Posted by: | September 15, 2014

Bankruptcy (Tax) Law Must Apply Equally to the Rich and Poor Alike . . .

Generally, subject to certain statutory exceptions, a debtor is permitted to discharge all debts that arose before the filing of his bankruptcy petition.[1] With respect to tax debts, the Bankruptcy Code provides that a debtor may not discharge any tax debts “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” [2]

Today, the Ninth Circuit Court of Appeals “reversed and remanded” a district court’s earlier affirmance of the bankruptcy court’s judgment that a chapter 11 debtor’s tax debts should not be discharged on the basis of his alleged “willful attempt to evade or defeat taxes” under 11 U.S.C. § 523(a)(1)(C).[3]

The Rich Are Different . . . They Have More Money. In a somewhat colorful opinion, the Ninth Circuit Majority stated “F. Scott Fitzgerald observed early in his career that the very rich ‘are different from you and me,’[4] to which Ernest Hemingway later rejoined, ‘Yes, they have more money.’[5] As with many bankruptcy cases involving the wealthy, our saga reads like a Fitzgerald novel, telling the story of acquisition and loss of the American dream, and the consequences that follow.”

In association with various “tax shelter” transactions, the IRS made aggregate assessments against the underlying taxpayer for tax years 1997–2000 totaling $21 million and the California Franchise Tax Board also made assessments which totaled $15.3 million. With overall limited financial resources, the taxpayer ultimately found himself attempting to resolve these debts in a bankruptcy proceeding. The bankruptcy court opinion determined that the taxpayer (and his wife) “did very little to alter their lavish lifestyle after it became apparent in 2003 that they were insolvent and that their personal living expenses exceeded their earned income.”

Changing direction, the Ninth Circuit noted that the taxpayer “sold his primary residence and paid the entire $6.5 million net proceeds to the IRS. A month later, the FTB seized $6 million from various financial accounts. In September of that year, the [taxpayer] filed a Chapter 11 bankruptcy petition, which the bankruptcy court found was for the primary purpose of dealing with their tax obligations. Shortly after filing, the [taxpayer] sold the La Jolla condominium for $3.5 million and paid the proceeds to the IRS. Even after these payments and the seizure by the FTB, the IRS filed a proof of claim for $19 million and the FTB filed a claim for $10.4 million.”[6] To settle the remaining IRS liability, the taxpayer submitted an offer in compromise of $8 million, which was rejected.

The Ninth Circuit deemed it important that most of the expenditures by the taxpayer along the way “were made consistent with [taxpayer’s] past spending practices, and investments were made in property that would be subject to tax liens. As far as the record discloses thus far, there were no financial transfers into nominee accounts or concealment of assets, although the government claims that some funds ordered paid into trust by the family court were done so with the intent of tax evasion.” It also appears the taxpayer was investing funds improving or preserving property encumbered with tax liens that would ultimately accrue in a benefit to be received by the government when the property was sold.

The IRS and FTB alleged that the assessed liabilities could not be discharged in bankruptcy pursuant to 11 U.S.C. § 523(a) (1) (c), which excludes from discharge any debt “with respect to which the debtor . . .  willfully attempted in any manner to evade or defeat such tax.” (Emphasis added).  The primary, but not exclusive, theory of the IRS and FTB was that the [taxpayers] maintenance of a rich lifestyle constituted a “willful attempt to evade taxes.”

The bankruptcy court rejected most of the other government theories, but stated that the [taxpayer's] personal living expenses from January 2004 to September 2006 were “truly exceptional.” The bankruptcy court estimated that the couples’ personal expenses exceeded their earned income by $516,000 to $2.35 million during the years at issue. Given these facts, the bankruptcy court concluded that, as to the Taxpayer-Husband, the tax debts were excluded from discharge; the district court affirmed and the appeal to the Ninth Circuit followed.

Specific Intent Required? The Ninth Circuit noted that “The key question in this case is the meaning of the word ‘willful’ in the statute. Unfortunately, the plain words of the text do not answer that question because, as the Supreme Court has observed, ‘willful . . . is a word of many meanings, its construction often being influenced by its context.’ Spies v. United States, 317 U.S. 492, 497 (1943). Context matters in this case. The Bankruptcy Code is designed to provide a “fresh start” to the discharged debtor. [Citation omitted]. As a result, the Supreme Court has interpreted exceptions to the broad presumption of discharge narrowly. See Kawaauhau v. Geiger, 523 U.S. 57, 62 (1998). As we have observed ‘exceptions to discharge should be limited to dishonest debtors seeking to abuse the bankruptcy system in order to evade the consequences of their misconduct.’ [Citation omitted].”

Further, “[t]hus, the ‘fresh start’ philosophy of the Bankruptcy Code argues for a stricter interpretation of ‘willfully’ than an expansive definition. . . . The structure of the statute also supports a narrow construction of ‘willfully.’ The discharge exception at issue, § 523(a) (1), lists tax and customs debts warranting exception in three categories. Under § 523(a) (1) (A), numerous types of debts are excepted from discharge on a strict liability basis. Under § 523(a) (1) (B), tax debts for which a return was not filed or was filed late may not be discharged. Section 523(a) (1) (C) is the grouping at issue here: no discharge is permitted for tax debts “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” 11 U.S.C. § 523(a) (1) (C). The grouping of the fraudulent return offense with the evasion offense in subsection (C)—rather than with the other offenses involving tax returns in subsection (B)—suggests that it is more akin to attempted tax evasion than to failing to file a timely return. If a willful attempt to evade taxation requires mere knowledge of the tax consequences of an act, and no bad purpose, then it is difficult to see how such acts resemble the filing of a fraudulent return. By contrast, if a willful attempt requires bad purpose, then such acts are naturally grouped with other acts requiring bad purpose, such as filing a fraudulently false return.” (Emphasis added).       

The Ninth Circuit Majority. Given the structure of § 523(a)(1) as a whole, the Ninth Circuit Majority concluded that declaring a tax debt nondischargeable under 11 U.S.C. § 523(a)(1)(C) on the basis that the debtor “willfully attempted in any manner to evade or defeat such tax” requires a showing of specific intent to evade the tax. Specifically, “[t]herefore, a mere showing of spending in excess of income is not sufficient to establish the required intent to evade tax; the government must establish that the debtor took the actions with the specific intent of evading taxes. Indeed, if simply living beyond one’s means, or paying bills to other creditors prior to bankruptcy, were sufficient to establish a willful attempt to evade taxes, there would be few personal bankruptcies in which taxes would be dischargeable. Such a rule could create a large ripple effect throughout the bankruptcy system. As to discharge of debts, bankruptcy law must apply equally to the rich and poor alike, fulfilling the Constitution’s requirement that Congress establish ‘uniform laws on the subject of bankruptcies throughout the United States.’ U.S. Const., art. I, § 8, cl. 4.”

The Dissent. With obvious passion, the dissent noted, in part,: “I respectfully dissent. I agree with the majority that the rich are different in many ways, but that difference should not include an unfettered ability to dodge taxes with impunity. . . . The majority’s conclusion, in my view, creates a circuit split and turns a blind eye to the shenanigans of the rich. . . . . Providing a fresh start under the Bankruptcy Code should not extend to aiding and abetting wealthy tax dodgers. I respectfully dissent.”

Conclusion. What mental state is required in order to find that a bankruptcy debtor’s federal tax liabilities should be excluded from a bankruptcy discharge under 11 U.S.C. § 523(a)(1)(c) because he “willfully attempted in any manner to evade or defeat such tax”? Consistent with similar provisions in the Internal Revenue Code, the Ninth Circuit Majority concluded that “specific intent . . . to evade or defeat such tax” is required for the tax debt to not be discharged in a bankruptcy proceeding and remanded the underlying case to the district for a re-evaluation under that standard.

The result in this case might seem obvious to most – to “willfully evade tax” it should be clear that the debtor took some actions with the specific intent of evading taxes, i.e., financial transfers into nominee accounts or concealment of assets, etc. Continuing to mostly live life as they had before the underlying debts accrued, selling assets such that all proceeds are distributed to the government, making investments in assets already subjected to the tax liens, etc. would not seem to support the requisite “specific intent . . . to evade or defeat such tax.

In tax nothing is obvious until various levels of courts and sometimes even the U.S. Supreme Court have had a chance to evaluate and re-evaluate potentially relevant events. Rich or poor, the tax code (and the bankruptcy code) apply to the taxpayer (debtor) and, at least in this situation (although the dissenting opinion certainly disagrees) the Ninth Circuit seems to have gotten it exactly right.


[1] 11 U.S.C. § 727(b) and 11 U.S.C. § 523

[2] 11 U.S.C. § 523(a)(1)(C) (emphasis added).

[3] See William M. Hawkins, III, aka Trip Hawkins, Appellant, v. The Franchise Tax Board of California; United States of America, Internal Revenue Service, Appellees (9th Circuit No. 11-16276; September 15, 2014).

[4] F. Scott Fitzgerald, The Rich Boy, in The Short Stories of F. Scott Fitzgerald: A New Collection 317  Matthew J. Bruccoli ed., Scribner 1989) (1926).

[5] Ernest Hemingway, The Snows of Kilimanjaro, in The Snows of Kilimanjaro and Other Stories 23 (Scribner 1961) (1936). (Hemingway, quoting the critic Mary Colum without attribution, used Fitzgerald’s name in the original magazine version of the short story, but altered the name to “Julian” in the later published book. See Eddy Dow, Letter to the Editor, The Rich Are Different, N.Y. Times, November 13, 1988, available at different-907188.html.)

[6] The Ninth Circuit also noted that the IRS received a $3.4 million distribution pursuant to a  liquidating plan of reorganization, which was confirmed by the bankruptcy court.


Voluntary Disclosure. Practitioners often struggle with the issue of whether a taxpayer can avoid a criminal tax investigation by making a disclosure to the IRS.  A “voluntary disclosure” is generally the process of voluntarily reporting previously undisclosed income (or false deductions) through an amended return or the filing of a delinquent return. A taxpayer’s timely, voluntary disclosure of a significant unreported tax liability is an important factor to the IRS in considering whether the matter should be referred to the U.S. Department of Justice for criminal prosecution.

A voluntary disclosure must be truthful, timely and complete, and the taxpayer must demonstrate a willingness to cooperate (and must in fact cooperate) with the IRS in determining the correct tax liability. Further, the taxpayer must make good faith arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable. Additionally, the policy only applies to income earned through a legal business – so called “legal source” income.

