IRS Acquiesces in Action on TurboTax Decision

Guest blogger Bob Kamman analyzes the latest IRS announcement on the taxability of special state payments made in 2022. Previous PT coverage is here and here. PT readers may also be interested in Professor Annette Nellen’s excellent posts on the issue. Christine

As promised a week earlier, IRS announced late Friday afternoon, February 10, in Information Release 2023-23, its views on whether various “special payments made by 21 states in 2022″ are taxable. 

The announcement is a landmark “Action on Decision.”  Rather than expressing its views on a court ruling, IRS simply admitted that it will go along with what TurboTax and H&R Block have been doing for weeks. 

Of course, that’s not what IRS said in the Notice.  But it’s the only conclusion that can be drawn from the failure to cite any precedent or establish any new framework for analysis. Instead, we are told that “IRS will not challenge the taxability of payments related to general welfare and disaster relief.”

“Challenge” may be a word that describes working at IRS, but is it an appropriate term for interaction between the Service and taxpayers? 

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When I worked at National Office in the 1970s, one of the joys of reading the Washington Post was its daily example of bureaucratic “Gobbledygook.”  This 139-word sentence from the Notice would definitely be a winner, if the feature still existed:

The IRS has reviewed the types of payments made by various states in 2022 that may fall in these categories and given the complicated fact-specific nature of determining the treatment of these payments for federal tax purposes balanced against the need to provide certainty and clarity for individuals who are now attempting to file their federal income tax returns, the IRS has determined that in the best interest of sound tax administration and given the fact that the pandemic emergency declaration is ending in May, 2023 making this an issue only for the 2022 tax year, if a taxpayer does not include the amount of one of these payments in its 2022 income for federal income tax purposes, the IRS will not challenge the treatment of the 2022 payment as excludable for income on an original or amended return.

Translation: TurboTax and other software companies, along with H&R Block and other major tax preparation companies have been ignoring these payments for the last three weeks.  Exclusion was the only practical solution.

Still, IRS did not answer all of the questions that tax preparers are asking, perhaps because IRS did not ask any of us to review the announcement.  Here are three examples:

Massachusetts:

The Bay State had two programs last year.  For one of them, it refunded about 14% of the state income tax that individuals paid.  IRS must have called the Massachusetts Department of Revenue, asked them what was happening, and were told about this program.  So, they put it in the category of “state tax refunds” taxable only if claimed as an itemized deduction on last year’s 1040.

But there was also a “Covid-19 Essential Employee Premium Payments” program, which sent $500 payments to Massachusetts residents with household income less than 300% of federal poverty level and earned income of at least $12,750 in 2020 or $13,500 in 2021.  Everyone was considered an Essential Employee, so this was in the nature of an Earned Income Credit.  No 1099’s were issued because the amounts were under $600.  The IRS announcement ignores these payments.

Illinois:

As an IRS footnote explains, “Illinois and New York issued multiple payments and in each case one of the payments was a refund of taxes, which should be treated as noted above, and one of the payments is in the category of disaster relief payment.” 

Illinois made one refund of property taxes, only to people who paid property taxes.  They also made payments to people who filed state income tax returns, regardless of whether they paid state income tax.  The amounts in this second category were $50 per person, and $100 per dependent up to three. Which would you say should be reported as a tax refund, and which is disaster relief?  There were AGI limits for both of these payments.

California:

Some of the payments from this 2022 legislation are not being made until early in 2023.  California taxpayers, however, report receiving 1099-MISC forms from the Franchise Tax Board for 2022 even though their debit cards had not yet been issued last year.  The IRS announcement has some of them worried that it applies only to 2022 payments, and that this time next year, after having more time to think about it, IRS will issue new guidance.

Parting Thoughts:

The last word on this issue should come from Michael Desmond, former Chief Counsel, who participated in a Webinar sponsored by Tax Analysts on February 1, along with former Commissioner Charles Rettig and former National Taxpayer Advocate Nina Olson. Not referring specifically to this situation, which had not yet attracted media attention, but to IRS challenges in general on how to spend new funding, Desmond said:

And I look at that through an enforcement lens, perhaps, when things go wrong on the back end and you do end up in an audit situation, but I think the IRS can really do a lot on the front end to lay out those programs in a way, put guidance out on the front end and address all of the open questions or as many as possible for new programs like that, so you don’t have compliance issues on the back end. Having more resources, I look at it from the lens of Counsel, but having more resources to be able to issue letter rulings in areas where historically there has not been the staffing to do that, to answer those questions on the front end. That is, call it compliance, call it enforcement, call it service, whatever it is, from the taxpayers perspective, getting those questions answered through a letter ruling up front, through published guidance up front, so you never have the audit start, you don’t have the enforcement issue on the back end is I think a way that the deployment of resources, the new resources can really be utilized effectively, and that will increase voluntary compliance.

That “former” in front of his title is unfortunate.

An Open Letter to the Last IRS Commissioner

Phoenix lawyer Bob Kamman, an occasional guest blogger and frequent commenter, turns 74 this week. He tells us that his clients won’t allow him to retire. And, some of them must file California returns, so he keeps up with developments west of the Colorado River.

Mr. Charles Rettig

Beverly Hills

I bet it feels great to be back in California, even with the recent bad weather and worse mass shootings.  At least you are thousands of miles from the Capitol, where IRS is not always welcome or appreciated.  Now that you are back among friends, though, you probably are expected to answer their tax questions.  I can guess which one comes up the most: the MCTR.

Californians wish you had pushed IRS to answer this question before you left office  November 12.  After all, IRS should have anticipated it when Governor Newsom signed AB 192 into law on June 30, 2022.

More than 30 million beneficiaries know about Middle Class Tax Relief, but the rest of the country might want some details.  It provided payments ranging from $200 to $1,050 for residents who filed a 2020 state income tax return with AGI less than $250,000 (single) or $500,000 (joint).  Yes, in California that’s middle class.

