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 »

The IRS Should Not be able to Solicit Criminal Information from Non-Lawyer Tax Practitioners

Civil tax cases often turn into criminal tax cases. In those instances the IRS initially investigates the tax crime and then refers the case to the Department of Justice. The IRS efforts to investigate the potential tax crime often require that they obtain information from third parties, such as the taxpayer’s employer, neighbors, and financial advisers. These types of inquiries can be detrimental to the taxpayer’s reputation in the community and livelihood – all before the taxpayer has had a chance to defend him or herself. The Congress and the courts have recognized that these types of visits should be minimized if at all possible.

The Congress and the courts have specified that the IRS must gather information from the taxpayer before looking to third parties. The idea is that taxpayers should be able to fully comply with IRS tax investigations in order to limit the damage that they suffer when the IRS conducts a criminal investigation. Yet the IRS has interpreted the law, as outlined by Congress and the courts, to mean that the IRS can gather information from third parties without first considering whether the taxpayer would produce the information if it is “helpful” or “appropriate.” That interpretation negates the very law it is based upon.

That interpretation is often detrimental to the taxpayer’s fundamental civil liberties. For example, imagine a situation where the taxpayer hires a non-lawyer tax practitioner to resolve a tax dispute with the IRS. In that case the IRS would initially begin soliciting information from the taxpayer and third parties to build a civil case against the taxpayer. But the IRS would begin soliciting information to support a criminal case if the IRS suspects that a tax crime has been committed. At that point the taxpayer may be subject to questioning by government actors without the aid of competent counsel, which raises some serious Constitutional issues. But ignoring those issues, the IRS may turn to third parties to gather information to support the criminal case. Those third parties will probably include the taxpayer’s non-lawyer tax practitioner. Believing that they are helping the taxpayer resolve a civil tax matter, the non-lawyer practitioner may make damaging statements or turn over otherwise privileged information to the government. This can result in the non-lawyer practitioner making the government’s criminal case.

This situation results in the government being able to gather information that might not otherwise be admissible in court if it were gathered after the government had announced its plan to pursue a criminal case against the taxpayer.

But can you fault the non-lawyer practitioner? In most cases the tax practitioner does not have any legal training to spot these issues and there may be no indication that the government has begun soliciting information for anything other than a civil case. After all, at that point the IRS may not have even contacted the Department of Justice.

If that is not bad enough the investigation may reveal that the non-lawyer practitioner has knowledge of information surrounding the criminal tax matter. In that event the investigation may result in the non-lawyer tax practitioner being compelled to testify in court against the taxpayer. Congress has passed a statute exempting some tax practitioners from having to make such disclosures, but that law was poorly drafted and to my knowledge it has never been tested in court. The statute appears to be so poorly drafted that it would not withstand judicial scrutiny.

If we continue to allow non-lawyer tax practitioners to represent clients with tax matters then we should limit the IRS’s ability to solicit criminal information from them.

August 21st, 2005 | No Comments »

Estate & Trust Attorneys Will Increasingly be Subject to Malpractice Actions Brought by Beneficiaries

It is now well established that a plaintiff s attorney should be subject to malpractice liability for not proposing a structured settlement annuity versus a lump sum payment to their injured clients and for not seeking the advice and assistance of a competent financial adviser in the process. The principles underlying this type of malpractice liability seem to justify holding estate and trust attorneys liable for failing to take steps to protect inheritors of wealth.

The lawyer’s liability in personal injury cases is based on the notion that the recipient of a lump sum payment will most likely not be able to competently manage the wealth. As a result it is thought that the wealth will dissipated before the needs of the injured party are met. So imposing liability on the lawyer helps to ensure that the injured party is not able to easily use the wealth for the purposes other than those in which it was received.

In addition, the lawyer’s liability may be based on failing to bring in a financial adviser to prevent the defense’s financial adviser from proposing an unfair transaction. Defense advisers typically have a commission arrangement with the defendant insurance companies. As a result they often have a strong incentive to make the settlement as low as possible (I am sure they would object to that statement). The plaintiff’s financial adviser helps level the playing field.

How is this any different than beneficiaries of inheritances who win the birth lottery? Like the injured party in a personal injury case, the beneficiary of new-found-wealth is probably in a weakened state. More times than not they grew up wealthy, meaning that they were protected by their wealth and therefore they did not develop the life skills necessary to manage their own affairs — yet alone their new-found-wealth. Recognizing this situation, wealth creators often turn to their estate and trust attorneys to help ensure that their wealth continues to protect their beneficiaries in light of the beneficiary’s wealth-created limitations. The typical response of estate and trust attorneys is to form various entities, such as a family limited partnerships or other business structures or a spendthrift trusts with sprinkling or discretionary or hold back provisions.

When the wealth creator meets his or her demise, the beneficiary finds his or herself in front of a trust officer, insurance agent, and/or investment broker. The trust officer earns a living by drawing down the funds over time; whereas, the insurance agent and investment broker earn a commission by encouraging the beneficiary to spend the money up front.

