Posted by: Taxlitigator | July 20, 2016

CA Residents May Exclude Aliso Canyon Gas Leak Reimbursements

In IRS Announcement 2016-25, the IRS confirmed that residents who were living near and affected by a natural gas leak discovered at Southern California Gas Co.’s Aliso Canyon storage field may exclude from gross income amounts that the company paid or reimbursed for some relocation and cleaning expenses incurred between November 19, 2015, and May 31, 2016.

For nearly four months, the northern Los Angeles community of Porter Ranch suffered from the largest natural gas leak in U.S. history.  More than 7,000 families were displaced from their homes and forced to relocate. Schools in the area were also closed. This announcement came at the urging of Congressman Brad Sherman (D-Porter Ranch), who worked with the Treasury Department and the IRS over the last six months to reach this result.

On October 23, 2015, Southern California Gas Company (SoCal Gas) discovered a natural gas leak at the Aliso Canyon storage field, which was sealed on February 18, 2016. Residents of nearby areas complained of numerous adverse health effects as a result of the gas leak, including nausea, dizziness, vomiting, shortness of breath, and headaches. Because the gas leak caused significant symptoms for area residents, the Los Angeles County Department of Public Health directed SoCal Gas to offer free, temporary relocation to affected residents. Pursuant to the directive and subsequent court orders, SoCal Gas is required to either pay on behalf of or reimburse affected residents for certain relocation and cleaning expenses incurred generally for the period beginning November 19, 2015 through May 31, 2016. These expenses include:

º Hotel expenses, including meal reimbursement ($ 45
per day for an individual age 18 and older; $ 35
per day or $ 25 per day for a child based on age),
mileage reimbursement, parking expenses, pet boarding
fees, internet fees, electric vehicle charging fees,
and laundry fees;

º Expenses of staying with friends or family at the
rate of $ 150 per day, and mileage reimbursement;

º Expenses of renting another home for a lease term
(including a lease term extending beyond May 31,
2016) as approved by SoCal Gas, including expenses
of housewares, appliances, pet fees, furniture rental,
utility fees, and moving expenses;

º Mileage allowances or alternative transportation
for a resident whose child or children attended the
relocated area schools until the date the resident
exited the relocation program. If, however, a resident
enrolled a child in a school outside of the affected
area, SoCal Gas must pay the mileage allowance until
the child no longer attends the reenrolled school
or the school year ends, whichever occurs first;

º Expenses of cleaning the interior of an affected
individual’s home prior to returning home according
to protocols established by the Los Angeles County
Department of Public Health;

º Air filtration and purification expenses;

º Expenses of cleaning residue from the exterior of
an affected individual’s home, outdoor fixtures,
and exterior furniture and appliances;

º Expenses of a vehicle detailing treatment; and

º Other expenses not specifically described in the
relocation plan based on SoCal Gas’s evaluation of
the expenses.

Questions have been raised concerning the taxability of these expenses paid on behalf of or as reimbursements to affected area residents. Existing guidance does not specifically address these questions.

The IRS will not assert that an affected area resident must include these payments or reimbursements in gross income. However, family and friends who received payments under the relocation plan for housing affected area residents must include these payments in gross income under section 61 of the Internal revenue Code unless these amounts are properly excludable from gross income under section 280A (relating to the exclusion for rental income from a taxpayer’s residence for less than 15 days during the taxable year).

See https://sherman.house.gov/sites/sherman.house.gov/files/wysiwyg_uploaded/IRS%20Porter%20Ranch%20Notice.pdf

 

What is so surprising about a court holding that a tax return for nonbankruptcy purposes is a tax return for bankruptcy purposes? Three federal appeals courts that have considered the question have held that a late filed return that is treated as a return for nonbankruptcy purposes is not a return for purposes of the bankruptcy discharge rules.  Fahey v. Massachusetts Dep’t of Revenue (In re Fahey), 779 F.3d 1, 4-5 (1st Cir. 2015); Mallo v. IRS (In re Mallo), 774 F.3d 1313, 1325-27 (10th Cir. 2014); McCoy v. Miss. State Tax Comm’n (In re McCoy), 666 F.3d 924, 928, 932 (5th Cir. 2012) . The reason given by these courts was a 2005 amendment to the Bankruptcy Code’s discharge rules.  The amendment states that a “return” means a return that satisfies the requirements of nonbankruptcy law, including applicable filing requirements.  According to these courts, the date for filing a return is an “applicable filing requirement.”  Thus, a person who files a return even one day late would not be able to discharge the unpaid tax in bankruptcy.

In Smith v. IRS, decided July 13, Mr. Smith failed to file his 2001 tax return. The IRS issued a notice of deficiency based on a “substitute for return.”  When he did not file a Tax Court petition, the IRS assessed the tax.  In 2009, Mr. Smith filed a return for 2001 reporting more income than the IRS had determined.  The IRS increased the assessment by the additional tax due.  Mr. Smith made some monthly payments.  In 2013 he filed a bankruptcy petition.  He sought to have his tax debt discharged.

Consistent with its position that taxes based on a substitute for return are not dischargeable, the IRS conceded that the additional tax based on Mr. Smith’s return was discharged. It argued that the original assessment was not discharged.  Mr. Smith claimed that the entire liability was discharged and the bankruptcy court agreed.  The district court reversed.  The Ninth Circuit affirmed the district court.

Unlike the First, Fifth and Tenth Circuits, the Ninth Circuit refused to interpret the 2005 amendment as requiring that a return be filed by the due date to be a “return” for bankruptcy purposes. Instead, it adhered to the four part test that the Tax Court has consistently used: to be a return, a document 1) must purport to be a return, 2) must be signed under penalty of perjury, 3) must contain sufficient data to allow tax to be calculated and 4) must be “an honest and reasonable attempt to satisfy the requirements of the tax law.”  Both the IRS and Mr. Smith this was the test that should be applied.

The Ninth Circuit held that Mr. Smith did not make an honest and reasonable attempt to satisfy the requirements of the tax law. The “return” he filed was 7 years late and three years after the IRS assessment.  Mr. Smith’s claim that “honest and reasonable” requires the court to look only at the face of the return was rejected.

The Ninth Circuit did not discuss the three circuit cases holding that the 2005 amendment requires a return to be filed on time in order to be a return for purposes of bankruptcy. The Ninth Circuit cited two circuit courts as supporting its interpretation.  In one, In re Justice, 817 F.3rd 728 (11th Cir. 2016), the court expressly avoided deciding the issue and assumed, for the sake of argument, that the four part test applied.  It held, on facts similar to those in Mr. Smith’s case, that the tax was not dischargeable.  In the other, In re Ciotti, 638 F.3rd 276 (4th Cir. 2011), the debtor failed to notify Maryland of a federal adjustment to a tax return.  The question before the court was whether Maryland’s requirement that notice be given of federal adjustments was the equivalent of a return.  There was no issue as to whether a late filed “return” is a return.