IRS and JOJ Voluntary Disclosure Practice. Importantly, the IRS Voluntary Disclosure Practice describes a voluntary disclosure to include: (6) Examples of voluntary disclosures include: a. a letter from an attorney which encloses amended returns from a client which are complete and accurate (reporting legal source income omitted from the original returns), which offers to pay the tax, interest, and any penalties determined by the IRS to be applicable in full and which meets the timeliness standard set forth above. This is a voluntary disclosure because all elements . . . above are met.” See Internal Revenue Manual (IRM) If this process is pursued, it is important that all the appropriate “bells and whistles” set forth in the IRM are followed, exactly.

The Department of Justice maintains a voluntary disclosure policy that provides: “Whenever a person voluntarily discloses that he or she committed a crime before any investigation of the person’s conduct begins, that factor is considered by the Tax Division along with all other factors in the case in determining whether to pursue criminal prosecution. If a putative criminal defendant has complied in all respects with all of the requirements of the Internal Revenue Service’s voluntary disclosure practice, the Tax Division may consider that factor in its exercise of prosecutorial discretion. It will consider, inter alia, the timeliness of the voluntary disclosure, what prompted the person to make the disclosure, and whether the person fully and truthfully cooperated with the government by paying past tax liabilities, complying with subsequent tax obligations, and assisting in the prosecution of other persons involved in the crime.” Section 4.01, Criminal Tax Manual, U.S. Department of Justice (2008).

Further, the Department’s Policy Directives and Memoranda provides: “. . . the Service’s voluntary disclosure policy remains, as it has since 1952, an exercise of prosecutorial discretion that does not, and legally could not, confer any legal rights on taxpayers. If the Service has referred a case to the Division, it is reasonable and appropriate to assume that the Service has considered any voluntary disclosure claims made by the taxpayer and has referred the case to the Division in a manner consistent with its public statements and internal policies. As a result, our review is normally confined to the merits of the case and the application of the Department’s voluntary disclosure policy set forth in Section 4.01 of the Criminal Tax Manual.” Section 3, Policy Directives and Memoranda, Tax Division, U.S. Department of Justice (02/17/1993).

A practitioner should always advise a client seeking advice about a potential voluntary disclosure that the client must comply with the next set of filing requirements. Any suggestion to the contrary by the practitioner could subject him or her to potential criminal liability for aiding or assisting in the failure to file a return or the filing of a false return. This precept becomes important because many clients express a fear that a current filing may trigger scrutiny of their prior conduct, and some change their minds about making a voluntary disclosure prior to actually filing. Thus, the practitioner should always advise the client of the legal requirements for the current filing season and memorialize in the file that such advice was given.

Taxpayers cannot rely on the fact that other similarly situated taxpayers may not have been recommended for criminal prosecution.  A timely voluntary disclosure will not guarantee immunity from criminal prosecution, but a true voluntary disclosure will normally result in the IRS not even recommending a criminal prosecution to the Department of Justice.

Timely? To be timely, the disclosure must generally be received before: (i) the IRS has initiated a civil examination or criminal investigation of the taxpayer, or has notified the taxpayer that it intends to commence such an examination or investigation; (ii) the IRS has received information from a third party (e.g., informant, other governmental agency, or the media) alerting the IRS to the specific taxpayer’s noncompliance; (iii) the IRS has initiated a civil examination or criminal investigation which is directly related to the specific liability of the taxpayer; or (iv) the IRS has acquired information directly related to the specific liability of the taxpayer from a criminal enforcement action (e.g., search warrant, grand jury subpoena).

Any taxpayer who contacts the IRS regarding voluntary disclosure may be directed to IRS-CI for an evaluation of the disclosure. To determine whether the disclosure is truly voluntary, IRS will review the actual status of any prior interest in the taxpayer, the taxpayer’s potential knowledge of such interest, and the taxpayer’s fear of some potential trigger that could have alerted the IRS.  A voluntary disclosure cannot be made anonymously. Any plan by a taxpayer, or their representative, to resolve a tax liability, file a correct return, or offer payment of taxes for an anonymous client is not likely to be considered a voluntary disclosure.

A voluntary disclosure does not occur until IRS has actually been contacted.  As such, it is imperative that the disclosure occur as quickly as possible.  Since returns filed pursuant to a timely voluntary disclosure have significant audit potential, they should be “bulletproof” in correctly reflecting the taxpayer’s income and expense items.

Fed-State Information Sharing. Due to various federal-state information sharing agreements, any applicable state returns should be contemporaneously filed or amended with the federal returns. Returns for related entities should also be contemporaneously filed or amended. Questions or doubts should likely be resolved in favor of the government. If a return filed pursuant to a voluntary disclosure is less than accurate, the taxpayer is compounding – not helping the problem.

Qualified Amended Return (QAR). Under certain situations, a timely  filed amended return may reduce or eliminate accuracy-related penalties. The “amount shown as the tax by the taxpayer on his return” not subject to penalties includes an amount shown as additional tax on a QAR, except that such amount is not included if it relates to a fraudulent position on the original return. See Treas. Reg. § 6664-2(c).  A QAR effectively eliminates accuracy-related penalties by removing amounts shown on the amended return from the penalty calculation. Significantly, even if timely, an amended return does not qualify as a QAR if the tax deficiencies that are corrected in the amended return relate to a fraudulent position on the original filed return.

How many returns must be filed or amended?  While there is certainly no well-established rule as to how many returns must be filed in making a voluntary disclosure, the general consensus is probably six tax years since the applicable statute of limitations for most tax related crimes is six years.  The disclosure should eliminate any government concern that there might be any potential issues with respect to a particular tax year for which the applicable statute of limitations for criminal prosecutions has not already expired. Additional returns could be in order since the statute of limitations for a criminal prosecution is tolled for the period of time a taxpayer is outside of the United States or is a fugitive from justice.

Typically, in a civil context, it is also the IRS policy to enforce the filing of returns for the prior 6 tax years.  In considering whether shorter or longer periods should be civilly enforced, the IRS will determine the prior history of non-compliance, the possible existence of income from illegal sources, the effect on voluntary compliance, the anticipated revenue in relation to the time and effort required to determine the tax due, and special circumstances existing in the case of a particular taxpayer, class of taxpayer, or industry, which may be particular to the class of tax involved.

Should IRS be Contacted Directly? Counsel must determine whether to contact the IRS before submitting a voluntary disclosure and actually filing the delinquent or amended tax returns. Some practitioners prefer to submit a Freedom of Information Act (FOIA) request seeking income information already in the possession of the IRS before filing the returns.  Some simply choose to file the delinquent or amended returns, with payment of tax and interest, with the appropriate IRS service center (now referred to as a “campus”) by certified mail, return receipt requested.  Such filings occur during the typical tax return filing season (around April 15 and October 15 for individual returns).

Some prefer making the voluntary disclosure in a meeting with the Special Agent in Charge of the local IRS-CI where the investigation would be conducted.  At this meeting, the potential voluntary disclosure would initially be discussed in a hypothetical format.  Counsel would generally outline the facts in hypothetical form (probably in writing) and would request whether IRS-CI would consider the return filing to be a voluntary disclosure in order to avoid recommendation of a criminal prosecution.

Counsel may also attempt to secure an IRS waiver of all applicable penalties before revealing the taxpayers identity.  In the event that IRS-CI responds affirmatively, counsel would then disclose the client’s identity and taxpayer identification number. However, IRS will assert that there has not been the requisite “disclosure” until the taxpayers information has been provided to the IRS.Properly resolving these issues can mean the difference between a taxpayer being subjected solely to civil tax adjustments (and possibly civil penalties), criminally excused of a tax crime or being convicted on the basis of admissions derived from the voluntary disclosure itself.

Certainly, the IRS has a somewhat limited capacity to perform criminal investigations. However, a significant amount of time is not required to criminally investigate and seek to prosecute a non-filer, particularly one who files delinquent or amended returns following an IRS inquiry. Without adequate representation, the perceived light at the other end of the voluntary disclosure tunnel . . . may be the IRS train coming straight at the taxpayer!

Posted by: | September 8, 2014

IRS Non-Filers Beware: Who’s That Knocking at Your Door ?

For numerous reasons, many taxpayers fail to timely file required U.S. income tax returns and associated reports. A “non-filer” is described as a taxpayer (or someone who ought to be a taxpayer) who does not file their return before the deadline to file the next year’s return. A “late filer” is taxpayer who misses the deadline for the year in question, but files the return within the following year. Many non-filers analyze optional strategies given the probability of audit and detection and the extent of penalties, if discovered. Others claim to be trapped into non-filing status because of past decisions. Typically, non-filers fall into three categories:

i)          Procrastinators – Know they should file but need assistance and/or prompting.  They will typically respond and always indicate that they will cooperate when contacted by the IRS.  However, information is generally slowly provided in a piecemeal fashion.

ii)         Uncooperative Non-Filers – They refuse to acknowledge and respond to correspondence and/or phone calls and if contacted by the IRS clearly state that they will not cooperate.

iii)        Tax Protestors – Advocate and/or use tax protestor’s schemes (i.e. refusal to file because of alleged constitutional reasons).

Failing to file returns is not a reasonable response to the inability to pay the tax liability associated with the returns. If in doubt, file the returns and work out a payment arrangement with the IRS. Also, know that the civil “failure to file” penalty accrues at 5.0%/month (up to 25% of the tax deficiency). The civil  “failure to pay” penalty accrues at the rate of 0.5%/month (up to 25% of the tax deficiency). When you do the math and factor in the numerous other risk factors associated with the failure to file a tax return, the decision to file becomes somewhat obvious in most cases.

The IRS has identified at least 10 million delinquent returns and has been pursuing a cross-functional National Non-Filer Strategy to identify non-compliant taxpayers and design methods to encourage their compliance.  Before contacting a non-filer, the IRS will often attempt to identify the non-filer’s occupation, location of bank/savings accounts, sources of income, age, current address, last file returned, adjusted gross income of last file returned, taxes paid on last file returned – amounts and methods of payment (withholding, estimated tax, pre-payments), number of years delinquent, and the non-filer’s standard of living.

They will search public records for evidence of additional unreported income, tax assessor and real estate records for assets held by the non-filer, and records of professional associations and business license bureaus for information on businesses being operated by the non-filer. They will also search sales tax returns and the state records to disclose corporate charter information including principals of any businesses that have failed to file returns. They will contact the last known employer to determine if the non-filer is still employed and the specific occupation of the non-filer.

