The Often Topsy-turvy World of EITC Litigation

In today’s guest post, Carl Smith discusses how the EITC can put the IRS in the unusual position of arguing that the taxpayer overstated her taxable income and was required to take deductions.

We have written a number of posts discussing the somewhat unusual fit of the EITC and tax procedure and tax administration, looking at for example the EITC’s special due diligence rules and the separate EITC civil penalty regime. The post and case raise some interesting issues and unanswered questions, including what role if any a preparer played in the taxpayer’s decision to pinpoint the income needed to maximize the EITC and whether incentives under the ACA to overstate income may lead the IRS to more aggressively pursue taxpayers who fail to claim eligible deductions. Les

Litigation over the earned income tax credit (EITC) is a perennial of low-income taxpayer clinics.  For those readers who were never clinicians, but who want to help pro se individuals showing up at Tax Court calendar calls, I thought it might be useful to discuss a recent bench opinion out of the Tax Court that illustrates how the EITC can reverse litigation roles when the IRS tries to disallow the credit — with the IRS being in the unusual position of denying the taxpayer’s receipt of reported gross income and occasionally even asserting the taxpayer’s entitlement to unclaimed deductions.  This income-related litigation is probably the second-most-common issue litigated in EITC cases — with the top issue being where each child who the taxpayer claims as a “qualifying child” lived for purposes of increasing the amount of credit.  This post will only discuss the income issue that was involved in the bench opinion, Kalokoh v. Commissioner, Docket No. 29859-13 (order dated March 18, 2015). Pro bono lawyers need to be aware of why the IRS takes this topsy-turvy position in order to effectively represent EITC taxpayers.

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There are four kinds of taxpayers who can claim the EITC — ones with no dependents, ones with one qualifying child, ones with two qualifying children, and ones with three qualifying children.  The more qualifying children a taxpayer has, the bigger the potential EITC.  There are three filing statuses that can claim the EITC:  single, head of household, and married filing jointly.  Married filing separately taxpayers cannot claim the EITC.  Section 32(d).  Single and head of household filers with the same “earned income” get the same amount of EITC.  So, basically, there are two types of filers who can get the credit and four amounts of credits (varying on how many qualifying children, if any, the taxpayer has).  That means that the EITC tables have eight columns of figures for EITCs at various levels of “earned income”.

A review of the EITC tables in the Form 1040 instructions for 2014 (at pages 61-69) shows that for each of these eight possibilities, the EITC amount rises as earned income rises, and then for a several thousand dollar range of earned income, the EITC stops rising.  It reaches a maximum and stays there.  Finally, once the range is exceeded, the EITC falls as earned income rises further until the EITC finally disappears.  The area of earned income where the maximum EITC is received looks like a plateau on a graph.  Using a different metaphor, clinicians often call this plateau the “sweet spot.”

As an example of the amounts we are talking about, for a taxpayer who is head of household (as, I assume that Ms. Kalokoh was, though the bench opinion does not say) and looking at the EITC tables for 2012 (the taxable year involved in Kalokoh), the credit keeps rising as earned income rises, then reaches the following maximum amounts in the following earned income ranges:  one child (maximum EITC of $3,169 at any earned income of between $9,300 and $17,100), two children (maximum EITC of $5,236 at any earned income of between $13,050 and $17,100), and three children (maximum EITC of $5,891 at any earned income of between $13,050 and $17,010).  (Note that the maximum EITCs are the same for married filing jointly filers, but the sweet spots of earned income are at higher levels.)  It beats me what the policy reason is for the EITC to start falling after $17,100 of earned income, no matter how many children one has.  Don’t extra children add extra living expenses?  And it also beats me what the policy reason is for the sweet spot to begin and end at the same amounts of earned income whether one has two qualifying children or three.  Part of this may have to do with Congressional compromises when the third child credit was added during the recent recession.  For our head of household filer in 2012, the credits would gradually descend from the sweet spot amounts to reach zero at earned income figures as follows:  no children ($13,980), one child ($36,920), two children ($41,950), and three children ($45,060).

The IRS doesn’t challenge reported income that is supported by third-party Forms W-2 and 1099.  However, there are a lot of people in the low-income community who get paid in cash (by multiple customers) for whom there will never be a Form W-2 or 1099 issued.   In my experience, the two most common professions in low-income communities where there is no third-party form generated supporting income are daycare or “babysitting” services and hair cutting services.  Although to cut hair, one has to have a license in many states, having such a license doesn’t prove that one actually engaged in the activity or how much money was made in the activity.  Unfortunately, very few low-income taxpayers in these professions write down how much they receive each day in cash income and keep receipts as to their expenses.

The IRS is aware that there are totally unscrupulous people who never earned any income or got Forms 1099 and who claim the EITC from working as babysitters or hair cutters.  These people tend to file returns with a Schedule C on which they report the gross income (often in a round number) and a few expenses (all fictitious).  Any EITC that is generated offsets the self-employment taxes payable thereon.  For income tax purposes, the claimed dependents, a personal exemption, and the standard deduction brings taxable income down to zero, so no income tax is due to be offset against the EITC.  (We won’t discuss the refundable additional child tax credit in this post, but, for children under 17, that often is also generated by these returns, and that credit’s amount also depends on the amount of earned income.) Unscrupulous preparers in the low-income taxpayer community know to prepare such returns showing income in the sweet spot for the EITC — to generate the maximum check from the federal government.  Though these returns are prepared by commercial preparers, the preparers hide their identities by writing “self-prepared” in the area for identifying the commercial preparer.

Not all babysitters and haircutters are phony, though.  Often, they go to an unscrupulous preparer and admit that they did not keep good income records and have no Forms 1099.  So, the preparer (knowing the sweet spots) may say something like:  “Well, would you say you earned about $300 a week for 50 weeks?”  That works out to $15,000 of gross income, which will put the taxpayer in the sweet spot even after having to subtract $1,060 (which is half the self-employment tax thereon required to be subtracted to reach “earned income”).  The taxpayer will honestly respond, “That sounds about right.”  So, the return will be prepared seeking the maximum EITC refund possible.

It is impossible for the IRS to know in advance whether a person filing an EITC sweet spot return who got no Forms 1099 is a fraudster or a person really entitled to roughly that amount of the EITC reported.

In my experience, about 90% of the people who came to me in my clinic with a notice of deficiency in which they were denied the EITC based on an alleged lack of income were people whose returns were filed seeking the sweet spot amount of EITC.  So, I assume that IRS computers are programmed to do this funny computer matching looking for the absence of Forms 1099 or W-2 to support an EITC claimed in the sweet spot.  Since a fraudster is unlikely to come to my clinic to complain when caught, I generally believed the taxpayer who came to my clinic that he or she had worked in the profession shown on the Schedule C, though I tried harder to pin down estimated income figures.

In EITC litigation where the taxpayer has children and is at or below the sweet spot, it is in the interest of the IRS to claim that the taxpayer earned less or, usually, no income or had additional unreported deductions.  I actually have not seen the IRS argue before for unreported deductions.  But, it probably does sometimes.  It certainly did so in the Kalokoh case.

In Kalokoh, the taxpayer claimed to have run a haircutting business in an area consisting of about half of the lowest floor of a three-story house she rented.  On her 2012 Schedule C, she reported gross income from the activity of $15,900 and took a deduction of $500 for “threads and gels.”  Thus, regardless of how many children she claimed (which the opinion does not indicate), her return put her in the sweet spot for getting the maximum EITC refund.  Lacking any Form 1099 to support the gross income, the IRS disallowed the EITC, in part claiming that she had no income in 2012.  The taxpayer and the IRS stipulated that she was entitled to an unspecified (in the opinion) number of dependency exemptions.  So, the sole issue in the case was what amount of net income, if any, she had earned from haircutting.  Bucking the usual IRS position, here, to get the taxpayer below the sweet spot, the IRS argued for reducing gross income and increasing unreported deductions.

