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

Financial Status Audit Techniques. 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 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.[ii] 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 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 IRM 4.10.4.6.8.3 for possible defenses the taxpayer might raise regarding the availability of nontaxable funds.

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.

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

[i].  See IRM 4.10.4.6.3  (09-11-2007) and United States v. Johnson, 319 U.S. 503 (1943).

[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).

 

It seems like discussions of burden of proof and the definition of “willful” in FBAR cases are getting to be as routine as discussions of what it means to be a “responsible person” and to act “willfully” for the trust fund recovery penalty under Internal Revenue Code sec. 6672.  And the courts have so far fallen in with the line espoused by the Department of Justice.

The latest case in point is United States v. Garrity, No. 3:15-cv-00243 (D. Conn. April 3, 2018), a suit brought to reduce to judgment a penalty assessed under 31 USC sec. 5321(a)(5) for willful failure to file an FBAR, in violation of 31 USC sec. 5314.  The Court had ordered the parties to file pre-trial briefs on the burden of proof and what must be proven to establish “willful.”

The Government argued that its burden of proof is by a preponderance of the evidence rather than by clear and convincing evidence as defendants claimed.  The Court sided with the Government based on Supreme Court cases holding that this is the normal burden of proof in civil cases, including those involving monetary penalties, at least where the interests at stake are only financial and not “important individual rights and interests” that would warrant a higher standard.  The Court rejected defendants’ analogizing the FBAR penalty to a civil fraud penalty, where the Government must prove fraud by clear and convincing evidence.  It also rejected defendants’ assertion that since willful involves a question of intent the burden of proof should be greater.

Every published case involving a willful FBAR penalty has held that the government’s burden of proof is by a preponderance.  This includes the Bedrosian case, which held that the plaintiff did not act willfully.  Practitioners should take comfort that the courts have not held that the assessment of the FBAR penalty is entitled to a presumption of correctness and placed the burden of proof on the person against whom the penalty was assessed.  In a trust fund recovery penalty case, the taxpayer has the burden of proving two negatives: 1) that he was not a responsible person and 2) that he did not act willfully.

The Garrity Court also held that the Government can prove that the defendant committed a willful violation by showing he acted recklessly, rejecting the defendants’ argument that the Government must prove that the failure to file an FBAR penalty was a voluntary and intentional violation of a known legal duty.

The Court stated that defendants’ arguments “do not account for the well-established distinction between civil and criminal formulations of willfulness.”   The Court relied upon the Supreme Court’s holding in Safeco Insurance Co. v. Burr, 551 US 47 (2007), which held that proof of reckless conduct was sufficient to establish a willful violation of the notice provisions of the Fair Credit Reporting Act.   Since numerous cases have held that reckless conduct is sufficient to establish a willful violation of the FBAR reporting provisions, and the defendants could only point to criminal cases defining willful as a “voluntary and intentional violation of a known legal duty,” the Court found no reason to deviate from the cases holding that reckless conduct equals willful conduct.

The courts in FBAR cases have so far ignored the fact that in civil trust fund recovery penalty cases the courts apply a similar definition of “willful” as is applied in criminal cases: a voluntary, conscious and intentional violation of the known legal duty to pay withholding taxes.   Phillips v. United States, 73 F. 3rd 939 (9th Cir. 1996).  The Ninth Circuit in United States v Easterday, 594 F. 3rd 1004 (2009) and United States v. Gilbert, 266 F. 3rd 1180 (2001), both defined willful for purposes of the criminal trust fund recovery penalty under Internal Revenue Code sec. 7202 in a virtually identical way as it defines willful for purposes of the civil trust fund recovery penalty.  And in Slodov v. United States, 436 US 238 (1978), the Court stated that the same conduct subjecting a taxpayer to liability for the civil trust fund recovery penalty subjects him to liability for the criminal penalty:

Also, §7202 of the Code, which tracks the wording of §6672, makes a violation punishable as a felony subject to fine of $10,000, and imprisonment for 5 years. Thus, an employer-official or other employee responsible for collecting and paying taxes who willfully fails to do so is subject to both a civil penalty equivalent to 100% of the taxes not collected or paid, and to a felony conviction.

436 US at 245.  This would support an argument that willful should be construed in the same way for civil penalties for violating the Bank Secrecy Act provisions as it is for criminal penalties.

The Government has convinced the courts that willful for purposes of the civil FBAR penalty includes both reckless disregard and willful blindness. Under both Williams, 489 Fed. Appx. 655 (4th Cir. 2012) and McBride, 908 F.Supp. 2nd 186 (Utah 2012), a taxpayer’s failure to review a tax return is sufficient to establish a conscious attempt to avoid learning of the FBAR reporting requirements.  Under this reasoning, every person with an offshore account who signs a tax return with a Schedule B and fails to file an FBAR would be liable for the willful penalty.

This interpretation appears to ignore what the Supreme Court held was required to show reckless disregard or willful blindness.  In Safeco Insurance Co., the Court stated:

While “the term recklessness is not self-defining,” the common law has generally understood it in the sphere of civil liability as conduct violating an objective standard: action entailing “an unjustifiably high risk of harm that is either known or so obvious that it should be known.”  Farmer v. Brennan511 U. S. 825, 836 (1994); see Prosser and Keeton §34, at 213–214. The Restatement, for example, defines reckless disregard of a person’s physical safety this way:

“The actor’s conduct is in reckless disregard of the safety of another if he does an act or intentionally fails to do an act which it is his duty to the other to do, knowing or having reason to know of facts which would lead a reasonable man to realize, not only that his conduct creates an unreasonable risk of physical harm to another, but also that such risk is substantially greater than that which is necessary to make his conduct negligent.” Restatement (Second) of Torts §500, p. 587 (1963–1964).

It is this high risk of harm, objectively assessed, that is the essence of recklessness at common law. See Prosser and Keeton §34, at 213 (recklessness requires “a known or obvious risk that was so great as to make it highly probable that harm would follow”).

In Global-Tech Appliances, Inc. v. SEB SA, 563 U.S. 754 (2011), the Court held that in a civil case alleging inducement to violate a patent the defendant’s knowledge can be established by showing willful blindness, which requires more than negligence or recklessness.  Relying on criminal cases, the Court stated:

While the Courts of Appeals articulate the doctrine of willful blindness in slightly different ways, all appear to agree on two basic requirements: (1) the defendant must subjectively believe that there is a high probability that a fact exists and (2) the defendant must take deliberate actions to avoid learning of that fact

According to the Court these “requirements give willful blindness an appropriately limited scope that surpasses recklessness and negligence. Under this formulation, a willfully blind defendant is one who takes deliberate actions to avoid confirming a high probability of wrongdoing and who can almost be said to have actually known the critical facts.”  Deliberate indifference is insufficient to establish that the person acted knowingly or willfully.