But these were not tax rebates or tax refunds, because they weren’t based on whether tax was paid or how much.  The General Assembly explained the purpose:

“Increased costs for goods, including gas, due to inflation, supply chain disruptions, the effects of the COVID-19 emergency, and other economic pressures have had a significant negative impact on the financial health of many Californians. The Legislature hereby finds and declares that the payments authorized . . .as added by this act, serve the public purpose of providing financial relief for Californians who may have been adversely impacted by these economic disruptions and do not constitute gifts of public funds within the meaning of Section 6 of Article XVI of the California Constitution.”

The state initiated direct deposits to more than 7 million filers, and then mailed another 9 million debit cards.  Total cost: about $9 billion.  And they haven’t finished yet. 

The state law made it clear that these payments were not subject to state income tax.  But apparently no one was sure how IRS would view them.  So with an abundance of caution, envelopes and postage, the Franchise Tax Board (that’s what California calls its Department of Revenue) decided to send 1099-MISC forms to anyone who received $600 or more.  The FTB explained it was doing this because “The MCTR payments may be considered federal income.”

Or, they may not be.  Don’t ask them, ask IRS.  It must be a difficult question, because so far there is no answer.  And it has now become a subject of debate for tax practitioners.

There are those for whom “may be considered federal income” means “must be, if there is a 1099.”  They are preparing and electronically filing returns already because they don’t want their clients to receive a CP-2000 notice proposing an assessment  next year. 

But there are others who reason that these payments come under the category of “general welfare.”  The Internal Revenue Service has consistently concluded that payments to individuals by governmental units under legislatively provided social benefit programs for the promotion of the general welfare are not includible in a recipient’s gross income (“general welfare exclusion”). See, e.g., Rev. Rul. 74-205, 1974-1 C.B. 20; Rev. Rul. 98-19, 1998-1 C.B. 840. To qualify under the general welfare exclusion, payments must: (i) be made from a governmental fund, (ii) be for the promotion of general welfare (i.e., generally based on individual or family needs), and (iii) not represent compensation for services. Rev. Rul. 75-246, 1975-1 C.B. 24; Rev. Rul. 82-106, 1982-1 C.B. 16. 

You see the problem here?  And why it would be helpful to have a respected  tax expert from California  push IRS to decide how to answer this question, before the Taxpayer Service phone lines are jammed with Californians calling to ask what to do with their 1099 from the FTB?

The San Francisco Chronicle tried to get an answer from IRS in December. But it reported:

“The IRS could not provide a clear answer. ‘I can tell you, we are aware of it. California is not the only state doing this,’ IRS spokesman Raphael Tulino said. The only answer Tulino provided was this excerpt from IRS Publication 525. ‘In most cases, an amount included in your income is taxable unless it is specifically exempted by law. Income that is taxable must be reported on your return and is subject to tax. Income that is nontaxable may have to be shown on your tax return but isn’t taxable.’”

Fortunately, there is still one Great California Hope left in D.C. who might be able to push for an IRS answer.  She is National Taxpayer Advocate Erin Collins.  Her job is to listen to everyone, but she might pay more attention to you if you could explain to her the importance of this matter.  Please, send her a text or give her a call. 

Thanks in advance,

Bob Kamman

P.S.  Do you ever hear from Kevin McCarthy or Nancy Pelosi?  They might also encourage IRS to provide guidance for their constituents.

A Checklist for Approval of Stipulated Decisions

We welcome back Commenter in Chief Bob Kamman who has been looking at Tax Court orders returning (bouncing) decision documents to the parties. Today, Bob looks at orders from eight days in November.  I will follow up in the coming days with a more detailed discussion of some of the orders.  You will be struck by how many mistakes the parties make in submitting decision documents.  Because these documents are generally prepared by Chief Counsel attorneys and because so many taxpayers are pro se, the post suggests additional training is needed for the Chief Counsel attorneys.

This post addresses orders regarding stipulated decisions, but we want to note that this morning the Tax Court has already begun issuing what will be a deluge of orders dismissing the approximately 400 cases being held in abeyance pending the outcome in the Hallmark case decided yesterday.  A team will be carefully reviewing each order and taking steps to protect the interest of petitioners with viable equitable tolling arguments.  Keith

You have avoided the hazards of further litigation by agreeing to a settlement with IRS in a Tax Court case. Now comes the final step of what should be easy but seems difficult: getting the stipulated decision past the eagle eyes of the judge who must sign it. Have rejections of these become more frequent this year? Has the quality of Chief Counsel paperwork diminished? Does this have something to do with the Tax Court changing the top line on its orders from 12-point Times New Roman to 20-point Gothic-style Archive Black Title, similar to the mastheads of the Washington Post and New York Times?

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My guess is that the judges have a checklist, but Chief Counsel does not. Petitioners, represented or not, can assist the Court by learning from the mistakes of others. The following are from orders issued in the eight business days between November 14 and November 23, 2022. Petitioner surname and docket number are shown. All of them order that “the Proposed Stipulated Decision is hereby deemed stricken from the Court’s record in this case.” Unless otherwise indicated, the order came from Chief Judge Kerrigan.

Gaddie, Docket No. 12604-22: On November 21, 2022, the parties filed a Proposed Stipulated Decision for the Court’s consideration. However the deficiency proposed therein for the 2018 taxable year, $5,173.00, is more than the deficiency determined for that year in the Notice of Deficiency, $3,449.00. Respondent did not assert an increased deficiency in the Answer and nothing below the line in the Proposed Stipulated Decision accounts for the increase. Accordingly, the Court is unable to process the parties’ Proposed Stipulated Decision.

