Sticker Shock and Settling on the Issues: Designated Orders, July 15 – 19

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There were five designated orders for the week of July 15, three of which were perfunctory decisions in collection due process cases where the petitioner “filed and forgot” -in other words, after filing the petition, the taxpayer stopped doing much of anything to advance their case or respond to court orders. For the curious, those orders are here, here, and here. The remaining two orders appealed to my dual professional obligations: lessons in working with clients and teaching tax law. We’ll begin with one of the messy issues that arise in working with clients in tax controversy: backing out of settlement.

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Stipulated Issues and Sticker Shock: Kirshenbaum v. C.I.R., Dkt. # 10135-17S (order here)

The parties in this case have agreed on virtually everything, and even signed a stipulated settlement… and yet now the Kirshenbaums are having second thoughts. Why might that be? When the (fairly simple) issues are settled, the amount of tax that results is almost entirely a matter of math. My bet is that the Kirshenbaum’s had second thoughts when the numbers flowing from the stipulated words began to coalesce. A sticker-shock on the tax that would be due… and a sudden (futile) desire to renege. As an attorney, it demonstrates the two different languages you have to speak in settling tax matters: dollars and cents to the client, issues and law to the IRS. The last thing you want is the client backing out of settlement, wanting to argue issues with little merit, because they now realize that the merits mean they will owe more than they’d like.

The Kirshenbaum’s situation demonstrate how quickly taxes and penalties can cascade when there are errors on the return, and the return was late filed. To begin with, for late filers the “failure to file” penalty (IRC 6651(a)(1)) is a much quicker way to increase your bill than just filing on time without paying: the penalty accrues at a 5% monthly rate (to a maximum of 25%) rather than the 0.5% rate for failing to pay. Further, the amount of tax that the failure to file penalty is multiplied against is the amount “required to be shown on the return” (i.e. not necessarily the amount you actually report), so a later audit can retroactively bump up your penalty quite a bit. 

There is really no benefit I can think of to filing late, even if you are going to get late payment penalties. Perhaps the Kirshenbaum’s had a legitimate reason for filing late (though to get out of the penalties for “reasonable cause,” you generally need a really good reason, and demonstrate that you exercised “ordinary business care and prudence.” See Boyle v. C.I.R., 469 U.S. 241 (1985) and Les’s post on issues in the e-file age).

In any event, the Kirshenbaum’s return was both filed late and filled with easily detectable errors. The first easily detected error was a matter of calculation: the amount of taxable social security they reported (note that this wasn’t an instance of omitting social security income, but listing an amount received, and a corresponding “taxable” amount that doesn’t add up). That error was (presumably) fixed through IRC 6213(b)(1) “math error” authority. But then, on second (likely automated) look, the IRS also noticed that the return completely omitted roughly $38,006 of retirement distributions. A notice of deficiency was issued showing the increased tax, as well as increased failure to file penalty, along with an IRC 6662(a) penalty for good measure. That added up to a bill likely over $12,000, which the Kirshenbaums were not going to take lying down.

And their fight may actually have saved them some money, but only with regards to the IRC 6662 penalty. The other issues were largely foregone conclusions: if the additional retirement distribution was received and omitted by the Kirshenbaums, there would be additional tax due on it, as well as an increase in their taxable social security benefits simply as a matter of cold math. Since it was fairly clear that the additional retirement distributions were received (and taxable), the IRS and the Kirshenbaums were able to stipulate all of the issues, with the IRS conceding the IRC 6662 penalty (perhaps in good faith, perhaps because of a procedural infirmity). The Kirshenbaums signed the stipulation of settlement, thus avoiding the need to appear at calendar. All that remained was the decision document with a calculation of the deficiency (per Rule 155).

But when that calculation was done, the Kirshenbaums wanted to backtrack and argue the very issues they had stipulated to. The Tax Court was not having it: “They entered into an agreement, and we will hold them to their word.” Further, as Judge Gustafson alludes, there doesn’t really appear to be a “serious dispute to maintain about the matters[.]” The Kirshenbaums are grasping, agreeing that they received the retirement proceeds but picking fairly arbitrary amounts to treat as taxable. The Court isn’t going to play that game, especially after you fail to show up at trial after agreeing to all the issues. 