This doesn’t square with the willfulness standard adopted in the reported FBAR cases, where several courts have deemed that a taxpayer has constructive knowledge of the contents of his tax return, which contains on Schedule B, Part III, a statement that if you have a foreign financial account you may have to file FinCen Form 114 and directs the taxpayer to the form and its instructions.   Are the Courts saying that a taxpayer who fails to read every line on his return is willfully blind or acting with reckless disregard?  If so, I think the courts are jettisoning the mens rea requirement of sec. 5321(a)(5).

Perhaps the courts are turning around.  In Norman v United States, No. 15-872 (Court of Fed. Claims), the government moved for summary judgment on the ground that the fact that Ms. Norman signed a return that checked the No box to the question of whether she has a foreign return is enough to prove willfulness because a taxpayer has constructive knowledge of the contents of the return, and thus is deemed to know of the requirement for filing an FBAR and she thus willfully failed to do so.  Convoluted, but it is a logical reading of Williams and McBride.  The court in an order denied the motion on the ground that there were material facts in dispute requiring trial.

The Court in Garrity did not say would establish recklessness.  I hope, after trial, the courts in Garrity and Norman will hold that willfulness requires at a minimum knowledge that the law requires a person knew he may have to report offshore accounts to the Government.

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 first of a six part series devoted to sensitive issue examinations of cash intensive businesses. In these situations, examiners frequently utilize various indirect methods of determining the income of a taxpayer.

Financial Status Audit Techniques (FSAT). FAST’s include 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). 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.

Cash Intensive Businesses. A cash intensive business is one that receives a significant amount of receipts in cash. 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. This can be a business such as a restaurant, grocery or convenience store that handles a high volume of small dollar transactions. It can also be an industry that practices cash payments for services, such as construction or trucking, where independent contract workers are generally paid in cash.

The IRS has long been interested in business operations that receive most of their income in cash. Since certain businesses do not always deposit all of their cash receipts, there are various methods by which an examiner may be able to reconstruct total gross receipts and expenditures. Cash transactions are believed by some to be anonymous, leaving no trail to connect the purchaser to the seller, which may lead some individuals to believe that cash receipts can be unreported and escape detection. If cash is misappropriated a business by being skimmed from receipts and pocketed before it is recorded, the skim will likely not be discovered by auditing the books.

A significant indicator that income has been underreported is a consistent pattern of losses or low profit percentages that seem insufficient to sustain the business or its owners. Other indicators of unreported income include a life style or cost of living not fully supported by the reported income; a business that continues to operate despite losses year after year, with no apparent solution to correct the situation; a Cash T shows a deficit of funds; bank balances, debit card balances and liquid investments increase annually despite reporting of low net profits or losses; accumulated assets increase even though the reported net profits are low or a loss; debt balances decrease, remain relatively low or don’t increase, but low profits or losses are reported; a significant difference between the taxpayer’s gross profit margin and that of their industry; and unusually low annual sales for the type of business.

If the IRS examiner believes the business may not be reporting all of its income, the examiner may issue a summons to suppliers and other third-parties for records of sales or deliveries to the business, including original purchase invoices, during the period under examination. The examiner may then mark-up the purchases by a reasonable amount based upon industry standards to determine what are known as the audited sales for the business. Absent a reasonable explanation for a discrepancy between audited sales and reported sales, the IRS will determine income tax adjustments (and maybe penalties) based upon the discrepancy.

The IRS examiner will formulate taxpayer interview questions based on the preliminary Cash-T information, and, at the initial interview, inquire regarding possible loans or gifts received or whether a cash hoard maintained. When questioned, some taxpayers wrongfully respond that unexplained deposits or cash represents loans and gifts from relatives who may live outside the United States although there are no records to support the claim that the amounts are loans or gifts, except a copy of a letter from a relative stating that the relative gave the amounts at issue.

If the examiner believes the unexplained amounts represent unreported income, the examiner may ask the taxpayer for the specific dates and amounts of the currency received from friends or family – a vague and self serving letter from a friend or relative is not likely a sufficient response. The examiner will inquire about exactly how much currency was received on each specific date. Was it U.S. currency or foreign currency? Can the loan be verified by any other source? Can the lender show it was withdrawn from their bank on that date? Were FinCEN forms filed if currency was brought into the country? What day did the taxpayer get the money? How much did the taxpayer receive on that day? What did the taxpayer do with the money that day?

The examiner may ask for the name, address, telephone number of each person providing cash loans and inform the taxpayer that the examiner will be contacting these individuals for proof, including requesting copies of their tax returns or other documents. How the foreign currency was converted to U.S. currency? Where did the lender convert the currency? The examiner will ask for a copy of the exchange receipt issued by the bank or whomever exchanged the foreign currency for U.S. currency. If the lender converted the currency and brought it into the U.S., the examiner will request a copy of their passport showing entry to the U.S. on that day. If the taxpayer converted the currency,  the examiner will request a copy of the exchange receipt.

When foreign currency is given by gift or loan, exchange rates can be found for the transfer dates. If they were not favorable, it is unlikely a friend or relative would have exchanged the currency at that time unless it was absolutely necessary. And, if it was absolutely necessary, the money would go into the bank or into the business immediately. If the amounts in issue are asserted to be a loan, the examiner will inquire about repayment and how interest is calculated. The loan will have occurred in the examination year, and by time of the later examination, the taxpayer should have paid some of it back. If the taxpayer is repaying by taking currency to the foreign country, the examiner will ask for the same type of specific information (exchange receipts and copies of their passport, etc.). Does the business show enough profit to be able to pay back loans on those dates If only one payment is made during the year, it would likely be a larger than normal loan payment. Can withdrawals be found in the amount claimed to be paid back? Examiners will analyze the cash receipts and disbursements for the week of the repayment.

Examiners often request to interview the lenders and review their tax returns. They will inquire about the specific dates and amounts provided to the taxpayer? Was it foreign or U.S. currency? Who converted the currency to U.S.? When? Where? What records do you have to prove this? What records do you have to guarantee the money will be repaid? Have any repayments been made? When? Where? How much? If not, why not? They will ask to see copies of their passports to show they traveled into the country when they say they did and copies of their bank withdrawals if money was withdrawn to lend to the taxpayer. It is possible that, when face to face with the examiner, the lender will make statements inconsistent with the taxpayer’s statements or give some evidence that they did not really have the ability to make these suggested loans.