The Ninth Circuit’s decision in Smith v. IRS creates a direct conflict between the circuits.  Will either side seek certiorari?  No.  Both the IRS and the debtor agree that the four-part test applies and that the 2005 amendment does not impose a timeliness requirement.  Neither wants the Supreme Court to hold that the 2005 amendment requires a return to be filed on time in order to be dischargeable.  We will have to wait for the question to be decided by the Supreme 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

Posted by: Taxlitigator | June 12, 2016

IRS Methods of Indirectly Determining Taxable Income

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

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

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

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

The examiner will attempt to total the deposits and reconcile deposits of nontaxable funds and transfers between accounts focusing on transfers in, out, and between accounts as previously unknown accounts may be identified. Checks deposited by the taxpayer but later returned by the bank (e.g., the maker of the check did not have sufficient funds in the account to pay the check) are categorized as nontaxable transactions. Nontaxable funds, transfers-in, and returned deposits need to be subtracted from total deposits to get “taxable deposits.” The examiner will determine disbursements by adding the opening bank balance to the total deposits and then subtracting out the ending balance. To the extent possible, cancelled checks will be reviewed to determine whether nondeductible expenditures (personal expenses, investments, payments on asset purchases, etc.) are included with business expenses and if so, the amount. If cancelled checks are unavailable, transactions will be traced from the bank statement to the check register and the original document. Significant commingling of accounts may warrant a more in-depth analysis by the examiner. When nondeductible expenditures are deducted from the total disbursements the remainder should approximate the deductible business expenses on the tax return (other than non-cash expenses such as accruals and depreciation).

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

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

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

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

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

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

If repayments of loans are identified, the examiner will request the debt instruments to establish that a loan was made, the terms of the debt, and the repayment schedule. Before an examiner can reach any conclusion about the relationship between deposits and reported receipts, transfers and 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.

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

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

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

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

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

Summary. 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.

When the Internal Revenue Service audits a taxpayer, it requests the taxpayer to voluntarily provide documents and information. Where a taxpayer fails or refuses to provide the information, the IRS often issues summonses to the taxpayer or third parties.  Failure to comply with a summons can be costly. As two recent appeals court cases make clear, it is very hard for a taxpayer to get an evidentiary hearing to challenge a summons. United States v. Clarke (11th Cir. 3/15/2016), on remand from 573 U.S. ___, 134 S. Ct. 2361 (2014) and Gangi v. United States (1st Circuit, 3/30/2016).

First, some background on the IRS’s summons power. Internal Revenue Code (IRC) §7602(a) authorizes the IRS to issue a summons for the purpose of “ascertaining the correctness of any return, making a return where none has been made, determining the liability of any person for any internal revenue tax . . ., or collecting any such liability.”  Unlike an IDR, the IRS can obtain a court order enforcing a summons. A taxpayer can also seek a court order to quash a summons.  Where this occurs, the IRS will usually ask the court to enforce the summons.

To obtain a court order enforcing a summons, the IRS must establish that (1) the investigation is being conducted for a legitimate purpose, (2) the information sought may be relevant to the purpose, (3) the information sought is not already in the IRS’s possession, and (4) all administrative steps required by the Code have been followed. United States v. Powell, 379 U.S. 48, 57-58 (1964).  The IRS normally makes this showing through a declaration signed by the IRS agent conducting the audit.  A person contesting enforcement must then either disprove one of the four elements or establish that enforcement of the summons would constitute an abuse of the court’s process. However, a court reviewing an enforcement petition “may ask only whether the IRS issued a summons in good faith, and must eschew any broader role of ‘oversee[ing] the [IRS’s] determinations to investigate.'” Clarke, 573 U.S. at ___, 134 S. Ct. at 2367 (alterations in original).

The Supreme Court’s decision in Clarke clarified what a taxpayer must show to get an evidentiary hearing in which he can examine IRS agents about their motives for issuing a summons. A “taxpayer is entitled to examine an IRS agent when he can point to specific facts or circumstances plausibly raising an inference of bad faith.” Id. at ___, 134 S. Ct. at 2367.  As discussed in a prior blog, in Microsoft v United States, the court granted an evidentiary hearing only to find that the IRS did not abuse its summons power.  See http://www.taxlitigator.com/microsoft-decision-emphasizes-the-heavy-burden-a-taxpayer-must-bear-to-defeat-enforcement-of-a-summons-by-robert-s-horwitz/

In Clarke, the IRS was auditing a partnership, DHLP.  During the audit, DHLP twice extended the statute of limitations.  After it refused to extend the statute a third time, the IRS issued five summonses to third parties, all of whom failed to comply.  Instead of seeking enforcement, the IRS issued a Final Partnership Administrative Adjustment (FPAA).  The partnership petitioned the Tax Court to challenge the FPAA.

After the IRS filed its answer in Tax Court, the Government filed petitions in U.S. district court to enforce the summonses, together with a declaration from the IRS agent establishing the four Powell elements.  DHLP opposed enforcement on the grounds that the summonses were issued in retaliation for its refusal to extend the statute and to circumvent the Tax Court’s discovery rules.  It requested an evidentiary hearing.  The district court denied the request for an evidentiary hearing and ordered the summons enforced.  On appeal, the Eleventh Circuit reversed, holding that DHLP was entitled to an evidentiary hearing.

The IRS appealed to the Supreme Court, which reversed the Eleventh Circuit and remanded the case for further proceedings to determine whether DHLP was entitled to an evidentiary hearing in light of the standard enunciated by the Court. The Eleventh Circuit sent the case back to the district court to “determine, in light of all of the evidence and the affidavits highlighted by the Supreme Court, whether Appellants pointed to specific facts or circumstances plausibly raising an inference of improper purpose …. [and] whether the improper purposes alleged by Appellants . . . are improper as a matter of law.”

After remand, the district court allowed further briefing but denied DHLP’s request to submit additional evidence. To support their allegations of retaliation, DHLP and the summoned parties stressed the timeline of the IRS’s decision to seek enforcement, which was six months after the summonses were issued, four months after the FPAA was issued, and in the same month that the IRS answered the Tax Court petition. They also pointed out that the FPAA was signed prior to the date the summonses were issued, to support the inference that the summonses were retaliatory.