So if the trust officer is the first to arrive on the scene it is likely that the trust officer, under the hold back provision, will talk the beneficiary out of spending each and every penny. The trust officer will employ several avoidance techniques, such as not answering the phone and not returning phone calls. The trust officer may also exploit the dynamics underlying the beneficiary’s family relationships to “encourage” the beneficiary not to spend any of his or her wealth. Not having the ability to manage their own affairs and having no money to remedy the situation, the beneficiaries will (sadly) be in an unenviable position. On paper they are monetarily rich, but in reality they are monetarily and probably emotionally poor. Even if they knew where to look for help, the beneficiary would not want to do so for fear of the trust company, family members, and even fear of exposing their own limitations. This is probably a far cry from what the wealth creator had envisioned.

On the other hand, if an insurance or investment professional was the first responder then it is likely that the beneficiary will make a large and probably inappropriate purchase and neither the insurance nor the investment professional will stick around to help the beneficiary obtain the necessary life skills to competently manage their new-found-wealth. As a result of the commission that the professional earned and of the lack of proper guidance, the wealth will probably dissipate in a very short period of time.

In a number of ways these situations are strikingly similar to situations involving plaintiffs’ attorneys who fail to recommend structured settlements and/or fail to bring in a knowledgeable financial adviser. I am not aware of any particular malpractice case brought on these grounds, but I do believe it is only a matter of time before creative malpractice attorneys start filing these types of cases (the amount of money at steak makes these types of cases prime candidates for contingent-fee-motivated plaintiff attorneys).

Just imagine the case where a beneficiary of a sizable estate blows through his or her inheritance in a relatively short period of time (or conversely where the trust officer does not allow the beneficiary to spend a penny). The wealth creator’s estate and trust attorney is sued and takes the stand to testify. On cross-examination the cross-examiner asks the witness what steps they took to help prevent this situation from occurring. The witness responds, “I created a family limited partnership that included various transfer restrictions and provisions for replacing the manager.” The cross-examiner asks the witness basic questions about the wealth creators family and about the beneficiaries. For the most part the witness responds, “I don’t know.” The cross-examiner asks the witness if they have ever even met the beneficiary. The witness responds, “No.” Then the clincher. The cross-examiner asks the witness whether they knew that the beneficiary had a history of using drugs, a history of poor money management, a history of dominating other family members, etc. The witness responds, “No.”

These cases are out there. So what should trust and estate attorneys do in these cases to ward off this type of liability? Find a wealth coach and bring them in at the point where the wealth creator is proposing to pass wealth to others. This would help prevent this type of case from being brought. But if it were brought then the cross-examination might look something like this: The cross-examiner asks the witness what steps they took to help prevent this situation from occurring. The witness responds, “I referred the wealth creator and his/her beneficiaries to a wealth coach who helped manage the wealth transfer process and who educated and counseled the beneficiary so that they would be able to competently manage their new-found-wealth. After that I followed up with the wealth coach to make sure that the beneficiary was making progress.”

While it is not an iron-clad defense, it is at least a defense.

August 11th, 2005 | No Comments »

The Art of Speaking out of Both Sides of Your Mouth

As with other attorneys, tax attorneys often find themselves taking contrary positions on the same law in different cases. These situations can be difficult. The professional rules governing attorneys’ conduct help to spell out the attorneys’ duties in these instances. The more challenging situations for tax attorneys arise when the attorney is called upon to take contrary positions on the same law in the same case. This often arises when the tax attorney does tax planning which includes the creation of various legal entities. I will discuss the example of creating a family limited partnership to highlight the problem.

A family limited partnership is a structure that is established with the aim of passing a family business to the next generation. Family limited partnerships often have estate and gift tax benefits. During the lifetime of the business owner shares of the partnership can be given away at substantial tax valuation discounts (thus saving the unified credit and gift taxes). Similarly, the estate of the original owner of the family limited partnership is reduced by lifetime transfers and the shares of the partnership owned by the decedent upon his or her demise often qualify for substantial tax valuation discounts (thus saving estate taxes).

The IRS often attacks family limited partnerships by arguing that the transaction lacks a valid business purpose. In some cases the family limited partnership may consist of nothing more a group of stocks that are all publicly traded. In response tax attorneys often argue that the family limited partnership has a valid business purpose. They argue that the business purpose is not merely tax savings, it is creditor protection (i.e., or to put the business assets in an entity that contains restrictions so that lower generations creditors or spendthrift habits will not deplete the business assets).

But, if the business owner has an outstanding liability with a creditor at the time that the entity was established or if such a creditor materializes within a certain period after the formation of the entity (usually four years), then the attorney must argue that the transfer was not for creditor protection, it was for tax savings. This (hopefully, but not always) allows the business owner to avoid civil and even criminal liability for making a fraudulent transfer and, by extension, allows the tax attorney to avoid the same liability for aiding and abetting the business owner. The state and federal fraudulent transfer rules have a number of requirements, such as evidence of certain badges of fraud or constructive fraud. The laws really are a fascinating read, but such a discussion is beyond the scope of this blog posting (I will save that one for later).

August 8th, 2005 | No Comments »