Typical Interview Questions Addressing Accumulated Funds. Taxpayers often assert that unexplained amounts represent accumulations of wealth over a period of time. Common interview questions include whether the taxpayer keeps more than $1,000 on their person, at home, at their business, or in any other location? What do the accumulated funds consist of? (For example, paper money, coin, money orders, cashier checks, etc.). In what denominations were the funds accumulated? Where are the accumulated funds maintained? How long have the accumulated funds been kept in the foregoing location? What kind of container were the accumulated funds kept in?

Further questions could include how much accumulated funds did the taxpayer have on hand at the beginning and end of the year under audit? How much in accumulated funds does the taxpayer have on hand presently? Over what period of time were the funds accumulated? Do the accumulated funds solely belong to the taxpayer or does it belong to more than one person? Identify each person having ownership of these accumulated funds. Do any of the other owners have access to these accumulated funds? Identify the increase or decrease in accumulated funds for each access. Identify the type of records kept to identify the name(s), date(s) and effect on the accumulated funds each time there was an access.

Why were the funds accumulated and not deposited in a financial account? What is the original source of the money included in the accumulated funds? How often are the accumulated funds accessed? What is the effect of each access? Are there additions or withdrawals from the accumulated funds? Was the taxpayer accompanied by another individual when the accumulated funds were accessed? If yes, provide the name and address of the persons involved. Does the taxpayer count the accumulated funds every time they are accessed? If not, provide the dates and purpose for when the funds were counted. Does anyone else know about the accumulated funds? If yes, provide the name, relationship, address, and phone number for the person. Also determine whether these persons have access to the accumulated funds and if so, the manner and circumstances under which their access was made (i.e., debit cards, etc.).

Summary. Every examination of a cash intensive business must be handled with extreme care. The practitioner should verify each response before it is provided to the IRS examiner during the examination. In certain circumstances, an accountant should be appropriately engaged by counsel in a Kovel arrangement (see previous article regarding retention of a Kovel accountant). IRS Audit Techniques Guides (ATGs) can be helpful in identifying potential areas where the examiner might be particularly interested for various types of businesses or tax issues (many ATGs are available for review at IRS.gov). Preparation and diligence in representation should help streamline the examination process.

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

In civil tax audits that include potentially sensitive issues, counsel will often engage a team of representatives, including a forensic accountant. Engagement of the accountant by counsel should be carefully designed to extend the attorney-client privilege to communications with the accountant pursuant to the engagement by counsel.

The Kovel Accountant. Although Code Section 7525 extends common law protections of confidentiality to tax advice rendered between a taxpayer and a federally-authorized tax practitioner (to the extent such communications would be considered privileged if they occurred between a taxpayer and counsel), this statutory privilege only applies to non-criminal tax matters before the IRS and non-criminal tax proceedings in federal court. The protections afforded by Code section 7525 are not available when truly needed the most — when a civil tax proceeding moves into the criminal arena.  It also may not be available in state-related tax proceedings, or non-tax civil litigation.

Pursuant to United States v. Kovel, 296 F.2d 918 (2nd Cir. 1961), the attorney-client privilege is extended to an accountant retained specifically to assist an attorney in rendering legal services to a client, both during the investigative stages of the case and if necessary, during trial. If the accountant is appropriately engaged by counsel, the common law attorney-client privilege will apply to all communications rendered in furtherance of the legal services being provided to the client, both during the examination stages of the audit and, if necessary, during any subsequent civil or criminal proceedings.

A critical inquiry is often whether counsel should retain the taxpayer’s prior accountant or a new accountant. Many practitioners prefer to engage a new accountant to avoid the necessity of delineating between non-privileged communications (communications prior to counsel’s engagement of the accountant), and privileged communications (communications following counsel’s engagement of the accountant). Retention of a new accountant avoids issues relating to whether information possessed by the accountant may have been obtained prior to the accountant’s engagement by counsel.

Counsel’s engagement of the accountant should be in writing, and should indicate that the accountant is acting under the direction of counsel in connection with counsel’s rendering of legal services to the client, communications between the accountant and the client are confidential and are made solely for purposes of enabling counsel to provide legal advice; the accountant’s work-papers are held solely for counsel’s use and convenience and subject to counsel’s right to demand their return; and the accountant is to segregate their work papers, correspondence and other documents gathered during the course of the engagement and designate such documents as property of counsel.

Assistance in Indirect Method Audits. Historically, conventional audit techniques have been discovered to be grossly inadequate for the purpose of demonstrating an understatement of taxable income. In such event, the government has often resorted to one or more indirect methods of detecting unreported income by essentially auditing a taxpayer, rather than a return.

The use of indirect methods of proving income, historically referred to as the IRS Financial Status Audit Techniques (FSAT), is not prohibited by Code Sec. 7602(e). If the examiner has a “reasonable indication” that unreported income exists, the IRS has the authority to use an indirect method of reconstructing income to determine whether or not the taxpayer has accurately reported total taxable income received. The indirect method need not be exact, but must be reasonable in light of the surrounding facts and circumstances.

The use of a “formal” indirect method, however, is not precluded by the presentation of books and records. Use of an indirect method is often supported by circumstances that, individually or in combination, would support: (1) a financial status analysis that cannot be balanced; i.e., 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; (2) irregularities in the taxpayer’s books and weak internal controls; (3) gross profit percentages change significantly from one year to another, or are unusually high or low for that market segment or industry; (4) the taxpayer’s bank accounts have unexplained items of deposit; (5) the taxpayer does not make regular deposits of income, but instead uses cash for many transactions; (6) a review of the taxpayer’s prior and subsequent year returns show a significant increase in net worth not supported by reported income; (7) 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, determine who destroyed them, why, and when); or (8) no method of accounting has been regularly used by the taxpayer or the method used does not clearly reflect 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 under-reported or unreported income. Examiners will 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 government routinely uses the various indirect methods to reconstruct income including specific item; net worth plus expenditures; bank deposits; and a combination of the above methods. The accountant may be called upon to analyze indirect methods used by government to develop unreported income.

Relevant inquiries include the standard of living of the taxpayer. What do the taxpayer and their dependents consume economically? How much does it cost to maintain this consumption pattern? Is reported net income sufficient to support this standard of living? What are the possible sources of funds to support these expenditures?