To support the allegation that the IRS sought enforcement of the summonses to evade more stringent Tax Court discovery rules, DHLP pointed to the fact that a summoned person who complied was examined by the attorney who was representing the IRS in Tax Court and not by the IRS agent.

The district court held that none of the grounds alleged were improper as a matter of the law and that no facts were submitted that gave rise to a plausible inference of improper motive regarding the issuance of the summons. It denied the request for an evidentiary hearing and ordered the summonses enforced.  On appeal, the Eleventh Circuit affirmed the district court.

Although it affirmed the district court’s order denying an evidentiary hearing and enforcing the summonses, it rejected two of the district court’s determinations. First, the Eleventh Circuit concluded that issuing a summons for the sole purpose of retaliation against a taxpayer would be improper as a matter of law.  Second, the Eleventh Circuit concluded issuing a summons in bad faith for the sole purpose of circumventing Tax Court discovery would be an improper purpose as a matter of law.

Addressing the district court’s denial of the request to submit additional evidence, the Eleventh Circuit held that in light of the summary nature of a summons enforcement proceeding, the district court did not abuse its discretion.

The Eleventh Circuit also found that while DHLP made a number of allegations, the evidence it presented did not give rise to any plausible inference of improper motive. First, the submission that the timeline of the issuance of the summonses supports an inference of retaliation by the IRS requires substantial conjecture that is both implausible and unsupported by the record. Further, none of the’ submissions suggest that the summonses were issued in bad faith anticipation of Tax Court proceedings rather than in furtherance of the audit. Thus, DHLP and the summoned parties were not entitled to an evidentiary hearing.

The Eleventh Circuit also pointed out that the validity of a summons is tested at the date of issuance. Thus, neither the subsequent issuance of an FPAA nor the initiation of Tax Court proceedings affected the IRS’s summons authority or the summoned parties legal obligation to comply.

Prior to the Supreme Court’s decision in Clarke, the Eleventh Circuit was alone in holding that a bare allegation of improper purpose was sufficient to entitle a person challenging a summons to an evidentiary hearing. In Gangi, the taxpayer filed a petition to quash summonses.  The district court denied the petition and ordered the summonses enforced.  Shortly afterwards, the Supreme Court issued its decision in Clarke.  The taxpayer moved to reopen the case and obtain an evidentiary hearing on the ground that Clarke set a new standard for determining when a taxpayer can get an evidentiary hearing.  The district court denied the motion.  The First Circuit affirmed.  In doing so, it held that the Supreme Court’s requirement that a taxpayer must allege “specific facts and circumstances” sufficient to raise a plausible inference of bad faith was virtually identical its standard that a taxpayer needs to allege specific facts and evidence supporting a claim of bad faith in order to obtain an evidentiary hearing.

Based on these two cases and the district court decision in Microsoft, it has become even more difficult after the Supreme Court’s Clarke decision to quash a summons than it was pre-Clarke if the IRS meets the four-part Powell test.  And if the taxpayer petitions to quash a third-party record keeper summons, or intervenes in a proceeding to enforce a summons, the statute of limitations on assessment is suspended until the conclusion of the proceeding and any appeals.  Thus, a taxpayer’s challenging a summons can result in giving the IRS more time to gather information and examine the return.

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

 

Since the Supreme Court in Mayo Foundation v. U.S., 562 US 44 (2011)’ held that IRS regulations are subject to the same standard of review as are regulations of other agencies, several prominent attorneys have kicked around the idea that IRS notices of deficiency were subject to review under the Administrative Procedures Act (APA) just like the adjudicative determinations of other agencies. After all, the Tax Court and federal appeals courts have turned to the APA to decide whether a tax regulation was procedurally valid.   The taxpayers raised a claim that the APA applies to deficiency proceedings in Ax v Commissioner, 114 TC No. 10 (April 11, 2016), only to have the claim felled by the Tax Court.

The taxpayers owned a S corporation that had set up a captive insurance company. After audit, the IRS issued a deficiency notice disallowing deductions for payments to the captive insurer on the ground that a) the arrangement was not insurance and b) the taxpayers failed to substantiate the payments.   Seven months after it answered, the IRS moved to amend its answer to raise 2 new claims: a) that the transactions lacked economic substance and b) that the payments were not ordinary and necessary business expenses.  The taxpayers opposed the motion on the grounds that allowing amendment would violate the APA and Chenery Corp. v SEC, 318 US 80 (1943).   They also argued that granting the motion would cause undue prejudice.

The taxpayers’ argued that under the APA and Chenery an agency adjudication can only be reviewed on the grounds articulated in the agency’s determination.   The Tax Court explained that, under Chenery, a court can review an action left to the agency’s sole discretion only on the grounds articulated by the agency in its decision.   A reviewing court cannot “perform a pseudo-review” of a decision that the court may have reached if it were the agency.  This is not the situation in a deficiency case.  While the IRS makes the initial determination that there is a deficiency, the Tax Court is authorized to “redetermine” the deficiency and also has the authority to determine that more is owed than claimed in the deficiency notice or that the taxpayer is owed a refund for the years under review.  Further, while the notice of deficiency must describe the basis for the deficiency determination, an inadequate description does not affect the validity of the notice.

Turning to the APA, the Tax Court noted that under the APA, review of agency action “is the special statutory review proceeding relevant to the subject matter in a court specified by statute,” in this case the Tax Court. Deficiency procedures were in existence 20 years before the APA was enacted and the APA was not meant to supplant these procedures.  In deficiency cases, the IRS had always been allowed to raise new matters, for which it had the burden of proof. Mayo Foundation did not affect deficiency procedures, since it only dealt with the deference to be accorded IRS regulations.

A motion to amend can be defeated by showing that granting the motion will cause undue prejudice.   Since the case had not been set for trial, the taxpayers had adequate time to prepare to meet the IRS’s new contentions.  Thus, the motion to amend was granted.

The taxpayers in this case wanted to have their cake and eat it to, in a sense. Under the Administrative Procedures Act, a reviewing court not only is limited to considering the grounds upon which the administrative agency based its determination, it is also normally limited to reviewing the agency record to determine whether the agency’s determination was an abuse of discretion.  This is the standard used in collection due process cases.  A case in which a court applied the Administrative Procedures Act was Moore v. United States, the non-willful FBAR case we will revisit in the near future.

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 blog has previously discussed various issues regarding restitution in criminal tax cases. Three recent cases illustrate why a restitution order in a criminal tax case is an extremely bad thing from the defendant’s point of view.

