On Effective Tax Administration

I often wonder if our tax laws could be administered in a more cost-effective manner. Why is it that cases continue to come out where taxpayers have to spend years arguing about a tax debt with the IRS, only to have the IRS concede the issue when it comes time for the government to prove its case? This brings me to the recent case of Lites v. Commissioner.

Lites is a case that involves taxpayers who filed their federal income tax returns late (1999 and 2000 federal income tax returns were eight days late and 2001 federal income tax return twenty nine days late), failed to make the ~$66,000 tax payment, and who failed to comply with an installment agreement (after making ~$3,000 in payments). The evidence showed that the taxpayers were a husband and wife. The husband was a financial products salesman and the primary breadwinner for their family of four. The husband underwent a number of employment changes, due to a downturn in the financial markets and due to a heart condition. The taxpayer received the notice of levy, requested a hearing (a collections due process hearing), and proposed an installment agreement. Over the course of a year the taxpayers ended up making three such proposals: one for $750 per month, one for $1,000 per month, and one for $1,200 per month. In support of these offers the taxpayers asserted that they had $888 of monthly excess income. The IRS Appeals Office rejected the taxpayers’ offers, arguing that the taxpayers had $2,732 of monthly excess income and that that amount should be paid to the IRS on a monthly basis.

At trial the IRS conceded that the taxpayers excess income was $888 a month. The court opinion does not specify whether the IRS explained how they came up with the $2,732 figure or why the IRS stuck to this figure for more than a year if it was not accurate. Our tax laws require the IRS to perform an investigation of the taxpayers financial circumstances when they consider installment agreements, so the IRS must have conducted an investigation. Because the IRS conceded that the taxpayers $888 figure was correct, the IRS investigation must have confirmed the taxpayers $888 figure. Therefore the IRS claim that the taxpayers had $2,732 of excess income was not truthful, was deceptive, and was misleading. The IRS made these misrepresentations on several occasions over a period of several years.

One would think that after the IRS disclosed that it had made these misrepresentations it would agree to settle the case. However, that did not happen. Instead, the IRS took the position that it was correct in denying the taxpayers offers because the offers exceeded what the taxpayers could afford to pay. Note that the IRS had originally rejected the taxpayers offers because they were too low. Now the IRS argues that it was entitled to reject the taxpayers offers because the offers were too high.

The court correctly noted that there is no such law that permits the IRS to reject offers because they were too high. The court stated that it was confused and perplexed by the IRSs position. The court went on to say that the IRS could not have it both ways, so it remanded the case back to the IRS for reconsideration. It would be interesting to speak with these taxpayers to see if the IRS subsequently accepts their offer. It is likely that the IRS will reject the taxpayers offer once again, requiring them to seek judicial intervention again.

It is now late in the 2005 tax year and this case was partially to resolve tax liabilities for 1999. It is likely that the IRS will not fully deny the taxpayers most recent offer by the end of this year and perhaps not by the end of next year. Why is it that the IRS cannot just tell taxpayers such as the ones in this case that the IRS investigation corroborated the taxpayers claim? Why does a case like this have to drag out for the better part of a decade? The reality is that by the time that this case is resolved the government will have spent considerably more money defending its erroneous position than the amount of the underlying tax liability. It just seems like there is something wrong here. Are we missing the big picture?

September 16th, 2005 | No Comments »

The IRS Did What?

We all make mistakes. The IRS often prosecutes taxpayers who make mistakes. On the other hand taxpayers occasionally prosecute the IRS when its employees make mistakes. This brings me to the case of Ward v. United States, a Colorado Springs case.

Ward is a case where the IRS seized a taxpayers retail business that was located in the Colorado Springs mall. The taxpayer alleged that shortly after the seizure several IRS employees unlawfully disclosed the taxpayers confidential tax return information. The government admitted that its employees unlawfully disclosed the taxpayer’s confidential tax return information when IRS employees participated in a live radio talk show program, when IRS employees provided a fact sheet to the television program Inside Edition, and when an IRS employee wrote a letter to the editor of the local newspaper. The Colorado District Court awarded the taxpayer $325,000 in damages, which was $111 more than the initial tax assessed against the taxpayer.