The most “difficult” clients I have are the ones that agree to the issues but want me to try to get the IRS to knock a few more dollars off the deficiency purely as a matter of negotiation. When the merits aren’t clear and there are hazards of litigation, there can be some wiggle room (see IRM 35.5.2.4). But where the correct outcome is clear there is really no “art of the deal” magic that can be done. This reality, I think, cuts against the popular conception of what lawyers do in back-room negotiations. At its worst, it can lead to clients wanting to back out of settlement when the issues are clear, as they were in the Kirshenbaum’s case. For an interesting and more detailed look at when settlement becomes binding, including when the IRS unexpectedly backs out, I highly recommend Keith’s piece here.

Bench Opinions, Substantive Law, and Innocent Spouse: Mayer v. C.I.R., Dkt. # 23397-17S (order here)

The crew at Procedurally Taxing have blogged about the value and nuances of S-cases and bench opinions before: here, here, and here. Keith has also written about bench opinions in more detail here. In the above order we have a bench opinion on an innocent spouse case that presents some interesting, though clearly not precedential, substantive application of IRC 6015(b) and (c). Because bench opinions are non-precedential (and not reviewed), the Judges sometimes appear more willing to bite on general equity concerns (even if they don’t present their opinions with that explicit rationale). To me, this opinion had some hints of that, and possibly even gets the law itself a bit wrong. 

The relevant facts can be boiled down to the following: husband (the requesting “innocent” spouse, in this case) and wife want to buy a house. To pay for it, they have to rely on their 401(k)s. Husband decides to borrow against the 401(k), whereas wife just takes a straight withdrawal. Wife pretty much controls the finances, including preparing the tax returns. When it comes time to file, wife omits the 401(k) withdrawal. Husband “paid little or no attention to the return” and signs it. The legal question at issue seems pretty straightforward: did the husband have “reason to know” of the understatement of tax by omitting the 401(k) withdrawal? He clearly knew she received money (i.e. knew of the transaction): is that enough for him to have “reason to know” of the understatement?

Judge Buch says “no, the husband did not have reason to know” because he was “not aware that there was an understatement,” since he did not really pay attention to the return when he signed it. Judge Buch also finds the other elements of IRC 6015(b) are met, including equity concerns, because “there is no indication that [the husband] benefitted in any way from [the 401(k) withdrawal].” 

I question both of those conclusions, but my bigger issue (as I’ll get to) is the legal reasoning applied to IRC 6015(c). For now, I’d say that I find it curious that in this case the husband appears to benefit from “paying little or no attention to the return” rather than asking reasonable questions… like whether his wife borrowed or withdrew the money he knows she took from her 401(k). See Treas. Reg. 1.6015-2(c). Similarly, I find it a bit charitable to say that he did not benefit from the withdrawal, when it went towards the purchase of their marital home. But perhaps there were other facts I am unaware of (including what happened to the home after the fact) that could better lead to those conclusions. 

Still, while there may be additional facts not referenced in the opinion that led to the decision (and the intervening ex-wife may also not have advanced her case well), the application of the law under IRC 6015(c) was a bit more troublesome to me. Generally, IRC 6015(c) relief is easier to get than relief under IRC 6015(b), because under (b) the requesting spouse can’t have “reason to know” of the understatement, whereas under (c) the requesting spouse can’t have “actual knowledge” of the item giving rise to the deficiency. The IRS bears the burden of proof in showing “actual knowledge” of the requesting spouse, which only makes the relief that much easier to come by. 

Judge Buch finds no “actual knowledge” of the item leading to the deficiency in this case because, again, the husband “was not aware that [his wife] took a premature distribution [rather than a loan] from a retirement account.” But is the fact the husband didn’t know (without asking) whether it was a loan and not a taxable distribution relevant, if he clearly knew that she received the money leading to the deficiency? And that is where I believe there was an error in the legal analysis.

Quoting King v. C.I.R., 116 T.C. 198 (2001), Judge Buch describes actual knowledge as “actual knowledge of the factual circumstances which made the item unallowable as a deduction.” He also directs readers to Treas. Reg. 1.6015-3(c)(2)(B) to further bolster the proposition. 

And Judge Buch is correct, as far as deductions go. But the “erroneous item” in this case is not a deduction: it is an omission of income. In fact, one paragraph above the treasury regulation cited to is a completely different standard for omitted income: “knowledge of the item includes knowledge of the receipt of income.” Treas. Reg. 1.6015-3(c)(2)(A). Both King and the regulation cited appear inapposite. In fact, much of King is spent discussing another precedential Tax Court case, Cheshire v. C.I.R, 115 T.C. 183 (2000) that expressly found you don’t need to know the tax consequences of an omitted retirement distribution to have “actual knowledge” of the item. Cheshire seems close to being on all-fours with the husband’s matter. King expressly reaches a different conclusion for actual knowledge of deductions, while preserving Cheshire’s actual knowledge of omitted income inquiry. 

