Posted by: Cory Stigile | September 18, 2018

How Long Should You Keep Tax-Related Records? by CORY STIGILE

The length of time you should keep a document depends on the action, expense, or event which the document records. Generally, you must keep your records that support an item of income, deduction or credit shown on your tax return until the period of limitations for that tax return runs out. For most taxpayers, the general recommendation is to retain copies of tax returns and supporting documents at least three years. Some documents should be kept up to seven years in case a taxpayer needs to file an amended return or if questions arise. Taxpayers should retain records relating to real estate for at least seven years after disposing of the property.

Health care information statements should be kept with other tax records. Taxpayers do not need to send these forms to IRS as proof of health coverage. The records taxpayers should keep include records of any employer-provided coverage, premiums paid, advance payments of the premium tax credit received and type of coverage. Taxpayers should keep these — as they do other tax records — generally for three years after they file their tax returns.

Whether stored on paper or kept electronically, taxpayers are urged to keep tax records safe and secure, especially any documents bearing Social Security numbers. Consider scanning paper tax and financial records into a format that can be encrypted and stored securely on a flash drive, CD or DVD with photos or videos of valuables.

Now is a good time to set up a system to keep tax records safe and easy to find when filing next year, applying for a home loan or financial aid. Tax records must support the income, deductions and credits claimed on returns. Taxpayers need to keep these records if the IRS asks questions about a tax return or to file an amended return.

Keep tax, financial and health records safe and secure whether stored on paper or kept electronically. When records are no longer needed for tax purposes, ensure the data is properly destroyed to prevent the information from being used by identity thieves.

The period of limitations is the period of time in which you can amend your tax return to claim a credit or refund, or the IRS can assess additional tax. Unless otherwise stated, the years refer to the period after the income tax return was filed. Returns filed before the due date are treated as filed on the due date. Filed tax returns can be helpful in preparing future tax returns and making computations if you file an amended return.

Period of Limitations that generally apply to income tax returns:

  1. Keep records for 3 years, if situations (4) and (5) below do not apply to you.
  2. Keep records for 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later, if you file a claim for credit or refund after you file your return.
  3. Keep records for 7 years if you file a claim for a loss from worthless securities or bad debt deduction.
  4. Keep records of gross income for 6 years, which is the statute of limitations for assessment where a return omits more than 25% of gross income or 25% of gross receipts of a trade or business. Examples where this can occur is reclassification of a related-party loan as income, constructive dividends, failure to report alimony, failure to report discharge of debt income, and failure to report income from a pass-through entity.
  5. Keep records indefinitely if have not filed a return.
  6. Keep employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later.

The following questions should be applied to each record as you decide whether to keep a document or throw it away.

Are the records connected to property? Generally, keep records relating to property until the period of limitations expires for the year in which you dispose of the property. You must keep these records to figure any depreciation, amortization, or depletion deduction and to figure the gain or loss when you sell or otherwise dispose of the property.

If you received property in a nontaxable exchange, your basis in that property is the same as the basis of the property you gave up, increased by any money you paid. You must keep the records on the old property, as well as on the new property, until the period of limitations expires for the year in which you dispose of the new property. 

What should I do with my records for nontax purposes? When your records are no longer needed for tax purposes, do not discard them until you check to see if you have to keep them longer for other purposes. For example, your insurance company or creditors may require you to keep them longer than the IRS does.

Caveats:  There is no statute of limitations on assessment where the taxpayer files a fraudulent return.  If the taxpayer was required to file reports relating to foreign assets or foreign transfers, the statute of limitations does not begin to run until those reports are filed.

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at www.taxlitigator.com

Long ago, some practitioners may have thought “PFIC” was a type of electric plaque removal devise.  OVDI changed all that.  Now we know it stands for “Passive Foreign Investment Company” and that special rules exist for determining taxable income from owning PFIC stock.  See §§ 1291 et seq.

Toso v Commissioner, 151 T.C. No. 4 (Sept. 4, 2018), here, addresses the six-year statute of limitations for assessing deficiencies due to a substantial understatement of gross income where gain from the sale of PFIC stock is involved and whether net PFIC losses can be offset against PFIC gains.  The taxpayers had an account at UBS in 2006, 2007, and 2008.  Their original timely filed returns did not report items relating to the UBS account.  They subsequently filed amended returns reporting items related to the UBS account.  On January 15, 2015, the IRS issued a statutory notice of deficiency for 2006, 2007 and 2008.  It determined that gain reported on the amended returns was from the sale of PFIC stock.  The taxpayers argued that the notices of deficiency were barred by IRC §6501(a)’s three-year statute of limitations on assessment.  The IRS contended that the six-year statute under IRC §6501(e)(1)(A)(i), for substantial understatements of gross income, applied.  The issues before the court were whether gains from the sale of PFIC stock are counted as gross income for purposes of the six-year statute of limitations and, if so, whether PFIC losses could be offset against PFIC gains.  The answers were no and no.