Shoemaker, 1793-22: On November 22, 2022, the Court received from the parties in the above docketed matter a Proposed Stipulated Decision resolving this litigation. That decision was premised on a Settlement Stipulation filed the same date purportedly establishing an overpayment for the underlying 2020 taxable year. However, review shows that the Settlement Stipulation fails to attach the Statement of Account referenced therein reflecting such overpayment. (Similarly, Dudeck in 29676-21S, noting that this is Form 3623; and Lockwood, 2379-22S, both Judge Leyden. )

Sletten, 29431-21 (Judge Copeland): On November 9, 2022, the parties filed with the Court a Proposed Stipulated Decision (Index No. 9). Upon review of the Proposed Stipulated Decision, it was discovered that there was an incorrect docket number listed on the signature page. On November 18, 2022, the parties filed with the Court a corrected Proposed Stipulated Decision (Index No. 10).

Henderson, 35625-21S (Judge Landy): This case is scheduled for trial at the session of the Court to commence at Dallas, Texas on December 5, 2022. On November 16, 2022, the parties filed a Proposed Stipulated Decision (Doc. 11) which contained extraneous documents. The Court is therefore unable to process the parties’ Proposed Stipulated Decision.

Ordonez-Haggard, 1088-22S (Judge Choi): On November 18, 2022, the parties filed a Proposed Stipulated Decision document (index # 7). Upon review it was seen that on in [sic] the second paragraph indicating there is a penalty due from petitioner, the taxable year listed is 2018 instead of the taxable year at issue, 2019. Therefore, the Proposed Stipulated Decision document is erroneous, and we will strike it and instruct the parties to file a corrected one.

Kostelac, 9711-15 (Judge Paris): On October 28, 2022, docket entry 82, the parties filed a Proposed Stipulated Decision. The document had several inconsistencies, making the Stipulated Decision incorrect. Therefore, the Court will strike this document. On November 16, 2022, docket entry 83, the parties again filed a Stipulated Decision. This decision document appears to be correct, and the Court will accept and enter this Decision. On November 18, 2022, docket entry 84, due to an inadvertent clerical, the Court issued an Order to strike the Proposed Stipulated Decision document, filed October 28, 2022, docket entry 83. The Order which was intended for the case at Docket No. 9710-15, but instead was inadvertently filed in this Docket No., 9711-15. Therefore, the Court will strike the November 18, 2022, Order from the Court’s record for the case at Docket No. 9711-15.

Strickland, 19121-21S (Judge Landy): On November 18, 2022, the parties filed a Proposed Stipulated Decision (Doc. 17) which did not address the accuracy-related penalty pursuant to I.R.C. § 6662(a). The Court is therefore unable to process the parties’ Proposed Stipulated Decision.

Niedermayer,36207-21S (Judge Leyden): On November 18, 2022, the parties filed a Proposed Stipulated Decision. Upon review, it appears that the parties attached both the decision and the settlement stipulation in one document. Thus, it is an improper filing because the Settlement Stipulation and the Proposed Stipulated Decision shall be filed separately.

Rios, 8775-22S (Judge Landy): This case is calendared for trial at the Court’s Miami, Florida Trial Session, scheduled to commence on February 27, 2023. On November 10, 2022, the parties filed a Proposed Stipulated Decision (Doc. 8) which does not address the addition to tax pursuant to I.R.C. § 6651(a)(3). The Court is therefore unable to process the parties’ Proposed Stipulated Decision.

Yoozbashizadeh, 25837-21S (Judge Choi): This case was calendared for trial at the Court’s Los Angeles, California trial session, which was scheduled to begin November 14, 2022. On November 14, 2022, this case was called. There was no appearance by nor anyone on behalf of petitioner. Respondent’s Counsel appeared and was heard. At that time respondent informed the Court that on November 10, 2022, a Proposed Stipulated Decision (index #14) had been electronically filed with the Court. The Court then informed respondent that petitioner’s signature was typed and that an original signature was needed. Respondent agreed, therefore the Proposed Stipulated Decision filed by the parties on November 10, 2022, (index #14) is erroneous and we will strike it.

Stuhlman, 6504-20S (Judge Nega): This case was calendared for trial at the session of the Court conducted in person on Tuesday, September 6, 2022, in Fresno, California. On July 10, 2020, petitioner filed the petition commencing this case. In that petition, petitioner requested that the Court proceed with this case under the Court’s small tax case procedures. On November 16, 2022, the parties filed a Proposed Stipulated Decision. The caption of that decision reflects the correct docket number associated with this case but failed to include the “S” designation. (Similarly, Burke, 31804-21S, Judge Leyden.)

McBride, 34784-21S (Judge Copeland): On August 31, 2022, the parties filed with the Court a Proposed Stipulated Decision (Index No. 10). Upon the Court’s review, an error was noticed. The Proposed Stipulated Decision stated that there was no penalty for taxable year 2018 under I.R.C. Section 6651(a)(2) and should have stated that there was no penalty for taxable year 2018 under I.R.C. Section 6651(a)(1). On November 16, 2022, the parties filed with the Court a corrected Proposed Stipulated Decision (Index No. 13).

Martin,7427-22: By Order served August 26, 2022, the Court directed petitioner to pay the Court’s $60.00 filing fee on or before September 23, 2022. To date, the Court’s filing fee in this case remains unpaid. Upon due consideration and for cause, it is ORDERED that the parties’ Proposed Stipulated Decision, filed August 25, 2022, is hereby deemed stricken from the Court’s record in this case.

Loper, 2492-22: On November 16, 2022, the parties filed a Joint Proposed Stipulated Decision. Upon review of the proposed decision, the Court notes that petitioners signed the proposed decision using a cursive font. The Court does not accept for electronic filing a stipulated decision that contains a stylized signature such as one using a cursive font. See Rules 23(a)(3); Frequently Asked Questions About DAWSON.