For once I don’t think any commentary is necessary. This case seems to speak for itself.

September 13th, 2005 | No Comments »

The (D)Evolution of our Tax Law

Our tax laws seem to evolve (devolve?) over time. This evolution seems to follow a pretty predictable pattern. I will use Action on Decision 2005-001, which is an interesting decision in and of itself, to describe this process.

In this AOD the IRS announces that it will not follow the Ninth Circuit Court of Appeal decision in Estate of Paul Mitchell v. Commissioner. The Mitchell case is yet another stock valuation case. In this case the taxpayer estate reported a stock valuation of $28.5 million and the IRS issued a notice of deficiency based on a $105 million value for estate tax purposes. At trial the IRS valuation expert placed the value at $81 million, $34 million less than the IRS’ original claim. There was evidence that the IRS valuation expert had originally appraised the value at $85 million as a minority interest, but then increased the value to $105 million at the request of the IRS. The tax court set the value at $41 million after considering the evidence.

On appeal the Ninth Circuit rejected the method that the tax court used to reach the $41 million value, noting that the discount factor used was not within the range of figures provided by the evidence (contrary to the express statement made by the tax court). The valuation issue is interesting; however, that is not the issue that the IRS chose to dispute in its AOD.

The IRS AOD contests the Ninth Circuit holding that the burden of proof at trial remains with the IRS when there is evidence that the IRS determination is invalid. For the non-lawyers, the burden of proof is the procedural rule that slants tax cases in favor of the government and often results in taxpayers having no chance of winning tax disputes. In general the government starts out with the burden of proof. The court presumes that that burden is met if the government produces a notice of deficiency (which is simply an entry in the IRS records showing that the taxpayer owes a tax). However, if there is evidence that the IRS deficiency is invalid then the burden remains with the government. In that case the government must prove that there were additional taxes owed, not the taxpayer proving that no additional taxes were owed. This may sound like mere semantics, but it is really important in determining which party will prevail in many cases.

In Mitchell there was evidence that the value used in the notice of deficiency was changed by the valuation expert at the IRS request and the IRS even asserted in court that the stock value was much less than what the value asserted in the notice of deficiency. In its AOD the IRS takes the position that this evidence should be ignored. I do not think I need to address this argument because readers will understand that it is without merit.

The IRS also takes the position that the cases that support shifting the burden of proof are not applicable because they involved cases of unreported income, not stock valuation cases. The IRS position tries to distinguish unreported income and stock valuation; however, both concepts are essentially the same for tax purposes. The reason why stock valuation is important is because, as the IRS asserted in the Mitchell case, low valuations result in additional taxes being owed. Similarly, the reason why unreported income is important is because it results in additional taxes being owed.

Furthermore, the burden shifting process employed at trial is a matter that is in the courts discretion. The court, with guidance by Constitutional principles, has the authority to say when and how the burden of proof shifts. The courts do not answer to the IRS and the IRS does not have the authority to establish our rules of judicial procedure. So the IRS decision seems to be saying to the Ninth Circuit and the Tax Court that if those courts choose to spell out how trials are to be conducted, the IRS is going to: To what? To pout? To sulk? To huff and puff and blow the house down? To nothing?

So why would the IRS issue such an AOD? The short answer is that this is the process by which our tax law evolves (or devolves). This process starts with a pro-taxpayer ruling. The IRS then begins to respond to that ruling by issuing decisions and rulings that downplay or reject the pro-taxpayer ruling. A mountain of paperwork rejecting the pro-taxpayer ruling starts to build up.