As to the income that she reported, Judge Gustafson found that “[m]ost of her customers paid in cash, and she often spent the cash without first depositing it in the bank, so her bank deposits do not reflect that total revenue.”  Presumably, though, the fact that there were bank deposits generally corroborated that the taxpayer was in some income-earning activity in 2012.  The judge also wrote that he was “convinced by her testimony, her records, and her corroborating witness that she did conduct the business and earn the revenue.  Her records leave something to be desired, but they are not wildly out of keeping with the modest scale of this home-based business.”

It was smart of the pro se Ms. Kalokoh to bring a corroborating witness.

Unfortunately for Ms. Kalokoh, the IRS still got her knocked out of the sweet spot.  Prior to the trial, it stipulated with her that she had spent an additional $1,074 in 2012 to purchase hair — which amount she had not deducted on her return.  The IRS also stipulated with her the annual figures for rent ($20,400), water ($1,449), and gas ($1,523) paid by her for her house — a combined figure of $23,372 of expenses.  Notably, the judge did not question how she could afford to pay all these amounts based on a reported net income of only about $15,400.

After finding that her gross income was as reported, though, the judge held that she used one-sixth of the house exclusively for business purposes, so was entitled to (and required to) deduct one-sixth of $23,372 (i.e., $3,895) in computing her earned income.  The judge also held that she must deduct the additional $1,074 in expenses for purchasing hair.  This effectively reduced her earned income by about a third and reduced the EITC.  While it also reduced her self-employment income and self-employment tax, the reduction in self-employment tax would have been less than the reduction in the EITC that the IRS achieved.

So, bottom line, if a taxpayer at the calendar call presents a notice of deficiency to you that seeks to remove all income and disallow the EITC, be prepared to argue something you would never argue for a high-income taxpayer — that the taxpayer actually earned the reported income, even though no Form W-2 or 1099 shows it.

 

Who Won the Sanchez Case?

Today we welcome first time guest blogger Bob Nadler. Bob is the perfect guest for this post about an innocent spouse issue because he authors “A Practitioner’s Guide to Innocent Spouse Relief.”  The ABA Tax Section published second edition of his book last year.  He also co-wrote the chapter on innocent spouse issues in the 6th Edition of “Effectively Representing Your Client before the IRS.” For over a decade Bob has represented low income taxpayers as an attorney at the Legal Aid Society of Middle Tennessee and the Cumberlands. Before becoming a representative of low income taxpayers, Bob worked for the Office of Chief Counsel, IRS for over 30 years in its Nashville office and was a valued colleague for me there as he is now as a clinician. Keith 

In sports, sometimes a team loses an important game and later is awarded the victory because the other team was disqualified. That is what may happen in the recently decided case,  Sanchez v. Comm.  In Sanchez, the taxpayer sought innocent spouse relief in the Tax Court and lost her case because the Court held no joint return was filed.  But the underlying assessment of a joint tax may have been erroneous.  If the assessment is found to be invalid the taxpayer will probably have no tax liability.

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Background 

The taxpayer and her spouse were married in 1988 and separated in November 2006. The taxpayer filed for divorce in 2007 and it became final in 2011.

For all years before 2006, the taxpayer and taxpayer’s husband (hereafter the TPH) filed joint returns. They relied upon an accountant, who communicated solely with the TPH.  Although she did not review the returns, the taxpayer did sign the prior year returns.

The TPH separately filed his 2006 income tax return in October 2007 and claimed a filing status of single. He did not claim the taxpayer as a dependent.  The taxpayer did not file an income tax return for 2006.  The taxpayer first became aware of the TPH’s return after it was selected for examination.

The Court noted in the opinion that the record was unclear if the taxpayer had a duty to file a separate 2006 income tax return.

After the IRS proposed a deficiency, the examiner informed the taxpayer and the TPH that it would benefit them if they filed a joint return. The benefit was the tax due would be less.  The taxpayer and the TPH signed a Form 4549 agreeing to the proposed adjustments to tax.   One of the adjustments involved a change in filing status from single to joint filing status.  In agreeing to the adjustments, the taxpayer agreed to joint and several liability.   The IRS accepted the agreement and assessed the tax as a joint tax.

On May 16, 2011, the taxpayer filed a claim for innocent spouse relief on Form 8857.

The IRS disallowed the claim and the taxpayer filed a petition in Tax Court.

The Court held that no joint return was filed.

A Joint Return is an Element of section 6015.

As the Court noted, section 6013(a) provides that a married couple may elect to file a joint return.    If a joint return is filed, both spouses are jointly and severally liable for the tax.  If a joint return has been filed, a taxpayer can file a claim for relief from joint and several liability.  A claim for innocent spouse relief request is normally initiated by filing a Form 8857 with the IRS.

Section 6015 provides for three types of innocent spouse relief.   All three subsections require that a joint return must have been filed.  See IRC sections 6015(b), (c) and (f). If no joint return has been filed, the taxpayer is not jointly and severally liable and the Court does not acquire jurisdiction to consider a claim for innocent spouse relief.

Was a Joint Return Filed in the Sanchez Case?

The threshold issue in the Sanchez case was whether a joint return was filed by the taxpayer and her spouse.    Whether married taxpayers file a joint income tax return is a question of fact.   As the Court noted in Estate of Campell, “Married taxpayers must intend to file a joint return.”  Many fact scenarios can arise.  For example, sometimes one spouse has not signed the return.  Another situation, which was presented in this case, is where one spouse files separately and then later the second spouse agrees to file a joint return.   The right to make a joint return after one spouse files a separate return is subject to certain exceptions not presented in the Sanchez case.  See IRC sec. 6013(b)(2).

The Court recognized the taxpayer’s right to file a joint return after her spouse’s separate return had been filed, but the Court concluded that the taxpayer’s efforts to file a joint return were not sufficient to constitute an election.

At the outset, it is surprising that the issue of whether a joint return was filed even arose in Sanchez.  Normally, you would expect this issue to arise in a case where a taxpayer contends that he or she either did not file a joint return or never intended to file a joint return.  For example, if one spouse insists that the other spouse improperly signed his or her name.  These cases often involve opposing testimony and might turn on a number of factors including whether the taxpayer tacitly approved the spouse signing their name to the original return.  It is unusual, in my experience, for the issue of a joint fling to arise when both the IRS and the taxpayer agree there was a joint filing.

In Sanchez, the court rejected the taxpayer’s argument for the following reasons: the Court held that the consent, Form 4549, signed by the taxpayer and her spouse agreeing to the joint and several liability should not be treated as a joint return.

The original return in the Sanchez case was audited and the revenue agent proposed a deficiency. During discussions with the spouse, who filed the original return, and the taxpayer, the revenue agent explained that if the spouse and the taxpayer agreed to file a joint return, the proposed deficiency would be reduced.  Although the full nature and extent of the discussions is not known, apparently the taxpayer concluded that it was in her best interests to agree to a joint filing.  It is not clear from the reported case, but it appears that the taxpayer may not have had any income in the taxable year.  So, in making the computation of taxable income, the revenue agent proposed making adjustments relating to the TPH’s income and the revenue agent also proposed making an adjustment to the filing status claimed on the original return.  Because the taxpayer was agreeing to joint filing, the filing status on the Form 4549 was changed from “single” to “joint”.  It is routine for the IRS and taxpayers to resolve cases through the use of Form 4549.  Further, it is not uncommon for a change in the filing status of taxpayers to be included on a Form 4549.