The Tax Court began with the definition of “gross income.”  Gross income for purposes of the statute of limitations is generally synonymous with gross income for purposes of IRC §61(a), which includes gains from dealings with property.  Gains from PFIC stock are taxed under special rules: normally §1291 applies unless the taxpayer elects to treat PFIC stock as a qualified electing fund under §§1292-1295 or to mark to market under §1296.  If no election is made, as was the case with the taxpayers, §1291 applies.

Sec. 1291 provides that gain from sale of PFIC stock is allocated ratably on a daily basis over the entire holding period of the stock.  Only PFIC gain attributable to the year of sale is included as ordinary income in gross income.  It is taxed as ordinary income.  The gain allocated to prior years is not included in current year PFIC income.  Instead, there is a “deferred tax amount” calculated by a) allocating non-current year PFIC gain ratably by day over the entire holding period, b) multiplying the amount of gain allocated to each prior year by the highest ordinary income rate in effect for that year, c) computing interest on the tax and d) summing up all the tax and interest.  This deferred tax amount is added to the taxpayer’s tax for the current year.  As a result, only the gain allocated to the current year is included in the current year’s gross income and included in determining whether there was a substantial understatement of gross income under §6501(e)(1)(A)(i).  Gain allocated to prior years is not included in gross income for any purpose.

The Tax Court rejected the IRS’s argument that all non-current year PFIC gain is gross income and that §1291 is nothing more than a method of calculating tax and interest.  According to the Court, such a reading treats §1291 out of existence.  Since it is part of the Code and is a specific provision, it overrides the general provision, §61.

According to the Court, this should have ended the issue, but it felt obliged to address the IRS’s policy argument.  The PFIC provisions were enacted in 1986.  Prior to that time, a taxpayer who invested in a foreign investment company that had no US source income, did not do business in the US, and retained earnings rather than paying dividends could defer tax until the foreign investment company stock was sold.  By contrast a domestic registered investment company (“RIC”) had to distribute 90% of its ordinary income each year to its shareholders.  If it did not, it was taxable as a C corporation.  Even if it distributed the requisite 90%, it would still pay a tax on retained ordinary income.  The PFIC provisions were enacted so that taxpayers who invested in PFICs would be treated similarly to taxpayers who invested in RICs.

From this, the IRS argued that since holders of PFIC stock are to be treated similarly to holders of RIC stock, all gain from the sale of PFIC stock should be treated as gross income for statute of limitations purposes.  This argument did not meet with approval.  That the PFIC provisions were meant to treat owners PFIC similarly to owners of RIC stock, they were not treated identically.  Among other things, gain from sale of PFIC stock under §1291 is taxed at ordinary income rates while gain from the sale of RIC stock is taxed at capital gain rates.  Similarity is not identicality.  The Court concluded that PFIC gain allocated to prior years under §1291 is not “gross income” for purposes of §6501(e)(1)(A)(i).

The Court next determined whether there was a substantial understatement of gross income for any of the three years before it.  2006 was the only year in which the amount of unreported gross income was more than 25% of what was reported on the original return.  The notices of deficiency for 2007 and 2008 were thus time barred.

Finally, the Court addressed the taxpayer’s argument that it should be allowed to net PFIC losses against PFIC gains.  Since §1291 only applies to PFIC gains, it found no basis for allowing the losses to be offset against the gains.

So one benefit of PFIC is if you didn’t report all of your gross income for one or more years, not all gains from the sale of PFIC stock will be treated as gross income.  That is if a court of appeal does not reverse the Tax Court.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney 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, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

The pending 2014 Offshore Voluntary Disclosure Program (OVDP) is set to close on September 28, 2018.  According to FAQs most recently updated by the IRS on July 26, 2018, pre-clearance requests take a minimum of 30 days and should be submited by August 24, 2018 to allow sufficient lead time for processing. (see OVDP FAQs)   The 2014 OVDP is the last in a series of offshore voluntary disclosure programs administered by the IRS since 2009.  The current OVDP began in 2014 and is a modified version of the OVDP launched in 2012, which followed similar programs offered in 2011 and 2009. These programs have enabled U.S. taxpayers to voluntarily resolve past non-compliance related to unreported foreign financial assets and failure to file foreign information returns.

SIGNIFICANCE OF CLOSING OVDP

So how does this impact the non-compliant taxpayer?  The answer depends on the culpability and prior actions of the taxpayer, and whether that person needs the protection and certainty afforded by OVDP.

