Court Finds Frivolous Return Penalty Applies To Trustee

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The Center for Taxpayer Rights has another session of its Tax Chat! series, Transforming Tax Administration: Toward an Effective, Trusted, & Inclusive IRS, on Wednesday April 26th at noon EDT.  The topic is the IRS Workforce: Current and Future Challenges. Our guests will be Doreen Greenwald, National Vice President of the National Treasury Employees Union;  Prof. Bob Tobias, American University and former member of the IRS Oversight Board; and Lotta Bjorklund Larsen, social anthropologist, of Exeter Business School.  If you haven’t registered for the series already, you can do so here.

Stanojevich v Commissioner is a precedential Tax Court opinion from early April that considers whether a trustee can be subjected to frivolous return penalties. I suspect that it rises to the level of a TC opinion because the returns in question were submitted on behalf of a grantor trust, which itself has no separate income tax liability.

Stanojevich filed Forms 1041 for four years in his capacity as trustee for Source Financial Trust (SFT) The returns reported interest income of between $40,000 and $58,000. The returns also reported that there were withholdings equal to each year’s interest income and that there was no tax liability. As such, the returns reflected overpayments equal to the amount of the withheld tax.

The returns included as attachments false Forms 1099, and those reflected the purported interest payments. The IRS determined that the Forms 1041 were frivolous for purpose of the $5,000 penalty under Section 6702, and it assessed $5,000 penalties for each of the four years.

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I note that the 6702 penalties are assessable penalties found in Title 26, Chapter 68, Subchapter B. The IRS’s assessment authority for penalties is a hot issue. In Farhy v. Commissioner, 160 T.C. No. 6 (April 3, 2023), the Tax Court held that the IRS lacked statutory authority to assess Section 6038(b) penalties against an individual taxpayer for failure to file information returns with respect to foreign corporations. For a somewhat critical discussion of Farhy, see Jack Townsend in Tax Court Holds that IRS Has No Authority to Assess § 6038(b) Penalties for Form 5471 Penalties and my earlier also skeptical take on the issue in Tax Court To Consider IRS Procedure For Imposing Information Reporting Penalties.  We address Farhy and related issues in the upcoming update in Saltzman and Book IRS Practice and Procedure, Chapter 7B, a chapter also currently in process for a rewrite, with Stephen Olsen talking the lead on that important work.

Back to Stanojevich. After the IRS filed a notice of federal tax lien in respect of the penalties, Stanojevich timely requested a CDP hearing, challenging the penalty. After losing at Appeals, he timely petitioned the Tax Court.

The main issue in the case, which is teed up on the government’s summary judgment motion, is penalty liability.  It is not clear why the court allowed the taxpayer a hearing on the merits.  When the IRS assessed the penalty, I would have thought it offered the taxpayer the right to respond to the proposed penalty assessment and to appeal the decision to impose the penalty.  If so, why wouldn’t that “prior opportunity” to go to Appeals shut down a merits determination on the penalty issue?

Congress beefed up the frivolous return penalty in 2006, increasing the cost from $500 to $5,000 per submission. Section 6702 now imposes a penalty when there is a purported return that reflects a position that the IRS has identified as frivolous or is submitted to delay or impede administration of the tax laws. In addition, the statute requires that a ”person files what purports to be a return of a tax imposed by this title but which—

(A) does not contain information on which the substantial correctness of the self-assessment may be judged, or (B) contains information that on its face indicates that the self-assessment is substantially incorrect.”

IRC § 6702(a)(1)(A) & (B)

The opinion has little problem concluding that the conduct trips clauses (A) and (B). As to the first requirement, that the return “does not contain information on which the substantial correctness of the self-assessment may be judged” and “contains information that on its face indicates that the self-assessment is substantially incorrect” the opinion notes that there was no way to tell from the returns” how no tax could be self-assessed on SFT’s reported taxable income and how SFT could be entitled to a refund equal to the amount of its reported taxable income.”

As to the second requirement, Notice 2010-33 identifies “frivolous” for purpose of section 6702 a “claim on an income tax return or purported return an amount of withheld income tax . . . that is obviously false because it . . . is disproportionately high in comparison with the income reported on the return or information on supporting documents filed with the return.”