Under the Beard test, a document must meet four tests to be a return:  (1) purport to be a return, (2) be executed under penalty of perjury, (3) contain sufficient data to allow the calculation of tax, and (4) represent an honest and reasonable attempt to satisfy the requirements of the law.   In Sanchez, the Court rejected the Form 4549 in large part because the Form 4549, signed by the parties, did not contain language regarding perjury.   Notwithstanding the absence of a jurat, the author believes that the IRS and the taxpayer made an honest and reasonable attempt to satisfy the requirements of the law.

While the Court rejected the Form 4549 as sufficient to establish a joint filing, there is much to suggest that signing the Form 4549 is sufficient. First, the parties made mutual promises.  The IRS allowed the spouse and the taxpayer to benefit from the more favorable tax rates for joint filers.  On the other side, the taxpayer agreed to joint and several liability for the taxes.  It does not matter if the taxpayer fully understood the consequences of agreeing to the joint return.  What matters is that she understood that she was filing a joint return and receiving consideration – a lower tax – for her consent.   It is a fair bargain and it should be binding on the IRS and the taxpayer.

Certainly both the IRS and the taxpayer went forward with the belief that the taxpayer had elected a joint filing. Based upon the taxpayer’s agreement to be bound by the joint filing, the IRS assessed the tax and began collection activity.  On the other side, believing that she owed the taxes, the taxpayer eventually filed for innocent spouse relief.  The IRS accepted the Form 8857 for processing.  It is a condition for processing a request for innocent spouse relief that the taxpayer has filed a joint return.   If the IRS did not believe that there had been a joint filing, it would not have made a final determination denying innocent spouse relief.  The final determination was the basis for the court proceeding in the Sanchez case.

But the court has now ruled that no joint return was filed and there is no appeal from a small case and the Court’s decision will soon be binding on both parties.

Tax Consequences 

Normally, after a decision in an S case, the amount of a deficiency, if any, is established.  But that is not the case in the Sanchez case.  The tax liability was not before the court – only the innocent spouse issue.   Because the filing of a joint return is a prerequisite to the Court granting appropriate relief under IRC section 6015(e), the Court never reached the merits of the Service’s final determination denying innocent spouse relief.  The Court’s decision denied the taxpayer a right to review, but the decision appears to have created other rights.

At the end of the opinion, the court wrote:

…it is appropriate to state that nothing in this Summary Opinion should be taken to comment as to the assessment made against petitioner on the basis of the consent.

Although the court’s comment does not address the tax consequences of the decision, the tax consequences appear to heavily favor the taxpayer.  While she did not achieve a favorable result on her request for innocent spouse relief, she did not leave the court without a potential remedy.  While an S case cannot be cited as precedent and may not be appealed, the decision is final as between the parties. See  IRC section 7463(b).

The court ruled that the taxpayer did not file a joint return with her spouse.  The decision has significant legal impact on the taxes assessed pursuant to the consent.   As assessment based upon a joint filing no longer exists.  Moreover, the statute of limitations for filing a joint return has probably expired.  See IRC section 6013(b)(2)(A).  It is hard to imagine that the IRS would take the position that petitioner remained liable for the taxes based upon the reported income of the taxpayer and her spouse.  If the statute of limitations on assessment is still open, it is far more likely that the IRS will split the joint account into two separate accounts and recompute each individual’s separate tax based upon their separate income and expense items.  But, the year involved is 2006 and it is unlikely that the statute of limitations on assessment is still open.

If the IRS stubbornly continues to pursue collection, it seems to me that the taxpayer could file a petition in Tax Court alleging that the IRS had not followed the deficiency procedures and was collecting the tax based upon an illegal assessment.  The Tax Court would almost certainly rule in the taxpayer’s favor.

At the end of the day, it turns out that the taxpayer in Sanchez, not the IRS, may be the ultimate winner in this dispute.

Upcoming Symposia on Tax Administration

There are some interesting tax administration symposia coming up. I will briefly describe two of them.

Tomorrow the University of Minnesota School of Law is hosting a conference on reforming the IRS. Top academics in the area such as Professors Kristin Hickman, Steve Johnson and Leandra Lederman are delivering papers; other participants include prior PT guest posters such as Professors Andy Grewal and Chris Walker. NTA Nina Olson is delivering a keynote speech that seems fascinating (looking at recent research linking trust and compliance). We will link to papers as they become available.

On Friday April 24 Deena Ackerman at Treasury and I are co-organizing an American Tax Policy Institute conference called Delivering Benefits to Low-Income Taxpayers Through the Tax System. The conference is an all day-event and will be held at Skadden’s DC office. The ATPI conference has an international as well as domestic focus, and will bring together academics, government officials from here and abroad and other policy makers to discuss creative approaches for better delivery of benefits. Prior PT guest posters Dave Williams and Bryan Camp and many others will be among the presenters. Stay tuned for more on this.

More Bad News for Late Filers

The First Circuit in Fahey joins the Fifth and the 10th in holding that the hanging paragraph at the end of Bankruptcy Code Section 523 excepts from discharge the tax liability for any year in which the taxpayer files the return late – even by one minute.  We have written about this issue before here and here . The issue is not going away and would seem to be headed to the Supreme Court if Congress does not step in to fix the language it created in 2005 which causes this problem.

At approximately the same time the First Circuit joined the others in interpreting that any late return gets excepted from discharge, the bankruptcy court in the Southern District of Florida issued a well-reasoned explaining why it does not. In re Coyle, 524 B.R. 863 (Bankr. S.D. Fla. 2015).  The court in Coyle adopted the approach taken by the IRS that the Circuit court holdings cannot be reconciled with Section 523(a)(1)(B)(ii) allowing discharge of late filed returns after the passage of two years.  If Coyle or another case can get Circuit approval, the necessary conflict will exist to make a Supreme Court decision likely although the administrative importance of the issue argues for acceptance of cert on the most recent decision.

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The issue is getting attention from many quarters at this point. The Bankruptcy and Tax Committee of the ABA Tax Section drafted a legislative proposal on this issue that the ABA sent to Congress last fall. [The National Taxpayer Advocate suggested a legislative proposal in her annual report.

The First Circuit case, which is really four cases combined for appeal all containing essentially the same facts, looks at the issue from a state law perspective. Massachusetts Department of Revenue sought to prevent the debtors from discharging their taxes in the situation where they did not timely file their returns (each case involved failure to timely file for multiple years), subsequently filed the missing returns, waited two years after filing to cross the hurdle created by Bankruptcy Code section 523(a)(1)(B)(ii) and then filed a bankruptcy petition.  The First Circuit first looked at the language of section 523 (a)(1)(B) and said that if it stopped there this case would present little difficulty except for the hurdle of defining “what is a return.”  It then looks at the 2005 amendment to section 523 adding the hanging paragraph designed to clear up the confusion surrounding the issue of what is a return.

Looking at the hanging paragraph for guidance on what is a return it finds that to meet the definition of a return the document must “satisfy the requirements of applicable nonbankruptcy law (including filing requirements).” The First Circuit then looks at Massachusetts law to determine whether timely filing is a “filing requirement’ under state law and finds the answer is “plainly yes.”  The Court addresses the ever present concern that this reading of the statute would “vitiate in its entirety the two-year provision of section 523(a)(1)(B) rendering it superfluous.  It finds this concern incorrect because of the exception in the hanging paragraph allowing late returns filed pursuant to IRC 6020(a) to qualify as returns that could lead to discharge.  The First Circuit acknowledges that very few returns end up being filed under the provisions of 6020(a) and that the IRS has total control over the use of that provision to file a late return.  Nonetheless, it viewed Congress as making a strong statement about timely filing.  While I disagree with the conclusion, the Court gave careful thought to all of the arguments presented by the debtors and the amici in their briefs.