OVDP is a voluntary disclosure program specifically designed for taxpayers with exposure to potential criminal liability and/or substantial civil penalties due to a willful failure to report foreign financial assets and to pay all tax due in respect of those assets.  OVDP is designed to provide taxpayers with such exposure with protection from criminal liability and terms for resolving their civil tax and penalty obligations.

Taxpayers participating in the OVDP generally agree to file amended returns and file FINCEN Form 114 (formerly Form TD 90-22.1, Report of Foreign Bank and Financial Accounts “FBARs”), for eight tax years, pay the appropriate taxes and interest together with a 20% accuracy related penalty and an “FBAR-related” penalty (in lieu of all other potentially applicable penalties associated with a foreign financial account or entity) of 27.5% of the highest account value that existed at any time during the prior eight tax years (or 50% for those foreign banks or facilitators on the IRS list) (see list of foreign financial institutions or facilitators).  The OVDP did not have a stated expiration date, until recently when the IRS announced its intention to close OVDP on September 28th in a IRS Notice issued on March 13, 2018 (see IR-2018-52).

There are various considerations before a taxpayer should determine whether to pursue a voluntary disclosure of prior tax indiscretions through the OVDP or through some other manner. When considering OVDP, many look to whether the taxpayer might be considered a realistic candidate for a criminal prosecution referral by the IRS or prosecution by the Department of Justice?  If so, the determination to participate may be relatively quick and easy.   Other factors may include: (1) Is there a possibility of reducing penalty exposure by filing amended or delinquent returns and FBARs in lieu of a direct participation in the OVDP: (2) What would be the potentially applicable penalties upon an examination of such returns and FBARs; and (3) Would the government be able to carry their burden to demonstrate the taxpayer “willfully” violated the FBAR filing requirements.  Because OVDP asserts an offshore penalty based on foreign financial accounts and asset valuations, for many with smaller financial account values, the aggregate offshore penalty determination, even for multiple years, may actually less outside the OVDP.

Taxpayers with criminal exposure or those wishing to resolve their civil tax and penalty obligation should quickly act to meet the deadline. The first step is to confirm eligibility through the IRS pre-clearance process.  While a preclearance request is not required to participate in OVDP, it assists the taxpayer in learning whether the IRS has received information that can disqualify one from participation in OVDP before one reveals to the IRS additional information required by OVDP.

The deadline to make a pre-clearance request is August 24, 2018.  We suggest pre-clearance requests in all cases where there is an intent to participate in OVDP.  Those who further wait may not benefit from a pre-clearance check, potentially exposing themselves to the risk that the IRS obtains information about that person even though that person may not be accepted into OVDP which is something that should be avoided, if possible.

Any client presently not in compliance should seriously consider availing themselves of the OVDP prior to its expiration. One should anticipate that the IRS may treat those failing to take timely, voluntary corrective action in a more severe manner. There may still be mechanisms for those who take corrective action post OVDP, but the civil penalty regime will be uncertain and taxpayers will be left without the benefits of an informed approach to resolution.

There has definitely been an increased interest by clients in the program since the sunset of the program has been announced.   We have seen this before with each successive closure of the 2009, 2011 and 2012 program.  This time, however, it appears that most clients have been better informed about the benefits and burdens involved.  Practitioners have been educating the public about these issues for more than a decade now, and the IRS has been hugely successful in publicizing the existence of the programs.

TAX ENFORCEMENT

Since 2009, more than 56,000 taxpayers have used one of the OVDP programs to comply voluntarily. All told, these taxpayers paid approximately $11.1 billion in back taxes, interest and penalties.  The number of taxpayer disclosures under the OVDP peaked in 2011, when about 18,000 people came forward and has steadily declined thereafter, falling to only 600 disclosures in 2017.  The planned end of the current OVDP also reflects advances in third-party reporting and increased awareness of U.S. taxpayers of their offshore tax and reporting obligations, according to the IRS.  The IRS will continue to use tools besides voluntary disclosure to combat offshore tax avoidance, including taxpayer education, Whistleblower leads, civil examination and criminal prosecution.

The Streamlined and Delinquent filing procedures will continue to remain open for the non-willful taxpayer.  There presently is no sunset date for these procedures.  The IRS resources dedicated to these filing procedures appear well worth it, given the number of taxpayers who have voluntarily corrected under these procedures.

Programs come and programs go, including “last chance” programs and programs following those. We do not know what will happen after the expiration of the current program on September 28, but what we do know is that this could be the last best chance for taxpayers and their advisors to take a hard look at this option before it becomes history.