In Rebuck v. Commissioner, T.C. Memo 2016-3, Rebuck pled guilty along with co-defendants to conspiracy to defraud the United States under 18 USC §371 by promoting abusive trust packages that purported to allow the purchasers to legally avoid all income tax.  He was ordered to pay restitution to the IRS in the amount of $16,389,199.  The restitution judgment was joint and several with his co-defendants.  Rebuck subsequently filed a balance due income tax return for 1996 and the IRS assessed promoter penalties against him.  He entered into an installment agreement to pay the 1996 income tax and the penalties.

After entering into the installment agreement, Rebuck filed balance due income tax returns for 1998-2002. The IRS assessed the amounts shown due on those returns plus penalties and interest.  After a Collection Due Process notice was issued in August, 2012, Rebuck filed a timely protest and sought to enter into an offer in compromise.  IRS Appeals rejected the offer on the ground that Rebuck had to include in his offer full payment of the $16 million plus owed as criminal restitution.  Rebuck petitioned the Tax Court.  The Tax Court held that the IRS did not abuse its discretion in requiring Rebuck to full pay the criminal restitution:

The fundamental problem with petitioner’s OIC is that it did not address his outstanding court-ordered restitution. Petitioner’s OIC sought to compromise (1) Federal income tax liabilities for the taxable years 1996, 1998, 1999, 2000, 2001, and 2002 and (2) section 6700 civil penalties for 1999-2003.  However, petitioner’s OIC did not address his outstanding criminal restitution.  When a taxpayer owing  restitution submits an OIC to the IRS, IRM pt. 5.1.5.24.5 requires that the offer provide for the full payment of the restitution amount. Petitioner’s OIC did not address hi outstanding criminal restitution as required by the IRM. Generally, an Appeals officer does not abuse his or he discretion in rejecting an OIC when following guidelines set forth in the IRM. Veneziano v. Commissioner, T.C. Memo 2011-160.

Although the Tax Court pointed to the IRM as the basis for why the restitution could not be compromised, by statute a criminal restitution order cannot be reduced (except in very unusual circumstances) and the Government cannot compromise it. So unlike a regular tax assessment, you cannot compromise an order to pay restitution to the IRS in a criminal tax case.

In U.S. v Del’Andrea (D. Utah 1/14/2016), the defendant pled guilty to tax evasion for both personal and corporate income tax.  She was ordered to pay restitution for both corporate and personal income tax in the amount of $136,509.50.  She paid the amount of the restitution order on the day the order was entered.  Because the corporation was protesting the IRS’s proposed assessment against it for one year, the IRS had the amount of restitution attributable to that year posted as pending.  The IRS assessed interest against the defendant on the amount of restitution from the due dates of the returns.   The defendant filed a motion with the district court to order the IRS to apply the tax attributable to the corporation to the corporate account and to hold that she is not liable for any interest other than that which would be owed from the date of the restitution order.  She also asserted that the IRS could not assess interest against her from the due dates of the return without following the deficiency procedures.  The district court ruled against the taxpayer on these issues.

As to the corporate tax, due to the protest, application of the restitution payment to the corporate account would have resulted in an automatic refund, since the account had a zero balance owed. Thus, the court held that the IRS did not violate the restitution order by not crediting the payment to the corporate account.  The court held that the IRS could assess restitution interest when it assessed the restitution under 26 USC §6401(a)(4) without needing to follow deficiency procedures as to interest:

The court concludes that the IRS has correctly assessed the restitution payments and associated interest in accordance with the procedures outlined in the Internal Revenue Code. The IRS correctly calculated interest on the restitution payments from the date that the taxes to which the restitution applied were originally due, and the IRS was not require to follow the deficiency procedures with regard to the restitution-based assessments or the interest assessments.

The defendant did prevail on one issue. The IRS had applied a refund owed the corporation to interest owed by the defendant on the theory that they were jointly and severally liable.  The court held that they were not jointly and severally liable.  Thus, the IRS could not apply a refund owed the corporation to interest on the defendant’s restitution.

Finally, in US v. Tilford (5th Circuit 1/19/2016), Mr. and Mrs. Tilford lived in a community property state.  He pled guilty to failing to file a tax return for 2006.  He was ordered to pay restitution of $453,547 in 2012.  His wife had filed for divorce.  The divorce became final in early 2014.  Shortly after the divorce became final, the United States garnished her pre-divorce wages, including accrued vacation pay, and pre-divorce contributions to her 401(k) and 403(b) plans.  Mrs. Tilford filed a motion for an order to quash the garnishment, claiming that she was entitled to innocent spouse relief under Internal Revenue Code §66(c).  Affirming the district court’s denial of the motion to quash, the Fifth Circuit held that innocent spouse provisions do not apply to criminal tax restitution.  This was so even though under §6201(a)(4)(A) the IRS is to “assess and collect … the restitution … for failure to pay any tax … in the same manner as if such amount were such tax.”

So, you cannot compromise a criminal restitution order. Even if the order does not expressly provide for pre-judgment interest, the IRS can assess interest from the due date of the return.  And the current or former spouse of the defendant cannot obtain innocent spouse relief if the Government seeks to seize the spouse’s property to satisfy the defendant’s tax liability.  On top of all this, a criminal restitution order is not dischargeable in bankruptcy.  It is the worst of all worlds for a criminal defendant against whom a tax-related restitution order is entered.

Robert S. Horwitz – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com Mr. Horwitz 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)  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 www.taxlitigator.com

Posted by: Taxlitigator | May 3, 2016

Tax Gap: A Roadmap to Future IRS Enforcement Efforts

The IRS just released their latest study of the “tax gap” covering tax years 2008 through 2010, which offers a broad view of the nation’s compliance with federal tax laws. The IRS now estimates the average annual tax gap at $458 billion, and the voluntary compliance rate at 81.7 percent. The last tax gap study performed in 2006 estimated the annual tax gap at $450 billion, and the voluntary compliance rate at 83.1 percent. The gross tax gap is the difference between the amount of tax imposed on taxpayers for a given year and the amount that is paid voluntarily and timely. It represents, in dollar terms, the annual amount of tax noncompliance.

The current estimated gross tax gap is $458 billion. The net tax gap is the gross tax gap less tax that will be subsequently collected, either paid voluntarily or as the result of IRS administrative and enforcement activities; it is the portion of the gross tax gap that will not be paid. It is estimated that $52 billion of the gross tax gap will eventually be collected resulting in a net tax gap of $406 billion. The 2008–2010 gross and net tax gap estimates ($458 billion, $406 billion) are 1.8 percent and 5.5 percent higher, respectively, than the previously released 2006 estimates ($450 billion, $385 billion).