As I have written before, Congress did not intend this result and should step up to fix the unintended consequences that the language of the ill-fated statutory change designed to resolve litigation that the language has spurred.  I will not spend any more time talking about the bad situation from a legal perspective but want to focus instead on the administrative problems caused when discharge issues exist.  I will do this from the perspective of the IRS but you can multiply the problem the IRS faces by the number of states with return filing requirements.  The administrative importance of this issue for tax administrators cries out for quick relief.

When a debtor finishes a bankruptcy cases, the IRS must look at all of the periods for which liability exists and make a discharge determination. If the bankruptcy discharged the debt, the IRS must write that debt off of its books and never try to collect it again (subject to certain exceptions related to liabilities for which the IRS may pursue specific property based on its lien interest.)  If the debt did not meet the discharge criteria, then the IRS leaves the debt on its book, removes the freeze code on the account caused by the automatic stay and sends the debt back into the collection stream.

The problem created by uncertainty in the application of the discharge provisions is that taxes, or whatever liability is impacted by an uncertainty, go back into the collection stream. Because the statute of limitations on collection of taxes lasts ten years, the lingering impact of uncertainty lasts a long time and becomes difficult, if not impossible, to unwind.  Unless the IRS keeps accurate records on the cases with unfiled returns involving the Hindenlang or the McCoy issue, it will have great difficulty going back through its closed bankruptcy cases to identify the ones in which it decided to leave a liability on the books due to its position regarding discharge at a particular moment in time.  To the extent that the IRS will have difficulty doing this, I imagine that the problem becomes even more difficult for states which may have fewer resources to apply to the problem.  Some states have a statute of limitations on collection that runs longer than the ten year statute applicable to federal tax debts which again makes the unwinding of any discharge determination even more difficult.

The thirteen states covered by the three circuits ruling on the hanging paragraph so far have an answer for how to treat late filed returns. The other 37 states do not have an answer.  The answer may change if Congress or the Supreme Court reverse the decisions.  If these decisions are reversed, it may take some years.  Taxpayers who pay during the intervening years may need to file protective claims in order to preserve their right to the return of money collected on the debts should they ultimately be determined to be discharged.  The IRS has taken the legal position that the hanging paragraph does not mean what three circuits have now said it means and in one of those circuits the decision specifically addressed federal tax debt.  Does the IRS continue not to pursue these liabilities in the face of circuit precedent allowing it to do so?  How many circuits does it take before the IRS reverses its position?  If it does reverse its position will it code these cases so it can abate these liabilities should legislation or case law reverse the current circuit trend?

Uncertainty in the application of the discharge provisions makes for very difficult administration as well as difficult times for the impacted debtors. When uncertainty on this scale exists in a discharge provision, quick action needs to occur in order to prevent large scale administrative disruption and dire consequences to debtors who thought bankruptcy provided a path to a fresh start.  If the courts have misinterpreted the intention of the statutory change, Congress should step in quickly.  In the absence of Congressional action, this issue seems to have sufficient administrative importance to warrant Supreme Court review even in the absence of a circuit conflict.

 

Proposal to Amend Section 7453 to Provide that the Tax Court Apply the Federal Rules of Evidence

Today’s post explores in greater detail a topic briefly covered last month as part of a broader discussion of proposed legislative changes with respect to the Tax Court.  First time guest blogger, Joni Larson, is the perfect person to discuss the proposed change in the application of the rules of evidence because she wrote the book on evidentiary issues in Tax Court.  She has clerked in the Tax Court for Judge Irene Scott, she has worked in the Office of Chief Counsel, IRS and for over a decade she has taught at Western Michigan University – Cooley Law School where she is also the Director of the Graduate Tax Program. Keith

The Tax Court has always been an interesting and challenging forum in which to litigate. Because the judges circuit ride, a different judge might preside over each trial calendar, making it nearly impossible to anticipate any judge’s preferences, idiosyncrasies, or tendencies.  These differences can show up in anything from how they handle calendar call to how they deal with evidentiary issues.  And, depending on the issue to be presented, evidentiary issues can have a big impact.  With no jury, the judge is the arbiter of the facts.  When deciding whether evidence is admissible, some judges stick close to the bright lines offered by the Federal Rules of Evidence.  Others give a passing nod to the rules and err on the side of allowing in most proffered evidence with the caveat that it will be considered “for what it is worth.”

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But it isn’t just the judges’ application of the rules that might make you scratch your head. There has long been an application issue lurking within the Code section that makes the Federal Rules of Evidence applicable in Tax Court.  Section 7453 provides “the proceedings of the Tax Court and its divisions shall be conducted in accordance with . . . the rules of evidence applicable in trials without a jury in the United States District Court of the District of Columbia.” Tax Court Rule 143(a) echoes this rule: “Trials before the Court will be conducted in accordance with the rules of evidence applicable in trials without a jury in the United States District Court for the District of Columbia.”  This seems to suggest that the Tax Court look to the District of Columbia District Court (and its appellate court), and not the Circuit Court of Appeals to which the case could be appealed, for interpretation of the rules.

This result is in direct contrast to the Tax Court’s Golsen rule.  Under the Golsen rule, when there is a disagreement among appellate courts, the Tax Court will follow the opinion of the Circuit Court of Appeals to which the case could be appealed.  But, what about instances where the appellate courts disagree on the application of a rule of evidence?  Section 7453 was enacted long before the Tax Court adopted the Golsen rule, and a judicial rule cannot take precedence over a statutory provision.

One evidentiary rule where there is disagreement among the appellate courts is Rule 106. If a party introduces a writing or a portion of a writing, the opposing party may require the introduction of any other part of the writing or any other writing that in fairness ought to be considered at the same time.  The conflict between the appellate courts is whether the other part or other writing must satisfy the rules of evidence to be admissible.  Four appellate courts, including the District of Columbia  (and the First, Third  and Seventh Circuits) will admit the other part if fairness requires its admission.  In contrast, four different appellate courts (the Second, Fourth, Sixth, and Ninth Circuits) require the other part or writing to satisfy the rules of evidence before it can be admitted, finding that Rule 106 does not make admissible what is otherwise inadmissible.  Curiously, a case being tried in the Tax Court and appealable to the Second, Fourth, Sixth, or Ninth Circuits would seem to require the Tax Court to apply the contrary interpretation of the District Court of the District of Columbia.

Admittedly, an issue involving Rule 106 arises infrequently and the potential differential treatment is unlikely significant enough to create a demand for change. Rule 301 is at the opposite end of the spectrum.  It is implicated in many more cases and, because it is so intertwined with substantive rules applied by the courts, demonstrates the unworkability of the Golsen rule and Section 7453 operating simultaneously.

The determination made in the notice of deficiency is presumed correct, and, generally, the taxpayer has the burden of proof by a preponderance of the evidence. Rule 301 provides that the party against whom a presumption is directed has the burden of producing evidence to rebut the presumption.  However, the courts have that that if the Commissioner has determined the taxpayer has unreported income, he must introduce substantive evidence linking the taxpayer to the income.  For example, the Commissioner may establish a link between the taxpayer and the alleged business activity that generated the income.  Or he may establish a link between the taxpayer and the unreported income, such as through a source and application of funds analysis, without necessarily making a link to the alleged activity that generated the income.  The appellate courts disagree on whether, to be considered, the evidence used by the Commissioner to establish the link must satisfy the rules of evidence.  In the Second Circuit, a statutory notice of deficiency based on such inadmissible evidence is arbitrary, the notice is not entitled to the presumption of correctness, and the burden of production shifts to the Commissioner.  In the Fourth, Seventh, and Ninth Circuits, inadmissible evidence may be considered in determining if the Commissioner has established the requisite link.