What is the accumulated wealth of the taxpayer? How much has the taxpayer expended in the acquisition of capital assets? When and how was this wealth accumulated? Has reported income been sufficient to fund the accumulations? What is the economic history of the taxpayer? What is the long term pattern of profits and return on investment in the reported business activity? Is the taxpayer’s business expanding or contracting? Does the reported business history match the changes in the taxpayer’s standard of living and wealth accumulation? Is reported interest income increasing or decreasing?

What is the business environment for the taxpayer’s industry? What is “typical” profitability and return on investment for the taxpayer’s market segment and locality? What are typical patterns of non-compliance in the taxpayer’s market segment? What are the competitive pressures and economic health of the market segment within which the taxpayer operates?

Has the taxpayer made assertions to receipts of funds which were considered to be non-taxable? Do claims of non-taxable sources of support make economic sense (cash hoard, credit history)? How credit worthy is the taxpayer in view of the taxpayer’s assertion that funding was secured from loans? In situations where the taxpayer has asserted that funds were received from other than conventional lending institutions, what was the lender’s source of funds? Was it a disguised loan of funds that originated with the taxpayer?

The Kovel accountant’s responsibility in analyzing the above indirect methods of proof may include analyzing bank statements and financial information; assisting the attorney in interviewing witnesses; developing a cash-on-hand figure; assisting the attorney in developing questions for the agent which may highlight weaknesses in the government’s position; and joining the attorney in meetings with the examining agent in an attempt to further explain and highlight weaknesses in the agent’s position.

A civil examination involving potentially sensitive issues where civil or criminal fraud potential exists requires the utmost of judgment, discretion and caution. The primary examination objectives are to limit the scope of the inquiry; to avoid the presentation of false or misleading information; to avoid false statements by the taxpayer or the taxpayer’s representative; and to limit the information provided so as to avoid the waiver of the privilege against self-incrimination.

Notwithstanding extreme resource challenges, the IRS remains well equipped to identify potentially fraudulent returns as a result of increased transaction and information reporting, better developed audit plans and techniques which focus on specific industries, substantially increased access to computerized data banks and an overall increased level of scrutiny of the taxpayer, the taxpayer’s business, the taxpayer’s standard of living and how these relate to issues reported – or not – on the return under examination.

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

Section 5321(a)(5)(A) provides that the Secretary of Treasury “may impose a civil money penalty” on anyone who violates the FBAR reporting requirements.  Originally, the penalty for willful violation was the greater of the amount in the account (not to exceed $100,000) or $25,000. In 2004, Congress amended the FBAR penalty provision to increase the maximum willful penalty from the amount in the account (up to $100,000) to the greater of $100,000 or 50% of the amount in the account.  Section 5321(a)(5)(C)(i). Based on the statute, the IRS has routinely imposed FBAR penalties equal to 50% of the high balance in the taxpayer’s offshore accounts, sometimes for several years.  As a result, taxpayers have been faced with millions of dollars in FBAR penalties.

Along with a handful of other commentators, I had pointed out that these confiscatory penalties violate a Treasury regulation issued after sec. 5321(a)(5(C)(i) was amended.  That regulation, 31 C.F.R. sec. 1010.820, provides that the maximum FBAR penalty is $100,000.  See “Is it Illegal for the IRS to Assess More than $100,000 for a Willful FBAR Violation?” posted November 17, 2017.

On May 16, 2018, a District Court held that a willful FBAR penalty of over $100,000 was illegal.  United States v. Colliot, Docket No. 1:16-cv-01281 (W.D. Tex.). The Government sued Mr. Colliot to collect FBAR willful penalties assessed against him for 2007, 2008, 2009 and 2010. The penalties assessed were $548,773 for 2007 and $198,082 for 2008. The penalties for 2009 and 2010 were smaller. Mr. Colliot moved for summary judgment on the ground that the IRS improperly assessed penalties of over $100,000 in violation of the regulation. The Government opposed the motion on the ground that regulation was invalidated by the statute. The Court disagreed.

The Court found that there was “little reason to believe” the statute “implicitly superseded or invalidated” the regulation. The maximum penalty is discretionary and the regulation, issued by notice-and-comment rulemaking, “is consistent with § 5321’s delegation of discretion to determine the amount of penalties to be assessed.”  The regulation was neither unreasonable nor contrary to the provisions of the statute. As a result the IRS acted “arbitrarily and capriciously” when it when it assessed penalties in excess of the regulatory cap.

The Court left open the issue of the appropriate relief in this situation: could the IRS still collect up to $100,000 per year if it proved willful violations or was the entire penalty invalid?

This case is a significant victory for taxpayers.  Persons who did not go into the Offshore Voluntary Disclosure Program and are facing 50% penalties have a new weapon to defeat the IRS. The Government will have to consider whether it wants to appeal the decision or just promulgate a new regulation that authorizes a penalty of up to 50% of the maximum balance in the undisclosed offshore accounts.

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

 

Beware: some IRS Agents are modifying Form 872 (Consent to Extend the Time to Assess Tax) to include additional language for international penalties and blown statutes.  Although, the forms appears to be the standard preapproved Form 872, reflecting “last revised in July of 2014” or “last revised January 2018”, the altered form contains an additional paragraph typed into the body of the agreement.

First example of additional language:

(6) Without otherwise limiting the applicability of this agreement, this agreement also extends the period of limitations for assessing any penalty imposed under IRC §§ 6038, 6038A, 6038B, 6038D, 6677 or 6679.

This additional paragraph relates to extending the assessment statute specifically to include international penalties in Chapter 61 of the Code.  Interestingly, the IRS has claimed that section 6038 penalties have no statute of limitations.  If so, why are agents typing in and including this language on the consent form?

The Code provides the general rules for assessments including various exceptions including extension of time by agreement[1].  By timely executing a valid Form 872, the parties can extend the time for the IRS to assess.[2]  Once the tax and penalties are assessed, the IRS uses its formidable administrative collection powers to collect.[3]

Question is what are taxpayers agreeing to if they sign this version of the Form 872?  Does the IRS even need to extend the statute for section 6038 penalties?  What, if any, impact is there to the IRS’s ability to assess the stated international penalties if the taxpayer executes this version of the agreement?   Is the taxpayer agreeing or stipulating that the international penalties are assessable?  Is the taxpayer waiving its defense that the section 6038 international penalties are not assessable?