Leo, 32671-21S (Judge Landy): On October 26, 2022, the parties filed a settlement stipulation and proposed stipulated decision at Doc. 8 and 9. Upon review of the settlement stipulation and proposed stipulated decision, the Court was concerned whether the notice of deficiency (notice) for the taxable year at issue underlying this proceeding was valid. The settlement stipulation suggested that the deficiency was paid prior to the issuance of the notice. By Order served October 27, 2022, the Court directed respondent to file either: (1) a report addressing and establishing the validity of the notice of deficiency for 2019, or (2) an appropriate jurisdictional motion. Respondent filed a response on November 9, 2022, attaching a complete copy of the notice. On November 14, 2022, respondent filed a Motion to Dismiss for Lack of Jurisdiction on the ground that the deficiency was paid prior to the issuance of the notice. Respondent’s motion stated that petitioners do not object to the Court granting this motion, and petitioners confirmed this statement on November 14 and 17, 2022.

Deverter, 8675-22: On November 10, 2022, the parties filed a proposed stipulated decision for the Court’s consideration. A review of that document discloses that it does not address a penalty under I.R.C. section 6662(a) that is set forth in the notice of deficiency on which this case is based and includes additions to tax under I.R.C. sections 6651(a)(1) and (a)(2) that do not appear to have been set forth in the notice of deficiency.

Wong, 20602-21 (Judge Foley): Upon review of the record, there are several typographical errors on the Proposed Stipulated Decision, filed November 10, 2022. Further, discrepancies exist between the Stipulation of Settlement, filed November 10, 2022, and the Proposed Stipulated Decision.

Conrad, 17750-21: On November 10, 2022, the Court received from the parties in the above docketed matter a Proposed Stipulated Decision purporting to resolve this litigation. However, review reveals multiple shortcomings. First, there is a typographical error in one of the references to the 2018 taxable year. Second, the decision appears to deal with a penalty under section 6662(b)(1) of the Internal Revenue Code, whereas the underlying notice of deficiency involves section 6662(b)(2), I.R.C. Third, the signature block does not reflect the current address of record for petitioner.

Brevil, 29919-22: On November 3, 2022, the parties filed for the Court’s consideration a proposed stipulated decision. By Order served November 7, 2022, the Court removed the small tax case designation and amended the docket number by deleting the “S”. On November 10, 2022, the parties filed a revised proposed stipulated decision.

Gallegos, 1177-22S: On November 15, 2022, the parties electronically filed a Joint Proposed Stipulated Decision and a Joint Settlement Stipulation. Upon review of the proposed stipulated decision, the Court notes that the overpayment amount is incorrect.

Ritchings, 4261-22S: On November 9, 2022, the parties filed a Proposed Stipulated Decision (Doc. 15) which states a deficiency for taxable year 2018, not 2019, and the decision does not address the accuracy-related penalty, pursuant to I.R.C. § 6662.

Licorish, 3524-22S: On November 10, 2022, the parties filed a Settlement Stipulation and a revised Proposed Stipulated Decision. However, upon review of the former, the Court notes that the Settlement Stipulation appears to be a duplicate of the Settlement Stipulation filed October 11, 2022, at Docket Index No. 5. Upon review of the latter, the Court notes that the proposed decision document references an I.R.C. section 6662(a) penalty. Conversely, the underlying Notice of Deficiency upon which this case is based does not. Moreover, the Court notes that the proposed decision document does not address petitioner’s liability, if any, for the I.R.C. section 6676 penalty determined in the Notice of Deficiency.

Vailes, 27998-21 (Judge Ashford): On November 10, 2022, the parties filed a Proposed Stipulated Decision. However, on the same day, the Court entered and served on the parties an Order and Decision that resolved all issues in this case (reflecting the same terms as the Proposed Stipulated Decision) and this case was closed.

And so forth. These errors should be caught by attorneys or paralegals before documents are filed. I assume that Tax Court judges have clerks or administrative staff to review filings for obvious mistakes, but it wastes judicial resources when rejections must be signed by a Presidential appointee whose confirmation by the Senate was not based on proofreading skills.

I looked at a similar period during 2021. There were about as many “bounced” stipulated decisions, but often the reasons were different. Then-Chief Judge Foley caught cases, for example, where the stipulation and the decision were the same document, rather than separate ones as required. Or the “S” designation was missing from captions. Or the Notice of Deficiency was not filed, or its contents varied from the stipulation.

In the military, troops are sometimes ordered to “stand down,” taking a break from regular duties to address major operational concerns. Perhaps it is time for Chief Counsel to order a “stand down” for all personnel to review document preparation after a Tax Court case has settled.

Congress Should Make 2022 Donations to Ukraine Relief Deductible in 2021

We welcome back commenter in chief Bob Kamman with a suggestion to Congress regarding how it could help further to provide relief for the individuals impacted by the crisis in Ukraine.  Keith

Ukraine President Volodymyr Zelensky addressed the United States Senate on March 5, 2022, by video connection.  President Zelensky is a law-school graduate, although he chose to follow what some consider the more respectable profession of acting until called to politics.  But he is probably not familiar with American tax law and specifically the enactment 17 years ago of the Indian Ocean Tsunami Relief Act.

That law allowed Americans to deduct on their 2004 federal income tax return, any contributions made in January 2005 for relief of tsunami victims.   The tsunami occurred on December 26, 2004, with an epicenter near Sumatra, Indonesia.

Generally, retroactive legislation early in the following year has been more of a disaster than the one it is trying to ameliorate.  But come on, guys, as our President might say.  This is a war on a European country of more than 40 million people.  The refugee count is already in the millions. 

So, announce it now.  Donations made to qualified organizations by April 18 may be claimed on either a 2021 or 2022 return.  Yes, many people have already filed, but those with deeper pockets are more likely to file closer to the deadline or to request an extension.

The legislation doesn’t have to be passed tomorrow.  Just introduce it with enough bipartisan sponsors that the effective date is certain. 

And maybe this would be more symbolic than productive in net donations for the year.  But when was a better time for symbolism?