Burden of proof issues can be difficult. Moreover, the substantive opinions of the appellate courts that shift the burden of production to the Commissioner are intertwined with evidentiary rules and there is no easy way to separate the two avenues of analysis.  When is the court making a substantive ruling and when is the court applying the rules of evidence?  More specifically, from the Tax Court’s perspective, when is the Goslen rule applicable and when are the rules from the District of Columbia District Court applicable?  Of course, exasperating the problem is the lack of any tax case arising in the Tax Court that specifically has looked to the District Court of the District of Columbia for assistance in interpreting an evidentiary issue.

On February 11 the Senate Finance Committee marked up 17 miscellaneous tax bills, one of which would provide that the Tax Court apply the federal rules of evidence applicable in the Circuit Court to which the case is appealable.  Not only is it difficult to imagine anyone who would object to the passing of this rule, but the proposed change makes sense.  It would place the Code section in line with what the Tax Court and appellate courts are already doing and make application of the rules of evidence consistent with the Golsen rule.

 

 

Between the National Taxpayer Advocate and the Courts: Steering a Middle Course to Define “Willfulness” in Civil Offshore Account Enforcement Cases Part 2

In Part 2 of their post on offshore compliance issues, Peter Hardy and Carolyn H. Kendall of Post & Schell discuss the standard necessary to prove willfulness for failing to file an FBAR. Les

In our first post yesterday, we discussed United States v. Sturman, in which the Sixth Circuit in 1991 upheld a criminal conviction for a willful failure to file an FBAR, and made clear that the standard for willfulness is an intentional violation of a known legal duty. We also observed that the IRS, in a 2006 Chief Counsel Advisory Memorandum, embraced this same definition of willfulness for the purposes of imposing civil FBAR penalties. In this post, we examine how some court opinions have eroded that willfulness standard in the civil FBAR context, a trend that leads us to agree with the recommendation made by the January 14, 2015 Report of the National Taxpayer Advocate that the willfulness requirement for civil FBAR actions be amended legislatively to reflect that willfulness requires not mere recklessness, but a voluntary and intentional violation of a known legal duty.

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Civil FBAR Case Law: Williams and McBride

In contrast to Sturman, two courts that have considered the scope of willfulness in the civil FBAR context have suggested that failing to answer accurately the question regarding a foreign account on Schedule B can, without more, support a finding of willfulness with respect to a failure to file an FBAR. Further, these courts have stated that willfulness in the civil FBAR context includes mere recklessness, which includes careless disregard. These decisions clearly reflect that the government has disavowed the 2006 IRS memorandum’s embrace of a higher standard for willfulness in the civil FBAR context. Regardless of the exact fact patterns at issue in these cases, they state rules of law that may haunt future, more sympathetic account holders.

Williams

In United States v. Williams, the government filed a complaint to recover civil FBAR penalties assessed against the defendant for the year 2000. The defendant had deposited more than $7 million in assets into two Swiss bank accounts from 1993 through 2000, earning more than $800,000 on the deposits, and had failed to disclose these accounts or the income derived therefrom. On his individual income tax returns, Williams checked the relevant box on Schedule B “no,” thereby indicating that he had no foreign accounts. Likewise, Williams indicated on a tax organizer provided to him by his accountant in January 2001, for the purposes of his then-upcoming 2000 tax return, that he did not have a foreign account. However, Williams had retained counsel in the fall of 2000 because Swiss and U.S. authorities had become aware of his Swiss accounts, which were frozen in November 2000 on the day after Williams and his counsel had met with the Swiss authorities to discuss the accounts. Over the course of 2002 and 2003, Williams disclosed these accounts to the IRS, and disclosed them on his 2001 tax return and amended tax returns for 1999 and 2000, as part of his bid to participate in the IRS’s voluntary disclosure program. Williams was not accepted into the program, and he pleaded guilty in June 2003 to tax fraud, on the basis of the funds held in his Swiss accounts from 1993 through 2000. In 2007, he filed FBARs for all years going back to 1993, including for the year 2000.

After a bench trial regarding the basis for the civil FBAR penalties assessed for the 2000 tax year, the district court found that “[d]espite hiring tax lawyers and accountants, Williams had never been advised of the existence of the [FBAR] form prior to June 30, 2001, nor had he ever filed the form in previous years with the Department of Treasury.” The district court also found that Williams had not acted willfully as to his 2000 year FBAR. Specifically, it found that when Williams checked the “no” box on his 2000 personal income tax return indicating that he had no foreign bank accounts, and when he failed to file an FBAR on June 30, 2001, he already knew that the tax authorities were aware of his noncompliance, and he already had begun to meet with Swiss authorities. The district court found that this lack of willfulness was corroborated by Williams’s later disclosures of the accounts to the IRS and his filing of accurate returns. Finally, the district court rejected the government’s claim that Williams’s plea to tax evasion estopped him from arguing that he did not willfully violate his 2000 year FBAR obligation.

The Fourth Circuit, purporting to apply the standard of clear error, reversed the district court’s factual finding that Williams had not acted willfully in a 2012 unpublished opinion. When doing so, the Fourth Circuit also stated that, in the civil context, willfulness includes not just knowing violations, but also reckless ones. Citing Sturman for the proposition that willfulness may be inferred under the willful blindness doctrine, the Fourth Circuit emphasized that Williams had signed his 2000 income tax return, which had put him on notice about the 2000 FBAR filing requirements because of the question on Schedule B regarding foreign bank accounts, which references the FBAR – i.e., Williams should have realized that he had an FBAR filing requirement, but avoided learning about it. The Fourth Circuit also found that Williams’s guilty plea allocution for his tax convictions confirmed that his FBAR violation was willful. However, the Williams opinion contained a dissent, which argued that the record contained sufficient evidence supporting the conclusion of the district court, which had not clearly erred when it found a lack of willfulness. Moreover, the dissent observed that the district court correctly rejected the government’s collateral estoppel argument because Williams never admitted during his guilty plea to failing to file an FBAR, much less failing to do so willfully.

Although Williams involves unusual facts, it implies – because it reversed for clear error the contrary conclusion of the fact finder – that willfully filing a false tax return that does not disclose a foreign account can be inherently synonymous with willfully failing to file the separate FBAR form for the same tax year, at least in a civil penalty case. Although the court also pointed to the inaccurate information Williams provided on his tax organizer as an example of additional conduct meant to conceal, that conduct seems secondary and intrinsic to its immediate consequence – the failure to disclose the account on the tax return. Whether the outcome in Williams was the product of the court’s embrace of the recklessness standard, or was the inevitable product of the court’s interpretation of the willful blindness doctrine, cannot be gleaned from the opinion. Certainly, the court made clear that it viewed the willfulness standard in a civil penalty case as different from the willfulness standard in a criminal case.

McBride

The District of Utah cited Williams when holding in 2012 that the willful filing of signed false income tax return supports a finding of willfulness with respect to failing to file an FBAR. In United States v. McBride, the defendant sought to reduce his tax liabilities arising from his increasingly successful company, and so contacted a financial management firm devoted to tax minimization, Merrill Scott and Associates (MSA). MSA presented McBride with a plan to shift his company’s income to offshore accounts owned by MSA’s foreign entities, over which McBride would have indirect control. MSA also gave McBride a pamphlet setting forth duty as a U.S. taxpayer to report his interest in any foreign account to the government. Pursuant to MSA’s plan, McBride created a transfer pricing scheme whereby the company purchased inventory from a manufacturer at an inflated price and the manufacturer then deposited the overpayment into the offshore accounts that McBride indirectly controlled. During 2000 and 2001, McBride routed roughly $2.7 million through these offshore accounts. McBride failed to inform his preparers of the MSA plan or his interest in the offshore accounts. On his individual income tax returns for both years, he checked “no” on Schedule B and signed the returns. In 2004, the IRS began to investigate McBride; he denied using MSA’s plan or having an interest in the foreign accounts and refused to complete FBARs for 2000 and 2001. Ultimately, the IRS asserted civil penalties against McBride for tax years 2000 and 2001.