Once the Service determines that a section 6038 penalty applies, the Manual instructs its agents to prepare a Form 8278, Assessment and Abatement of Miscellaneous Civil Penalties, and Form 886-A, Explanation of Items, and forward to the Service Center to assess the penalty.[4]  The Manual also states that section 6038 penalties are not subject to deficiency procedures.  The Service fails to address how the IRS can automatically assess a nonassessable penalty.  Can taxpayers agree to allow the IRS to assess a nonassessable penalty even though the Internal Revenue Code does not provide the authority?  Does the IRS explain to taxpayers they may be waiving any potential rights to challenge the assessment?

The Code distinguishes between assessable and non-assessable penalties.  Section 6201(a)[5] provides the general authority for the IRS’s ability to assess all taxes, which include “interest, additional amounts, additions to the tax and assessable penalties imposed by this title (emphasis added).”  The section states that to assess a penalty it must be an assessable penalty.

Section 6671 provides the rules for assessment of assessable penalties as identified in Chapter 68  – Subchapter B  – Assessable Penalties ((§§ 6671 to 6725).[6]  Chapter 68 (Additions to the Tax, Additional Amounts, and Assessable Penalties) also contains section 6665(a) [7] a companion section to 6671 on a slightly different subject.  Section 6665(a) appears to expand the assessable penalty assessment rules to include any penalty under Chapter 68, not just the penalties in Subchapter B.

Penalties on the Modified Form 872

  • Section 6038: Information returns required for certain foreign corporations (Form 5471) and partnerships (Form 8865), and foreign disregarded entities (Form 8858); the associated penalty is in the text of section 6038 all in Chapter 61 (Information And Returns (§§ 6001 to 6117));
  • Section 6038A: Information returns required for certain foreign-owned U.S. corporations (Form 5472); the associated penalty is in the text of section 6038A all in Chapter 61 all in Chapter 61 (Information And Returns (§§ 6001 to 6117));
  • Section 6038B: information returns required for certain transfers to foreign persons (Forms 926 and 8865); the associated penalty is in the text of section 6038B all in Chapter 61 (Information And Returns (§§ 6001 to 6117);
  • Section 6038C: Information returns required for certain foreign corporations engaged in U.S. business (Form 5472); the associated penalty is in the text of sections 6038C all in Chapter 61 (Information And Returns (§§ 6001 to 6117);
  • Section 6038D: Information returns regarding foreign financial assets (Form 8938); the associated penalty is in the text of section 6038D all in Chapter 61 (Information And Returns (§§ 6001 to 6117);
  • Section 6048: Information returns required for certain reportable events for a foreign trust (Forms 3520 and 3520-A)[8]. However, the associated penalty, section 6677 is in Chapter 68 – Additions To The Tax, Additional Amounts, and Assessable Penalties (§§ 6651 to 6751) and is an assessable penalty.

Section 6046: United States persons, in certain circumstances, required to file a return if they acquire or dispose of an interest in a foreign corporation, or if their proportional interest in a foreign corporation changes. (Form 5471 Schedule O). However, the associated penalty, section 6679 is in Chapter 68 – Additions To The Tax, Additional Amounts, and Assessable Penalties (§§ 6651 to 6751) and is an assessable penalty.

  • Section 6046A: United States persons, in certain circumstances, required to file a return if they acquire or dispose of an interest in a foreign partnership, or if their proportional interest in a foreign partnership changes. (Form 8865). However, the associated penalty, section 6679 is in Chapter 68 – Additions To The Tax, Additional Amounts, and Assessable Penalties (§§ 6651 to 6751) and is an assessable penalty.

Observations:

None of the section 6038 penalties itemized in paragraph (6) above are governed by the statute of limitations.  The Internal Revenue Manual[9] specifically states these International Penalties are not considered taxes and generally have no statute of limitation for assessment, whereas, penalties related to tax are generally treated as taxes and governed by the statute of limitation for assessment for the underlying return.

As there is no statute of limitations for assertion of the penalties under IRC §§ 6038, 6038A, 6038B, or 6038D what is the purpose of paragraph 6 on the modified Form 872?  As far back as 1959, the Service has a general policy of not asserting taxes retroactively for more than a few prior years even though sometimes there is no statutory bar to assessing unpaid taxes for all prior periods.  The guidance provides that under ordinary circumstances the normal three-year statute may be followed as a guideline in making determinations on the extent of retroactivity.[10]  And, for delinquent returns, the Manual provides guidance that enforcement of delinquency procedures should not be for over six (6) years back.[11]

Chapters 63 and 68 of the Code give the IRS the authority to assess the penalties under section 6677 and section 6679.  But there is no corresponding authority in the Code giving the IRS the authority to assess the section 6038 series of penalties.[12]  If the IRS cannot assess the penalties, the IRS must request the Department of Justice to sue the taxpayer in District Court to collect the penalties and reduce them to a judgment.

Back to the initial question, if the IRS has no authority to assess the section 6038 series of penalties what is the taxpayer agreeing to in paragraph 6? And would signing the Form 872 with the above paragraph constitute a stipulation to the IRS’s ability to assess these penalties or, at least, waive the taxpayer’s ability to make an argument on the validity of the assessment?

Second example of additional language:

(6) With respect to the returns for the period(s) listed in paragraph (1) above, if the three-year period for assessing tax, under Internal Revenue Code section 6501(a), ended prior to the date of this consent, then this consent serves to extend the time to assess tax under any other provision of section 6501 for which the period of time to assess has not ended as of the date of this consent.

Observations:

It appears the IRS is requesting taxpayers to extend any possible provisions of the code that may kept the assessment statute open as of the execution of the Form 872 without identifying what they are focusing on.  This new paragraph seems to be a catch all or safety net for the Service.  It acknowledges the general assessment statute may be expired and it is asking the taxpayer to extend any possible statute exception that might apply.  Although, the law states the IRS cannot revive a closed statute[13] this extension request is usual.

Has the IRS identified a 25% omission of income that may have a six-year assessment statute?  Is the IRS expecting to argue that under the Hire Act the foreign information forms were not substantially correct and the failure extends the normal three-year statute?  Does executing this form trigger waiver on other items extending the assessment statute?  Is the IRS pushing for fraud or another exception and using this language to coax the taxpayer in agreeing to extend?