The voluntary compliance rate (VCR) is a ratio measure of relative compliance and is defined as the amount of tax paid voluntarily and timely divided by total true tax, expressed as a percentage. The VCR corresponds to the gross tax gap. The estimated VCR is 81.7 percent. The net compliance rate (NCR) is a ratio measure corresponding to the net tax gap. The NCR is defined as the sum of “tax paid voluntarily and timely” and “enforced and other late payments” divided by “total true tax”, expressed as a percentage. The estimated NCR is 83.7 percent.

The tax gap results confirm that the compliance rate is high for income that is subject to third-party information reporting, and even higher when there is withholding of estimated future tax obligations. The extent of coverage by information reporting and/or withholding is called “visibility” because incomes that are reported to the IRS are more “visible” to both the IRS and taxpayers. Misreporting of income amounts subject to substantial third-party information reporting and withholding is only 1 percent; of income amounts subject to substantial information reporting but not withholding, misreporting is 7 percent; and for income amounts subject to little or no information reporting, such as nonfarm proprietor income, misreporting jumps to 63 percent.

The IRS believes that differences between the 2008-2010 tax gap estimate as compared to the estimate for 2006 are mostly a result of the overall decline in the nation’s tax revenues due to the severe recession, as well as improved estimation techniques. IRS efforts to enhance the voluntary compliance rate include increased educational efforts aimed at preparers and taxpayers; ongoing efforts to improve compliance in the international tax arena; and working with businesses on employment tax issues. 

Roadmap to Future Tax Enforcement Efforts. The gross tax gap map for 2008 though 2010   (and for 2006) is composed of three components: nonfiling, underreporting, and underpayment. The estimated gross tax gaps for these components are $32 billion, $387 billion, and $39 billion respectively. The gross tax gap estimates can also be grouped by type of tax. The estimated gross tax gap for individual income tax is $319 billion, for corporation income tax is $44 billion, for employment tax is $91 billion, and for estate and excise tax combined is $4 billion. The estimated net tax gap for individual income tax is $291 billion, for corporation income tax is $35 billion, for employment tax is $79 billion, and for estate and excise tax combined is $1 billion. 

Since the “Tax Gap” represents unpaid taxes any estimate is, at best, a WAG (wild-guess). However, it represents the best WAG currently available and provides significant guidance in defining the present allocation of limited IRS tax enforcement resources and assists in making future tax policy decisions seeking more cost-effective ways to increase overall voluntary tax compliance.

The bigger tax enforcement targets are, quite obviously, the tax gap components having the most significant compliance problems underreporting ($382 billing), underpayment ($39 billion) and nonfiling of required returns ($32 billion). By type of tax, those most concerned should be individuals ($319 billion), those with employment tax issues ($91 billion), corporations ($44 billion) and those facing estate and excise tax issues (a combined $4billion).

Employment tax issues are currently receiving a heightened look from both the Department of Justice and the IRS. IRS Commissioner John Koskinen recently stated “The IRS is committed to working with the Justice Department to protect this important area, and there’s a long list of efforts we’ve taken in both civil and criminal investigation areas when employers try to evade their legal responsibilities and, in the process, gain an advantage over their competitors who are honoring their legal responsibilities.” According to statistics provided by IRS Criminal Investigation, in the 2015 fiscal year, individuals convicted of employment tax crimes were sentenced to an average of 24 months in prison.

Increased information reporting to the IRS and expedited reporting by the IRS with state and foreign governments have a significant impact on the federal and state versions of the tax gap. As a result of various electronic matching programs, the government can better identify taxpayers who have underreported or not reported income or have otherwise failed to file returns. Hunting for under-reporters and non-filers has gotten significantly easier as we move further into the electronic age lessening the historical need for “in person” audits tax returns by the IRS.

Will Increased Tax Penalties Help Enforcement Efforts? The “kinder, gentler” IRS of years ago led to an unprecedented decline in IRS enforcement. Declining enforcement relies on a strong voluntary compliant constituency. Increased penalties do not increase compliance; increased tax enforcement increases compliance. Increased penalties only increase penalties on a smaller class of taxpayers actually discovered by a relatively ineffective taxing agency. A low examination rate may only encourage certain taxpayers and practitioners to push the compliance envelope since a low risk of detection could then be deemed worthwhile.

Reduced IRS Budget and Now Increased Enforcement Staffing. Significant reductions to the IRS budget over the last several years have had a negative impact on their tax enforcement efforts. Current IRS funding is now $900 million below what it was in 2010, and IRS has 17,000 fewer full-time employees – more than 5,000 of those employees have been in the area of tax enforcement.

After Congress provided $290 million specifically for taxpayer service, identity theft and cyber-security, IRS was able to add more than 1,000 Wage & Investment employees to assist taxpayer phone lines. The large number of retirements and attrition among enforcement employees is now going to be partially replaced by a just announced addition of between 600 and 700 new IRS employees in the area of tax enforcement – representing the first significant new enforcement hiring in more than five years!

The first wave of new hiring announcements will be in the next few weeks, with announcements being posted internally and externally for many entry-level positions, primarily in SB/SE. These revenue agents, revenue officers and other enforcement positions will be posted in locations around the country. Criminal Investigation special agents and some positions in W&I and Chief Counsel will also be part of this initial wave of hiring. As more personnel are brought on board, IRS anticipates a second wave of hiring later in 2016, providing employees with promotional opportunities for higher-level enforcement positions, including in LB&I, SB/SE, TE/GE as well as positions in IRS Appeals. Employees in the second wave of hiring will assist with high-profile enforcement areas, including international tax issues, refund fraud and identity theft.

Additional resources are essential for the IRS to hopefully reduce the annual tax gap. When you look at the IRS overall, every dollar invested returns at least $4 to the Treasury. The numbers are even higher when it involves enforcement. Each enforcement position typically returns almost $10 to the U.S. Treasury for every dollar spent — and in many instances, much more. Congress and the IRS must determine an appropriate level of tax enforcement resources taking into account the balance between taxpayer service and enforcement activities, and competing federal priorities. The perception of fairness (or unfairness) and complexity of our current tax system also contribute to the tax gap – fundamental tax reform and simplification is necessary to achieve significant reductions in the overall tax gap.

The IRS continues to be resource-challenged. It must maintain an appropriate presence in each taxpayer and professional neighborhood – not only in the high rent district. Initiatives administered without strong detection and enforcement efforts will not likely succeed. However, perceptions as to detection and enforcement are keys to an effective compliance response. The strategic placement of an empty police car will have a more significant impact than a motorcycle officer hiding in the bushes.