After a bench trial, the district court found that McBride’s failure to file FBARs for 2000 and 2001 was willful. As in Williams, the court stated that “willfulness” for civil FBAR enforcement proceedings has the same definition as in other civil contexts: recklessness and willful blindness both constitute civil willfulness, which can be inferred from circumstances, including actions taken to conceal or mislead. However, invoking a recklessness standard hardly seemed necessary to establish liability: according to the court, ample evidence demonstrated that McBride had actual knowledge of his obligation to file an FBAR. The court found that McBride had read the pamphlet from MSA discussing the filing requirement and, more tellingly, he testified that he did not check “yes” on Schedule B “because . . . if you disclose the accounts on the form, then you pay tax on them, so it went against what I set up [MSA] for in the first place.” Despite this seemingly ample evidence of actual knowledge, the court also engaged in an imputed knowledge analysis; it held that because “a taxpayer’s signature on a return is sufficient proof of a taxpayer’s knowledge of the instructions contained in the tax return form,” and because McBride signed the return, which contained instructions concerning the FBAR filing requirement, McBride had imputed knowledge of the FBAR requirement. The court further noted, relying on Sturman, that circumstantial evidence of McBride’s willfulness included his misstatements to, and concealments from, the IRS during their 2004 investigation, which also contradicted his claim that he did not know he had a legal duty to file FBARs.

Finally, the court rejected McBride’s contention that he was not willful because he subjectively believed that he lacked a reportable interest in the foreign accounts based on professional advice. The court held that any belief by McBride that he was not legally required to file an FBAR was “irrelevant” in light of his signing of his tax returns. According to the court, under Lefcourt v. United States, once it is established that a filing was required by law, the only relevant inquiry is whether the failure to file was voluntary rather than accidental. This statement, considered in the abstract, is simply contrary to a definition of willfulness requiring an intentional violation of a legal duty that is subjectively understood by the individual.

Legislative Proposal

The Williams and McBride opinions both reflect that the government has disavowed the more measured position articulated by the IRS in its 2006 Chief Counsel Advisory Memorandum. They also provide ammunition for the government’s anticipated efforts to advance in future civil FBAR cases a lax definition of willfulness which allows for mere recklessness. Further, the McBride court’s reasoning under Lefcourt and the Williams court’s reversal for clear error suggest that simply failing to “check the box” on Schedule B of a tax return regarding a foreign account might cause any failure to file an FBAR to be deemed – at least by the IRS, if not a court – a per se willful failure in a civil case. Given this erosion of the willfulness standard, the suggestion by the National Taxpayer Advocate that the willfulness requirement for civil FBAR actions be amended legislatively to make clear that willfulness requires not just recklessness, but a voluntary and intentional violation of a known legal duty, therefore makes particular sense. As the Report suggests, restoring the integrity of the willfulness standard in civil cases will honor the intent of Congress that the draconian 50% penalty address the problem of bad actors concealing their income. Likewise, clarity regarding the standard for willfulness, and excluding the merely reckless from its net, would accomplish several goals:

  • Imposition of the severe 50% penalty for willfulness would be limited, at least in principle, to those who actually deserve it and to whom it was intended to apply: those individuals who intentionally disregarded a known legal duty, rather than those who merely “should have known better.”
  • Public criticisms of the IRS offshore disclosure programs and related enforcement should be muted. Although case-specific disagreements likely will remain regarding the application of the willfulness standard, it simply will be easier as a matter of principle for the IRS to justify imposing high penalties on intentional law breakers.
  • Excluding recklessness from the definition of willfulness enhances the clarity and fairness of the process of certifying non-willfulness, as required by the current “streamlined” program for offshore accounts. Programs such as the streamlined program, which offer the government the benefits of administrative convenience and maximizing the amount of taxpayers who enter into compliance with the tax system, succeed best when individuals and their advisors feel relatively secure about how the rules are both defined and applied. If willfulness includes recklessness, it is simply harder to predict what conduct eventually may be deemed to be willful. Further, if not checking the box on one’s tax returns to indicate the presence of a foreign account is regarded by the government as synonymous with civil willfulness for the purposes of the FBAR, then the streamlined program becomes almost incoherent, because its benefits and purpose will not be realized except in the most unusual cases.

However, we respectfully disagree with the Report that any legislative or policy change should reflect that the government cannot meet its burden through “circumstantial evidence.” Given the entrenched role of circumstantial evidence in gleaning mental state in both civil and criminal contexts, such line drawing seems unworkable in practice and would contradict basic principles regarding proof of mental state, for which “direct evidence” – to the extent that it is even possible in practice to distinguish direct and indirect evidence – rarely is available. Likewise, we disagree that the government should not have access to the doctrine of willful blindness when attempting to prove mental state. Again, willful blindness – like it or not – is an accepted method of proving mental state. Although the doctrine of willful blindness invites the unfortunate risk that fact finders will inappropriately conflate negligence with actual knowledge or intent, the doctrine itself, properly articulated, demands more than mere recklessness. Indeed, as the Supreme Court made clear in 2011 in Global-Tech Appliances, Inc. v. SEB S.A., willfulness blindness is not a substitute for actual subjective belief, and the doctrine requires that the defendant take deliberate, affirmative actions to avoid learning the critical facts. Deliberate indifference and the existence of known risks, standing alone, will not suffice. Ultimately, a clear definition of willfulness as an intentional violation of a known legal duty will harmonize the civil and criminal law for FBARs; how mental state may be proved should be left to traditional principles of civil and criminal law.

Between the National Taxpayer Advocate and the Courts: Steering a Middle Course to Define “Willfulness” in Civil Offshore Account Enforcement Cases Part 1

Today we welcome first time guest bloggers Peter D. Hardy and Carolyn H. Kendall who practice in the Internal Investigations & White Collar Defense Practice Group of the law firm of Post & Schell P.C., in Philadelphia, PA.  Peter, a principal in the firm, is the author of a legal treatise entitled Criminal Tax, Money Laundering, and Bank Secrecy Act Litigation (Bloomberg BNA 2010).  He also serves as an adjunct law professor for the Villanova University School of Law Graduate Tax Program, where he co-teaches a class on civil and criminal tax penalties. Carolyn, an associate at the firm, co-authored the 2014 Supplement to Criminal Tax, Money Laundering, and Bank Secrecy Act Litigation. Both conduct internal investigations and defend corporations, officers and other individuals facing criminal and civil investigations.  