Determining the specific occupation of the non-filer can lead to additional sources, such as labor unions, professional societies, trade associations, etc. The IRS will also determine whether there is a history of non-filing (multiple non-filed years provide a pattern of behavior), whether there have been repeated contacts by the IRS, indications that the non-filer had knowledge of filing requirements (i.e. professional with an advanced education, person who works directly in the tax field), whether there are a large number of cash transactions (i.e. purchases by cash, cash deposits as evidenced by currency transaction reports, etc.) and whether there are indications of significant unreported income (i.e. substantial interests and dividends earned, investments in IRA accounts, stock and bond transactions, high mortgage interest paid, etc.).

Tax Evasion and Fraud? If a non-filer is contacted by the government, the examiner will determine the cause (does the non-filer lack records, ability to pay, lack of education, etc.) and may offer necessary information or assistance (preparation of returns, payment arrangement information, etc.) to secure full cooperation. If the non-filer is not cooperative (won’t respond or refuses to cooperate), third party contacts may be made to determine the non-filer’s income and make an assessment.

When contacting the taxpayer, the IRS will attempt to gather as much information as possible to arrive at a substantially correct tax assessment.  They will also attempt to establish reasons for the non-filing by asking specific and direct questions (i.e. Why were returns not filed?  Did you know that you were required to file returns?).

If the examiner discovers subsequent acts of tax evasion (false statements, refusal to make records available, etc.), they will often consider whether the case should be referred for a criminal investigation. The examiner will also be alert to attempts by the non-filer to conceal or transfer assets to evade collection of tax later assessed. In these cases, a jeopardy (immediate) assessment may be considered.

The manner in which responses occur could dictate the future course of action by the IRS examiner (i.e., whether to pursue penalties and/or a referral for criminal investigation). Willful failure to file a tax return is a misdemeanor pursuant to IRC 7203. In cases where an overt act of evasion occurred, willful failure to file may be elevated to a felony under IRC 7201. If failure to file a return is fraudulent, a civil penalty known as the “fraudulent failure to file (FFTF) penalty” may apply under IRC 6651. The mere fact of failing to file a return does not constitute sufficient evidence to sustain fraud. Overt acts of evasion must be identified.

On the initial screening of a non-filer case, the IRS will attempt to determine if the facts indicate potential fraud. Indicators of fraud for consideration set forth in the IRS Internal Revenue Manual (IRM) include:

  • History of non-filing or late filing, and an apparent ability to pay;
  • Repeated contacts by the IRS;
  • Knowledge of the filing requirements (i.e., advanced education, business (especially tax) experience, record of previous filing etc.);
  • Experience of the taxpayer in tax matters such as a law professor, CPA or tax attorney;
  • Failure to reveal or attempts to conceal assets;
  • Age, health, and occupation of the taxpayer;
  • Substantial tax liability after withholding credits and estimated tax payments;
  • Large number of cash transactions, i.e., purchases by cash and large cash deposits evidenced by documented cash transactions, payment of personal and business expenses in cash when cash payment is unusual and/or the cashing (as opposed to the deposit) of business receipts;
  • Indications of significant income per Information Return Processing (IRP) documents (i.e., substantial interest and dividends earned, investments in IRA accounts, stock and bond transactions, high mortgage interest paid);
  • Refusal or inability to explain the failure to file; and
  • Prior history of criminal tax prosecutions for Title 26 violations.

If the IRS believes the possibility of fraud exists, the IRM instructs the IRS examiner to:

  1. DO NOT SOLICIT tax returns. If returns are submitted, they should be accepted but not processed, and clearly documented in the case history.
  2. DO NOT VOLUNTEER ADVICE to the taxpayer concerning any potential course of action to follow.
  3. DO NOT DISCUSS tax liabilities, penalties, fraud, or criminal referral possibilities with the taxpayer.

During non-filer examinations, the IRS examiner will determine if related returns (corporate, partnership, employment tax, and excise tax returns) have been filed as required.  They will also search for spin-off cases involving relatives, employees, employers, subcontractors, partners, and even return preparers!  If a non-filer is involved in a family business, the examiner will determine if all family members have filed returns.  If the non-filer is involved in a partnership, the IRS will determine if partnership returns have been filed and determine if all partners have filed returns.  For delinquent corporate returns, they will attempt to determine if all shareholders have filed returns. Penalties are not typically be easily waived in non-filer cases without reasonable cause.

During the non-filer examination, the IRM suggests that the examiner:

  1. Interview the taxpayer to determine the reason or the intent of the taxpayer’s noncompliance.
  2. Ask sufficient questions to determine the extent of the delinquency, including the periods and tax due.
  3. Document verbatim, if possible, the questions asked and the taxpayer’s response or lack of response.
  4. Identify any personal reasons that could affect the taxpayer’s ability to comply. If the information is not provided by the taxpayer, attempt to secure the information from third party sources.
  5. Attempt to get a definitive statement from the taxpayer regarding additional expenses not listed in the books and records. These expenses could include, but are not limited to, expenses paid in cash or “under-the-table” payments to employees.
  6. Attempt to establish year-end cash on hand for each year under investigation.

The role of IRS Criminal Investigation (IRS-CI) in the IRS non-filer strategy is the enforcement of the tax laws for individuals who are not responsive to outreach efforts. IRS-CI has historically devoted resources to identify these individuals, and in the more flagrant cases, criminal prosecution has been and will continue to be recommended. IRS-CI has developed and investigates high impact investigations of non-filers in various occupations and industries, as well as those who file non-processable returns or employ frivolous arguments which the courts have repeatedly rejected.

Substitute for a Return. If the taxpayer does not respond to government inquiries, the IRS may independently prepare a tax return and the related assessments under Internal Revenue Code § 6020 (b).  These assessments are generally based on very limited information, such as that gathered from Forms W-2 and 1099.  For these cases, IRS assesses the maximum potential tax owed based on gross receipts since they don’t have access to potential deductions, exemptions or credits available to the taxpayer. By failing to file a return, a taxpayer may also lose a refund of any amounts withheld. The failure to file and pay self-employment tax by self-employed individuals could cause them to be ineligible for social security retirement or disability benefits.

What to do? A taxpayer’s timely, voluntary disclosure of a significant unreported tax liability is an important factor to the IRS in considering whether the matter should be referred to the U.S. Department of Justice for criminal prosecution. Properly resolving this issue can mean the difference between a taxpayer being criminally excused of a tax crime or being convicted on the basis of admissions derived from the voluntary disclosure itself.

Counsel should likely determine whether to contact the IRS before submission of a voluntary disclosure and should be consulted before actually filing the delinquent or amended tax returns.  If not properly coordinated (or not timely), submission of amended or delinquent returns might be deemed an important admission in a later criminal proceeding. If timely and submitted in accordance with the IRM, a timely voluntary disclosure can avoid a criminal referral and may significantly reduce or possibly eliminate the imposition of civil penalties on any resulting tax deficiency.

Generally, people who come forward and file returns prior to being contacted by IRS are not pursued through a criminal investigation, might be able to reduce or eliminate potential civil penalties, and may be able to coordinate an effective installment payment arrangement (or Offer in Compromise) for any resulting deficiencies.  Regardless, a non-filer should not wait since the “first knock on the door” may be that of a special agent from IRS-CI.



AGOSTINO & ASSOCIATES –To download a few great articles prepared by our very close friends at the Law Firm of Agostino & Associates in Hackensack, NJ ( ), see the Agostino & Associates Newsletter*/ACFrOgB3DcF0a_jTmvIpYCiuNKqO7L9fgn3s-OoYgXI80f841xzDJ5w3W4RQJIos9LXs1ctCT2z8v3FIziSDS2y-W6ct63hwuBzvEW_vnXAgbmb31pJpOwZuVMW1Ou8=?print=true

DE NOVO REVIEW OF ASSESSABLE INTERNATIONAL PENALTIES By Frank Agostino, Brian D. Burton, and Lawrence A. Sannicandro    – Many taxpayers and tax professionals believe that Collection Due Process (“CDP”) rights do not attach to international information return penalties. This confusion likely stems from the (well known) fact that the usual CDP rights do not attach to penalties for failure to file a timely, complete and accurate Financial Crimes Enforcement Network (“FinCen”) Form 114, Report of Foreign Bank and Financial Accounts (“FBAR”).

To this end, the TaxCourt has specifically  held that it “has no jurisdiction to review the [IRS’s] determination as to [taxpayers’] liability for FBAR penalties.” However, one must distinguish between FBAR penalties, a product of the Bank Secrecy Act of 1970 (“BSA”), which cannot be challenged via CDP procedures, and assessable international penalties for untimely, incomplete or inaccurate IRS Forms 926, 3520, 3520A, 5471, 5472, 8865, or 8938 which are products of the Code and subject to de novo CDP and Tax Court review. FOR THE FULL ARTICLE SEE



For further information, contact Frank Agostino at (201) 488-5400 or visit  

AGOSTINO & ASSOCIATES, with a national practice based in Hackensack, NJ, specializes in tax and tax controversies (civil and criminal), offers in compromise, voluntary disclosures, tax lien discharges,  innocent spouse determinations, forfeitures, estate planning and probate, contract and contract litigation.  A firm comprised truly great, caring people who want the best for their clients !

Posted by: | August 26, 2014


All tax planning is not to be condemned. “It is no surprise that a knowledgeable tax attorney would use numerous legal entities to accomplish different objectives. This does not make them illegitimate. Unfortunately such ‘maneuvering’ is apparently encouraged by our present tax laws and codes.” [1]

CIRCULAR 230 – Cir. 230 provides the regulations governing the practice of federally authorized tax practitioners before the IRS, authorizing specific sanctions for violations of the duties and obligations; and, describing the procedures that apply to administrative proceedings for discipline.