Improved Audit Selection Process. Tax law is complex; tax returns are incredibly complex. Complex, detailed examinations of taxpayers are not easily concluded. Neither the taxpayer nor the IRS examiner have any desire to unnecessarily prolong the audit process and there is frequently a good working relationship developed that somewhat accelerates the overall examination process. However, the IRS often has little if any information initially available to help it determine whether the tax returns were substantially accurate as filed.

Auditors audit, that is the purpose of an IRS examination. Audits directly detect and correct noncompliance by the audited taxpayers and indirectly create an environment to encourage non-audited taxpayers to voluntarily comply. The presence and visibility of the IRS among varying taxpayer communities creates an inherent deterrent effect to those who might otherwise ignore their filing and reporting requirements. Again, even an empty police car parked in a visible location will cause people to slow down or stop, where appropriate.

Tax gap data assists the IRS in filtering potentially noncompliant returns for audit using a multiphase process intended to narrow the large pool of available returns to those that most merit investment of limited audit resources. For audits to be conducted in the field, this process generally includes (1) identifying an initial inventory of tax returns that have audit potential (e.g., reporting noncompliance), (2) reviewing that audit potential to reduce the number of returns that merit selection for audit (termed “classification”), (3) selecting returns by assigning them to auditors based on a field manager’s review of audit potential given available resources and needs, and (4) auditing selected returns.

The IRS Small Business / Self Employed operating division the SB/SE uses 33 separate methods, called work-streams, to identify and review filed tax returns that may have significant audit potential. SB/SE initially identifies returns through seven sources which include referrals; computer programs that run filters, rules, or algorithms to identify potentially noncompliant taxpayers; and related returns that are identified in the course of another audit.

The IRS Wage & Investment operation division conducts correspondence audits—an audit conducted through mailed correspondence between the IRS and the taxpayer being audited. Audit programs in W&I mainly cover refundable credits reported on the Form 1040, Individual Income Tax Return. Most W&I returns are selected via computer systems that automatically send notices to taxpayers based on certain criteria, such as the validity of dependents. Most are selected with a specialized computer tool called the Dependent Database (DDb), while the remainder are selected through a combination of referrals and manual selection methods.

Improved Classification of Returns Actually Selected for Audit. IRS classifiers use their technical expertise, local knowledge, and experience to identify hidden, as well as obvious, issues within a return. Classifiers also consider whether the taxpayer has insufficient income for the lifestyle indicated on the return, including efforts to determine family size and personal living expenses in relationship to the income stated on the return.

Classifiers use various guidelines when identifying individual returns issues for examination. They will review the amount by which the itemized deductions exceed the standard deduction and verify that itemized deductions are not claimed elsewhere on the return when the standard deduction has been elected (e.g., personal real estate taxes and mortgage interest deducted on rental schedule). Exemptions claimed by the non-custodial parent often have a significant audit potential. When married persons file separately, both taxpayers may not have made the same election for standard or itemized deductions. If dependent children are claimed, there will be an effort to determine whether the other spouse might also be claiming them.

Changes in address will be considered when reviewing real estate taxes (e.g., Form W–2, Form 1040, Form 2119). Classifiers will check to see if charitable contributions exceed 50 percent of adjusted gross income (AGI), large donations made to questionable miscellaneous charities, payments which may represent tuition, and large dollar non-cash contributions. Gains on sales of rental and other depreciable property, where the taxpayer has been using an accelerated method of depreciation are often questioned since the taxpayer may have to report ordinary income. Loss on the sale of rental property, recently converted from a personal residence, is also a frequent issue. Current year installment sales and exchanges of property are also scrutinized given the potential errors in computing the recognized gain. There may also be issues to determine whether the reported gain is large enough to require the alternative minimum tax computation.

When reviewing issues involving rental properties, the classifier will consider whether repairs might instead be capital improvements, whether the cost of land is included in the basis, and consider passive activity rules if rental losses are greater than $25,000. In searching for potential unreported income, the classifier might look to determine whether the income is sufficient to support the claimed exemptions; tip income for those having a stated occupation as waiter, cab driver, porter, beautician, etc., tip income is a productive issue; substantial interest expenses with no apparent source of funds to repay the loans; claimed business expenses for an activity that shows no income on the return (e.g., beautician supplies, but no Form 1099 or Form W-2, Wage and Tax Statement, for that occupation). Expenses for clubs, yachts, airplanes, etc., are often productive audit issues as failing to satisfy the facilities definition of IRC 274. Claimed employee business expenses should be reasonable when compared to the taxpayer’s occupation and income level.

Future Tax Enforcement Efforts? Few other countries can boast of a tax compliance rate of over 80%! However, all agree that a non-compliance rate approximating 20% amounting to several hundred billion dollars per year is clearly unacceptable in our self-assessment tax system. Consider that a one-percent increase in voluntary compliance will increase tax receipts by about $30 billion in tax receipts! Appropriately funding appropriate IRS tax enforcement efforts can significantly impact the tax gap going forward. . .

When the Internal Revenue Service audits a taxpayer, it requests the taxpayer to voluntarily provide documents and information. Where a taxpayer fails or refuses to provide the information, the IRS often issues summonses to the taxpayer or third parties.  Failure to comply with a summons can be costly. As two recent appeals court cases make clear, it is very hard for a taxpayer to get an evidentiary hearing to challenge a summons. United States v. Clarke (11th Cir. 3/15/2016), on remand from 573 U.S. ___, 134 S. Ct. 2361 (2014) and Gangi v. United States (1st Circuit, 3/30/2016).

First, some background on the IRS’s summons power. Internal Revenue Code (IRC) §7602(a) authorizes the IRS to issue a summons for the purpose of “ascertaining the correctness of any return, making a return where none has been made, determining the liability of any person for any internal revenue tax . . ., or collecting any such liability.”  Unlike an IDR, the IRS can obtain a court order enforcing a summons. A taxpayer can also seek a court order to quash a summons.  Where this occurs, the IRS will usually ask the court to enforce the summons.

To obtain a court order enforcing a summons, the IRS must establish that (1) the investigation is being conducted for a legitimate purpose, (2) the information sought may be relevant to the purpose, (3) the information sought is not already in the IRS’s possession, and (4) all administrative steps required by the Code have been followed. United States v. Powell, 379 U.S. 48, 57-58 (1964).  The IRS normally makes this showing through a declaration signed by the IRS agent conducting the audit.  A person contesting enforcement must then either disprove one of the four elements or establish that enforcement of the summons would constitute an abuse of the court’s process. However, a court reviewing an enforcement petition “may ask only whether the IRS issued a summons in good faith, and must eschew any broader role of ‘oversee[ing] the [IRS’s] determinations to investigate.'” Clarke, 573 U.S. at ___, 134 S. Ct. at 2367 (alterations in original).