After dispensing with those issues, the opinion considers whether the penalties apply when the return itself was signed and submitted by the fiduciary and supposedly relates to an entity that has no separate tax liability. The statute requires that a “person files what purports to be a return of a tax imposed by this title.”  As to the absence of liability associated with a grantor trust, the opinion notes that income tax may be imposed on a trust, and that trusts, through their fiduciary, are required to file returns when gross income is greater than $600. This requirement applies regardless of taxable income or tax liability if the trust were to qualify for pass through treatment (I note that the IRS disputed whether the entity was a valid trust but conceded for purposes of the summary judgment motion that it was).

The assessable penalty provisions define person to include certain officers or employees of a corporation, or to certain members or employees of a partnership. The opinion notes that definition is not exclusive. For good measure, Section 7701(a) states that a person “shall be construed to mean and include an individual, a trust, estate, partnership, association, company or corporation.”

Putting it together, the opinion sustains the penalties, and finds that the statute or Code more generally does not prevent the IRS from imposing a penalty for filing a frivolous return that is not a taxpayer’s personal return:

We read nothing in section 6702 that conditions the applicability of section 6702(a) on a person’s filing of his or her personal income tax return. In fact section 6012(b)(4) points to our contrary reading through its mandate that the return of a trust “shall be made by the fiduciary thereof,” or in other words, by its trustee. See also § 7701(a)(6) (defining the term “fiduciary” as a “trustee . . . or any person acting in any fiduciary capacity for any person”).

Conclusion

The opinion reaches a sensible result, but in reading this and the recent Farhy case and other penalty cases for the treatise it strikes me that Congress may wish to take a fresh look at the scattered assortment of civil penalties, as well as the IRS’s process for determining whether a taxpayer has reasonable cause. It has been over three decades since the IRS asked Congress to step in and overhaul the Code’s penalty regime, and since then Congress has taken an ad hoc approach to sanctioning taxpayer and third party conduct. It is time for a fresh look.

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Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

Comments

  1. Norman Diamond says

    ‘When the IRS assessed the penalty, I would have thought it offered the taxpayer the right to respond to the proposed penalty assessment and to appeal the decision to impose the penalty.’

    When the IRS _proposes_ the penalty, it offers the taxpayer 30 days to correct the return. This works only if the taxpayer can guess what their frivolous position was because the position is presented in the IRS’s list, and if the taxpayer lives in a place where mail between their country and the US is sufficiently speedy.

    After the IRS _assesses_ the penalty, it does not offer the taxpayer any further opportunities to make corrections. If the IRS decides to take lien or levy action then the taxpayer is supposed to be allowed to argue merits in a CDP hearing. A settlement officer might disallow merits arguments in the CDP hearing, asserting that the taxpayer had a previous opportunity for a hearing on the merits, but Tax Court does not remand to make the IRS provide such a hearing. As far as I can tell, the only relevant statute specifies that assessment and collection of penalties is done by the same method as assessment and collection of tax, which should provide for a Notice of Deficiency for the amount of the penalty, but the IRS and courts don’t agree with me. Also, if the IRS decides _not_ to take lien or levy action then the taxpayer is SOL, the IRS can use offset to confiscate all future refunds owing to the taxpayer.

    ‘If so, why wouldn’t that “prior opportunity” to go to Appeals shut down a merits determination on the penalty issue?’

    Prior opportunities do not go to Appeals.

    ‘Notice 2010-33 identifies “frivolous” for purpose of section 6702 a “claim on an income tax return or purported return an amount of withheld income tax . . . that is obviously false because it . . . is disproportionately high in comparison with the income reported on the return or information on supporting documents filed with the return.”’

    Yes indeed. I did not hold any of the positions presented in earlier lists and could not guess what my frivolous position was. Years later I figured out that maybe the IRS intended to assert that my claim of withholding was frivolous because 30% of gross proceeds (the amount of US withholding) exeeded capital gain (the amount of income), but the IRS had to shift gears when they discovered that the obviously false claim was factually true.

    Eventually the IRS decided that it’s frivolous to write an honest declaration on a US federal return. I listed of ways in which I committed perjury in replacement returns that I proffered to IRS counsel (which, as we saw recently, is not a method of filing). For example after the Japanese government and Tokyo District Court already knew that an employer had falsified the Japanese equivalent of US W-2, IRS counsel coerced me to declare under penalty of perjury that to the best of my knowledge and belief the attached form was true and correct. The “position” that it is OK to tell the truth on a US federal return still needs to be added to the IRS’s published list of frivolous positions.

    (Subsequent news is that the IRS and courts decided that neither I nor my wife filed the frivolous returns in the first place. Honesty remains frivolous, but I don’t know what makes a return filed or not filed.)

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