Conclusion:  Sign nothing without understanding the consequences of the document.  Practitioners should be appraised of the repercussions and consider pushing back on agents.  The altered forms appear to be the pre-approved standard agreement; however, it has been modified by the field agent.  It seems agents amend or alter the preapproved standard Form 872 without noting the change to the taxpayer.  Practitioners should carefully review the Form 872 to identify any potential changes and understand the consequences before signing these altered statute extensions.

EDWARD M. ROBBINS, Jr. is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., and specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court. Prior to joining the firm, he served as the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal).  Mr. Robbins may be reached at EdR@taxlitigator.com or 310.281.3247.

[1] Sec. 6501. Limitations on assessment and collection

(a) General rule – Except as otherwise provided in this section, the amount of any tax imposed by this title shall be assessed within 3 years after the return was filed. . . ..

[2]  Sec. 6501(c)(4).

[3] See Chapter 64 – Collection (§§ 6301 to 6361).

[4][4] IRM 8.11.5.1(2) (12-18-2015) Introduction of International Penalties.

[5]  Sec. 6201(a) Authority of Secretary

The Secretary is authorized and required to make the inquiries, determinations, and assessments of all taxes (including interest, additional amounts, additions to the tax, and assessable penalties) imposed by this title . . ..

[6]  Sec. 6671. Rules for application of assessable penalties

The penalties and liabilities provided by this subchapter shall be paid upon notice and demand by the Secretary, and shall be assessed and collected in the same manner as taxes.  Except as otherwise provided, any reference in this title to “tax” imposed by this title shall be deemed also to refer to the penalties and liabilities provided by this subchapter.

[7] Sec. 6665(a) Additions treated as tax

Except as otherwise provided in this title–

(1) the additions to the tax, additional amounts, and penalties provided by this chapter shall be paid upon notice and demand and shall be assessed, collected, and paid in the same manner as taxes; and

(2) any reference in this title to “tax” imposed by this title shall be deemed also to refer to the additions to the tax, additional amounts, and penalties provided by this chapter.

[8]  These forms are filed as stand-alone forms that are not part of another tax return.

[9] IRM 20.1.9.1.1(3) (10-24-2013)(Common Terms).

Statute of Limitations—Penalties that are not considered taxes generally have no statute of limitation for assessment. Penalties related to returns are generally treated as taxes and governed by the statute of limitation for assessment.

[10]  IRM 1.2.13.1.30 Policy Statement 4-102 (07-10-1959).

[11] IRM1.2.14.1.18 Policy Statement 5-133 (08-04-2006).

[12] The Treasury Regulations under sections 6038, 6038B, 6038C and 6038D do not say the penalty can be assessed.  These regulations use language like “penalty shall be imposed,” or “person shall pay a penalty,” or “person is subject to a penalty,” or “a penalty will apply.”  Whereas, the regulation under section 6038A says the penalty “shall be assessed” but does not provide any authority for the assessment.

[13] To be valid, an agreement by the taxpayer to extend the statute of limitations on assessment must be (1) in writing; (2) entered into before the expiration of the original collection period or a previously agreed upon extension; and (3) executed by the taxpayer and an authorized delegate of the Commissioner. I.R.C. § 6502(a); Treas. Reg. § 301.6502-1(a)(2)(i).

Posted by: Steven Toscher | April 13, 2018

Tax Problem for Departing Aliens by Steven Toscher

The regulations[1] require that no alien, whether resident or non-resident, can depart from the United States unless he or she first procures a certificate that he or she has complied with the obligations imposed upon him or her by the income tax laws.[2] Failure to do so may result in a termination assessment.

Certain types of individuals, however, are not required to obtain a certificate of compliance. These include:

(1)        employees of foreign governments or international organizations;

(2)        alien students and industrial trainees admitted on F or H-3 visas, respectively, who have limited income (as defined by the regulations); and

(3)        other aliens temporarily in the United States.

The last category includes an alien visitor for pleasure admitted solely on a B-2 visa; an alien visitor for business admitted on a B-1 visa; an alien in transit to the United States or any of its possessions on a C-1 visa; an alien admitted to the United States on a border-crossing identification card or regarding whom passport visas and border identification cards are not required, if that alien is a visitor for pleasure, if that alien is a visitor for business who does not remain in the United States or its possessions for a period exceeding ninety days during the taxable year, or if that alien is in transit through the United States or its possessions; an alien military trainee admitted to the United States; and, finally, an alien resident of Canada or Mexico who commutes between that country and the United States at frequent intervals for employment and whose wages are subject to the withholding of tax.[3]

Note that holders of a Permanent Resident Card (“ a Green Card”) are not excused from this regulation.

Except for the above individuals, every alien departing the country must obtain a certificate of compliance wherein the district director determines whether the alien’s departure jeopardizes the collection of any income tax. If the district director finds that the departure of the alien will result in jeopardy, the taxable period of the alien will be terminated and the alien will be required to file returns and make payment for the shortened tax period. If the district director finds that the departure of the alien does not result in jeopardy, the alien will be required to file a statement on Form 2063, U.S. Departing Alien Income Tax Statement,[4] but will not be required to pay income tax before the usual time for payment.[5]  See I.R.S. Publication 519 (U.S. Tax Guide for Aliens) for more details.

The intended departure of an alien who is a resident of the United States or a U.S. possession and who intends to continue that residence will not be treated as resulting in jeopardy and, therefore, will not require a termination of the alien’s taxable year, unless the district director has information indicating that the alien intends by his or her departure to avoid payment of income taxes. With a non-resident alien or a resident alien discontinuing residence, the fact that the alien intends to depart from the United States will justify termination of the taxable period unless the alien establishes that he or she intends to return to the United States and that his or her departure will not jeopardize the collection of any taxes. The determination is to be made on a case-by-case basis. Evidence tending to establish the nonexistence of jeopardy from the departure includes showing that the alien is engaged in a trade or business in the United States or that the alien leaves enough property in the United States to secure payment of his or her income tax for the taxable year.[6]

Every alien required to obtain a certificate of compliance, whether a resident or a nonresident, whose taxable period is terminated upon departure because of jeopardy is required to file with the district director a return in duplicate on Form 1040C, U.S. Departing Alien Income Tax Return,[7] for the short taxable period resulting from the termination. Income received and reasonably expected to be received through the taxable period, during and including the date of departure, must be stated. Moreover, other income tax returns due but not filed must be submitted.[8]

Upon compliance with the foregoing requirements and payment of the income tax required to be shown on the return and of any income tax due and owing for prior years, the departing alien will be issued a certificate of compliance. The departing alien can postpone payment of the tax required to be shown on the return until the usual time of payment by furnishing a bond.[9]

STEVEN TOSCHER – For more information please contact Steven Toscher – toscher@taxlitigator.com Mr. Toscher is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., specializing in civil and criminal tax litigation. Mr. Toscher is a Certified Tax Specialist in Taxation, the State Bar of California Board of Legal Specialization 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 http://www.taxlitigator.com

 

[1] Treas. Reg. § 1.6851-2.