They also assist clients in offshore account disclosure and compliance via IRS disclosure programs (OVDP and Streamlined Procedures) which is the subject of today’s blog post. Picking up on a recommendation in the National Taxpayer Advocate’s 2014 Annual Report, they explain in a two part post the change they feel necessary to the willfulness standard applied to the reporting (or failure to report) offshore bank accounts. Today’s post describes the problem and early case law. Tomorrow’s post will explain where the standard veered off course and how to get it back on track with the appropriate legislative change. Keith

The government has pursued for several years a successful enforcement campaign against undisclosed offshore accounts; the definitive opening salvo in this campaign was the deferred prosecution agreement in February 2009 involving Swiss banking giant UBS. In addition to numerous prosecutions of account holders, professionals, and banks, the IRS has reported that over 38,000 U.S. taxpayers to date have self-disclosed their offshore accounts. The reporting form that has driven this enforcement campaign is the Foreign Bank Account Report, or FBAR, an annual report required under the Bank Secrecy Act (BSA) for U.S. taxpayers holding offshore accounts with a value above $10,000 at any point in the year. Underlying the success of the campaign and the number of voluntary disclosures has been the potentially draconian civil penalties associated with failing to file an FBAR: a “willful” failure to file an FBAR, or the “willful” filing of a false FBAR, can produce a civil penalty equal to fifty percent of the entire account balance, for every year of violation. Given a six year statute of limitations, stacked civil penalties could equate to three times the account balance. Thus, although a “willful” FBAR violation can result in criminal penalties, the tail of potentially very severe civil penalties often has wagged the dog of most taxpayers’ very unlikely real world criminal exposure, and has allowed the IRS to dictate some tough terms when outlining its offshore disclosure programs, which permit taxpayers to avoid criminal prosecution and avoid the harsh 50% penalty.

On January 14, 2015, the National Taxpayer Advocate issued a detailed report (“Report”) regarding suggested reforms of the civil FBAR penalty regime. Although the Report contains many good proposals, we focus here on just one, which seems to strike at the heart of the many critiques raised over the years regarding the perceived inequities in the structure and application of the IRS’s various offshore voluntary disclosure (OVD) programs. The OVD programs have netted many people who may have inadvertently failed to file FBARs, and who are not wealthy people with substantial accounts. As the Report explains, uncertainty has compelled some individuals who never committed fraud to resign themselves to significant civil penalties because“[b]enign actors cannot be sure that IRS will not view their FBAR violations as ‘willful,’ and attempt to impose severe penalties. This is because the government has eroded the distinction between willful and non-willful violations.”

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We agree. Court victories by the government in civil FBAR enforcement actions have diluted the willfulness threshold, from the more appropriate standard of an intentional and voluntary violation of a known legal duty, to a standard of mere recklessness. A “recklessness” standard lacks precision and invites severe penalties simply because an individual is presumed – or is concerned about being presumed – to have “known better,” even if he in fact did not know.

The Report therefore wisely proposes that the willfulness requirement for civil FBAR actions be amended legislatively to make clear that willfulness requires not just recklessness, but a voluntary and intentional violation of a known legal duty. In the first part of this two-part post, we describe how, prior to the current offshore enforcement campaign, willfulness in the civil FBAR context was understood to be equivalent to willfulness in the criminal context. In the second part, we describe how recent case law in the civil FBAR context has eroded this definition, and why the Report’s legislative proposal would benefit both taxpayers and the IRS by correcting this apparent trend. As practitioners who assist taxpayers with disclosing their offshore accounts and becoming fully tax compliant, we join with the Report and the public and private comments of many of our colleagues in observing that this erosion of the willfulness standard fails to distinguish adequately between most account holders and true bad actors, and therefore can discourage those who otherwise wish to become fully compliant.

Admittedly, the Report’s legislative proposal is unlikely to attract much Congressional support, given current budget deficits and the presumed desire of legislators to avoid being depicted as protecting offshore account holders. Nonetheless, the legal point remains: if an individual did not act with the intent to violate a known legal duty, then it is difficult to argue why he should be subject to a very draconian, albeit civil, penalty from the perspective of either fairness or the smart use of limited enforcement resources. As the Report states, the enhanced civil penalties for willful conduct were enacted to target bad actors, not to ensnare the inadvertent or negligent. Moreover, and aside from the benefits of attaining consistency between the civil and criminal penalty regimes for willful conduct, the practical reality is that the current IRS “streamlined” program for disclosing offshore accounts, which requires that the taxpayer submit a certificate attesting to his non-willfulness, is complicated by the possibility that the taxpayer is really being asked to assert that he did not act “recklessly,” which is a potentially much murkier claim than asserting that he did not act with fraudulent intent. Indeed, and as we explain, even the IRS used to state that willfulness for the substantial civil FBAR penalties demanded the same heightened showing required for criminal willfulness.

However, and as we note in our second post, we respectfully disagree with the Report that any legislative or policy change should prevent the government from meeting its burden through use of circumstantial evidence or the doctrine of willful blindness. Such proposals would contradict well-settled methods of showing mental state, and would be unworkable in practice.

United States v. Sturman and the IRS’s 2006 Chief Counsel Advisory Memo

If performed “willfully,” failing to file an FBAR, or filing a false FBAR, is a felony violation of the BSA under 31 U.S.C. §§5314 and 5322(a). A “willful” act, for the purposes of Section 5322 – and also for the vast majority of criminal tax offenses – means a voluntary and intentional violation of a known legal duty.

Prior to the government’s relatively recent offshore account enforcement campaign, the federal courts offered scant guidance as to what qualified as a “willful” failure to file an FBAR. In 1991, the Sixth Circuit upheld a criminal conviction for a willful failure to file an FBAR in United States v. Sturman. Defendant Sturman challenged on appeal his convictions for tax fraud and failing to file FBARs pertaining to business proceeds deposited into Swiss bank accounts. He argued in part that the government had failed to establish he was aware of the legal requirement to file FBARs. The Sturman court rejected this claim and upheld the convictions. In so doing, it cited Cheek v. United States, the seminal case regarding willfulness in the criminal tax context, for the propositions that the test for willfulness is a “voluntary, intentional violation of a known legal duty” and that willfulness “may be proven through inference from conduct meant to conceal or mislead sources of income or other financial information.” In upholding the convictions, the Sixth Circuit noted that the defendant had taken multiple steps to conceal his overseas assets from the government apart from his failure to file the FBAR, including concealing his signatory authority, interest in various transactions, and interest in the corporations that were transferring money to the foreign accounts. The Sturman court also noted that the defendant had admitted his “knowledge of and failure to answer” the question on Schedule B of his federal income tax return, which referred taxpayers to a booklet outlining the FBAR reporting requirements. The court found that the evidence of Sturman’s “acts to conceal income and financial information, combined with the defendant’s failure to pursue knowledge of further reporting requirements as suggested on Schedule B[,]”established willfulness.

The analysis in Sturman therefore reflects that an individual’s mere knowledge of and failure to answer correctly the question on Schedule B concerning foreign bank accounts, absent some other affirmative acts of concealment, is insufficient evidence to establish that the individual knew of the FBAR reporting requirement and willfully violated it – at least in a criminal case.

Once, the IRS itself took its cues from Sturman and embraced a more robust definition of willfulness in the civil FBAR context. In an IRS Chief Counsel Advisory Memorandum released on January 20, 2006, the IRS outlined its position on the willfulness requirement for imposing elevated civil penalties under 31 U.S.C. §5321(a)(5)(C) for an FBAR violation. The IRS stated in this 2006 memorandum that there were no cases “in which the issue presented is construing ‘willful’ in the civil penalty context[,]” a statement that was true at the time. The IRS then expressed its view that the willfulness requirement for imposing a Section 5321 civil penalty is identical to the willfulness requirement for criminal penalties under Section 5322 – i.e., a voluntary and intentional violation of a known legal duty – because both sections use the same word: “willful.” The IRS further noted in the 2006 memorandum that willfulness can be inferred where an “entire course of conduct establishes the necessary intent,” and as an example in the context of a criminal FBAR violation cited to Sturman. This reference to Sturman was potentially instructive because, as noted, the defendant’s criminal conviction for failing to file an FBAR in that case rested on additional affirmative acts of concealment beyond merely failing to check the correct box on Schedule B of his income tax return.

In our second and final post, we will discuss how some recent court rulings have relaxed this standard of willfulness in the civil FBAR context, so as to allow for mere recklessness, and how a legislative fix regarding the definition of willfulness would help to inject needed clarity into the “streamlined” program for offshore accounts, and restore overall fairness.

