also that two real life titans (of industry) got in dustup in ’96 about that bankruptcy, Ronald Perelman and Carl Icahn.  You can read more about the amazing twenty year turn around here and here.   That story is more interesting than the law in this one.  Under Section 108(a), discharge of indebtedness income is not included as income if the discharge is pursuant to a Chapter 11 bankruptcy.  The excluded income reduces certain other tax attributes in certain circumstances, including a reduction of NOLs that carryover from prior years.  See 108(b)(1)(2).  Marvel’s subsidiary only reduced the carryover for the subsidiaries  in Chapter 11, and not the parent group that filed consolidated returns with the subs.  The Tax Court found that the aggregate approach was required, and the COD income had to reduce the NOLs of the consolidated full group.  I’ve glossed over the analysis, which is worthwhile if you have this specific type of issue.

 

 

 

Examining the Interaction between Section 6020(b) and Deficiency Assessments

Today we welcome first time guest blogger Jeffrey Sklarz. He practices with the firm of Green and Sklarz in New Haven, CT with a practice focused heavily on the intersection of tax and bankruptcy law.  Jeffrey writes today about a recent full Tax Court opinion where the taxpayer attacked the sufficiency of the substitute for return prepared by the IRS.  The substitute for return in this case differs from most because the IRS used the bank deposits method in calculating the income.  The taxpayer has the type of small business not susceptible to an easy determination of unreported income.  Nonetheless, the case does not focus on the amount of unreported income the taxpayer had during his many years of nonfiling but rather the method used by the IRS in documenting it through the substitute for return process.  While this self-represented taxpayer wanders over into constitutional arguments with sufficient force to draw the IRC 6673 penalty for delaying the proceeding, and while the taxpayer may not have presented the arguments in the most articulate manner, the Court nonetheless uses this case to closely examine the substitute for return process.  

Les briefly discussed the substitute for return process last year in a post. The issue comes up with frequency in bankruptcy cases after the assessment of the liability and we have posted several times on impact of failing to file a return and failing to work with the IRS in filing a return on the ability to obtain a discharge in bankruptcy.  See A Cogent Look at the “What is a Return?” Question (Sept. 26, 2014); Willful Attempt to Evade or Defeat the Payment of Tax (Sept. 8, 2014); What Constitutes an Attempt to Evade or Defeat Taxes for Purposes of Section 523(a)(1)(C) of the Bankruptcy Code: The Ninth Circuit Parts Company with Other Circuits (Part 1),(Part 2) (Sept. 2014); What is a Return – The Long Slow Fight in the Bankruptcy Courts (Dec. 4, 2013)Jeffrey will focus on the importance of this decision for taxpayers later facing bankruptcy. Keith

When analyzing whether a bankruptcy filing can discharge income tax debts, the taxpayer’s IRS account transcript are a practitioner’s most important tool. IRS transcripts can be very confusing.  One particularly vexing set of entries occur when the IRS begins investigating a non-filer.  The transcript reflects a code of “150” followed by the designation “substitute for return” (“SFR”) with an amount due of “$0.00.”  It appears that this is simply the opening of the investigation, not the actual “filing” of an SFR or assessment, even though the IRS explains a 150 code as “return filed and tax liability assessed.”  IRS Transaction Codes Pocket Guide, IRS Document 11734 (Rev. 2012).  Thereafter, when an assessment is made, a “290” code will be entered, meaning an additional tax has been assessed; but, has the IRS actually filed any document that constitutes an SFR?  What the transcript reflects, and the IRS actually does, is highly relevant when considering the efficacy of a bankruptcy filing to resolve a client’s tax debts.

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The case of Radar v. CIR provides a helpful discussion of the interplay between SFR procedures and the deficiency assessment process.  This explanation is particularly important when considering whether taxes may be dischargeable for bankruptcy purposes, since 11 U.S.C. § 523(a)(*) states that a return filed by the IRS on behalf of a taxpayer pursuant to § 6020(b) is not a “return” for purposes of discharge.  This leads to the question of whether there is a qualitative difference between an income tax deficiency assessed through the standard deficiency procedure versus an assessment following the IRS filing a § 6020(b) return. Radar helps to answer the above question by holding that the two work in tandem.

The taxpayer in Radar was a self-employed plumber who did not file tax returns for several years.  Following an audit, the examiner, using third-party sources, pieced together income information and issued notices of deficiency to both the taxpayer and his wife as “single” people.  The taxpayer and his wife timely filed a petition in Tax Court seeking redetermination arguing, among other things, that (a) the SFRs were deficient and, therefore, the notices of deficiency were invalid, and (b) the taxpayer’s wife was not the recipient of any income.  The IRS agreed that the taxpayer’s wife did not receive any income and amended its answer acknowledging the tax treatment would be “married filing separately.”

The Court considered the validity of the SFRs. The taxpayer (representing himself pro se) argued that the SFRs were invalid because the IRS failed “to cite a deficiency statute and/or a tax statute from which the deficiency and penalties could arise.”  The taxpayer also claimed that the IRS’s filing of a “nearly blank SFR 1040” was not a valid SFR.

Analyzing the validity of the SFR, the Court looked to § 6020 of the Tax Code, which authorizes the IRS to prepare and file returns for non-filers. The Court held that the IRS properly followed the non-filer procedures for assessing a deficiency and that the SFR was valid under § 6020(b).  The Court reasoned that the IRS issued a 30-day letter and revenue agent report (Form 4549, Income Tax Examination Changes) and the “combination of documents is sufficient to constitute a valid SFR under section 6020(b).”  (Emphasis added.) See also, IRM § 4.19.17.1.  Thereafter, the IRS issued a statutory notice of deficiency.  Accordingly, the Court held there was a valid SFR filed under § 6020(b) by the IRS, followed by a notice of deficiency.

Turning back to § 523(a)(*) of the Bankruptcy Code, returns filed by the IRS pursuant to § 6020(b) of the Tax Code render related taxes nondischargeable. However, § 523(a)(*) of the Bankruptcy Code provides two safe harbors: (1) if the taxpayer agrees to the audit report and signs the Form 4549, which following the logic of Radar, means that the audit report is treated as an SFR and would constitute a “§ 6020(a) return” and be dischargeable, and (2) if the “return” is pursuant to a “written stipulation to a judgment or a final order entered by a nonbankruptcy tribunal,” such as Tax Court.  In re Kemendo, 516 B.R. 434 (Bankr. S.D. Tex. 2014) (return was considered a “§ 6020(a) return” and related taxes were dischargeable).  Therefore, Mr. Radar’s taxes may be dischargeable as the “return” came into existence by way of a Tax Court order, however, other conduct of the taxpayer would likely render the taxes nondischargeable, such as his willful tax avoidance.

Radar provides clarity to the SFR process and when the SFR actually arises for dischargeability purposes. SFRs arise when the 30-day letter and audit report are issued, which constitute “§ 6020(b) returns” for purposes of dischargeability, unless the taxpayer agrees to the audit report or files in Tax Court.  While this is a highly technical point, Radar provides much needed guidance when analyzing transcripts and advising clients about SFRs and their impact on a potential bankruptcy filing.  Most importantly, Radar stands for the proposition that SFRs in income tax cases are “§ 6020(b) returns” under § 523(a)(*) of the Bankruptcy Code.