[2] See Pub. 519 (U. S. Tax Guide for Aliens).

[3] Id.

[4] Available at www.irs.gov.

[5] Treas. Reg. § 1.6851-2(b)(1).

[6] Id.

[7] Available at www.irs.gov.

[8] Treas. Reg. § 1.6851-2(b)(3)(iii).

[9] Id.

 

Generally, when a taxpayer files a tax return, the federal tax laws afford the Internal Revenue Service (“IRS”) with a limit of only three-years within which it must act to examine and assess additional taxes and penalties on any unreported income. While the Internal Revenue Code provides various exceptions to this three-year limit[i], on January 2, 2018, the Tax Court in Rafizadeh v. Commissioner[ii], not only narrowed one of those exceptions, but did so in the context of the IRS’s ability to assess tax on unreported income derived from an undisclosed foreign bank account.

In February 2009, the United States entered into a deferred prosecution agreement with Switzerland’s largest bank, UBS AG, in connection with the bank’s facilitation of the creation and use of non-disclosed foreign bank accounts by U.S. taxpayers. The agreement was unprecedented and resulted in the IRS obtaining secret bank account information on tens of thousands of U.S. taxpayers.

The landmark settlement with UBS was further exemplified by the concerted efforts of the Department of Justice and the IRS to not only utilize its criminal powers but also its civil tools to obtain additional secret foreign bank account information, such as the filing of a John Doe summons action, whereby the IRS received thousands of additional undisclosed foreign accounts and the Offshore Voluntary Disclosure Initiative, an administrative compliance program which resulted in over 14,700 additional taxpayers coming forward to report previously-undisclosed foreign bank accounts.

Notably, at the time the government was involved these efforts, which can fairly be described as very public actions to obtain information about what were previously viewed as “secret” foreign bank accounts, the U.S. tax laws did not impose a separate filing obligation on U.S. taxpayers, under Title 26, with respect to such interests in foreign bank accounts. Congress, on March 18, 2010, as part of the Hiring Incentives to Restore Employment (HIRE) Act, created this additional filing obligation by enacting Section 6038D. Section 6038D imposes a duty on U.S. taxpayers to file a report of information relating to an interest in a “specified foreign financial asset,” e.g., foreign bank accounts, where the aggregate value of such asset(s) exceed $50,000.  This newly enacted reporting obligation applied only to tax years ending after December 19, 2011.[iii]  Thus, for tax years ending after 2011, the tax laws required that U.S. taxpayers – in addition to the underlying obligation to report all income from all sources – separately report, on Form 8938, their interests in foreign bank accounts. Form 8938 is then required to be submitted with the U.S. taxpayer’s income tax return.[iv]  

In imposing the new Form 8938 reporting requirement on taxpayers, Congress determined that the IRS should be entitled to additional time to examine and assess a tax related to the foreign bank account information now required to be disclosed directly to the IRS under Section 6038D. As a result, Congress, under HIRE, also enacted Section 6501(e)(1)(A)(ii), which provided a six-year statute of limitations for the IRS to assess a tax deficiency, rather than the more narrow three-year limit, in cases involving omitted gross income attributable to assets required to be reported under Section 6038D, where the amount of omitted gross income exceeded $5,000.

This brings us to Mr. Rafizadeh. For the tax years 2006 through 2009, Mr. Rafizadeh, a U.S. taxpayer, owned a foreign bank account, the gross income of which he did not disclose when he filed his tax returns for those years. Prior to his attempt to submit an offshore voluntary disclosure, the bank at which the taxpayer owned this account received a John Doe summons from the IRS. As a result, the IRS determined that the taxpayer was not eligible for the administrative compliance program. The IRS then proceeded to examine not only the taxpayer’s foreign account issues for 2006 through 2009, but also his income tax returns for those same years.

On December 8, 2014, the IRS, relying upon the six-year statute of limitations under Section 6501(e)(1)(A)(ii), issued a notice of deficiency to the taxpayer asserting tax deficiencies as well as the accuracy-related penalty for each of those years. The additional tax assessed for each year, other than 2009, exceeded $5,000.  The taxpayer petitioned the Tax Court, asserting the three-year statute of limitations to assess additional tax for the years 2006-2009 had expired and the six-year statute upon which the IRS had relied was inapplicable to these tax years as Section 6038D, unambiguously on its face, did not impose a duty on him to file the Form 8938 for these tax years.

The IRS in response, after conceding the inapplicability of Section 6501(e)(1)(A)(ii) to 2009 on grounds that the amount in issue for that year was less than $5,000 (an additional factor mandated for the application of the six-year statute of limitations), asserted the six-year statute extension should be interpreted to apply to not only years in which the Form 8938 was required but years, such as 2006-2008, in which the omitted gross income involved the type of assets required to be reported under Section 6038D as long as the statute of limitations on the underlying income tax return was still open.

The Tax Court, relying upon Supreme Court precedent[v], noted that it “must presume that a legislature says in a statute what it means and means in a statute what it says there” found that absent a preexisting obligation to file a report under Section 6038D (akin to the statute’s unambiguous $5,000 threshold), the six-year statute of limitations did not apply.[vi]  As such, the Tax Court found the notice of deficiency for 2006, 2007, and 2008 to be untimely.[vii]

In short, while the holding in Rafizadeh serves to limit the IRS’s ability, under Section 6501(3)(1)(A)(ii), to extend the general three-year statute of limitation for years prior to 2011, where the taxpayer’s omission of income from any source, including but not limited to a “specified foreign financial asset” exceeds 25% of the gross income reported on the return or is the result of fraud, the IRS doesn’t need that statute to extend its time to six years, or even, to forever. At least in the context of the IRS’s use of its civil tools. Of course, the IRS’s criminal tools are a whole different story . . .

Sandra R. Brown is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., and specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court. Prior to joining the firm, she served as the Acting United States Attorney, the First Assistant United States Attorney and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal).  Ms. Brown may be reached at brown@taxlitigator.com or 310.281.3217.

[i] 26 U.S.C. §6501, et seq.