The Supreme Court’s decision in Clarke clarified what a taxpayer must show to get an evidentiary hearing in which he can examine IRS agents about their motives for issuing a summons. A “taxpayer is entitled to examine an IRS agent when he can point to specific facts or circumstances plausibly raising an inference of bad faith.” Id. at ___, 134 S. Ct. at 2367.  As discussed in a prior blog, in Microsoft v United States, the court granted an evidentiary hearing only to find that the IRS did not abuse its summons power.

In Clarke, the IRS was auditing a partnership, DHLP.  During the audit, DHLP twice extended the statute of limitations.  After it refused to extend the statute a third time, the IRS issued five summonses to third parties, all of whom failed to comply.  Instead of seeking enforcement, the IRS issued a Final Partnership Administrative Adjustment (FPAA).  The partnership petitioned the Tax Court to challenge the FPAA.

After the IRS filed its answer in Tax Court, the Government filed petitions in U.S. district court to enforce the summonses, together with a declaration from the IRS agent establishing the four Powell elements.  DHLP opposed enforcement on the grounds that the summonses were issued in retaliation for its refusal to extend the statute and to circumvent the Tax Court’s discovery rules.  It requested an evidentiary hearing.  The district court denied the request for an evidentiary hearing and ordered the summons enforced.  On appeal, the Eleventh Circuit reversed, holding that DHLP was entitled to an evidentiary hearing.

The IRS appealed to the Supreme Court, which reversed the Eleventh Circuit and remanded the case for further proceedings to determine whether DHLP was entitled to an evidentiary hearing in light of the standard enunciated by the Court. The Eleventh Circuit sent the case back to the district court to “determine, in light of all of the evidence and the affidavits highlighted by the Supreme Court, whether Appellants pointed to specific facts or circumstances plausibly raising an inference of improper purpose …. [and] whether the improper purposes alleged by Appellants . . . are improper as a matter of law.”

After remand, the district court allowed further briefing but denied DHLP’s request to submit additional evidence. To support their allegations of retaliation, DHLP and the summoned parties stressed the timeline of the IRS’s decision to seek enforcement, which was six months after the summonses were issued, four months after the FPAA was issued, and in the same month that the IRS answered the Tax Court petition. They also pointed out that the FPAA was signed prior to the date the summonses were issued, to support the inference that the summonses were retaliatory.

To support the allegation that the IRS sought enforcement of the summonses to evade more stringent Tax Court discovery rules, DHLP pointed to the fact that a summoned person who complied was examined by the attorney who was representing the IRS in Tax Court and not by the IRS agent.

The district court held that none of the grounds alleged were improper as a matter of the law and that no facts were submitted that gave rise to a plausible inference of improper motive regarding the issuance of the summons. It denied the request for an evidentiary hearing and ordered the summonses enforced.  On appeal, the Eleventh Circuit affirmed the district court.

Although it affirmed the district court’s order denying an evidentiary hearing and enforcing the summonses, it rejected two of the district court’s determinations. First, the Eleventh Circuit concluded that issuing a summons for the sole purpose of retaliation against a taxpayer would be improper as a matter of law.  Second, the Eleventh Circuit concluded issuing a summons in bad faith for the sole purpose of circumventing Tax Court discovery would be an improper purpose as a matter of law.

Addressing the district court’s denial of the request to submit additional evidence, the Eleventh Circuit held that in light of the summary nature of a summons enforcement proceeding, the district court did not abuse its discretion.

The Eleventh Circuit also found that while DHLP made a number of allegations, the evidence it presented did not give rise to any plausible inference of improper motive. First, the submission that the timeline of the issuance of the summonses supports an inference of retaliation by the IRS requires substantial conjecture that is both implausible and unsupported by the record. Further, none of the’ submissions suggest that the summonses were issued in bad faith anticipation of Tax Court proceedings rather than in furtherance of the audit. Thus, DHLP and the summoned parties were not entitled to an evidentiary hearing.

The Eleventh Circuit also pointed out that the validity of a summons is tested at the date of issuance. Thus, neither the subsequent issuance of an FPAA nor the initiation of Tax Court proceedings affected the IRS’s summons authority or the summoned parties legal obligation to comply.

Prior to the Supreme Court’s decision in Clarke, the Eleventh Circuit was alone in holding that a bare allegation of improper purpose was sufficient to entitle a person challenging a summons to an evidentiary hearing. In Gangi, the taxpayer filed a petition to quash summonses. The district court denied the petition and ordered the summonses enforced.  Shortly afterwards, the Supreme Court issued its decision in Clarke.  The taxpayer moved to reopen the case and obtain an evidentiary hearing on the ground that Clarke set a new standard for determining when a taxpayer can get an evidentiary hearing. The district court denied the motion.  The First Circuit affirmed.  In doing so, it held that the Supreme Court’s requirement that a taxpayer must allege “specific facts and circumstances” sufficient to raise a plausible inference of bad faith was virtually identical its standard that a taxpayer needs to allege specific facts and evidence supporting a claim of bad faith in order to obtain an evidentiary hearing.

Based on these two cases and the district court decision in Microsoft, it has become even more difficult after the Supreme Court’s Clarke decision to quash a summons than it was pre-Clarke if the IRS meets the four-part Powell test.  And if the taxpayer petitions to quash a third-party record keeper summons, or intervenes in a proceeding to enforce a summons, the statute of limitations on assessment is suspended until the conclusion of the proceeding and any appeals.  Thus, a taxpayer’s challenging a summons can result in giving the IRS more time to gather information and examine the return.

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 Panama Papers. A massive law firm data breach of otherwise secretive financial information identifying numerous high-ranking government and public officials around the world was recently disclosed online by the International Consortium of Investigative Journalists (ICIJ). Almost forty years of confidential information from 1977 to December 2015 was somehow obtained by an anonymous source from the internal database of Panama-based law firm Mossack Fonseca & Co. and apparently includes approximately 11.46 million files comprising approximately 2.6 terabytes (the equivalent of approximately 600 DVDs) of otherwise confidential financial data.

“John Doe” Explains Reasons for His Actions – and as a Call to Action. “John Doe,” the anonymous individual who leaked the Panama Papers, issued a manifesto on May 6, describing his reasons for exposing what he referred to as a “massive, pervasive corruption” contributing to global income inequality. His manifesto  was published on the website of Suddeutsche Zeitung, the German newspaper to which he made the original disclosures over a year ago.