There are many charities that qualify for a tax deduction under Sec. 501(c)(3) The Philadelphia Inquirer put together a list of some organizations last week.  I am sure there are others, and publicity about a new option on year of deduction will spur efforts to put out the word on them.

Memoirs of the Last Century: Some Notes on Economic Reality and Section 7602(e)

We welcome back Bob Kamman who writes today about the past and how it matters in having a full understanding of the current debate forbidding the use of financial status or economic reality examination techniques.  Like Bob, I remember when the IRS rolled out economic audits.  His remembrances and insights help inform the current debate.

Les and I will be working with the Pittsburgh Tax Review to create a special edition on RRA 98 for its 25th birthday.  Maybe this will become one of the resources Bob seeks for Caleb’s students.  We welcome stories and comments from others who remember the lead up to that memorable tax procedure legislation.  Keith

In two recent posts available here and here, Professor Caleb Smith has discussed the current status and future implications of Code Section 7602(e), which forbids the use of “financial status or economic reality examination techniques” unless there is a “reasonable indication that there is a likelihood of unreported income.” 

Whatever that means.

The prohibition was part of the IRS Restructuring and Reform Act of 1998, and therefore has been law during all of Professor Smith’s professional career.  I am sure he knows much of the history behind RRA98, but are there resources for explaining its meaning to his students?

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Allow me to reminisce about the events of 27 years ago, because a page of history may be worth a volume of statutory analysis.  I was there.  In fact, I was among the first to see it coming.

The first mention I encountered of “lifestyle audits” was at a regional gathering of 400 tax practitioners in Ogden, Utah in September, 1994.  We had been invited to seminars and a rare tour of the Service Center by former IRS Assistant Commissioner Robert Terry, who had stepped down from his position in Washington to become Director of that facility in his home state. Commissioner Margaret Milner Richardson was a keynote speaker.  (I asked her when IRS would implement the long-promised program of providing a PTIN so that preparers would not have to enter their SSN on every return they prepared.  She had no idea what I was talking about.)

The details on “Economic Reality” audits, meanwhile, came from John Monaco, the IRS Assistant Commissioner for Examination.  I wrote about it in an article for the November 1994 edition of “Tax Savings Report.”  From that article:

Every IRS auditor is going back to school for a week this Fall to learn a radical new approach to the job.

For years, IRS auditors have focused on paper and numbers – tax returns and the entries on them.  Now, auditors are being told to take a closer look at individual taxpayers using the increased capacity of computer matching.  When they see the whole picture, they ask, “What’s wrong with it?”

In an Economic Reality audit, inquiring minds at the IRS want to know:

– Your net worth.  Has it grown over a period of years due to hidden income?

– Your lifestyle, and especially your personal living expenses.  Do you indulge champagne tastes, when your Form 1040 shows a beer budget?

– How you make a living.  The IRS will pay attention to typical ways it has caught others in the same business who understate income or exaggerate deductions.

Auditors will go into an Economic Reality examination armed with data assembled through improved computer technology. [They] will already know whether you live in an affluent neighborhood and how much your car is worth.

Will the public approve of this increased interest by the federal government in private financial affairs?  Privacy concerns have to be addressed, acknowledged [Monaco], in a recent presentation to tax preparers on Economic Reality.

“You don’t get into these questions until there is an indication of unreported cash.  Most of the public demands that we do it,” Monaco said. “What else do you do when you see someone buy a $100,000 boat, and support a family of four in a wealthy neighborhood, on a reported income of $20,000 for each of the last three years?”

In IRS field tests, Monaco said, Economic Reality has succeeded.  When confronted with questions concerning their lifestyle and net worth, taxpayers readily signed agreements to pay more tax.  “Our problem is deciding how many to refer for criminal investigation, and how many stay as civil matters only,” Monaco said.

And one local audit manager pointed out that Economic Reality can occasionally benefit a taxpayer, too.  One planned audit was canceled when a three-year review of a computer business showed that, after early profits from a software product, it became obsolete, and the taxpayer lived on savings and pursued unprofitable ventures.

To refine safeguards against auditors being too aggressive, the IRS has also scheduled them for follow-up training sessions, of two to four hours, every two weeks after the basic Economic Reality boot camp.

“If we’re not careful how we do it,” Monaco said, “we won’t be doing it for very long.  That’s when Congress will add provisions to the Taxpayer Bill of Rights.”

Four years before RRA98, he was certainly prophetic.

The newsletter editor Ellen M. Katz wanted to make sure that I had this scoop right, so she did some fact checking herself.

We asked IRS spokesman Wilson Fadely to describe the new “Economic Reality” audit program.  His reply:

“An auditor will no longer just say ‘let me see your canceled checks or cash journal.’ We’ll be looking at it a different way, by examining whether the tax return fits the economic situation.  Now, we’ll ask questions, like: ‘Are there very large interest payments or large mortgage payments and not much income?  If so, something is not right.  A lot of agents have been doing this for years.  But now the practice will be institutionalized and put in the training program for auditors to follow.”

In June 1995, I followed up with a newsletter article after trying to get more information on the program.  The IRS was beginning to sense the public was uncomfortable.  So I wrote:

When IRS Commissioner Margaret Milner Richardson was asked recently about the new audit methods that investigate taxpayer lifestyles, she shrugged off the major policy change as nothing innovative. 

“It’s the same technique we used on Al Capone” she said in a PBS interview.  So now, with the help of the auditing technique called “Economic Reality,” American citizens in the 1990s can be treated like Chicago mobsters of the 1930s.

But today, it only takes a few strokes of a computer keyboard for IRS to yield vast amounts of personal financial data on a targeted taxpayer.  “The IRS ‘culture’ as to how audits are done is changing and the ‘culture’ of our clients is also changing,” according to the training material the IRS uses to teach auditors about the new program.  The materials were released by the tax agency under a Freedom of Information Act request, but they were not obtained easily. 

