Designated Orders: 4/2 – 4/6/2018

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Designated Order guest blogger Patrick Thomas of Notre Dame brings us this week’s post. He examines a pair of bench opinions and expresses frustration with our complex tax system, the poor information provided to taxpayers by our financial system and the impact on compliance of asserting the substantial understatement penalty. In his last paragraph he speculates that the experience will make these two taxpayers more compliant which is logical thinking but there is a study by the National Taxpayer Advocate which reaches the conclusion that imposing penalties can make individuals less compliant. Imposing penalties without thought, which is how the substantial understatement penalty works, needs review as good policy and the NTA keeps suggesting such a review without success as yet. Keith 

This week’s orders bring us two bench opinions from Chief Special Trial Judge Carluzzo analyzing the reasonable cause exception to the substantial understatement penalty under section 6662. These two orders are the only ones discussed at length in this post.

Other orders include a helpful reminder of burden of proof considerations with unreported income, along with highlights of a few interesting procedural mechanisms in the innocent spouse and math error assessment contexts. Judge Carluzzo also issued another order that was light on publicly available facts, but a reminder that the Tax Court may consider what the Service designates as a “decision letter” to actually constitute a Notice of Determination.


Reasonable Cause – Late/Incorrect 1099 Forms Insufficient for Penalty Avoidance

Docket No. 9285-17S, Zschau v. C.I.R. (Order Here)

Docket No. 6628-17S, Cusack v. C.I.R. (Order Here)

Judge Carluzzo issued bench opinions in two cases, Zschau and Cusack, where the sole issues for decision was whether the petitioners qualified for a reasonable cause exception to the substantial understatement penalty under section 6662. In both cases, the petitioners relied on third parties to properly and timely issue information returns; those third parties (Janus Investments and Chase Bank) failed their statutory obligations. Nevertheless, Judge Carluzzo sustained the penalties in both cases—though in Zschau, only by a hair.

These cases are eminently frustrating to me. They reflect what I consider to be a wholesale failure of federal tax administration, stemming, it seems, from the taxpayers’ basic lack of understanding of just what the federal income tax is and what their reporting obligations are. I see this among many (though not all) of my clients in the LITC; I’m sure my fellow bloggers have similar experiences.

Indeed, just the other day, I spoke with a new client. Since retiring on a small pension about 10 years ago, she hasn’t filed an income tax return, because—she believed—there’s no requirement to file a tax return or pay taxes after one is retired. I explained the very basic concepts of income taxation and withholding to her. Her eyes lit up. “I had no idea. That makes sense, but no one has ever explained that to me,” she said. Fortunately, after obtaining her information returns, I determined she owed no tax on the unreported income—but had missed out on nearly $10,000 in refunds over the past 10 years.

The issues in Zschau and Cusack are more complex, but I believe, derive from the very same ignorance of how federal income taxation works and what obligations the Code imposes on taxpayers. Most taxpayers that I encounter (and I admittedly self-select those who have run into issues with the Service) understand taxation through unsolicited experience; that is, at some point in their lives, their employer or a payor sends them an information return, which they do not understand. The taxpayer may ignore that form; or they may take it to a trusted friend or relative, who eventually points them to a tax return preparer.

Eventually, the understanding emerges that all taxpayers have an annual filing obligation, and such forms should be provided to a tax return preparer on an annual basis. Taxpayers thus rely on and presume the accuracy and timely delivery of those forms. And perhaps, at some point, taxpayers come to understand the notion that if they receive income—especially in cash—they’re required to pay taxes on that income. But I think (and I’d welcome research on this point) that the provision of an information return with respect to that income would satisfy the taxpayer’s perceived obligation, so long as it was timely delivered to a return preparer; that the absence of such a form, generally speaking, signals to the taxpayer that nothing needs to be provided to a return preparer; and that any error on the form or in delivering the form is the fault of either the third party or the tax return preparer.

In Zschau, the taxpayers didn’t “see” any income from their investment account in cash—and didn’t receive a 1099-B to boot. In Cusack, the taxpayers received a (very) incorrect 1099-R. Both taxpayers had invested with large investment or banking organizations, which presumably have sophisticated tax reporting operations. In both cases, we see errors of the type I describe above.

Zschau’s investment account custodian did not send a 1099-B until long after the petitioners’ return preparer filed the tax return. As such, it wasn’t included on the return. Further, the amounts distributed were reinvested into the account; thus, the Zschau’s didn’t intuit that they had received taxable income, as one might have, had the proceeds been converted to cash in a bank account. They didn’t know about the discrepancy until receiving correspondence from the Service, and then submitted an amended return to include the income (which was unprocessed, due to the outstanding Notice of Deficiency). They also paid the deficiency.