MICHEL R. STEIN – For more information please contact Michel Stein – Stein@taxlitigator.com  Mr. Stein is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Mr. Stein has significant experience in matters involving previously undeclared interests in foreign financial accounts and assets, the IRS Offshore Voluntary Compliance Program (OVDP) and the IRS Streamlined Filing Compliance Procedures. Additional information is available at www.taxlitigator.com

This is the sixth of a six part series devoted to utilization of various indirect methods of determining the income of a taxpayer.

Financial Status Audit Techniques. (FSAT). 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. 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 FSAT, is not prohibited by Code Section 7602(e)[i]. 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.

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.[ii] The government must prove every element beyond a reasonable doubt, though not to a mathematical certainty.

When to Anticipate an Indirect Method. Circumstances that might support the use of an indirect method include a financial status analysis that cannot be easily reconciled – 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 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.

[i].  See IRM 4.10.4.6.7.1 (06-01-2004). And Holland v. United States, 348 U.S. 121 (1954).

 

[ii].  Internal Revenue Manual 4.10.4.6.1 sets forth the requirements for examining income and FSATs. The indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954). “Examination techniques” include examining and testing the taxpayer’s books and records, analytical tests, observing, and interviewing the taxpayer. These techniques are unique to the use of a formal indirect method and will not routinely trigger the limitation of Code Section 7602(e).

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at http://www.taxlitigator.com

What is the Potential Maximum Willful FBAR Penalty? In the wake of United States v. Colliot, here, another district court recently held that the regulation at 31 CFR §1030.820 limits the maximum willful penalty.  In United States v Wadhan, here, (D. Colo. July 18, 2018), the Wadhans had one account at UBS.  They closed the UBS account in 2008 and had the funds transferred to multiple accounts in Jordan.  They did not file an FBAR for 2008.  They filed FBARs for 2009 and 2010.  The FBARs did not list all their offshore accounts and for the ones listed the reported maximum account balance was “over $10,000.”  The 2008 penalty was for 50% of the maximum amount in the UBS account.  For both 2009 and 2010, the IRS assessed a $599,234.54 penalty equal to 50% of the maximum amount in the largest account.  It also assessed multiple penalties of $100,000 for each of the other accounts.

Relying on 31 CFR §1030.820, the Wadhans moved for judgment on the pleadings, which the court treated as a motion for summary judgment.  Holding that the IRS “is not empowered to impose yearly penalties in excess of $100,000 per account,” the court granted the motion.

In granting the motion, the court rejected the Government’s assertion that the 2004 amendment to 31 USC §5321(a)(5)(C), which increased the maximum FBAR penalty from $100,000 to 50% of the maximum balance in the account at the time of the violation, superseded the regulation.  First, both pre- and post-amendment versions of subsection (a)(5)(C) give the Secretary discretion to assess the FBAR penalty.  Second, the regulation is not inconsistent with the statute, since the regulation can be interpreted as an exercise of the Secretary’s discretion to limit the penalty.  Third, since 2004 the Secretary has made at least five adjustments to penalties under 31 CFR §1010.821 but never increased the $100,000 cap.  Finally, the court rejected the Government’s argument that the 1987 preamble to the predecessor of §1010.820, which states that Treasury intended to enforce the Bank Secrecy Act “to the fullest extent possible” without any “safe harbor,” does not indicate that it intended that the regulation would automatically incorporate any changes to §5321.

Note that the IRS assessed only one penalty for 2008, but penalties for each account for 2009 and 2010.  Will the Government move for reconsideration on the ground that it is entitled to penalties of $100,000 for each account that was open in 2008?  It has filed a motion asserting it can do so in Colliot.  The statute provides that the Secretary “may impose a civil money penalty on any person who violates, or causes any violation of, any provision of section 5314.”  Note the singular “a civil penalty” which can be imposed on “any person” who violates any provision of the section, not a penalty for each violation.  It does not provide a penalty for “each violation.”

The Balance in the Account at the Time of the Violation? A second point relating to the 2008 penalty:  even if the regulation did not limit the penalty, shouldn’t the maximum penalty for the UBS account have have been the greater of zero or $100,000?  Under §5321(a)(5)(D), the amount is determined by “in the case of a violation involving a failure to report the existence of an account or any identifying information required to be provided with respect to an account, the balance in the account at the time of the violation.”  Emphasis added.  The violation occurs on the date the FBAR was filed or was due to be filed.  On June 30, 2009, the UBS account balance was zero.  Nonetheless, the IRS often assesses penalties based on the maximum account balance during the year for which the report is due, not for the balance on the due date of the FBAR.