In September, a FOIA request was submitted for Tax Savings Report.  Such requests are supposed to be filled in thirty days, and often are.  Five months later, after repeated letters and phone calls, IRS finally sent part of the materials.

IRS auditors learning how to conduct “Economic Reality” audits are told that “to be effective, we need to adapt” to the changing culture.  They are told to discuss various topics, including the following subjects, but the training materials do not elaborate on what should be said:

– Diversity

– Respect for Government Authority

– Influx of Immigrants

– Emphasis on Expeditious Closing (how quickly an audit is completed)

– Aggressive vs. Kinder/Gentler (approach toward taxpayers).

Auditors learn that Economic Reality “finds meaning through a process of gathering information about a taxpayer,” and “is built upon a universe of financial information about the taxpayer and their lifestyle.”  In a later session, auditors learn “to develop a picture, or profile of the taxpayer’s lifestyle and its cost.  The process is designed to compare lifestyle cost with available resources and to alert you to inconsistencies.”

Shortly after my first article was published in November 1994, the Washington Post picked up on the story.  Noted Washington Post financial writer Albert Crenshaw, in a story syndicated to other newspapers, wrote:

After years of checking W-2s and 1099s and making sure that taxpayers have receipts for their deductions, the Internal Revenue Service is adding a new weapon to its audit arsenal.  It’s called “economic reality,” and it means that IRS agents are going to start looking beyond the numbers of the return to make sure the report jibes with the taxpayer’s assets and lifestyle.” …. The agency already has begun training auditors in “economic reality” techniques, and agents will be expected to implement them as soon as they complete the course. 

IRS officials say the training includes a heavy emphasis on privacy and ethics, designed to make sure taxpayers’ rights are protected.  Nonetheless, some experts and a number of the agency’s regular critics are voicing concern.

Crenshaw’s article finished with a quote.  “This represents a fundamental shift in the philosophy behind audits,” said Pete Sepp of the National Taxpayers Union.  NTU was the publisher of the Tax Savings Report newsletter.

Later that month, financial columnist Kathy Kristof of the Los Angeles Times also reported the latest news about tax audits:

…[IRS] just launched an auditing initiative called economic reality, an expanded and improved method of nabbing people who understate their incomes.

…When these folks get audited, they’ll also find that the IRS is not focusing completely on their tax returns.  Through the wonders of computer matching, IRS agents can find out if you own a boat, a plane or a luxury car.  They can determine the size of your mortgage.  And they can subpoena your bank records to find out just how much money is going in and out of your accounts, says Bob Kamman, a Phoenix tax accountant.

(Journalists sometimes have a problem with identifying me as a lawyer.)

It wasn’t until July 28, 1996 that the New York Times discovered the issue. The story by Barbara Whitaker led with an anecdote:

When an Internal Revenue Service agent said she wanted to audit Dave and Lucille Miller’s 1993 and 1994 tax returns, the couple thought it sounded like a simple thing.

“She called my wife, asked her a few questions and said, ‘Well, you seem to be pretty well in the know of what’s going on,’ ” said Mr. Miller, an auto salvage dealer in Clearwater, Minn. ” ‘Maybe we’ll just sit down at the kitchen table and hash this out.’ “

They hashed it out for a month and never once made it into the kitchen. The meetings, at Mr. Miller’s salvage yard and at his accountant’s office, were a free‑for‑all of questions about expenditures on everything from the most mundane items, like groceries and clothing, to past vacations.

“Can you tell me just off the top of your head how many groceries you bought two years ago?” Mr. Miller asked rhetorically. “How many vacations did you take? Well, what do you call a vacation? If you went away for the weekend?”

At the heart of Mr. Miller’s frustration is what the I.R.S. calls its “financial status auditing technique,” more commonly known as an “economic reality” or “life style” audit. The principle is simple. Rather than just examine a tax return to see that all the items add up, as in a regular audit, revenue agents look at whether the figures mesh with how the person lives. If the taxpayer has a new Mercedes in the garage and declares only $20,000 in income, the I.R.S. would likely raise an eyebrow.

…Anita L. Horn, a spokeswoman for the American Institute of Certified Public Accountants, said her organization had received more than 100 complaints about life‑style audits since September, when the group started keeping track. She said there were complaints about the nature of the questions and about agent demands to interview taxpayers rather than deal with their representatives. The group said the technique often led to drawn‑out audits.

Looking over some of the complaints, Ms. Horn cited a case in which an agent asked what a woman kept in her bedroom drawers. Another taxpayer was asked how much cash was buried in the backyard, and a California couple had to meet with an agent in their home when the woman was on bed rest, eight months pregnant with triplets.

As Professor Smith points out, “financial status or economic reality” audits are not defined by Code Section 7602(e).  Students of tax history, though, should realize that both Congress and IRS knew in 1998 exactly what they were talking about.

The Law Does Not Forbid a Helpful Internal Revenue Policy

Commenter in chief Bob Kamman returns with a colorful story following up on yesterday’s topic of jeopardy assessment.

The Fumo case, of course, is small potatoes.  If you want a real jeopardy assessment involving a real politician, you have to go back to March 13, 1925, when Internal Revenue assessed James Couzens, United States Senator from Michigan, $10.9 million in tax based on his sale in 1919 of Ford Motor Company stock to Henry and Edsel Ford.  Until 1915, Couzens had been vice president and treasurer of Ford Motor.

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The assessment was announced on the Senate floor by Couzens himself, who accused Treasury Secretary Andrew Mellon of initiating the audit to discipline Couzens for his investigation of the Bureau of Internal Revenue.  Couzens was a former mayor of Detroit who had been appointed to a vacant Senate seat in 1922 and then elected for a full term, starting nine days before the jeopardy assessment. 