These taxable events that do not result in liquid income often confuse my clients in the Clinic, such that the income is not reported on the return. This is especially true if there’s a delay, like in Zschau, in issuing the 1099-B or other information return, as the tax preparer cannot catch that income either. Cancellation of debt income, pass-through income, reinvested taxable income, and improperly performed retirement account rollovers often lie at the heart of Automated Underreporter (and eventually, Automated Collection Systems) cases in my clinic, and reflect the general ignorance of federal income taxation that I describe above.

The amounts underreported clearly established a substantial understatement under section 6662(d), as the underreported tax exceeded 10 percent of the tax required to be shown on the return (and presumably also exceeded $5,000). Thus, the only legal issue was whether reasonable cause existed for the underreporting.

Before deciding the issue, Judge Carluzzo noted that this was “a very close case”, and that further he was “disappointed that the parties were unable to resolve it between themselves by splitting the penalty.” That short comment struck me and creates a fertile ground for a longer discussion. Notwithstanding the preferences of judges for private settlement, the Tax Court’s institutional interest in efficiency, and litigants’ interests in avoiding the cost and time of trial, surely it’s this very sort of case that the Tax Court exists to decide: a case where equities exist on both sides, are difficult to balance, and where cause the parties to hold seemingly strong views regarding their positions.

Of course, we can only speculate as to what happened before trial. We don’t know whether settlement negotiations occurred, and if so, what took place therein. Perhaps had the Zschaus retained counsel, they would have benefited from a more accurate analysis of litigation hazards. Or perhaps it was respondent who was intransigent.

Putting aside my speculation, Judge Carluzzo ultimately held for the Service. The decision hinged on the Zschaus having received a 2014 year-end summary from Janus before filing the tax return. While the summary didn’t indicate whether any gains were taxable, it did show a large amount of capital gains. Zschau noted that he had only ever provided his return preparer with his Forms 1099-B; Judge Carluzzo found this insufficient (which may surprise a number of tax return preparers). Not helping matters was Zschau’s ownership of an insurance brokerage agency, suggesting he should have known to provide the summary to his return preparer—though I submit that general financial literacy (if that can be imputed to Zschau from ownership of an insurance agency) does not substitute for tax literacy.

Bottom line: a cautionary tale for taxpayers with investment accounts and tax preparers who only require a 1099-B from their clients. To enable accurate reporting and penalty avoidance, taxpayers should provide their year-end summaries to their return preparers, in addition to their tax reporting forms.

The Cusack matter is more straightforward, though still frustrating to me and for the taxpayers. The Cusacks owned an IRA, from which they took distributions amounting to $36,500 due to financial hardship. However, Chase issued the Cusacks a 1099-R reporting only $2,780, which they provided to their return preparer and reported on their return. Chase did not issue a corrected or additional 1099-R for this year.

Judge Carluzzo noted that the taxpayers “were obviously aware that the distributions were made” and that “one or both of them must have known that the amount shown on the return as an IRA distribution was understated.” He concluded that, “we cannot excuse their failure to question the relatively low amount the return preparer included on the return as an IRA distribution.” As such, he upheld the penalty, as the Cusacks did not demonstrate reasonable cause.

We can indeed easily conclude that the Cusacks were aware of the distributions, given they compensated for the taxpayers’ difficult economic circumstances. But I do wonder: were the taxpayers afforded an opportunity to review their return before filing? Could the taxpayers effectively read and understand the items listed on a Form 1040? Did they presume that Chase had accurately reported taxable income from the IRA on Form 1099-R? Did they understand how an IRA works, in the first instance?

I realize that the answers to these questions are not necessarily determinative in the 6662(a) context. Yet the stated purpose of the accuracy penalties is to encourage voluntary compliance. I’d indeed bet that the Zschaus and the Cusacks now have a better understanding of their federal income tax obligations, and are therefore more likely to comply in the future (at least if similar issues arise).

But will these cases have any effect on taxpayers writ large, outside of those already tax-educated few who read this blog? I very much doubt it.


Patrick Thomas About Patrick Thomas

Patrick W. Thomas is the founding director of Notre Dame Law School’s Tax Clinic, in which he trains and supervises law students representing low-income clients in disputes with the Internal Revenue Service. Prior to joining the law school faculty in 2016, he received an ABA Tax Section Public Service Fellowship to work as a staff attorney for the LITC at the Neighborhood Christian Legal Clinic in Indianapolis.


  1. My father-in-law has an engineering Ph.D. (and taught at Notre Dame). After my husband became a CPA, he prepared my in-laws’ tax return and had a lengthy argument with his father about investment income needing to be included on the return. It’s not only those with lower incomes or less education who might lack tax literacy.

  2. Bob Kamman says

    Here is a brief report from the real world of tax return preparation on what happened in these cases.

    Zschau: For many years, 1099-DIV forms reliably showed up by January 31. Then Congress added complications to the law – for example, with a new definition of “qualified” dividends. So investment companies were given an extra 15 days to issue the forms, and it was (and still is) not uncommon for corrected 1099’s to be issued in late February or even March. Taxpayers, however, are creatures of habit. If they regularly meet with their tax preparer on their early-February anniversary, or on Valentine’s Day (I have had such clients), then they are not easily convinced to wait a few extra weeks.