An example of the IRS assessing willful penalties that are less than 50% of the maximum balance during the year is the recent decision in United States v. Markus, Civil No. 16-2133 (RBK/AMD) (D. N.J., July 17, 2018).  The defendant served as an Army engineer deployed in Iraq.  For several years he oversaw an oil pipeline project.  He received bribes from several businessmen in exchange for confidential bid information.  He placed some of the bribes in an in Egypt.  The rest he deposited in three accounts in Jordan.  He filed an FBAR for 2008 reporting only one of the accounts in Jordan.  He did not file FBARs for 2007 or 2009.

In 2012, Markus pled guilty to one count of wire fraud and one count of willfully failing to file an FBAR for 2009.  In April 2014, the IRS assessed the following FBAR willful penalties:

Maximum

Year            Bank                    Balance                 Penalty

2007           Egypt Bank          $299,250               $100,000

2007           Jordan I               $744,854               $372,427

2007           Jordan II              $90,000                 $45,000

2008           Egypt Bank           $364,950               $100,000

2009           Egypt Bank           $400,000               $218,225

2009           Jordan III              $680,000               $6,362

Four days before the statute of limitations expired, the Government filed a suit to reduce the FBAR assessments to judgment.  After discovery, it moved for summary judgment.  Markus, who represented himself, raised only legal arguments in his opposition and did not refute the Government’s factual assertions.  Based on Markus’ criminal conviction and his filing an FBAR for 2008, together with his deposition testimony, the court found that Markus willfully failed to file FBARs for 2007 and 2009 in order to hide his taking bribes.  Since the regulation limiting the maximum penalty was not raised in the motion or opposition, the court did not address the issue.  The court  made one modification to the penalties: because the evidence establish that the maximum balance in the Egyptian account was $400,000 in 2009, it reduced the penalty for that year from $218,225 to $400,000.

One peculiarity is that while two accounts had maximum balances of over $200,000 in 2007 and Jordan account III had a balance of $680,000 in 2009, Markus was assessed a 50% penalty for only one account for 2007.  The penalty for 2009, $6,362, was less than 1% of the maximum balance.  No explanation is given, although it should be noted that according to the court Markus transferred $580,000 from Jordan account III to an account in the U.S. in 2009.

Further FBAR news:  Internal Revenue Manual 4.26.16.6.5.1 states that for purposes of the FBAR penalty “willful” is a “voluntary, intentional violation of a known legal duty.”  A Chief Counsel Technical Advice Memo, here, was recently released that states that “willful” is not limited to voluntary and intentional violations but also includes violations due to “willful blindness” and “reckless disregard.”  The TAM also stated that the Government’s burden of proof is by a preponderance of the evidence and not by clear and convincing evidence.

For more information please contact ROBERT S. HORWITZ – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney 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, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

In 1998 Congress added §7433(e) to the Code.  It provides that a taxpayer can sue the US for damages as a result of collection action that “willfully violates” either the bankruptcy stay imposed by 11 USC §362 or a bankruptcy discharge order under 11 USC §524.  The statute provides:

(e)Actions for violations of certain bankruptcy procedures –

(1) In general:  If, in connection with any collection of Federal tax with respect to a taxpayer, any officer or employee of the Internal Revenue Service willfully violates any provision of section 362 (relating to automatic stay) or 524 (relating to effect of discharge) of title 11, United States Code (or any successor provision), or any regulation promulgated under such provision, such taxpayer may petition the bankruptcy court to recover damages against the United States.

(2) Remedy to be exclusive

(A) In general:  Except as provided in subparagraph (B), notwithstanding section 105 of such title 11, such petition shall be the exclusive remedy for recovering damages resulting from such actions.

(B)  Certain other actions permitted;  Subparagraph (A) shall not apply to an action under section 362(h) of such title 11 for a violation of a stay provided by section 362 of such title; except that—

(i) administrative and litigation costs in connection with such an action may only be awarded under section 7430; and

(ii) administrative costs may be awarded only if incurred on or after the date that the bankruptcy petition is filed.

Despite subsection (e) having been around for twenty years, it was not until June 7, 2018, that a court of appeal issued an opinion interpreting “willful violation.”  In IRS v. Murphy, Dkt. No. 17-1601, the First Circuit considered whether there is a willful violation of a discharge order if the IRS had a good faith belief that its taxes were not discharged.

Murphy filed a bankruptcy petition.  Approximately 90% of his debts were taxes owed the IRS.  He was granted a discharge in February 2006.  Between that date and February 2009 the IRS “repeatedly informed” Murphy that his taxes were not discharged and that it intended to take collection action.  It finally issued levies in February 2009.  Six months later Murphy filed an adversary proceeding to determine that his tax liability was discharged.   In response to Murphy’s motion for summary judgment Assistant U. S. Attorney assigned the case failed to offer any admissible evidence to support the IRS’s fraud claim.  The bankruptcy court determined his liability was discharged.  The Assistant U. S. Attorney was subsequently diagnosed with dementia.