Once the mountain is large enough the IRS begins looking for taxpayers who face the same situation, but where the facts are slightly more favorable for the government (i.e., in this case the IRS’ valuation discrepancy will only be a few million dollars off of what was in the notice of deficiency and what was asserted in court). The IRS will also look for taxpayers who do not reside in the circuit that issued the pro-taxpayer ruling (in this case, the Ninth Circuit). More precisely, the IRS will shop for a circuit court that they feel will reject the other circuit courts pro-taxpayer ruling and they will seek out a taxpayer in that circuit.

Once the unsuspecting taxpayer comes along the IRS will spring its trap. The IRS will give the taxpayer no recourse but to litigate his or her case. The IRS will either win or lose. If the IRS wins it will reset its trap, which is now baited with the lower courts pro-government ruling. Eventually an unsuspecting taxpayer will take the bait and the IRS will lose in the lower courts. At that point the IRS will get what it wanted: the ability to contest the pro-taxpayer law in a particular circuit court.

By citing the new mountain of paperwork as precedent the IRS will probably be successful in convincing the circuit court to reject the other circuit court’s pro-taxpayer ruling. If the IRS loses then it faces the decision of whether to appeal the decision to the Supreme Court. Whether the IRS pursues the Supreme Court option will depend on the language used by the circuit court in its judicial opinion. If it is favorable then the IRS might go for it; if not, then the IRS will probably reset its trap and wait for another unsuspecting taxpayer in another circuit.

Over time this process results in our tax laws being slanted against taxpayers and in favor of the government. The IRS sets its trap, it bides its time, and it slowly chips away at pro-taxpayer rulings. Eventually the law gains such an anti-taxpayer bias that either the courts or the Congress step in to reset the law to more of a middle position and the process begins anew.

This process plays out year after year, case after case, and IRS decision after IRS decision. Is this is the best way to establish our tax law? Can we not come up with a system that is fairer to taxpayers? Can we not come up with a system that is less wasteful of our limited resources? Somehow it just seems like we are missing the big picture here.

September 11th, 2005 | No Comments »

IRS Rejects Court Orders, Law and Logic: Modus Operandi or Isolated Case?

Clients often ask me whether the IRS takes steps to slant the facts and law in the governments favor. I often explain that, as with most legal matters, there is really no right or wrong answer until the court makes a final determination and all appeals are exhausted. But when I say this I often think of all of the cases where courts have ruled against the IRS, the IRS lost the case on appeal, and the IRS simply rejected the rulings - justifying their defiance on a slanted view of the facts and an illogical interpretation of the law. There are numerous examples of this, but the IRS non-acquiescence in In re Macher case brought the issue back to mind so I will discuss the topic in light of that case.

The Macher case involves the IRS practice of not considering offers-in-compromises submitted by taxpayers who are undergoing bankruptcy (the offer-in-compromise is essentially a means for requesting that the IRS to accept less than what is owed). Because of this IRS practice Macher did not complete the IRS Form 656, which is the form used to submit an offer in compromise. Instead Macher asked the Bankruptcy Court to exercise its statutorily granted equitable powers to order the IRS to consider the taxpayers plan of reorganization as an offer in compromise. The Bankruptcy Court made that order and, on appeal, the District Court affirmed the order. The IRS issued a two-page action-on-decision to discount both courts rulings and to state that the IRS will not follow either ruling. The analysis in this two page decision is slanted, illogical, and it fails to fully address the applicable law.

The IRS decision starts by defining the issue as a question of the Bankruptcy Courts authority. In support of this argument the IRS decision cites to a non-bankruptcy related Tax Code section and the supporting Treasury Department Regulation, both of which define the IRS authority to compromise tax liabilities. By making this statement about the IRS authority the IRS seems to be implying that its authority is greater than the authority vested in the Bankruptcy and District Courts. That is just not the case. In bankruptcy matters, including tax matters arising during the bankruptcy process, Congress has vested power to resolve the matter in the Bankruptcy Courts, not the IRS. Moreover, the IRS opinion did not mention the power of the District Court that upheld the Bankruptcy Courts order, but we will ignore that issue as it is more complex.