“Practice before the IRS” generally includes all matters connected with a presentation to the IRS, or any of its officers or employees, relating to a taxpayer’s rights, privileges, or liabilities under laws or regulations administered by the IRS. Such presentations often include preparing tax and information returns; filing documents; corresponding and communicating with the IRS; rendering oral and written advice with respect to any entity, transaction, plan or arrangement, or other plan or arrangement having a potential for tax avoidance or evasion; and representing a client in front of an IRS representative at conferences, hearings and meetings. A copy of Cir. 230 is available at [2]

OFFICE OF PROFESSIONAL RESPONSIBILITY – The Mission of the IRS Office of Professional Responsibility (OPR), formerly known as the Director of Practice, is to “Interpret and apply the standards of practice for tax professionals in a fair and equitable manner.” OPR supports the IRS’s strategy to enhance enforcement of the tax law by ensuring that tax professionals adhere to tax practice standards and follow the law by, in part, enforcing the regulations governing the practice of federally authorized tax practitioners, generally defined to include attorneys, certified public accountants (CPAs), enrolled agents, enrolled actuaries and appraisers before the IRS as set forth in Treasury Department Circular No. 230 (Cir. 230; Rev. 06/2014). [3]

OPR has the authority to impose suspension, disbarment and/or significant monetary fines on federally authorized tax practitioners, firms and other entities. In addition, as part of any OPR investigation they may contact current and former clients. OPR has exclusive responsibility for practitioner conduct and discipline, including instituting disciplinary proceedings and pursuing sanctions, functioning independently of the Title 26 enforcement components of the IRS.

The IRS Internal Revenue Manual (IRM) indicates that misconduct under Cir. 230 which could warrant an OPR investigation include the following:[4]

  1. Failure to exercise due diligence – § 10.22(a).
  2. Conviction of any criminal offense under the revenue laws of the United States – § 10.51(a)(1).
  3. Conviction of any criminal offense involving dishonesty or breach of trust – § 10.51(a)(2).
  4. Conviction of any felony under Federal or State law for which the conduct involved renders the practitioner unfit to practice before the IRS – § 10.51(a)(3).
  5. Giving false or misleading information or participating in any way in the giving of false or misleading information in connection with any matter pending or likely to be pending before the IRS, knowing the information to be false or misleading -§ 10.51(a)(4).
  6. Willfully failing to make a Federal tax return in violation of the Federal tax laws, or willfully evading, attempting to evade, or participating in anyway in evading or attempting to evade any assessment or payment of any Federal tax – § 10.51(a)(6).
  7. Disbarment or suspension from practice as an attorney, certified public accountant, public accountant, or actuary – § 10.51(a)(10).
  8. Giving a false opinion, knowingly, recklessly, or through gross incompetence, including an opinion which is intentionally or recklessly misleading, or engaging in a pattern of providing incompetent opinions on questions arising under the Federal tax laws – § 10.51(a)(13).
  9. Contemptuous conduct, in connection with practice before the IRS, including the use of abusive language, making false accusations or statements, knowing them to be false, or circulating malicious or libelous matter – § 10.51(a)(12).
  10. Assertion of penalties under Internal Revenue Code (IRC) §§ 6694, 6695, 6700 and 6701.

REFERRALS TO OPR – Section 10.53 of Cir. 230 requires IRS employees to make a written report to OPR when there is reason to believe that a tax practitioner has somehow violated Cir. 230.[5] When disciplinary action is deemed appropriate, the report will include sufficient detail, documentation, and exhibits, to substantiate the character and extent of the violation.  IRS examiners are cautioned to exercise discretion in making referrals of asserted IRC 6694(a) (Understatement of liability due to an unreasonable position) penalties to OPR for attorneys, CPAs, enrolled agents, enrolled actuaries, enrolled retirement plan agents, and appraisers.[6] However, referrals to OPR can arise when the following penalties are asserted against a practitioner[7]:

  1. Referrals of asserted IRC 6694(a) penalties to OPR should be based on a pattern of failing to meet the required penalty standards under IRC 6694(a).
  2. Asserted preparer penalties under IRC 6694(b) (e.g., a willful attempt to understate the liability for tax) for attorneys, CPAs, enrolled agents, enrolled actuaries, enrolled retirement plan agents, and appraisers are mandatory referrals to OPR.
  3. For IRC 6695(a) through (g)(generally the (a) failure to furnish copy of return; (b) Failure to sign return; (d) failure to keep a copy of tax return or list of taxpayer), examiners should exercise discretion in making referrals to OPR.
  4. Anytime a penalty for promoting abusive tax shelters under IRC 6700 is assessed.
  5. Anytime injunctive action under IRC 7407 (injunction of a tax return preparer) or IRC 7408 (Injunction of specified conduct relating to tax shelters and reportable transaction) is pursued.[8]

Referrals are mandatory for violations of IRC §§ 6694(b), 6700, 6701(a), 7407 and 7408. Referrals are discretionary for violations of IRC §§ 6694(a), 6695 and 6702 (frivolous tax returns or submissions). However, the referral should be anticipated if any of the above penalties appear to become a pattern across taxpayers, tax issues or tax years since this could indicate reckless conduct or lack of competence.

Other circumstances that might anticipate a referral to OPR include inaccurate or unreasonable entries/omissions on tax returns, financial statements and other documents; a lack of due diligence exercised by the practitioner; a willful attempt by the practitioner to evade the payment/assessment of any Federal tax; cashing, diverting or splitting a taxpayer’s refund by any means, electronic or otherwise; “Patterns” of misconduct involving multiple years, multiple clients or inappropriate/unprofessional conduct demonstrated to multiple IRS employees; potential conflict of interest situations, such as representation of both spouses who have a joint liability or when representation is affected by competing interests of the practitioner; and any willful violation of Cir. 230.

OPR may, after notice and an opportunity for a conference, negotiate an appropriate level of discipline with a practitioner; or, initiate an administrative proceeding to Censure (a public reprimand), Suspend (one to fifty-nine months), or Disbar (five years) the practitioner. OPR may also, after notice and an opportunity for a conference, disqualify an appraiser from further submissions in connection with tax matters.

OPR may also, after notice and an opportunity for a conference, propose a monetary penalty on any practitioner who engages in conduct subject to sanction. The monetary penalty may be proposed against the individual or a firm, or both, and can be in addition to any Censure, Suspension or Disbarment. The penalty may be up to the gross income derived or to be derived from the conduct giving rise to the penalty. The OPR web site also has a searchable database containing the names of all the individuals currently under suspension or disbarment.[9]

NOTIFICATION OF STATE LICENSING AUTHORITIES – Many States have statutes and regulations requiring the notification of the State licensing authority in the event a practitioner receives notification of a practitioner penalty or an inquiry investigation from an agency such as the OPR. A failure to timely notify the licensing authority within the required time period (typically 30 days from receipt of knowledge of the notification or inquiry) could result in a separate, additional violation.

An example of a State statute requiring notification of the State licensing authority is the requirement in California Business & Professions Code § 5063 for California Certified Public Accountants to notify the State Board of Accountancy of a practitioner penalty. In part, California Business & Professions Code § 5063 provides:

“California Business & Professions Code § 5063.

(a) A licensee shall report to the board in writing of the occurrence of any of the following events occurring on or after January 1, 1997, within 30 days of the date the licensee has knowledge of these events: . . . (3) The cancellation, revocation, or suspension of the right to practice as a certified public accountant or a public accountant before any governmental body or agency.

(c) A licensee shall report to the board in writing, within 30 days of the entry of the judgment, any judgment entered on or after January 1, 2003, against the licensee in any civil action alleging any of the following:….(5) Any actionable conduct by the licensee in the practice of public accountancy, the performance of bookkeeping operations, or other professional practice.

(d) The report required by subdivisions (a), (b), and (c) shall be signed by the licensee and set forth the facts which constitute the reportable event. If the reportable event involves the action of an administrative agency or court, then the report shall set forth the title of the matter, court or agency name, docket number, and dates of occurrence of the reportable event.

(f) Nothing in this section shall impose a duty upon any licensee to report to the board the occurrence of any of the events set forth in subdivision (a), (b), or (c) either by or against any other licensee.”


Practitioners should routinely review their own procedures for gathering and documenting the information they process on behalf of taxpayers. Preparers should be documenting or know how they have arrived at reporting positions for transactions that might not meet the appropriate practice standard. Further, the preparer or their firm must have review procedures and these procedures must be followed.

Preparer penalty issues will most often arise during or at the conclusion of an IRS examination of the taxpayers return when some or all of an undisclosed or improperly disclosed position has been disallowed. Is it reasonable to believe that an agent, having disallowed a questionable position, will be convinced there was the requisite “substantial authority” for the undisclosed position? Is it reasonable to believe that an agent, having disallowed a questionable position, will be convinced there was a “reasonable basis” for the disclosed position? Also, most return positions are comprised of several sub-positions. If each sub-position has a 40% chance of success on the merits, the primary position might not have a similar overall 40% chance of success on the merits (40% of 40% of 40% is not 40% overall).

Although the preparer penalty regime is mostly intended for the “bad actors,” it can be applied to any preparer. The combination of a somewhat inattentive preparer and a somewhat aggressive government agent could result in preparer penalties being assessed in many otherwise unintentional situations.