Couzens (pronounced “cousins”) was one of several minority shareholders in Ford who complained that Ford was not paying dividends even though its profits could support them.  A state court agreed, so the Ford family agreed to buy them out.  The shareholders were reluctant to sell without knowing how much they would owe in income taxes, which were at a post-war high of 73% (with no break for capital gains).

And the shareholders did not know their cost basis because it depended on the value of the stock on March 1, 1913, when the income tax went into effect.  Ford was not publicly traded.  At the time, Internal Revenue would audit a company to determine this amount.  Henry Ford asked for an audit, and the Commissioner authorized it.

That “courtesy audit” placed the value at  $9,489 per share.  Couzens, who sold 2,180 shares for $29.3 million, used this audit result when he filed his 1919 return.  But then, under a later Commissioner, his return was audited under a new Commissioner.  (His return had also been audited in 1920, but for a different issue.)  And this time, the valuation was reduced to $2,634 per share.  A jeopardy assessment was required because the statute of limitations was about to expire on March 15, 1925, five years after the due date of the original return.  

Couzens and the other shareholders negotiated in secret with Internal Revenue lawyers until their lawsuit was filed in December 1925.  When it went to trial in January 1927 before the Federal Board of Tax Appeals (predecessor to the Tax Court), it was the largest income tax case in U.S. history. Government lawyers had reduced the claim by $1.5 million, allowing a value of  $3,548 per share, so only $9.4 million was at stake.

The petitioners argued estoppel required use of the higher valuation, but the BTA disagreed, and explained in terms that might be useful today:

The evidence shows that at the time of the valuation there was in the Bureau of Internal Revenue a policy of being helpful to taxpayers in adjusting them to the new tax law, but that this policy interfered with the administration of the assessment and collection of taxes and was soon restricted. . . .It should not be understood that the law forbids a helpful policy.  There is a public interest in the cooperation by the Bureau of Internal Revenue, and it should be given as freely as efficiency and good administration permit.  But it cannot go so far as to fix a responsibility beyond that contemplated by the statute, and it would be unjustified to stifle a spirit of helpfulness with a caution against binding and irrevocable action.

In May 1928, the three participating judges of the Board decided  the stock was worth $10,000 per share.  Couzens owed nothing, and could collect a refund of the $92,000 in taxes he had paid in 1924, having filed a timely claim, because of the earlier audit on an unrelated issue.  

Two other Ford shareholders involved in the case were the estates of John and Horace Dodge, also well known in the automobile industry. Another of the shareholders, John W. Anderson, was represented by E. Barrett Prettyman, who later became an Appeals Court judge and had a D.C. courthouse named after him.

Things That Make You Say Hmmm

We welcome back guest blogger and commenter in chief, Bob Kamman.  As usual, Bob has found things that the rest of us overlook. 

In addition to the interesting twists on the way things work that Bob discusses below, I received a message from Carl Smith who, though retired, still takes some interest in what is happening in the world of tax procedure.  Carl provides some data on the Tax Court that might be of interest to court watchers.  After checking DAWSON, Carl sent the following message:

The last docket number for 2020 was 15,351.  Since the court doesn’t give out the first 100 docket numbers (i.e., the court starts at docket no. 101), that means filings in 2020 totaled 15,251, which is the lowest in two decades.  (The 1998 Act so froze the IRS that, according to Dubroff and Hellwig (Appendix B), only roughly 14,000 petitions were filed in 1999 and 15,000 petitions were filed in 2000.)  The last docket number in 2019 was 23,105, so filings in 2020 fell off about a third from 2019 to 2020.

As of right now, May 27, before the court’s Clerk’s Office opens, the last docket number is 8856-21 — only slightly ahead of the pace for 2020, though I would note that the first 10 weeks of 2020 were not impacted by the virus at all.

Oddly, the Tax Court is still very backlogged in serving petitions on the IRS.  Docket 8856-21 was filed on 3/15, but says it was served 5/27 — i.e., it will be later today.  That time gap of two and a half months to serve the petition is typical right now. Looking to the last few dockets of 2019, it typically took only 14 days to serve a petition filed on Dec. 31, 2019.

Keith

I thought I knew at least the basics of tax procedure, but lately I am starting to wonder if they changed the rules while I was slipping into old age.

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For example, there is the statute of limitations for refunds of individual income tax.  From a Notice CP81 mailed from IRS in Austin and dated May 24, 2021: “We haven’t received your tax return for the year shown above.  The statue [yes, that’s what it says, not statute] of limitations for claiming a refund for the tax year shown above is set to expire.  As a result, you are at risk of losing the right to a potential refund of your credits and/or payments shown above.”

The credit on the account is $145. The tax year is 2017.

No, the taxpayer does not live in Texas or other disaster area.  I should say, did not live there.  He died in July 2020. 

Of course it’s possible that the credit came from a timely-filed extension request in April 2018.  No one alive now, has any records of what he did back then.  We do know that IRS paid him refunds on 2018 and 2019 returns, without any reminders or requests about 2017.  Requesting an account transcript for a decedent would take some time, to find out. 

And another thing.  I thought I knew the rules about when IRS would pay interest on refunds, and when it would not.

Then another tax practitioner reported that a Form 1040 that was e-filed on April 15 resulted in a refund deposited on April 23, with several dollars of interest added.  The refund was in the $10,000 range.  I had my doubts about this, until something similar happened with one of my clients.

They had filed their return in March, but claimed a “Recovery Rebate Credit” for a payment they had not received.  IRS is verifying all of these, so the refund was not approved and deposited to their bank account until April 28.  It included $1.31 in interest. 

I had always thought that IRS has 45 days from the date the return is due, or when received if later, to pay the refund without interest.  The IRS website states, “We have administrative time (typically 45 days) to issue your refund without paying interest on it.”

So I did some research, and this is what I found.  But I may not have gone far enough.

Code Section 7508A deals with disaster areas and allowed IRS to permit last year’s 3-month extension and this year’s 1-month extension.  It provides:

( c)        Special rules for overpayments
The rules of section 7508(b) shall apply for purposes of this section.