In February 2011 Murphy petitioned the bankruptcy court under §7433(e).  The bankruptcy court held there was a willful violation of the discharge order.  The district court reversed and remanded the case to the bankruptcy court to determine whether the Assistant U. S. Attorney’s dementia collaterally estopped the IRS from litigating the issue of whether the tax was discharged. The parties settled.  The IRS agreed to pay Murphy $175,000 subject to a final determination that its collection action was a “willful violation.”  The First Circuit held that a good faith belief that the tax was discharged does not shield the IRS from liability for a willful violation of the discharge order.

The Court looked at the definition of “willfully violates” in the context of bankruptcy cases existing on the date §7433(e) was enacted.  As of 1998, the courts had held that there is a willful violation of the automatic stay if a person knows of the stay and intentionally acts to violate the stay.  There was no good faith defense.  Shortly after enactment of the statute the First Circuit applied the same definition of “willfully violates” to violations of the stay and of the discharge order.

To further support its decision, the First Circuit turned to Internal Revenue Manual, which provides that a willful violation of the stay occurs when the IRS receives notice of the bankruptcy filing or discharge order and does not timely act to stop collection action.

The Court rejected the IRS’s argument that “willfully violates” should be narrowly construed because §7433(e) is a waiver of sovereign immunity.  The Court reasoned that its construction of “willfully violates” was consistent with the purpose of the bankruptcy code to provide debtors with a fresh start.  It also rejected the IRS’s argument that a ruling that good faith is not a defense would require it to seek a pre-enforcement determination that its tax was not discharged before it could ever take action to collect taxes post-discharge.  The Court stated that the IRS does not need to seek a pre-enforcement determination.  It can just collect and then defend if the taxpayer challenges the IRS claim that the tax was not discharged.

Judge Lynch dissented. He construed the statute as waiving sovereign immunity only where the IRS action is not reasonable and in good faith and interpreted “willfully violates” as an intentional violation of the discharge order rather than an intentional act that violates the order.  He pointed out that several appeals court cases decided before 1998 supported the IRS’s interpretation.  Finally, he believed that the Court’s decision would wrap the IRS up in time consuming and often pointless litigation to determine whether its tax was discharged.

The majority however may be correct in its interpretation of Congressional intent.  Subsection (e) was added to the Code as part of the 1998 IRS Restructuring and Reform Act, part of whose purpose was to provide taxpayers with the means to slow down the IRS collection process, such as collection due process rights.  The majority’s reading of “willfully violates” is consistent with this purpose.

Prior to enactment of subsection (e) a number of cases had applied the First Circuit’s reading of “willfully violates” to cases in which the IRS violated the automatic stay.   But the automatic stay is a bright red line.  Once a bankruptcy case is filed any collection action is prohibited unless the creditor obtains an order lifting the stay.  The discharge order does not contain a bright line for taxes.  While some taxes are discharged, others are not, including priority taxes, taxes where a return was not filed, taxes where there was fraud and taxes where there was an intent to evade or defeat.  For many types of tax (i.e., those for which a return was due within three years of bankruptcy, withholding tax, etc.) it is easy to determine whether the tax is discharged.  Others (i.e., fraud where there is no prior judicial determination, an attempt to evade or defeat) require intensive factual determinations.  While the First Circuit’s decision may make the IRS’s collection efforts post-discharge more problematic for the latter types of liabilities, ultimately it may not severely impact the IRS’s collection efforts any more difficult.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz, horwitz@taxlitigator.com or 310.281.3200.  Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney 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, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

 

For more than a decade, the Supreme Court has been chipping away at the notion that periods of limitation for filing suit are necessarily jurisdictional.  See Kontrick v. Ryan, 540 U.S. 443, 455 (2004).  The Supreme Court has held that a filing deadline is almost never jurisdictional unless Congress makes clear that it is.  United States v. Wong, 135 S. Ct. 1625 (2015).  In Nauflett v Commissioner, Docket No. 17-1986 (3d Cir. June 14, 2018), the Third Circuit joined the First and Second Circuits to hold that the ninety-day period for filing a petition for innocent spouse relief in Tax Court is jurisdictional.

Ms. Nauflett’s request for innocent spouse relief was denied by the IRS.  The deadline to file a petition with Tax Court was September 15, 2015. She filed on September 22 due to being misinformed by IRS employees as to the filing date.  The Tax Court dismissed her petition for lack of jurisdiction.  Ms. Nauflett appealed.