  1. Your Client is Not Your Friend. If you need a friend, get a dog!
  2. Think “Substantial Authority.” Penalties generally require a “substantial authority” standard, or “reasonable basis” plus disclosure. Take the time to analyze relevant facts and authorities before making the determination to disclose, or not.
  3. Think Disclosure. Appropriate disclosures within the return can generally avoid penalties, for the taxpayer and the preparer. All disclosures should be in writing. Review Rev. Proc. 2014–15[10] regarding disclosure within a taxpayers return and the appropriate form of disclosure. Signing Preparer - Disclosure on Forms 8275 or 8275-R, as appropriate, filed with the return. The “signing preparer” is generally the person who prepares the most entries on the return. Non-Signing Preparer - “Disclosure” is appropriately advising the client or the preparer. There can be more than one preparer for each return.
  4. Tax Advice is Sufficient for IRC §6694 Penalties to Apply. It is not necessary to see the return to be the preparer. A person who renders advice which is directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim for refund, will be regarded as having prepared that entry. Whether a schedule, entry, or other portion of a return or claim for refund is a substantial portion is determined by comparing the length and complexity of, and the tax liability or refund involved in, that portion to the length and complexity of, and tax liability or refund involved in, the return or claim for refund as a whole. There can be more than one preparer for each return.
  5. OPR Referrals. Be aware that IRS employees are required to make a referral to the OPR if there is a “pattern” of certain conduct and a preparer penalty is sustained. Although in some situations not required to make the referral to OPR in the event of a single violation, some within the IRS may feel compelled to make the OPR referral for a single violation.
  6. Limit the Nature and Scope of Services to be Provided in the Engagement Letter. Have separate engagement letters for separate engagements. Do not exceed the scope of an engagement letter without another engagement.
  7. Requirements to Notify State Licensing Authorities. Many States have requirements for a licensee to notify the State licensing authority in the event of a preparer penalty. Failure to provide timely notification could be a separate violation.
  8. Establish a System of Checklists for Preparation and Advice – and Follow the System. Best practices in the office strongly suggests a system for promoting accuracy and consistency in the preparation of returns or claims and should generally should include – in the case of a signing preparer – checklists, methods for obtaining necessary information from the taxpayer, a review of the prior year’s return and possibly all related returns, and internal review procedures.
  9. Emails Have a Life of Their Own. “Delete” merely takes the email off your screen. Experienced investigators will locate deleted emails. Only render such advice that you reasonably believe is accurate and appropriately supported by relevant facts and authorities.
  10. There Are No Hypothetical Questions. Do not respond unless you are confident you have received and understand all relevant facts. Responses should be limited to the facts presented.
  11. Fight, Fight, Fight . . . if Facing a Preparer Penalty. The primary issue is often the reasonableness of the preparer’s belief and good faith in the reported position. Although the economic penalty under IRC §6694(a) may not be significant when compared to the effort involved to dispute it, the related investigations by OPR and the State licensing authorities may destroy the preparers practice (and reputation). Anticipate that potential malpractice claims will routinely include allegations of a failure to comply with federal tax standard of care and Cir 230. Anticipate the government may contact the current and former clients and that they may require the preparer to also disclose the violations to their clients with a full explanation. Your reputation for integrity and credibility is at issue – protect it!
  12. Maintain the Appearance of Cooperation and Reasonableness When Representing Clients in a Tax Dispute. Many OPR referrals arise as a result of the examination of a taxpayer’s return and conduct of the representative during the examination. Respond timely, cooperate as reasonably required, inquire when faced with uncertainty, push back when necessary and watch your back at all times.
  13. New Clients. Each firm should set practical guidelines re the acceptance of new clients. Consider speaking with the clients prior representatives to ascertain potential issues. The prospective client who talks poorly of the last representative(s) may only be including you in the list for next year. Sometimes it’s not the horse but the jockey who loses the race.
  14. Supporting Data. Although the preparer is not required to independently examine or verify all supporting information, make sure to inquire as to whether such data has been satisfactorily maintained. Encourage the client to maintain proper information supporting the positions set forth within the return. Best practices suggests retaining documentation resulting from any tax related research (including authorities both for and against the tax position), the reasoning behind the conclusion, and relevant authorities supporting the conclusion.
  15. Preparer Judgment. The judgment of the preparer and other tax advisors, not the client, should be the determining factor regarding positions set forth on the return. If the client refuses to comply with the recommendations, the significance of each recommendation in relation to the return may be the deciding factor re whether to withdraw from representation.
  16. Document Your Advice to Clients and Others in Writing. Enough said – protect yourself and your firm.
  17. No Good Deed Goes Unpunished. “Off the cuff” advice and quick email responses may, in certain circumstances, be sufficient for penalties or Circular 230 sanctions to apply. Tax positions should be appropriately analyzed and discussed with the client, including: (a) review and document all relevant facts; (b) explain that the position is an opinion based on information presented by the client; c) include a discussion re any possible penalties that may be assessed; and (d) avoid technical terms that may be misunderstood by the client.
  18. Anticipate Potential Assertion of Preparer Penalties. The increased attention on preparers and their conduct may result in an increase in incidences of assertion of preparer penalties and sanctions. Referrals might occur as a result of confusion about the appropriate standard, inadvertent oversight, less than adequate disclosures or relatively minor infractions.
  19. Be Prepared, Not Paranoid. If a situation arises, handle it in a clear and appropriate manner. It will not go away if you ignore it or are simply “too busy” to respond to inquiries from the IRS or OPR. OPR understands the realities of a busy tax practice and good faith efforts to comply with an extremely complex IRC.
  20. Be Proud of Your Profession. It is an honor and a privilege to represent taxpayers before the IRS. Tax practitioners often devote untold personal hours being educated on new tax provisions, software updates, policies and procedures. Tax practice is a profession and professionals help other professionals. If struggling with a tax issue, ask an experienced colleague for advice. If asked by a colleague for advice, take the time to listen and provide whatever meaningful assistance you can and remember, someday you may be the person placing that call for assistance . . .

Be prepared, exercise your best judgment, document your recommendations . . . and know that 98% of the problems in practice emanate from 2% of the clients. Clients who refuse to comply with your valued recommendations should be encouraged to seek other representation.

Be proud of your profession and remember that today is the tomorrow that you worried about yesterday  . . . at the end of the day, if you are proud to go home and tell others about your day, you are practicing in the right profession!!

SUBSCRIBE TO NEWS AND UPDATES FROM IRS OPR – Subscribers will be notified by e-mail regarding OPR disciplinary actions, Press releases,  New items, Rules governing those who practice before the IRS and related updates, and Educational info about OPR, its mission and priorities. See

[1] Ballard v. Commissioner, Nos. 01-17249 (11th Circuit, April 7, 2008).

[2] Circular 230 is the common name given to the body of regulations promulgated from the enabling statute found at Title 31, United States Code § 330. This statute and the body of regulations are the source of OPR’s authority.


[4] Referrals to the Office of Professional Responsibility, IRM  (01-14-2011)

[5] 31 C.F.R. Section 10.53(a)).

[6] Referrals to the Office of Professional Responsibility, IRM  (01-14-2011)

[7] Id.

[8] Id.

[9] See

[10]Rev. Proc. 2014-5 (Internal Revenue Bulletin 2014-5; January 27, 2014)

Posted by: | August 20, 2014


Has this happened to you? You are in your office toiling away in the tax trenches when a colleague down the street who works the offshore cases sends you an e-mail:

“I’m sending over an OVDP client. He has a problem and I can’t represent him anymore.”

Eventually the client sits in your office and spins the following tale. He is a lawyer. He had an undisclosed account at UBS with about $1.5 million in it. He entered the 2009 OVDP represented by another tax practitioner and successfully obtained a closing agreement in 2012 after paying all of the necessary taxes, penalties and interest for 2003, 2004, 2005, 2006 2007 and 2008 as required by the 2009 IRS Offshore Voluntary Disclosure Program (OVDP).

THE INITIAL – FALSE – OVDP SUBMISSION. Recently the client received a letter from a second Swiss bank telling him, in effect, that the second Swiss bank would turn his bank data over to the United States unless he did a whole bunch of things, including waiving his rights to bank secrecy under Swiss law, proving he has complied with his filing and reporting obligations under the U.S. Internal Revenue Code and the U.S. Bank Secrecy Act, or in the alternative, proving he is participating in the OVDP. The client reveals that this second Swiss Bank account has held around $4 million since 2003, funded with unreported taxable income.

In 2012, after he “successfully” (in his mind) completed the 2009 OVDP, he transferred all of the money from the second Swiss bank to a more secure foreign bank in Vanuatu where it sits today. The client did not bother to mention this second Swiss bank to the lawyer down the street until a few days ago. Needless to say, he did not comply with any of his obligations under the U.S. Internal Revenue Code or the U.S. Bank Secrecy Act regarding this second Swiss account, let alone his Vanuatu account. The client is about ready to file his 2013 federal and state income tax returns which, like every return he filed for the last decade, will be fraudulent.

So what advice can you give this taxpayer client? You obviously can not advise him to flee to Vanuatu and live with his money, not only because it is unethical to say so but it may well also be a crime to provide such advice. Let’s look at some other options:

1. Do Nothing. A default move considered by many when confronted by life’s problems, but it is not indicated here. Any of FATCA or The Program for Non-Prosecution Agreements or Non-Target Letters for Swiss Banks (the “Program”) will reveal this second Swiss bank account to the United States with plenty of time on the statute of limitations to develop their criminal case. This case is a tax prosecutor’s dream. It has significant unreported income, lots of “badges of fraud,” a lawyer defendant, and an open statute of limitations.

Thanks to the client’s affirmative acts of evasion during the 2009 OVDP, his 2003 through 2008 criminal tax statute of limitations on tax evasion (26 U.S.C. Section 7201) is open until six years after he signed the closing agreement in 2012. Fortunately the statute of limitations for prosecuting FBAR crimes is fixed at six years. Count up the fraudulent original and amended federal and state income tax returns since 2003 and you get thirty-two. Thirty-four if you let the client follow through on his plan for 2013.

2. Do a “Quiet Disclosure.” Assuming the client can meet the basic requirements of the IRS Voluntary Disclosure Practice set forth in Internal Revenue Manual (IRM) in IRM (12-02-2009) the client may simply choose to file correct amended tax returns, with payment, with the appropriate IRS campus (a “quiet” voluntary disclosure). Since the criminal statute of limitations allows prosecution of the 2003 through 2012 income tax returns, the client would need to amend each of these returns. Although the IRS and Department of Justice have a dim view of quiet voluntary disclosures in the context of undeclared foreign bank accounts, we are aware of no situation where a taxpayer has been prosecuted for tax crimes after a proper quiet voluntary disclosure that FULLY complies with each of the terms and provisions set forth in the IRS Voluntary Disclosure Practice, IRM (12-02-2009).

Rather, the quiet voluntary disclosures that are later identified by the IRS are sometimes subjected to multiple 50% civil FBAR penalties as a punishment. That being said, if the client attempts a quiet voluntary disclosure here, it will not cure his willful failure to file his FBARs which alone, provides plenty of ammunition to the government for a tax related criminal prosecution. We have not seen FBAR prosecutions on a stand-alone basis, but in the appropriate case the government might well prosecute the FBAR counts alone. On balance, a “quiet” voluntary disclosure is not likely something the taxpayer should consider as a completely safe landing.

3. Try to Get Back into the 2009 OVDP. This could work, if at all, where the undisclosed second foreign bank account overlapped precisely the first foreign bank account. There you could work with the implicit, but always unspoken, excuse that the client basically “forgot” the second account. You would need to get someone in the IRS to reopen the client’s 2009 OVDP so that you could correct the first closing agreement and file amended income tax returns and amended FBARs and pay all of the necessary additional taxes, penalties and interest. Without help from the IRS, the IRS could reject your subsequent tax payments as beyond the collection statute of limitations and would likely ignore any increased FBAR penalty that you attempted to pay. If the IRS refuses to accept these payments, the client obtains no protection under the 2009 OVDP.

In our case, the client’s noncompliance on the second Swiss account stretches though the six 2009 OVDP years and also takes in 2009, 2010, 2011 and 2012. So what do you do with 2009, 2010, 2011 and 2012? It is unlikely the IRS would fold these later years into the 2009 OVDP.