And Section 7508(b) says

(b)         Special rule for overpayments
(1)         In general
Subsection (a) shall not apply for purposes of determining the amount of interest on any overpayment of tax.
(2)         Special rules
If an individual is entitled to the benefits of subsection (a) with respect to any return and such return is timely filed (determined after the application of such subsection), subsections (b)(3) and (e) of section 6611 shall not apply.

So what are these two parts of Section 6611 that should be disregarded?

The second one mentioned, 6611(e) has the 45-day rule. So IRS can’t rely on that.

But the first one, 6611(b)(3), deals only with “late returns”. That still leaves Section 6611(b)(2), which gives IRS 30 days to issue a refund with no interest:

(b)         Period
Such interest shall be allowed and paid as follows: . . .
(2)         Refunds
In the case of a refund, from the date of the overpayment to a date (to be determined by the Secretary) preceding the date of the refund check by not more than 30 days, whether or not such refund check is accepted by the taxpayer after tender of such check to the taxpayer. 

So the 45-day rule is out, but shouldn’t the 30-day rule still be followed? At least, that’s the way I followed the trail.  But I could be wrong. I’m expecting a TIGTA or GAO report later this year, telling me why IRS did it right.  But I also expect some members of Congress to lament the interest expenditures.

Then there came along the repeal of the tax on ACA premium underpayments in 2020.  If taxpayers paid less for health insurance last year because they underestimated their income and received too much premium tax credit, they would have to make up the difference – until that requirement was repealed by the American Rescue Plan (ARP) in mid-March.  So now IRS has started issuing refunds to those who had already paid this tax. 

According to other practitioners, these refunds have included interest, even when paid before May 15.

IRS is about to start paying refunds to taxpayers who included unemployment compensation in income, before it was excluded for most returns by ARP.  Should these refunds include interest, even if paid within 45 days of April 15?  I suppose so.  These are, after all, not normal times.

Congress Enacts Law of Unintended Tax Consequences

We welcome back occasional guest blogger and frequent commenter, Bob Kamman.  Bob has a practice in Phoenix that provides both representation and return preparation.  Today, he comes to the rescue of the PT team that has struggled to produce content this past week due to other obligations and provides us with insights on some of the quirks created by the legislation designed to provide relief for taxpayers impacted by the pandemic.  Keith

As the latest Covid-relief legislation makes its way through the Congressional meat grinder, a couple of tax inequities continue to be overlooked. Maybe it’s not too late to correct them.

One is mostly of interest to college students and the low-income taxpayer clinics where they may seek help. The other might interest college professors considering a sabbatical year abroad.

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I) The Unemployment Trap

Many people who lost their jobs in 2020 qualified for federally-funded unemployment benefits that were more generous than those allowed by state programs. Recipients were paid $600 a week for up to 17 weeks, in addition to normal state benefits. Even college students with part-time jobs qualified, in many cases. It didn’t matter if they were under 24 years old, and still being claimed as dependents by their parents.

The $600 weekly checks ended on July 31, 2020, and would not resume until this year. Meanwhile, some people had continued eligibility for state benefits, and for other Covid-related compensation.

Enter the dreaded Kiddie Tax.

Since 1986, children with unearned income of more than a certain amount have been taxed on it at the same marginal rate as their parent(s). This prevented high-bracket adults from shifting investment income to their low-bracket kids. But back then, it only applied to children under age 14.

Congress eventually applied the law to older “children,” including full-time students up to age 23 who were not providing at least half of their support with their own earned income. Their earnings are taxed at the usual rates, but their unearned income is taxed at the higher parental rate. And unemployment is considered unearned income.

Tax practitioners this filing season are finding it not unusual for young unemployed college students to bring in Forms 1099-G showing five-figure amounts for unemployment compensation. If federal tax was withheld at all, it was mostly at a 10% rate. If $10,000 was received, $1,000 was withheld. But if the student must use the higher tax rate of, for example, 24%, the tax could approach $2,400 and the balance due IRS even after withholding, nearly $1,400.

If earned at a job and reported on a Form W-2, none of the $10,000 in wages would be taxed because of the $12,400 standard deduction.

Is this what Congress intended? Probably not.

Will it be fixed by pending legislation? Predictions are welcome in the Comments section below.

II. Welfare for Expatriates

If our unemployed students in the example above must pay IRS another $1,400 on their “unearned” unemployment compensation, what will the federal government do with it? Maybe, send it to one of their instructors.

Suppose you have a job offer from the Sorbonne to teach in Paris for a year at a salary of $180,000. Would it help, if the Treasury added another $1,400 tax-free? And that much for your spouse, also. That’s how the “Economic Impact Payments” have worked in the last two rounds.

They are based on AGI, after the exclusion for income earned abroad. That amount in 2021 is a maximum of $107,600. Then the $1,200 and $600 payments were not reduced unless this post-exclusion AGI exceeded $75,000 – or $150,000 on a joint return. All you must do to claim the exclusion is meet the “physical presence test:” stay overseas more than 330 days out of any 12-month period. (You also have to show that you have not kept your “tax home” in the United States, but for many academics those rules are not onerous.)

Paris is too expensive on $180,000 a year? Try Auckland. Cost of living in New Zealand is lower, and there is less virus around once they let you in.

Of course, educators are just a small minority of the Americans who benefit from this loophole. Half a million taxpayers claim the Section 911 exclusion each year, according to IRS estimates based on 2016 returns.

Are Covid disaster-relief payments for well-paid Americans living abroad what Congress intended? Probably not. A bipartisan group of 16 senators in early February sponsored a budget resolution amendment that promised to target stimulus checks to low- and middle-income families. It passed 99-1.

How simple would this be to fix, with a sentence that defines AGI as the amount before the foreign earned-income exclusion? Very.

Will that happen? Again, your predictions are welcome.