Conceptually, I think there is a pretty good reason to hold taxpayers to a higher standard in relief from omissions of income than improperly taken deductions. I would say this is in part because income is presumably taxable, whereas deductions, as we are frequently told, are matters of legislative grace. In other words, you don’t have to be a tax expert to suspect that income should be on a return, whereas you do have to be closer to an expert to know if most deductions are really allowable.

To me, the innocent spouse husband got a far better deal than he would have if this were not a bench opinion. Apart from not being reviewed by other judges, bench opinions are given without the benefit of briefing from the parties (apart from, perhaps, pre-trial memoranda, which are generally optional in S-Cases like this one). I’d hope that IRS counsel would have hammered home on the distinction between omitted income and erroneous deductions if this were briefed. I am generally a fan of bench opinions when it involves simple questions of fact (and have been on the receiving end of a favorable Buch bench opinion in the past.)

I tell my tax procedure students that innocent spouse is about as far from typical tax law as you can get -that it usually involves equity and factual determinations far more than most other provisions in the Code. It is also fairly convoluted, as a matter of statute and regulation, because “innocent spouse” comes in three flavors. This bench opinion, perhaps, illustrates how easy it is to get tripped up on all the flavors and permutations even as a tax law expert. 

Application of IRC 6015, and particularly equitable relief under IRC 6015(f) is still being developed by the courts (and in some ways, by Congress in the Taxpayer First Act (see post here)). I believe the Court should have found “actual knowledge” from the requesting spouse in the above order, thus ruling out IRC 6015(c) relief. Since “actual knowledge” would necessarily meet the IRC 6015(b) “reason to know” standard, one would think that the only remaining avenue for relief would be “equitable relief” under IRC 6015(f) (Judge Buch found that the taxpayer was eligible for both (b) and (c), which both rules out and makes unnecessary relief under IRC 6015(f)). However, as noted in a previous post, the Tax Court appears to have taken a position that effectively makes “actual knowledge” a trump card, or at least far too heavily weighted as a factor, that may even preclude relief under IRC 6015(f). Keith and Carl have been working with that issue (the interplay of actual knowledge and equitable relief) in a case that is presently before the 7th Circuit. I naively hope that a decision is reached before I teach my class on innocent spouse relief this fall.

Caleb Smith About Caleb Smith

Caleb Smith is Visiting Associate Clinical Professor and the Director of the Ronald M. Mankoff Tax Clinic at the University of Minnesota Law School. Caleb has worked at Low-Income Taxpayer Clinics on both coasts and the Midwest, most recently completing a fellowship at Harvard Law School's Federal Tax Clinic. Prior to law school Caleb was the Tax Program Manager at Minnesota's largest Volunteer Income Tax Assistance organization, where he continues to remain engaged as an instructor and volunteer today.

Comments

  1. To remind everyone, the case that Keith and I are litigating and that Caleb refers to at the end of his post is Jacobsen v. Commissioner, where oral argument is in the 7th Cir. this Friday (two days from now). In Jacobsen, for the 2011 year (the year we appealed), the Tax Court held that H had actual knowledge of his wife’s embezzlement income after she went to jail and before the 2011 return was filed. I am still not sure he really had “actual knowledge” of the omitted income in 2011 because there is no evidence in the record showing that he ever saw any breakdown of how much she embezzled each year in a multi-year scheme in which the Tax Court said H could never have figured out the amount of embezzlement income on his own (since W hid it in small deposits to their joint account that could have been mistaken for Sched. C business receipts of one of H’s businesses). Anyway, even if H had actual knowledge, the case was decided under (f). The court denied relief under (f), saying that actual knowledge plus H’s help to a return preparer in preparing the return (the latter of which is not a separate factor ) outweighed four positive factors for relief (no longer married, no significant benefit to H [W gambled away the money due to a gambling addiction], H’s scrupulous compliance with later-year tax filings, and H’s serious health issues). H is also a veteran. Effectively, we believe, the court has elevated lack of actual knowledge to a but for requirement of (f) relief, though the statute doesn’t say that. And Rev. Proc. 2013-34 now says actual knowledge is to be weighed no more heavily than reason to know or any other factor. How does one factor (knowledge) ever outweigh four factors?

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