4. Go into the 2012 OVDP. On the face of things, the client seems to qualify for the 2012 OVDP. This would allow you to correct 2005 through 2012. What about those pesky 2003 and 2004 tax years where your client lied to the government during the 2009 OVDP, filed false income tax returns and false FBARS and the statute of limitations for tax prosecutions is still open for those years? Maybe you could convince your OVDP Revenue Agent into expanding the closing agreement to pick up 2003 and 2004. If accepted, that should solve the problem.

5. Combinations of the Above. The six year statute of limitations for criminal prosecutions relating to FBARS has expired for 2007. This means that the client might consider simply amending returns for 2003 through 2007 eliminating criminal tax exposure without worrying about any FBAR criminal prosecution. The client then could consider OVDP participation for 2009, 2010, 2011 and 2012.

WHAT TO DO? There are no clear “rules of thumb” for a situation where a taxpayer previously provided the IRS with a false or misleading submission seeking participation in an IRS OVDP. However, the taxpayer must somehow get into compliance with their filing and reporting obligations, fully into compliance.

Consult with experienced tax counsel at the earliest opportunity. For whatever reason, we seem to be seeing more of these scenarios are able to appropriately respond, if contacted in a timely manner. All relevant facts must be fully identified and developed by counsel with the assistance of others working for such counsel. The sensitive nature of things surrounding the initial false OVDP submission must be carefully handled.

The taxpayer and the prior representative are likely candidates for an interview by IRS representatives in the best case scenario.The IRS will likely inquire about what was disclosed to the representative who handled the initial, false OVDP submission. Did the representative make sufficient inquiries or simply look away?

Overall, the government seems able to acknowledge, to some degree, the benefit of this taxpayer coming into compliance the second time before the government had to go drag the person off the street. Regardless, all involved should be sure this taxpayer gets educated and, going forward, fully understands and respects their obligation to comply with all applicable domestic and foreign filing and reporting requirements.

EDWARD M. ROBBINS, Jr. – For more information please contact Edward M. Robbins, Jr. Mr. Robbins is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., the former Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at


Posted by: | August 12, 2014

HIDDEN RESOURCES: IRS Audit Techniques Guides

Historically, IRS examiners were assigned to audit taxpayers in many different industries. On one day, an examiner audited a grocery store and on the following day the examiner may have audited a computer retailer or a medical doctor. As a result, experience gained in one audit did not significantly enhance the examiner’s experience for purposes of conducting other audits.

More recently, the IRS has been attempting to identify and reduce non-compliance through efficiency, tax form simplification, education, and enforcement. In addition, the IRS has significantly modified its examination process in a manner designed to increase the available resources and experience of its examiners.

The IRS Audit Techniques Guides (ATGs) focus on developing highly trained examiners for a particular market segment or issue. A market segment may be an industry such as construction or entertainment, a profession like attorneys or real estate agents or an issue like passive activity losses, hobby losses, litigation settlements or executive compensation – fringe benefits. These guides contain examination techniques, common and unique industry issues, business practices, industry terminology, interview questions and procedures and other information to assist examiners in performing examinations.

IMPROVED IRS AUDIT EFFICIENCY.  The ATGs significantly improve IRS audit efficiency and compliance by focusing on taxpayers as members of particular groups or industries. These groups have been defined by type of business (artists, attorneys, auto body shops, bail bond industry, beauty shops, child care providers, gas stations, grocery stores, entertainers, liquor stores, pizza restaurants, taxicabs, tour bus industry, etc.), technical issues (passive activity losses, alternative minimum tax), and types of taxpayer or method of operation (i.e. cash intensive businesses). As examiners focus on the tax compliance of a particular industry, they have gained experience on specific issues to be examined for a particular type of business, whether or not the issues are set forth on a tax return. Examiners often spend the majority of their time auditing taxpayers in the particular market segment for which the examiner has become a specialist. Some may specialize in examining the construction industry while others may specialize in examining restaurants.

IRS examiners are routinely advised about industry changes through trade publications, trade seminars and information sharing with other examiners. As such, there is an increased understanding of the market segment, its practices and procedures, and the appropriate audit techniques required to identify issues unique to the market segment under examination. Utilizing an ATG, examiners attempt to reconcile discrepancies when income and/or expenses set forth on a taxpayer’s return are inconsistent with a typical market segment profile or where the reported net income seems inconsistent with the standard of living prevalent in a geographical area where the taxpayer resides. As a result, information and experience gained through the examination of returns for other taxpayers becomes the barometer for judging the accuracy of a particular return under examination.

Issues are continually being identified by their unique features requiring specialized audit techniques, technical or accounting knowledge, or the need to comprehend the specific business practices, terminology and procedures. The IRS has published numerous ATGs, including attorneys, auto body/repair shops, bail bondsmen, beauty/barber shops, car washes, child care providers, check cashing establishments, childcare businesses, construction contractors, farmers, restaurants and bars, various segments of the entertainment industry (motion picture/television, athletes and entertainers, music), garment industry, gasoline distributors, grocery stores, insurance agencies, jewelry dealers, liquor stores, mobile food vendors, parking lot operators, pizza parlors, real estate agents/brokers, real estate developers, recycling businesses, scrap metal businesses, taxicabs, the trucking industry, direct sellers and auto dealers.

DEVELOPMENT OF AN ATG. Once the IRS identifies a particular market segment project, an audit group may develop an ATG based upon the market segment’s unique business activities. Information developed during IRS examinations of similar issues or taxpayers is coordinated into what eventually become an ATG for such issues or type of taxpayer activity. The audit guides are then used by examiners throughout the country to develop a pre-audit planning strategy. As such, utilization of the ATG allows the examiner to streamline their examination resulting in more efficient examinations often targeting sensitive issues or issues involving industry non-compliance.

The ATGs explain the nature of each respective market segment or industry, the type of documentation that should generally be available, and the nature and type of information to search for during a tour of the business premises. They identify potential sources of additional income not otherwise readily apparent from the type of business activity being examined. As an example, the “Attorney ATG” identifies potential sources of revenue other than from the attorneys general practice, litigation, tax, and probate fees. The ATG indicates that the attorney “may also receive revenue from performing services as board directors for clients and non-clients, speaker’s honoraria, and other outside professional activities. Inquiries about these types of revenue should be made during the initial interview.”

ATG INTERVIEW QUESTIONS. The ATGs identify issues to be raised during an audit interview with the business owner/operator, including the need for a detailed discussion about internal controls (weak internal controls in a small business environment does not preclude the necessity of determining the reliability of the books and records since every taxpayer has a method of conducting business and safeguarding business operations), source of funds utilized to start the business, a complete list of suppliers, identification or business records that might be available and the individual that maintains the business records. The examiner will also explore the manner of business operations, including the hours and days it is open, the number of employees, the responsibilities of each employee, identification of the individual that maintains control over inventory (beer, wine, etc.), cash and credit card receipts, and the cash register tapes. Examiners are advised to search out payments of non-business or personal living expenses by the owner/operator from the business operations.

ATGs are designed to focus IRS examiners on the typical methods of operation for businesses operating within a particular market segment. For example, with respect to cash intensive businesses, the audit guides identify the potential for skimming in liquor stores, pizza restaurants, gas stations, retail gift stores, auto repair shops, restaurants and bars. However, the ATGs acknowledge that “chain” or “franchise” businesses may not participate in skimming to the same extent due to the somewhat intensive internal controls typically required in their operations. Internal controls are often stronger in franchises due to independent audits and verifications performed by the franchisor. Typically, the franchise fee is based on the gross revenue of the business. The franchisee usually must buy products from the franchisor to maintain the franchise. The franchisor also requires maintenance of certain books and records in a format determined by the franchisor and may conduct audits of the franchise operations.

The “Cash Intensive Business” ATG sets forth various ideas for the initial interview of the taxpayer, including:

  • Principal Products?
  • How long in business?
  • Who are your principal customers?
  • Ask if the taxpayer has any other source of income.
  • How are sales handled?
  • Method: cash or accrual?
  • Basis for recording?
  • If accrual, does he/she have a list of accounts payable and receivable?
  • How are prices set?
  • What is your markup percentage? (Ask for markup % on each major product)
  • How often is inventory taken, by whom?
  • Who keeps the books?
  • How did they learn recordkeeping?
  • What bank accounts maintained?
  • Do they deposit everything? Who deposits?
  • How do they get cash to spend?
  • Check to cash?
  • Personal withdrawals – how handled?
  • Safe deposit box?
  • How do they record expenses?
  • How were the return figures arrived at?
  • How are the expenses paid?
  • Cash-on-hand
  • How much?
  • Where located?
  • Non-taxable income.
  • Pensions, loans, gifts, inheritances?
  • Investments:
  • Stock?
  • Real Estate?
  • Major personal property?
  • Major Expenses:
  • Loan repayments?
  • Asset acquisitions? When? How?
  • Schooling?

SPECIFIC INDUSTRY APPLICATIONS OF AUDIT TECHNIQUES. IRS examiners are advised to make specific inquiries based on the type of taxpayers under examination. For example, in the retail liquor industry, examiners are advised to search for off-book inventory including purchases outside of the liquor distributor, i.e. local wholesaler, bottle redemption and check cashing as well as contacting for check with local/state beverage department for pending or completed investigations involving taxpayer and/or known suppliers of the taxpayer. For pizza restaurants, examiners are cautioned to reconcile the difference of the number of boxes sold verses the number of boxes used (less some account for spoilage boxes) as possible additional unreported sales. For gasoline service stations, examiners are advised use the indirect mark-up method of determining income (gallons purchased multiplied by the average selling price as representing total sales) and inquire about imaging reimbursements, incentive agreements, accommodations, blending and rebates.

For restaurants and bars, examiners are advised to inquire about rebates to franchisees from suppliers, compare restaurant averages (sales v. cost), reported net profits as compared to the industry average, spillage, whether “point of sales” machines, using bar averages (pour) to calculate income, etc. With respect to grocery stores, examiners are advised to search for potential sources of  unreported income that might include coupon processing rebate fees, cash discounts from vendors, rebates from vendors, receipt of high dollar promotional items from vendors, use of vending machines (i.e. newspaper), pinball machines/arcade games, bottle/can redeeming, money orders, credit card sales, food stamp sales and prepaid telephone cards.

PUBLIC ACCESS TO THE ATG. While ATGs are designed to provide guidance for IRS employees, they’re also useful to small business owners and tax professionals who prepare returns and are also quite helpful for business and tax planning purposes. Tax professionals should consider consulting the appropriate ATG before preparing returns or commencement of an IRS examination involving a type of taxpayer or issue covered in an ATG. Knowing what issues are important to the IRS is, quite simply, important.