“[T]housands of prosecutions could stem from the Panama Papers, if only law enforcement could access and evaluate the actual documents,” the manifesto states. “ICIJ and its partner publications have rightly stated that they will not provide them to law enforcement agencies. I, however, would be willing to cooperate with law enforcement to the extent that I am able.”

Searchable Data Base re Panama Papers!  On May 9 the ICIJ released  a searchable database with information on more than 200,000 offshore entities that are part of the Panama Papers investigation. The database includes information about companies, trusts, foundations and funds incorporated in 21 tax havens, from Hong Kong to Nevada in the United States and links to people in more than 200 countries and territories. ICIJ won’t release personal data en masse; the database does not include records of bank accounts and financial transactions, emails and other correspondence, passports and telephone numbers.

US Launches Criminal Inquiry into Several of the 200 US Citizens Named in the Panama Papers! ICIJ confirmed on April 19 that it received an email (published by the Guardian)  from U.S. Attorney Preet Bharara for the Southern District of New York indicating that his office had “opened a criminal investigation regarding matters to which the Panama Papers are relevant.” Further, his office would greatly appreciate the opportunity to speak as soon as possible with any ICIJ employee or representative involved in the Panama Papers Project in order to discuss this matter further.”

The Guardian reports that U.S. Attorney Preet Bharara has “led several crusades against criminal wrongdoing in the financial sector, is already investigating several of the more than 200 US citizens named in the papers.”

ICIJ Pushes Back! ICIJ Director Gerard Ryle responded to prosecutors in Preet Bharara’s office that it would not turn over unpublished data. “We certainly welcome the U.S. Attorney’s Office reviewing all of the information from the Panama Papers series that we have made available to our readers and conducting its own investigation,” said ICIJ Director Gerard Ryle. “However, ICIJ does not intend to play a role in that investigation. Our focus is journalism.”

“ICIJ, and its parent organization the Center for Public Integrity, are media organizations shielded by the First Amendment and other legal protections from becoming an arm of law enforcement,” said ICIJ Director Gerard Ryle.

ICIJ Will NOT Share the Panama Papers with Governments! The long-standing policy of ICIJ, and our parent organization, the Center for Public Integrity, is not to turn over such material. The ICIJ is not an arm of law enforcement and is not an agent of the government. We are an independent reporting organization, served by and serving our members, the global investigative journalism community and the public.

HOWEVER . . . What About Mossack Fonseca? Although the ICIJ may not cooperate with any government inquiries, Mosack Fonseca has indicated that “Due to recent events that have taken place in our office in Panama, we would like to offer the following statement: ‘We have a long history of working proactively with relevant authorities in various jurisdictions when questions are raised and additional information is required, and in many cases we’re the ones who actually initiate that contact when suspicious activities are detected. In this case, we’re the ones against whom a crime has been committed. Our systems having been unlawfully breached by parties external to the firm. As we’ve always done over nearly 40 years of doing business, we stand ready, willing and eager to cooperate with authorities again on their latest investigations to ensure this situation is brought to a just conclusion.’ ”

What About You? Anyone, located anywhere, who is potentially impacted by the public release of the Panama Papers should consider immediately contacting competent, experienced counsel. Although ICIJ reported that the Panama Papers were not purchased, there are some reports this information has been sold to the German tax authorities and may have been offered to tax authorities in the United Kingdom, the United States and elsewhere.

U.S. individuals (citizens or legal residents) should contact competent tax counsel. The failure to declare certain interests in foreign financial accounts and assets can potentially bring about significant civil penalties and, in egregious situations, the possibility of criminal problems. Concern is not limited to those having some possibly remote link to the Panama Papers. Leaks of perceived confidential information from an internal data base of a law firm, trust company, and financial institution or otherwise can occur at anytime, anywhere in the world.

If you may have any potentially undisclosed interest in any foreign financial accounts or assets, get in touch competent, experienced counsel to immediately determine if you should be concerned. The Panama Papers investigation by the ICIJ represents the largest media collaboration ever undertaken. Most individuals (and their professional advisors) will sleep better if they get it right, somehow get into compliance and move on in life. Waiting is simply not a viable option . . .

For additional information, see the articles published at taxlitigator.com

This author has previously argued that under the Tucker Act, 28 USC §1491(a)(1), the Court of Federal Claims has jurisdiction over suits to recover FBAR penalty payments.  The Court of Federal Claims recently held that it has jurisdiction over suits for the refund of FBAR penalties in Norman v. United States, Docket No. 15-872T (April 11, 2016), but suggested that the Government may want to appeal its order.

The facts of the case are simple. Mindy Norman paid an FBAR willful penalty that had been assessed against her and sued for a refund of what she had paid.  The United States moved to dismiss on the ground that, under 28 USC § 1355(a), the district courts have exclusive jurisdiction over suits to recover penalties paid to the Government.  Sec. 1355(a) provides:

The district courts shall have original jurisdiction, exclusive of the courts of the States, of any action or proceeding for the recovery or enforcement of any fine, penalty, or forfeiture, pecuniary or otherwise, incurred under any Act of Congress, except matters within the jurisdiction of the Court of International Trade under section 1582 of this title.

The Government argued under Crocker v. United States, 125 F.3d 1475 (Fed. Cir. 1997), the district courts alone have jurisdiction in cases involving penalties. In Crocker, the plaintiff sued to recover funds held forfeit to the Government and the Court dismissed on the ground that it lacked jurisdiction.  The Court rejected the Government’s argument that Crocker was controlling.  The Court noted that one year after deciding Crocker, the Federal Circuit held that the Court of Federal Claims had jurisdiction over a suit to recover a penalty imposed by a Government agency in San Huan New Materials High Tech, Inc. v. Int’l Trade Comm’n, 161 F.3d 1347 (Fed. Cir. 1998).

The Court recognized that where there is a specific and comprehensive statutory scheme for administrative and judicial review, its Tucker Act jurisdiction is preempted. The Bank Secrecy Act, of which the FBAR penalty is a part, does not contain a scheme for such review.  The Court distinguished the case before it from cases where it lacked jurisdiction since there was a comprehensive scheme, such as forfeiture cases and cases to recover fines imposed pursuant to a criminal conviction.

Although the Court denied the Government’s motion to dismiss, it recognized that “substantial” grounds existed for disagreement over the question of its jurisdiction and indicated that an interlocutory appeal may be appropriate.

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

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