The IRS decision then goes on to discount the Bankruptcy Code section that grants the Bankruptcy Court the power to make orders to carry out the intent of the Bankruptcy Code. The IRS decision cites dicta (legal term referring to ideas pulled out of a case that were not pertinent to the holding of the case; ideas which are often suspect because they are often taken out of context) from two cases that have no bearing on the present case. One cite states that the Bankruptcy Courts powers must be exercised within the confines of the Bankruptcy Code (this would mean that the Bankruptcy Court could make no order involving taxes that isn’t specified in the Bankruptcy Code, which is just not true) and the other states that the Bankruptcy Courts powers must not override specific provisions of the Bankruptcy Code (which seems to imply that there was some provision of the Bankruptcy Code regarding the Bankruptcy Courts powers that was overridden, which was not the case here).

What the IRS decision failed to mention is that Congress specifically enacted a rule that prohibits any agency or person from treating a debtor in bankruptcy different due to the fact that the debtor is in bankruptcy. It is as if the IRS does not recognize that refusing to consider otherwise valid offer in compromise from a debtor in bankruptcy while considering otherwise valid offers in compromises from non-debtors in bankruptcy violates that statutory provision. In addition, the IRS decision fails to consider how the IRS practice violates the taxpayers Constitutional rights, such as how this practice is just another instance where the government is treating similarly situated persons differently, how this practice is an arbitrary taking of the taxpayers property, or how this practice effectively prohibits taxpayers in bankruptcy the opportunity to present and defend their case. Perhaps the IRS should re-frame the issue in their decision as: whether the IRS has the authority to treat taxpayers undergoing bankruptcy less favorably than those not undergoing bankruptcy or whether the IRS has the authority to take taxpayers property without affording them any due process of law.

True to form, the IRS decision then concludes with an irrelevant holding. I cite it here just so that we can all enjoy the true splendor of how irrelevant the conclusion is: Offers in compromise submitted on Forms 656 by taxpayers who are currently in bankruptcy will continue to be returned as non-processable under the procedures set forth in [the IRS Treasury Regulation and IRS Policy Manual].

As you will recall this case was about a taxpayer that did not submit a Form 656. That was the whole point. The taxpayer skipped the Form 656 and asked the Bankruptcy Court to exercise its equitable powers.

The IRS conclusion continues: Payment proposals submitted by taxpayers in bankruptcy will be considered by Insolvency employees in the context of their review of proposed plans, subject to the time constraints and other factors that are unique to bankruptcy litigation, and will be accepted when it is in the interest of the United States to do so.

Again, this conclusion does not address the Bankruptcy Courts equitable powers. The IRS decision indicates that the IRS does and will not acquiesce to the exercise of the Bankruptcy Courts equitable powers (by listing the word nonacquiescence at the bottom of the decision), yet nowhere in the IRS decision does the IRS actually state that the IRS will not follow the Bankruptcy Courts order.

My take on the IRS decision not expressly stating a conclusion is that the authors of the IRS decision know that the IRS position is incorrect. The IRS does not have the power to ignore an express mandate by the Bankruptcy and District Courts that was made pursuant to a law enacted by Congress or to violate the taxpayers Constitutional rights. It will be interesting to see the fallout when another taxpayer asks a Bankruptcy Court to exercise its equitable powers in a similar fashion.

So for now the bottom line is that the next time a client asks me if the IRS takes steps to slant the facts and law in the governments favor I will simply respond by saying: “yes, yes they do.”

September 5th, 2005 | No Comments »

US Supreme Court Weighed In On Tax Court Violating its Own Rules - Yet Nothing has Changed

The US tax court has somewhat of a controversial history, as far as courts go. The court, initially named the board of tax appeals, fell under the aegis of the executive branch of the federal government. The court underwent two subsequent name changes and, in an effort to distance itself from the IRS, the court left the executive branch to become an independent court. It was hoped that an independent court would be more fair and impartial in handling taxpayers cases. The Supreme Court in Ballard v. Commissioner indicated that the tax court may still have some way to go in this regard – the question now is when will the court do so.