What good is your right to challenge the IRS’s position if you have no idea what it is?!

Today we welcome first time guest blogger Mandi Matlock. Mandi splits her time between private practice where she is an associate at Mondrik & Associates and Texas RioGrande Legal Aid where she founded the low income taxpayer clinic. I know Mandi through her work in the clinic.  Because she has a significant background in consumer law, she brings a perspective to tax law issues informed by her other practice knowledge.  In addition, she is the chapter author in Effectively Representing Your Client before the IRS of the chapter on the special tax issues faced when disaster strikes.  This post picks up on an issue identified by the National Taxpayer Advocate in her annual report and examines the problems created when the IRS fails to explain why it is disallowing a claim for refund.  Keith

National Taxpayer Advocate Nina Olson released her Annual Report to Congress this January expounding on her oft-repeated mantra that the continued erosion of taxpayer service does not bode well for future tax compliance or for public trust in the fairness of the tax system. In this blog post, we take a look at the Annual Report’s Most Serious Problems #17, which focuses on how deficient refund disallowance notices are harming taxpayers.

The Service’s specific problem here starts with that tiny little subsection endcapping Section 6402. It says that when the Service disallows a refund claim, it “shall provide the taxpayer with an explanation for such disallowance.” IRC 6402(l). How hard could that be, right?

Well, scrutinizing the Service’s efforts closely through the lens of the Taxpayer Bill of Rights, as the National Taxpayer Advocate did in her Annual Report, it turns out the Service has more than a little trouble complying.

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How Does the Service try to Meet its Obligations?

The Service uses of a patchwork of over 50 different claim disallowance notices, some of which are required by statute, to notify taxpayers of its decision to deny or partially deny a refund claim. In an obvious attempt to comply with 6402(l), various subsections of the IRM require these claim disallowance notices to contain specific reasons for the disallowance and an IRC section where possible.

The Annual Report categorizes the claim disallowance notices it reviewed as either statutory or non-statutory. The statutory notices are those the Service is required by statute to send by certified or registered mail to commence the two-year statute of limitations for challenging the denial by filing a refund suit in a United States District Court or the Court of Federal Claims. They include stand-alone notices such as Letters 105C and 1364 as well as any number of so-called combo-notices, such as Letter 3219 or even a Statutory Notice of Deficiency issued during an examination in which a refund claim is pending.

The non-statutory notices alert the taxpayer that a refund claim was denied, but have no effect on the statute of limitations for filing a refund suit. They include Letter 569 (SC), the initial letter from Examination proposing to deny or partially deny a claim for refund, and Letters 2681 and 2683 from Appeals sustaining a prior decision to deny a refund claim. Non-statutory notices may be sent before or after a statutory notice a statutory notice of claim disallowance. For example, Appeals may issue a non-statutory notice informing a taxpayer of its decision to sustain the denial of a refund where Examination has already sent a statutory notice of claim disallowance. There are some instances where the non-statutory notice is the only notice ever sent (i.e., cases where the taxpayer has signed a waiver of his or her right to statutory notice of claim disallowance).

TAS also included in its review what it called “no consideration” letters, which notify a taxpayer IRS will not consider his or her refund claim because it is somehow deficient. It makes sense to include these no consideration letters in the review because they work to deny refund claims in cases where the no consideration letter itself is so deficient the taxpayer has inadequate information with which to respond and remedy the defects in the original refund claim.

The Treasury Inspector General for Tax Administration found in a recent report that half of IRS letters and nearly two thirds of IRS Notices were not clearly written and did not provide sufficient information. Need we invoke the horror of the old CP-2000 Notices that rambled on with multiple pages of irrelevant and confusing explanations for items of income and equally irrelevant and confusing exceptions to the irrelevant items of income? You get the picture. But do refund claim disallowance notices suffer from similar logorrhea?

The Annual Report Gives Appeals and Examination an “F”

The IRS falls short in its efforts to comply with the letter and spirit of Section 6402, according to the Report, thereby interfering with at least two of the rights guaranteed under the Taxpayer Bill of Rights: the right to be informed and the right to challenge IRS’s position and be heard. The Taxpayer Advocate Service reviewed a sample of refund disallowance notices and found shortcomings running the gamut from notices providing no explanation at all(!) to notices providing lengthy, confusing explanations that nevertheless failed to supply adequate specific information from which a taxpayer could determine how to respond. Oh my!

What good is the gleaming new guaranteed right to challenge the IRS’s position if you have no idea what that position is?! How will you prepare your reply and exercise your right to be heard if you can’t figure out what the issue is in the first instance? Don’t even think about calling IRS for clarification. IRS projects it will be able to answer fewer than half of taxpayer calls in FY 2015. Those taxpayers who do manage to get through will be speaking with an IRS employee who most likely has no access to a copy of the correspondence because IRS does not keep copies of the most frequently used claim disallowance letters.

What specifically did the Annual Report find with respect to refund claim disallowance notices? Letters 105C and 106C variously failed entirely to state the specific reason for the disallowance, failed to state clearly and understandably the specific reason for the disallowance, failed to provide information adequate to permit a taxpayer to dispute the disallowance, or some combination of the three. TAS determined 92% of 105C letters reviewed failed to satisfy the purpose of 6402(l). 65% did not provide information necessary to respond. More than half did not adequately explain the reason for the disallowance. Almost a third contained sections that were not written in clear, plain language. The Report also finds fault with Appeals’ use of Letters 2681 and 2683, neither of which is designed to provide an explanation at all.

Specific examples cited in the report include notices that provided inapposite information, failed to identify which item of income was being disallowed, failed to identify which dependent, credit, or other tax benefit was being disallowed, and failed to correctly state the amount of the claim being denied.

How Far Should the Service Go?

But how much disclosure is too much disclosure? This is the perennial struggle of consumer rights advocates. Have you tried to struggle through your Cardholder Agreement for one of your credit cards lately? How about your home loan closing documents? Now consider that these documents are the streamlined – yes streamlined – products of decades of legislation and regulation intended to benefit consumers by mandating clear and conspicuous information in a format that consumers can understand. In short, as disclosure experts lament, better writing on its own cannot simplify complex concepts.

While proponents of increased disclosure view it as a means to empower consumers and increase market transparency, detractors complain disclosures are inaccessible to uneducated consumers in any event, and still other commentators take the cynical view that businesses gleefully agree to increased disclosure to avoid substantive reform and lull consumers into complacency with white noise. A recent New York Times piece sheds some light on that interesting debate.

Thank goodness the issue of disclosure in this context presents a much simpler paradigm. For example, while the Annual Report highlights certain notices’ “complicated descriptions” of refund statutes, the criticism remains largely on the Service’s failure to provide the underlying dates the Service relied on to deny the refund claims as untimely. Thus a recipient of one of these notices who may understand the Service’s complex description of the law still cannot adequately respond because he or she doesn’t know what basic facts IRS relied on. While the underlying legal issue can at times be so complex as to frustrate efforts to explain it in clear language accessible to all taxpayers, the Service can start by always including the taxpayer’s specific facts that were operative in the IRS’s decision-making process.

The Report heaps praise on the Innocent Spouse Unit and holds up its denial and no consideration letters as models of clarity the Service should look to in revising the Examination and Appeals correspondence and procedures. I think we can all agree the innocent spouse law is complex. And yet the IS Unit manages to explain it while also providing adequate information for taxpayers to understand its decision and how to respond. A great example of the Service striking the right balance!

We agree with the NTA that IRS can get refund claim disallowance notices right the first time. In view of the statutory mandate and the equally important Taxpayer Bill of Rights, it must!