Many of the IRS ATGs are publically available at See


Posted by: | August 8, 2014

Am I “Non-Willful” Under the IRS OVDP Streamlined Procedures ?

Posted by: | August 5, 2014

IRS Methods of Indirectly Determining Taxable Income

There are various audit and investigative techniques available to corroborate or refute a taxpayer’s claim about their business operations or nature of doing business. IRS audit or investigative techniques for a cash intensive business might include an examiner determining that a large understatement of income could exist based on return information and other sources of information. The use of indirect methods of proving income, also referred to as the IRS Financial Status Audit Techniques (FSAT), is not prohibited by Code Section 7602(e).

INDIRECT METHODS OF DETERMINING TAXABLE INCOME. Indirect methods include a fully developed Cash T, percentage mark-up, net worth analysis, source and application of funds or bank deposit and cash expenditures analysis. However, examiners must first establish a reasonable indication that there is a likelihood of underreported or unreported income. Examiners must then request an explanation of the discrepancy from the taxpayer. If the taxpayer cannot explain, refuses to explain, or cannot fully explain the discrepancy, a FSAT may be necessary. Common FSATs include:

• The Source and Application of Funds Method is an analysis of a taxpayer’s cash flows and comparison of all known expenditures with all known receipts for the period. This method is based on the theory that any excess expense items (applications) over income items (sources) represent an understatement of taxable income. Net increases and decreases in assets and liabilities are taken into account along with nondeductible expenditures and nontaxable receipts. The excess of expenditures over the sum of reported and nontaxable income is the proposed adjustment to income.

The Source and Application of Funds Method is typically used when the review of a taxpayer’s return indicates that the taxpayer’s deductions and other expenditures appear out of proportion to the income reported, the taxpayer’s cash does not all flow from a bank account which can be analyzed to determine its source and subsequent disposition, or the taxpayer makes it a common business practice to use cash receipts to pay business expenses.

Sources of funds are the various ways the taxpayer acquires money during the year. Decreases in assets and increases in liabilities generate funds. Funds also come from taxable and nontaxable sources of income. Unreported sources of income even though known, are not listed in this computation since the purpose is to determine the amount of any unreported income. Specific items of income are denoted separately. Specific sources of funds include the decrease in cash-on-hand, in bank account balances (including personal and business checking and savings accounts), and decreases in accounts receivable; increases in accounts payable; increases in loan principals and credit card balances; taxable and nontaxable income, and deductions which do not require funds such as depreciation, carryovers and carrybacks, and adjusted basis of assets sold.

Application of funds are ways the taxpayer used (or expended) money during the year. Examples of applications of funds include increases in cash-on-hand, increase in bank account balances (including personal and business checking and savings accounts), business equipment purchased, real estate purchased, and personal assets acquired; purchases and business expenses; decreases in loan principals and credit card balances, and personal living expenses. Determining the beginning amount of cash-on-hand and accumulated fund for the year is important. See IRS IRM for possible defenses the taxpayer might raise regarding the availability of nontaxable funds.

• The Bank Account Analysis compares total deposits with the reported gross income. for all accounts, whether designated as personal or business. The examiner will review the taxpayer’s business and personal bank accounts (including investment accounts); i.e., statements, deposit slips, and canceled checks, etc. looking for unusual deposits (size or source), the frequency of deposits, deposits of cash, specific deposits that do not follow the taxpayer’s normal routine or pattern, nontaxable deposits such as loans and transfers, commingling of personal and business activities, and cash-backs when a deposit occurs.

The examiner will attempt to total the deposits and reconcile deposits of nontaxable funds and transfers between accounts focusing on transfers in, out, and between accounts as previously unknown accounts may be identified. Checks deposited by the taxpayer but later returned by the bank (e.g., the maker of the check did not have sufficient funds in the account to pay the check) are categorized as nontaxable transactions. Nontaxable funds, transfers-in, and returned deposits need to be subtracted from total deposits to get “taxable deposits.” The examiner will determine disbursements by adding the opening bank balance to the total deposits and then subtracting out the ending balance.

To the extent possible, cancelled checks will be reviewed to determine whether nondeductible expenditures (personal expenses, investments, payments on asset purchases, etc.) are included with business expenses and if so, the amount. If cancelled checks are unavailable, transactions will be traced from the bank statement to the check register and the original document. Significant commingling of accounts may warrant a more in-depth analysis by the examiner. When nondeductible expenditures are deducted from the total disbursements the remainder should approximate the deductible business expenses on the tax return (other than non-cash expenses such as accruals and depreciation).

If the analysis results in the identification of excess deposits over the reported gross income, the excess represents potential unreported income. If specific transactions or deposits can be identified as the source of the understatement, the examiner may assert a specific item adjustment to income supported by the direct evidence of excess deposits. If the specific transactions or deposits creating the understatement are not identified, an adjustment to taxable income may be made based on the circumstantial evidence. If the business expenditures paid by check are less than the deducted business expenses on the return, then the taxpayer may be overstating expenses, paying expenses by cash (unreported income), or paying expenses from an undisclosed source of funds. If the analysis indicates significant commingling of funds, then the internal controls are weak and the books and records may be unreliable.

• The Bank Deposits and Cash Expenditures Method is distinguished from the Bank Account Analysis by the depth and analysis of all the individual bank account transactions, and the accounting for cash expenditures, and a determination of actual personal living expenses. The Bank Deposits and Cash Expenditures Method computes income by showing what happened to a taxpayer’s funds based on the theory that if a taxpayer receives money it can either be deposited or it can be spent . This method is based on the assumptions that proof of deposits into bank accounts, after certain adjustments have been made for nontaxable receipts, constitutes evidence of taxable receipts; expenditures as disclosed on the return, were actually made and could only have been paid for by credit card, check, or cash. If outlays were paid by cash, then the source of that cash must be from a taxable source unless otherwise accounted for and it is the burden of the taxpayer to demonstrate a nontaxable source for this cash.

The examiner will consider whether there are unusual or extraneous deposits which appear unlikely to have resulted from reported sources of income? The examiner may limit the examination to large deposits or deposits over a certain amount. However, the identification of smaller regular deposits may be indicative of dividend income, interest, rent, or other income, leading to a source of investment income. An item of deposit may be unusual due to the kind of deposit, check or cash, in its relationship to the taxpayer’s business or source of income. An explanation may be required if a large cash deposit is made by a taxpayer whose deposits normally consist of checks. Also, a bank statement noting only one or two large even dollar deposits, in lieu of the normal odd dollar and cents deposits, would be unusual and require an explanation.

Many taxpayers, due to the nature of their business or the convenience of the depository used, will follow a set pattern in making deposits. Deviation from this pattern may be reason for more in depth questioning. Bank statements or deposit slips which indicate repeat deposits of the same amount on a monthly basis, quarterly or semi-annual basis may indicate rental, dividend, interest or other income accruing to the taxpayer.

The examination of deposit slips may indicate items of deposit which appear questionable due to the location of the bank on which the deposited check was drawn. It is common practice when preparing a deposit slip to list either the name of the bank, city of the bank or identification number of the bank upon which the deposited check was drawn. If an identification number is used, the name and location of the bank can be determined by reference to the banker’s guide. In all cases, if the location of the bank on which the check for deposit was drawn bears little relation to the taxpayer’s business location or source of income, it may indicate the need for further investigation.

The examiner should identify all loan proceeds, collection of loans, or extraneous items reflected in deposits. If loan proceeds are identified, the examiner may request the loan application documents to verify the source and amount of the nontaxable funds and attempt to determine whether such information is consistent with other information; i.e., cash flows, assets, anticipated gross receipts, etc.

If repayments of loans are identified, the examiner will request the debt instruments to establish that a loan was made, the terms of the debt, and the repayment schedule. Before an examiner can reach any conclusion about the relationship between deposits and reported receipts, transfers and re-deposits must be eliminated. For example, if a taxpayer draws a check to cash for the purpose of cashing payroll checks and then re-deposits these payroll checks, the examiner would be incorrect if total deposits were compared to receipts reported without adjusting for this amount. The taxpayer has done nothing more than redeposit the same funds in the form of someone else’s checks.

• The Markup Method produces a reconstruction of income based on the use of percentages or ratios considered typical for the business under examination in order to make the actual determination of tax liability. It consists of an analysis of sales and/or cost of sales and the application of an appropriate percentage of markup to arrive at the taxpayer’s gross receipts. By reference to similar businesses, percentage computations determine sales, cost of sales, gross profit, or even net profit. By using some known base and the typical applicable percentage, individual items of income or expenses may be determined. These percentages can be obtained from analysis of Bureau of Labor Statistics data or industry publications. If known, use of the taxpayer’s actual markup is required.

The Markup Method is similar to how state sales tax agencies conduct audits. The cost of goods sold is verified and the resulting gross receipts are determined based on actual markup. The Markup Method is often used when inventories are a principal income producing factor and the taxpayer has nonexistent or unreliable records or the taxpayer’s cost of goods sold or merchandise purchased is from a limited number of sources such that these sources can be ascertained with reasonable certainty, and there is a reasonable degree of consistency as to sales prices.

 • The Net Worth Method for determining the actual tax liability is based upon the theory that increases in a taxpayer’s net worth during a taxable year, adjusted for nondeductible expenditures and nontaxable income, must result from taxable income. This method requires a complete reconstruction of the taxpayer’s financial history, since the government must account for all assets, liabilities, nondeductible expenditures, and nontaxable sources of funds during the relevant period.

The theory of the Net Worth Method is based upon the fact that for any given year, a taxpayer’s income is applied or expended on items which are either deductible or nondeductible, including increases to the taxpayer’s net worth through the purchase of assets and/or reduction of liabilities. The taxpayer’s net worth (total assets less total liabilities) is determined at the beginning and at the end of the taxable year. The difference between these two amounts will be the increase or decrease in net worth. The taxable portion of the income can be reconstructed by calculating the increase in net worth during the year, adding back the nondeductible items, and subtracting that portion of the income which is partially or wholly nontaxable.

The purpose of the Net Worth Method is to determine, through a change in net worth, whether the taxpayer is purchasing assets, reducing liabilities, or making expenditures with funds not reported as taxable income. The use of the Net Worth Method of proof requires that the government establish an opening net worth, also known as the base year, with reasonable certainty; negate reasonable explanations by the taxpayer inconsistent with guilt; i.e., reasons for the increased net worth other than the receipt of taxable funds. Failure to address the taxpayer’s explanations might result in serious injustice; establish that the net worth increases are attributable to currently taxable income, and; where there are no books and records, willfulness may be inferred from that fact coupled with proof of an understatement of taxable income. But where the books and records appear correct on their face, an inference of willfulness from net worth increases alone might not be justified. The government must prove every element beyond a reasonable doubt, though not to a mathematical certainty.