To decide the issue, the Third Circuit first looked at the statutory language, Internal Revenue Code §6015(e)(1)(A), which provides that an innocent person claiming innocent spouse relief may petition the Tax Court (and the Tax Court shall have jurisdiction) to determine the appropriate relief available to the individual under this section if such petition is filed—

(i) at any time after the earlier of—

(I) the date the Secretary mails, by certified or registered mail to the taxpayer’s last known address, notice of the Secretary’s final determination of relief available to the individual, or

(II) the date which is 6 months after the date such election is filed or request is made with the Secretary, and

(ii) not later than the close of the 90th day after the date described in clause (i)(I).

According to the Court, under the plain language of §6015(e)(1)(A), jurisdiction was granted the Tax Court only if the petition was filed within the 90-day period.  Thus, the filing period was jurisdictional.

The Court found further support for its understanding of Congressional intent from the context of the subsection.  Section 6015(e)(1)(B) prohibits the IRS from collection action until the end of the ninety-day period.  It also grants the Tax Court jurisdiction to enjoin collection activity if a timely petition is “filed under subparagraph (A).”  It rejected Ms. Nauflett’s arguments as “strained.”

In a previous blog, here, I commented on the Ninth Circuit’s decision in Duggan v Commissioner, and noted that based on the Supreme Court’s recent cases on filing limits, the 90-day period for filing a petition to challenge a deficiency may not be jurisdictional.  It turns out that there are two cases currently pending in the Ninth Circuit raising that issue, Organic Cannabis Foundation v Commissioner, Docket No. 17-72874, and Northern California Small Business Assistants v Commissioner, Docket No. 17-72877.

The argument advanced in support of the taxpayers is that §6213(a), which provides that a taxpayer may petition the Tax Court for redetermination of a deficiency within 90-days (or 150-days if the notice is addressed to a person outside the United States) after mailing of the deficiency notice, does not grant the Tax Court jurisdiction .  Jurisdiction over deficiency petitions is granted in §6214.   Thus, there is no clear indication that Congress intended to make the period for filing a petition jurisdictional.  The taxpayers and amicus note that the Ninth Circuit in Volpicelli v. United States, 777 F.3d 1042 (9th Cir. 2015), held that the time period for filing a wrongful levy action is not jurisdictional.  Additionally, they note that there are no Supreme Court cases holding that the period for filing in Tax Court is jurisdictional.  They also argue that equitable tolling applies to §6213(a).  The taxpayers in both cases are represented by Doug Youmans and Matthew Carlson of Wagner Kirkman Blaine Klomparens & Youmans, LLP, of Sacramento.  Amicus briefs on behalf of the taxpayers were filed by the Keith Fogg of the Harvard Law School Tax Clinic and Carlton Smith of New York.  These are important cases that could have major repercussions.  Keep an eye out for further developments.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney 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, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

 

 

 

This is the fifth of a six part series devoted to utilization of various indirect methods of determining the income of a taxpayer.

Financial Status Audit Techniques. (FSAT). 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. 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 FSAT, is not prohibited by Code Section 7602(e)[i]. 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.

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.[ii] 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.[iii]

When to Anticipate an Indirect Method. Circumstances that might support the use of an indirect method include a financial status analysis that cannot be easily reconciled – 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 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.

[i].  Internal Revenue Manual 4.10.4.6.1 sets forth the requirements for examining income and FSATs. The indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954). “Examination techniques” include examining and testing the taxpayer’s books and records, analytical tests, observing, and interviewing the taxpayer. These techniques are unique to the use of a formal indirect method and will not routinely trigger the limitation of Code Section 7602(e).

[ii].  See IRM 4.10.4.6.5.1 (08-09-2011) and United States v. Fior D’Italia, Inc., 536 U.S. 238 (2002).

[iii].  See IRM 4.10.4.6.5.2 (05-27-2011).

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at http://www.taxlitigator.com

 

Despite the fact that the new partnership audit rules are effective for tax years that began after December 31, 2017, TEFRA will remain relevant for a number of years, as can be seen by several recent decisions.

Foster v United States, Dkt. 1:06-cv-00818 (W.D. TX June 19, 2018), involved a TEFRA partnership’s 1984 tax year.  The taxpayers were partners in two farming partnerships set up by American Agri-Corp (“AMCOR”).  The partnerships filed timely 1984 partnership returns that were signed by an officer of AMCOR.  The taxpayers filed their 1984 returns and reported their share of partnership losses.  In 1991, the IRS issued Final Partnership Administrative Adjustments (“FPAA”) to the partnerships.  The taxpayers were non-notice partners and were not notified of the FPAAs.  Petitions were filed in Tax Court.  Among other things, the petitions asserted that the FPAAs were untimely.  The two partnerships in which plaintiffs’ invested agreed to be bound by proceedings in other AMCOR cases.  The Tax Court ultimately held that the returns were not valid returns since they were not signed by the tax matters partner.  As a result, the FPAAs were timely because. In 2002, the tax matters partner agreed to an entry of a decision that resulted in decreasing expenses reported by the partnerships.