[ii] Rafizadeh v. Commissioner, 150 T.C. No. 1 (2018).

[iii] Treas. Reg. §1.6038D-2(g).

[iv] Treas. Reg. §1.6038D

[v] Conn. Nat’l Bank v. Germain, 503 U.S. 249, 253-254 (1992).

[vi] Rafizadeh, 150 T.C. No. 1, at 7.

[vii] Id. at 12-13.

 

As we approach the tax return filing deadline of April 17 this year, taxpayers are scrambling for documents to substantiate their expenses and basis in assets. Tax practitioners are always asked low long should one keep records.  Three years?  Seven years?  Forever?  If you find yourself without records, all may not be lost thanks to early 20th century Broadway writer, producer, director George M. Cohan.[i]

Andrew Shank[ii] withdrew over $27,000 from his IRA and did not report any of it on his tax return despite receiving a Form 1099-R.  At trial he credibly testified that he opened the IRA in the 1990s when he was a high earner and therefore could not deduct the contributions.  The Court found it understandable that Mr. Shank didn’t have records from the 1990s and combined with his credible testimony used the Cohan rule to estimate his basis.  Although the Court ultimately determined a basis of only $4,760, there are several important lessons from this case.

First, although documentary evidence might be the best evidence to prove basis, testimony is evidence and credible testimony is valuable evidence. IRS Revenue Agents, Appeals Officers, and even lawyers frequently get tunnel vision and only look at documentary evidence and ignore the taxpayer’s words.  If a taxpayer can credibly tell his or her story the Court will consider it even where recordkeeping is light.  As a practitioner, you need to build your case around your client’s story to offer as much support as possible.  Cohan is not automatic.  You must establish a reasonable evidentiary basis.

Second, this case serves as a reminder that the Cohan rule does not only apply to expenses, but also basis. Taxpayers are frequently trying to prove their basis in stocks purchased years ago, or the cost of home improvements.  These issues are ripe for the Cohan rule, assuming you can establish a reasonable evidentiary basis.

Finally, when it comes to keeping records, if it deals with basis, it is wise to keep records for several years after you dispose of the asset. Without records you may not end up with zero basis, but even with Cohan, it is unlikely to be what you think you deserve.

Jonathan Kalinski specializes in both civil and criminal tax controversies as well as sensitive tax matters including disclosures of previously undeclared interests in foreign financial accounts and assets and provides tax advice to taxpayers and their advisors throughout the world.  He handles both Federal and state tax matters involving individuals, corporations, partnerships, limited liability companies, and trusts and estates.

Mr. Kalinski has considerable experience handling complex civil tax examinations, administrative appeals, and tax collection matters.  Prior to joining the firm, he served as a trial attorney with the IRS Office of Chief Counsel litigating Tax Court cases and advising Revenue Agents and Revenue Officers on a variety of complex tax matters.  Jonathan Kalinski also previously served as an Attorney-Adviser to the Honorable Juan F. Vasquez of the United States Tax Court.

[i] Cohan was famously portrayed by James Cagney, who won an Oscar for Yankee Doodle Dandy.  https://www.youtube.com/watch?v=StDpLge_ITM

[ii] Shank v. Commissioner, T.C. Memo. 2018-33.

There’s been a recent uptick in state and federal prosecutions of restaurants who use sales-suppression software (also known as “zappers”) that delete transactions on computerized point-of-sale systems, as governments have finally woken up to the fact that they are losing tens of billions of dollars per year in underreported sales and income taxes. These zapper programs are a modern update to an age-old practice in cash businesses – keeping one set of “real” books and another, showing lower sales, to give to the tax collectors. In the past few years, the IRS has teamed up with state taxing agencies on cases, training, and software to detect businesses – primarily restaurant so far – that are submitting false sales and income figures.

In the article, my brother Kirk, a Seattle attorney who defended a low-level zapper salesperson in the first prosecution of a zapper distributor, and I tracked the increasing frequency of zapper prosecutions. Kirk’s client’s case resulted from a federal-state partnership, whereby a restaurant owner was prosecuted by the State and Kirk’s client was prosecuted by the US Attorney’s Office. As we noted, what started out as one zapper prosecution every decade has increased to one prosecution every few months. We also discussed that states are sending their tax investigators to zapper training, hoping to detect and nab businesses who are using the software.

As if on cue, two months after our article, the next case dropped. On March 9, 2018, the Washington Attorney General filed charges against the owner of seven Tacos Guaymas restaurants for zapping more than $5.6 million in sales tax under a 2013 Washington law that specifically outlaws using zapper software. The AG touted the case as “potentially the largest in the country,” which very well may be true. Washington’s sales tax rate is roughly 10 percent, so the restaurants allegedly zapped more than $50 million of sales.

It’s worth noting this case was brought in Washington State. Washington is on the forefront of investigating and prosecuting zapper cases, and it appears they now have the expertise – using undercover agents as well as computer forensics – to investigate the cases without the IRS’s help. The IRS isn’t mentioned in the press release, which in the world of law enforcement would be a major faux pas if the IRS were involved. This development should make cash businesses in Washington as well as other states that have devoted training and agent resources to zapper cases – including Connecticut, Illinois, and California – nervous.

If you’d like to learn more, please forward an email requesting a copy of the article referenced above.

EVAN J. DAVIS – For more information please contact Evan Davis – davis@taxlitigator.com or 310.281.3288. Mr. Davis is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former AUSA of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) handling civil and criminal tax cases and, subsequently, of the Major Frauds Section of the Criminal Division of the Office of the U.S. Attorney (C.D. Cal) handling white-collar, tax, and other fraud cases through jury trial and appeal. He has served as the Bankruptcy Fraud coordinator, Financial Institution Fraud Coordinator, and Securities Fraud coordinator for the USAO’s Criminal Division, and the U.S. Attorney General awarded him the Distinguished Service Award for his work on the $16 Billion RMBS settlement with Bank of America.

Mr. Davis represents individuals and closely held entities in criminal tax investigations and prosecutions, civil tax controversy and litigation, sensitive issue or complex civil tax examinations and administrative tax appeals, and federal and state white-collar criminal investigations including money laundering and health care fraud. He is significantly involved in the representation of taxpayers throughout the world in matters involving the ongoing, extensive efforts of the U.S. government to identify undeclared interests in foreign financial accounts and assets and the coordination of effective and efficient voluntary disclosures (OVDP, Streamlined Procedures and otherwise).

Older Posts »

Categories