The Ballard case essentially involves one judge presiding over a case, siding with the taxpayers, and preparing a report stating the outcome of the case. The case was subsequently reassigned to a second judge who entered a contrary finding, a finding issued four years after the trial and made without even having heard the case. The tax courts own rules specify that the second judge is to adopt, modify, or reject the first judge’s report – not write a new report. When the taxpayers discovered that the second judge had disregarded the first judge’s report, they sought access to the report for appeals purposes. The tax court refused that request; expressly stating that the second judge had given due regard to the first judge’s report. On appeal, the appeals court found nothing wrong with the tax courts actions. However, the Supreme Court was not willing to do the same. The Supreme Court’s observed that:

“It is difficult to comprehend how a Tax Court judge would give [d]ue regard to, and presum[e] to be correct, an opinion he himself collaborated in producing. The tax court, like all other decision making tribunals, is obliged to follow its own Rules.”

and

“Should the Tax Court some day amend its Rules to adopt the idiosyncratic procedure here rejected, the changed character of the Tax Court judges review of special trial judge reports would be subject to appellate review for consistency with the relevant federal statutes and due process.”

What makes this case particularly troubling is that the tax court disregarded its own rules (for over twenty years!), made an expressly misleading (arguably false) statement, and the court took steps to cloak their rule violation. It appears that none of the judges involved were removed or barred from office or sanctioned in any other way. Moreover, the court has not amended its rules or taken any steps to ensure that taxpayers do not run into the same or similar situations in the future. After reading the Supreme Court’s opinion and considering the tax courts failure to reform its procedures and rules one can only wonder whether the tax court is a fair and impartial forum and whether an attorney can in good faith recommend that his or her client pursue their case in that forum. These are very serious questions.

If the tax court will not reform its own procedures and rules then perhaps it is time for Congressional intervention.

September 3rd, 2005 | No Comments »

The Forgetful CPA

This blog has been too serious as of late, so I am going to start talking about some fun tax cases. This brings me to the case of Paul A. Bilzerian v. Commissioner. This is another one of my favorite cases.

Poor Paul failed to report about $4 million dollars on his tax return. Paul blamed the error on a mistake made by his CPA. In all fairness to the CPA this mistake could have been an error and it could have resulted from the work of another accounting firm. But in honorable fashion the CPA tried to blame the error on his client, poor Paul. This was a very serious case. It involved substantial additions to tax, penalties, and interest. The client, poor Paul, could have easily gone to jail and he may very well have. So you might be asking what makes this case a fun tax case?

What makes this a fun case is not the taxpayer, the tax or even the law. Rather the CPA is what makes this a fun case. Put yourself in the CPA’s shoes. He is trying to argue that he was not at fault, so the CPA testified that he “missed about $4 million in income.” That was probably the only forthright statement that the CPA made, as the court summed up the rest of the CPA’s testimony as “vague, evasive, and contradictory.” Those are strong words. I cite some of the CPA’s testimony here so that you can judge for yourself:

• Question: All right. And is it true that you denied liability — any liability for malpractice in that case [referring to a malpractice case poor Paul filed against the CPA]?
• Answer: I really don’t remember what I said or didn’t say. I would assume that that’s true, but I don’t know for sure. I don’t remember the case now at all.
• Question: This would’ve been about eight years ago.
• Answer: Yes.
• Question: Did you get sued often?
• Answer: No, I have never been sued before.
• Question: And your testimony then is: you got sued and don’t remember anything.
• Answer: What I’m saying is that I turned it over to the attorney who is representing me and the insurance company, and he did whatever he needed to do, and I was involved to a very small degree.
• Question: What was the result of the lawsuit?
• Answer: It was, I think, withdrawn, I believe. I think it was withdrawn.
• Question: And you didn’t have to pay any money, did you, as a result of this lawsuit to Paul Bilzerian.
• Answer: No, not to him.
• Question: To anybody?
• Answer: Oh, I paid legal fees, and if it would’ve been my insurance company would’ve paid. I wouldn’t have paid him anyhow [note the CPA’s concern for his client].
• Question: Do you remember any depositions in connection with that lawsuit?
• Answer: I don’t, but I won’t say that there wasn’t, but the thing is is that, as I said, that whole thing is just been — I have forgot it all. It was not important for me to remember, and I haven’t gone back and reviewed any papers.
• Question: Do you remember accepting liability or denying liability in that lawsuit?
• Answer: I am assuming that if I went to the attorney I probably denied liability.
• Question: Okay. Didn’t we speak about a week ago or so?
• Answer: Yes.
• Question: And in that conversation you told me that you deny liability?
• Answer: I don’t remember if I said that to you. I probably said that to you, though. But you are asking me questions that I really, in my memory since, I don’t know. I can only tell you what I think [for the non-attorneys, the only way that the attorney could ask this last question is if it has a basis in reality, meaning that the CPA had in fact denied liability one week prior].

Wow! Would you hire that CPA (or have you)? The CPA’s mistakes could result in the taxpayer going to jail; facing penalties, interest, and additions to tax; and the loss of a hard-earned business reputation, the business itself, and even taxpayer’s family and friends. Yet, based on the CPA’s testimony, the CPA seems to be indifferent to his client’s situation. In fact, he seems to be completely at peace with his client’s situation.

This just goes to show that we don’t need religion, spirituality, medication, or even meditation or yoga to find inner peace. The secret to finding inner peace is simply to forget everything….

August 28th, 2005 | No Comments »

Tax Treatment of Settlement Agreements: A Review For Plaintiffs’ Attorneys

Certain types of tax disputes seem to arise again and again year after year. By way of example, for the past several years the US Tax Court has heard several cases involving injury settlement awards that were not properly structured. The fact patterns in these cases are all basically the same: taxpayer is injured, taxpayer enters into a settlement agreement, taxpayer fails to report the settlement award on their tax return, the IRS issues a notice of deficiency, the taxpayer initiates litigation, and the taxpayer ends up having to pay the tax, penalties, and interest. The rules and issues involved in these cases are relatively simple. This post is just a brief reminder of the rules for the Plaintiffs’ attorneys.

The analysis starts with the rule that all income is taxable income unless the item of income is specifically excepted by some other provision. One such provision provides that any damages (other than punitive damages) are excluded from income if they are received on account of personal physical injuries or physical sickness. Damages for emotional distress do not qualify for this exception. The damages that are allowed include damages received via litigation or settlements if they are based on tort or tort type rights and are received on account of personal physical injuries or sickness. Whether tort rights or tort type rights are involved is based on state law and requires an examination of the nature of the underlying claim. Similarly, whether damages are received on account of personal physical injuries requires an examination of the nature of the claim underlying the settlement.

Simply mentioning a physical injury in the initial pleading is not enough to qualify for this tax exemption. Likewise, simply stating in the settlement agreement that the agreement is for the release of the right to sue, to avoid the expense of trial, or to settle all claims is not sufficient. The settlement agreement must state that the settlement was made solely to compensate the recipient for his or her personal physical injury – even if the settlement is partially for emotional and physical injuries. If the agreement does not contain this language then the IRS will likely issue a notice of deficiency and argue that the intent of making the payment was not to compensate the taxpayer for his or her physical injuries. In these cases the courts almost always find that the intent and dominant reason is simply to settle all claims, rather than to compensate the taxpayer for his or her personal physical injuries.

That is just about all there is to these cases. They are not that difficult and they can easily be avoided; yet they continue to be a problem.

August 26th, 2005 | No Comments »