    To generate $5,000 in tax, at the lower rates for capital gains and qualified dividends, these taxpayers must have had a large investment in the Janus fund. But there has been at least one Janus fund in which one of my clients has invested, that will make no distributions in some years, and then make large payments in others.

    Judge Carluzzo shows his ignorance of mutual funds when he writes, “ Because of capital gains and other income earned by the Janus account during 2014 not distributed to petitioners, but reinvested in the account, the account enjoyed an increase in value by more than 15%. The increases are shown on the annual Overall Portfolio Summary that Janus provided to petitioners before the return was filed. The capital gains and other income that resulted in the increase in the value of the account apparently were reported on a paper Form 1099…”

    Funds can and do make large distributions in years that the market (and account value) goes down. Those of us who were around in 2008 know that. If a fund made investments in 2001 that it then sold in 2008, it would still have a large capital gain to distribute, even though the year-end account value decreased. (Watch for the same thing to happen in 2018.)

    The bottom line here is not that “taxpayers should provide their year-end summaries to their return preparers, in addition to their tax reporting forms.” The bottom line is that preparers should know, from previous years, what 1099’s to watch for. If one doesn’t show up, then require the client to do some homework. That might include providing the year-end summary, to show that there was no reportable income; calling the company to find that a late 1099 is expected; or discovering that an identity thief stole the timely 1099 from the mailbox.

    Cusack: “Petitioners made five or six withdrawals totaling $36,500 from the IRA,” and reported only the $2,700 shown on one 1099-R. It’s obvious that the bank issued separate 1099’s for separate transactions. There is no requirement that all withdrawals be reported on a single document. (Likewise, employers can issue multiple W-2s to employees who have breaks in service.) I see this all the time – the multiple documents may be more convenient for the IRA trustee because of address changes, or differences in federal and state tax withholding.

    To answer Mr. Thomas’s question, “But I do wonder: were the taxpayers afforded an opportunity to review their return before filing?” They may have had the opportunity, but they probably just signed the Form 8879 that authorized their preparer to send the digital file to the third-party software vendor that then forwarded it to IRS. The taxpayers sign the form, which shows only their AGI, tax, withholding, and refund or balance due, with the statement “Under penalties of perjury, I declare that I have examined a copy of my electronic individual income tax return and accompanying schedules and statements.” Just because people make declarations under penalty of perjury that they have done something, doesn’t mean it happened.

  3. Norman Diamond says

    I read these orders: “a few interesting procedural mechanisms in the innocent spouse and math error assessment contexts.”

    The latter case is a deficiency case, and it doesn’t matter if it resulted from a math error. This is important:
    ‘Petitioner utilized first-class postal mail to send his petition to the Court. The envelope in which the petition was mailed to the Court arrived without any postmark on it. […]
    Because the petition was received by the Court 19 days later, it was not timely filed.6 […]
    4 As previously stated, the envelope in which the petition was mailed to the Court does not bear any postmark. In order to demonstrate normal mailing time, including time for the irradiation of Government mail, respondent relies on a statement from the United States Postal Service. Also, s infra note 5 regarding a specific instance of mailing time in this case.’
    I quoted footnote 4 because it’s more relevant than 5 or 6.

    Tax Court’s web site posted a notice a while back that Tax Court is aware of USPS delays in delivering mail.

    Delays and other mishandlings vary wildly and do not accomplish some kind of uniformity from item to item just because the items pertain to the same Tax Court case.

    Two exhibits that my wife filed in Tax Court are USPS traces, though the addressee was the IRS not the Court. USPS reported delivery of a registered letter. A few days later USPS reported that USPS was handling the letter again, and then the letter fell into a black hole, neither delivered nor returned to sender. USPS returned the Advice of Receipt card (return receipt) showing no recipient and no date of delivery. USPS told Japan Post that there was no trace of the letter and Japan Post compensated my wife for disappearance of the registered letter.

    I sent a registered letter to Court of Federal Claims. USPS showed that the letter reached Washington DC a few days after mailing. The letter stayed in USPS for around 60 days (I didn’t count exactly) before being delivered to the Court. This doesn’t mean that USPS hangs onto all registered letters for 60 days, just that they did with this one.

    Here’s one that’s still visible online:
    This doesn’t mean that USPS hangs onto all registered letters for 10 days, just that they did with this one.

    When USPS didn’t put a postmark on an envelope, it is grossly unfair to blame the petitioner. Even through respondent is labelled Commissioner instead of United States, it is grossly unfair to let a partly benefit from the party’s own malfeasance.

  4. Norman Diamond says

    P.S. Although docket number 16772-17S has an S in it, it isn’t a small case (yet) because trial hasn’t begun (yet). Would someone please kindly appeal it. If it would help, I’ll scan documents related to the letter that USPS delayed for around 60 days.

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