Since the adjustments did not require partner level determinations, the IRS assessed taxes against the taxpayers, who paid and, two years later, filed refund claims.  In 2006, they filed refund suits in district court.  The cases were stayed pending resolution of related litigation.  After the stay was lifted, the taxpayers and the Government filed for summary judgment.  The taxpayers argued that the assessments were untimely because the timeliness of an assessment at the partner level is an affected item which is determined by whether the FPAA was issued while the statute of limitations for both the partnership and the partner was open and while the statute of limitations against the partnership was open.  The court rejected this argument.  Because the returns were invalid, the FPAA was timely; in any event, whether the FPAA was timely was a partnership item that had to be raised in partnership level proceedings.  Thus, regardless of whether it had been litigated in the partnership-level proceedings, the taxpayers could not challenge the timeliness of the FPAA in their individual proceeding.

The court also held that the refund suit was untimely. Under TEFRA, a partner who is assessed additional tax as a result of a partnership adjustment can only challenge the computation of the amount owed.  To do so, he must file a refund claim within six months of mailing of the notice of computational adjustment.  Since the taxpayers did not file a refund claim until two years after issuance of the notice, the refund claim was untimely.

In Dynamo Holdings Limited Partnership v Commissioner, 150 T.C. No. 10 (May 7, 2018), the tax years in issue were 2005, 2006, and 2007.  The FPAAs were issued in 2010.  A trial was held in early 2017.  Subsequent to the Tax Court’s opinion in Graev v. Commissioner, 149 T.C. ___, holding that part of the Commissioner’s burden of production as to penalties is to present evidence of written supervisor approval, the Commissioner moved to reopen the record to present evidence of supervisory approval and the taxpayer moved to dismiss as to penalties on the ground that the Commissioner failed to offer evidence of written supervisory approval.

Sec. 7491(c) places the burden of production on the IRS with respect to the liability of an individual for penalties and additions to tax.  This was a case that the Tax Court had not squarely addressed.  The Court noted that under the plain language of the statute, a partnership-level proceeding is not with respect to the liability of an individual.  The Tax Court’s jurisdiction is to determine to the tax treatment of partnership items.  It does not determine the liability of any partner.  Once the partnership-level proceeding is over, the partner’s individual liability is determined either by a computational adjustment or a notice of deficiency.  If a penalty is assessed, the partner can raise any individual defenses to liability.

The Court further held that §7491(c) is inconsistent with partnership level proceedings, which does not focus upon liability of any partner for tax or penalties.  Requiring the Commissioner to bear the burden of production would require the Court to look through the partnership to the individual partners who may be liable for the tax, which would adversely affect judicial and administrative efficiency.  Because reopening the record would not affect the outcome the Commissioner’s motion to reopen was denied.  And because the Commissioner does not bear the burden of production, the partnership’s motion to dismiss as to penalties was denied.

These cases are only two examples of recent decisions in TEFRA cases involving tax years that are more than ten years old.  See also RB-1 Investment Partners v. Commissioner, T.C. Memo. 2018-64 (involving the 2000 tax year).  Thus, we will have to deal with, and remain conversant with, TEFRA for a long time to come.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney 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, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

 

 

 

This is the fourth of a six part series devoted to utilization of various indirect methods of determining the income of a taxpayer.

Financial Status Audit Techniques (FSAT). 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. 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 FSAT, is not prohibited by Code Section 7602(e)[i]. 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.

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[ii]. 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 redeposits must be eliminated. For example, if a taxpayer draws a check to cash for the purpose of cashing payroll checks and then redeposits 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.

When to Anticipate an Indirect Method. Circumstances that might support the use of an indirect method include a financial status analysis that cannot be easily reconciled – 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 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.

[i].  Internal Revenue Manual 4.10.4.6.1 sets forth the requirements for examining income and FSATs. The indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances. Holland v. United States, 348 U.S. 121, 134 (1954). “Examination techniques” include examining and testing the taxpayer’s books and records, analytical tests, observing, and interviewing the taxpayer. These techniques are unique to the use of a formal indirect method and will not routinely trigger the limitation of Code Section 7602(e).

[ii].  See IRM 4.10.4.6.4.1 (09-11-2007) and Gleckman v. United States, 80 F.2d 394 (8th Cir. 1935).

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at http://www.taxlitigator.com

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