BE PREPARED. Circumstances that might support the use of an indirect method include a financial analysis that cannot be easily reconciled – such as if the taxpayer’s known business and personal expenses exceed the reported income per the return and nontaxable sources of funds have not been identified to explain the difference; irregularities in the taxpayer’s books and weak internal controls; gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry; the taxpayer’s bank accounts have unexplained deposits; the taxpayer does not make regular deposits of income, but uses cash instead; a review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income; there are no books and records (examiners should determine whether books and/or records ever existed, and whether books and records exist for the prior or subsequent years. If books and records have been destroyed, the examiner will attempt to determine who destroyed them, why, and when); no method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect income as required by Code section 446(b).

When considering an indirect method, the IRS examiner will look to the industry or market segment in which the taxpayer operates, whether inventories are a principle income producing activity, whether suppliers can be identified and/or merchandise is purchased from a limited number of suppliers, whether pricing of merchandise and/or service is reasonably consistent, the volume of production and variety of products, availability and completeness of the taxpayer’s books and records, the taxpayer’s banking practices, the taxpayer’s use of cash to pay expenses, expenditures exceed income, stability of assets and liabilities, and stability of net worth over multiple years under audit.

Practitioners often consider performing one or more of the foregoing indirect methods before commencement of an IRS examination for taxpayers operating a “cash intensive” business. Better to know before the audit begins than to be surprised about some unusual or undisclosed financial activity during the examination.

For every IRS examination, the advice is the same . . . prepare, prepare, prepare and learn to expect the unexpected.

Posted by: | July 31, 2014


The Internal Revenue Manual (IRM) contains a Penalty Handbook intended to serve as the foundation for addressing the administration of penalties by the IRS. It is the “one source of authority for the administration of penalties. . .”[1] and provides a “fair, consistent, and comprehensive approach to penalty administration.” As such, the IRM is often the first stop for IRS examiners attempting to determine whether conduct should be subjected to further review and, potentially, civil penalties. Under the “First Time Abate” procedures of the IRM the IRS is to eliminate certain penalties if the taxpayer has not previously been required to file a return or if no prior penalties have been assessed against the taxpayer within the prior 3 years

Objectives in Penalty Administration. Similar cases and similarly-situated taxpayers are to be treated in a similar manner with each having the opportunity to have their interests heard and considered. Penalty relief is to be viewed from the perspective of fair and impartial enforcement of the tax laws in a manner that promotes voluntary compliance. Penalties encourage voluntary compliance by defining standards of compliant behavior, defining consequences for noncompliance, and providing monetary sanctions against taxpayers who do not meet the standard.[2]

In this regard, the objective of penalty administration is to be severe enough to deter noncompliance, encourage noncompliant taxpayers to comply, be objectively proportioned to the offense, and be used as an opportunity to educate taxpayers and encourage their future compliance.[3]

IRM Approach to Penalty Administration. The IRM’s approach to penalty administration provides:

Consistency: The IRS should apply penalties equally in similar situations. Taxpayers base their perceptions about the fairness of the system on their own experience and the information they receive from the media and others. If the IRS does not administer penalties uniformly (guided by the applicable statutes, regulations, and procedures), overall confidence in the tax system is jeopardized.

Accuracy: The IRS must arrive at the correct penalty decision. Accuracy is essential. Erroneous penalty assessments and incorrect calculations confuse taxpayers and misrepresent the overall competency of the IRS.

Impartiality: IRS employees are responsible for administering the penalty statutes and regulations in an even-handed manner that is fair and impartial to both the government and the taxpayer.

Representation: Taxpayers must be given the opportunity to have their interests heard and considered. Employees need to take an active and objective role in case resolution so that all factors are considered.[4]

Relief Due to Reasonable Cause.  Many penalties may be avoided based upon a determination that reasonable cause existed for the positions maintained within a return. Reasonable cause is based on a review of all relevant facts and circumstances in each situation and allows the IRS to provide relief from a penalty that would otherwise be assessed. Reasonable cause relief is generally granted when the taxpayer exercises ordinary business care and prudence in determining their tax obligations but nevertheless failed to comply with those obligations.[5] Ordinary business care and prudence includes making provisions for business obligations to be met when reasonably foreseeable events occur. A taxpayer may establish reasonable cause by providing facts and circumstances showing that they exercised ordinary business care and prudence (taking that degree of care that a reasonably prudent person would exercise), but nevertheless were unable to comply with the law.[6]

Examiners are to consider various factors in determining penalty relief based on reasonable cause. What happened and when did it happen? During the period of time the taxpayer was non-compliant, what facts and circumstances prevented the taxpayer from filing a return, paying a tax, and/or otherwise complying with the law? How did the facts and circumstances result in the taxpayer not complying? How did the taxpayer handle the remainder of their affairs during this time? Once the facts and circumstances changed, what attempt did the taxpayer make to comply?

Death, serious illness, or unavoidable absence of the taxpayer may establish reasonable cause for filing, paying, or delinquent deposits. Information examiners consider when evaluating a request for penalty relief based on reasonable cause due to death, serious illness, or unavoidable absence includes, but is not limited to, the relationship of the taxpayer to the other parties involved, the date of death, the dates, duration, and severity of illness, the dates and reasons for absence, how the event prevented compliance, if other business obligations were impaired, and if tax duties were attended to promptly when the illness passed, or within a reasonable period of time after a death or return from an unavoidable absence.[7]

Explanations relating to the inability to obtain the necessary records may constitute reasonable cause in some instances, but may not in others. Reasonable cause may be established if the taxpayer exercised ordinary business care and prudence, but due to circumstances beyond the taxpayer’s control, they were unable to comply. Relevant information includes, but is not limited to, an explanation as to why the records were needed to comply, why the records were unavailable and what steps were taken to secure the records, when and how the taxpayer became aware that they did not have the necessary records, if other means were explored to secure needed information, why the taxpayer did not estimate the information, if the taxpayer contacted the IRS for instructions on what to do about missing information, if the taxpayer promptly complied once the missing information was received, and supporting documentation such as copies of letters written and responses received in an effort to get the needed information.[8]

Reliance on Advice. In certain situations, reliance on the advice of others may justify relief from penalties. Relevant information regarding a request for abatement or non-assertion of a penalty due to reliance on advice includes, but is not limited to, a determination of whether the advice in response to a specific request and was the advice received related to the facts contained in that request and if the taxpayer reasonably relied upon the advice.  The taxpayer is entitled to penalty relief for the period during which they relied on the advice. The period continues until the taxpayer is placed on notice that the advice is no longer correct or no longer represents the IRS’s position.

The IRS is required to abate any portion of any penalty attributable to erroneous written advice furnished by an officer or employee of the IRS acting in their official capacity.14 Administratively, the IRS has extended this relief to include erroneous oral advice when appropriate. Relevant inquiries include: Did the taxpayer exercise ordinary business care and prudence in relying on that advice? Was there a clear relationship between the taxpayer’s situation, the advice provided, and the penalty assessed? What is the taxpayer’s prior tax history and prior experience with the tax requirements? Did the IRS provide correct information by other means (such as tax forms and publications)? What type of supporting documentation is available?

Reliance on the advice of a tax advisor generally relates to the reasonable cause exception in Code Section 6664(c) for the accuracy-related penalty under Code Section 6662.[9] However, in certain situations, reliance on the advice of a tax advisor may provide relief from other penalties when the tax advisor provides advice on a substantive tax issue.

First Time Abatement. The IRS Reasonable Cause Assistant (RCA) is a decision-support interactive software program developed to reach a reasonable cause determination within the IRS.[10] The IRS will use the RCA after normal case research has been performed, (i.e., applying missing deposits/payments, adjusting tax, or researching for missing extensions of time to file, etc.) for the Failure to File (FTF), Failure to Pay (FTP), and Failure to Deposit (FTD) penalties.

RCA provides an option for penalty relief known as the “First Time Abate” for the FTF, FTP, and/or FTD penalties if the taxpayer has not previously been required to file a return or if no prior penalties (except the Estimated Tax Penalty) have been assessed on the same account in the prior 3 years.[11] A penalty assessed and subsequently reversed in full will generally be considered to show compliance for that tax period. If the RCA determines a “First -Time Abate” is applicable, the taxpayer will be advised that the penalty(s) was removed based solely on their history of compliance, that this type of penalty removal is a one-time consideration available only for a first-time penalty charge, and that any future (FTF, FTP, FTD) penalties will only be removed based on information that satisfies the previously mentioned reasonable cause criteria.[12]

Summary. Civil tax penalty administration pending any potential comprehensive tax reform must continue to promote and enhance voluntary compliance. Penalties should only be imposed in proportion to the misconduct. Penalties should not be asserted for the purpose of raising revenue or offsetting the costs of tax benefits nor merely to punish behavior without also promoting compliance.

Most taxpayers attempt to comply with their filing and payment obligations under the Code. Others comply because of a concern for the imposition of penalties. Somewhere in between are taxpayers who are subjected to penalties for conduct they failed to realize was somehow wrongful. In most situations, the IRS has the experience and dedicated staff to make the proper determination.

The penalty provisions set forth within the Code must retain the discretion of the IRS to appropriately punish those most deserving and not punish what are, at most, an inadvertent foot-faults. Those who appropriately respect their obligations to our system of taxation should be cautioned and educated about their present and future tax compliance without having to waltz through an almost unintelligible legislative minefield of civil tax penalties.


[1] Internal Revenue Manual (IRM)  (11-25-2011). Refer to IRM 9.1.3, Criminal Investigation – Criminal Statutory Provisions and Common Law, for Criminal Penalty provisions.

[2] Penalty Policy Statement 20-1 (IRM;  June 29, 2004)

[3] IRM  (11-25-2011)

[4] IRM  (11-25-2011

[5] IRM  (11-25-2011)

[6] IRM  (11-25-2011)        .

[7] IRM  (11-25-2011)

[8] IRM  (11-25-2011)

  1. IRC § 6404(f) and Treas. Reg. 301.6404–3

[9] IRC § 6404(f) and Treas. Reg. 301.6404–3

[10] IRM  (11-25-2011)

[11] Id.

[12] Id.

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