Improved tax compliance requires taxpayers (and those who ought to be taxpayers) to voluntarily come into compliance. When errors are discovered in a filed return, tax practitioners often pave the road to compliance through assurances that the tax-equivalent of water-boarding is not a typical government response to receipt of an amended return. Some assurances are purportedly provided in Treasury Regulation (Treas. Reg.) §1.6664-2(c)(2) relating to the timely filing of a Qualified Amended Return (QAR). Generally, the QAR Regulations are intended to encourage voluntary compliance by permitting taxpayers to avoid accuracy-related penalties if an amended return is filed before the IRS begins an investigation of the taxpayer or the promoter of a transaction in which the taxpayer participated.
Penalties Based on “Underpayment” of Tax. Internal Revenue Code (Code) §§ 6662(a) and (b) provide for a 20% penalty on an “underpayment” resulting from negligence, a “substantial understatement of income tax”, a substantial valuation misstatement, a substantial overstatement of pension liabilities, or a substantial estate or gift tax valuation overstatement.[i] Code § 6663 provides for a 75% civil fraud penalty on the portion of any “underpayment” attributable to fraud. For purposes of Code §§ 6662 and 6663, an “underpayment” is defined in Code § 6664 and the regulations as the difference between the correct amount of tax (determined without regard to payments and credits) and the “amount shown as the tax by the taxpayer on his return” (including amounts previously assessed and credits or refunds received). [ii]
Qualified Amended Return and the Civil Fraud Exception. Under certain situations, a timely filed an amended return may reduce or eliminate accuracy-related penalties. The “amount shown as the tax by the taxpayer on his return” includes an amount shown as additional tax on a QAR, except that such amount is not included if it relates to a fraudulent position on the original return.[iii] Treas. Reg. § 6664-2(c)(3) provides that a QAR is an amended return, or a timely request under Code § 6227 (regarding a request for an administrative adjustment of partnership items), filed after the due date of the original return for the specific tax year (determined with regard to extensions) and before the earliest of—
(A). The date the taxpayer is first contacted by the IRS concerning any examination (including a criminal investigation) with respect to the return. Note that the contact must be by the IRS; a QAR can be filed if the taxpayers has not been contacted by the IRS even though they were contacted by others. Also, the IRS contact must be “with respect to the return.” An initial IRS contact does not always identify the exact reason for the contact. Also, a contact for one tax year should not bar the filing of a QAR for a different tax year;
(B). The date any person is first contacted by the IRS concerning an examination of that person under Code § 6700 (relating to the penalty for promoting abusive tax shelters) for an activity with respect to which the taxpayer claimed any tax benefit on the return directly or indirectly through the entity, plan or arrangement described in Code § 6700(a)(1)(A). Contacts of a promoter under Code § 6700 must be examined to determine whether such promoter was a “person” contacted concerning the taxpayers’ particular transaction. Consistent with its promoter strategy, the Service has initiated a significant number of promoter examinations to obtain (among other objectives) tax shelter client lists. The IRS frequently conducts examinations under Code § 6707 (failure to register penalty) and Code § 6708 (failure to maintain investor list penalty), not under Code § 6700 (promoting abusive tax shelters)[iv];
(C). With respect to a pass-through item[v], the date the pass-through entity[vi] is first contacted by the IRS in connection with an examination of the return to which the pass-through item relates. Practitioners should determine whether any such contacts were “in connection with an examination of the return to which the pass-through item relates.” A contact for one tax year should not bar the filing of a QAR for a different tax year;
(D). The date on which the IRS serves a “John Doe” summons[vii] relating to the tax liability of a person, group, or class that includes the taxpayer (or pass-through entity of which the taxpayer is a partner, shareholder, beneficiary, or holder of a residual interest in a REMIC) with respect to an activity for which the taxpayer directly or indirectly claimed any tax benefit on the return. The foregoing applies to any return claiming a direct or indirect tax benefit from the type of activity that is the subject of the John Doe summons, regardless of whether the summons seeks the production of information for the taxable period covered by such return. This represents a distinction from the requirements relating to individual returns and partnership items for particular tax years; and
(E). The date on which the IRS announces by revenue ruling, revenue procedure, notice, or announcement, to be published in the Internal Revenue Bulletin, a settlement initiative to compromise or waive penalties, in whole or in part, with respect to a “listed transaction”. The foregoing only applies to a taxpayer who participated in the listed transaction and for the tax year(s) in which the taxpayer claimed any direct or indirect tax benefits from the listed transaction. Essentially, once the IRS announces an administrative settlement for a listed transaction, the taxpayer can no longer obtain penalty relief through the filing of a QAR[viii]
A QAR effectively eliminates accuracy-related penalties, by removing amounts shown on the amended return from the penalty calculation. Significantly, even if timely, an amended return does not qualify as a QAR if the tax deficiencies that are corrected in the amended return relate to a fraudulent position on the original return. Why? Taxpayers should be encouraged to voluntarily amend all returns, even returns that for some reason may be deemed to include fraudulent positions, before the occurrence of any of the events set forth in Treas. Reg. § 6664-2(c)(3). Historically, the IRS rarely examined amended returns setting forth a deficiency. The IRS is presently conducting examinations of good faith QARs and is aggressively seeking interviews of the taxpayer, the return preparer and others. What is an appropriate interview response as to the reason a taxpayer decided to amend a return and report an additional tax liability? Patriotism? Sleep therapy? Should we care?
It is not recommended that practitioners routinely allow the IRS to interview the taxpayer. The taxpayer’s representative may represent the taxpayer in an examination and is not required to produce the taxpayer for questioning, unless an administrative summons is served on the taxpayer.[ix] Agents typically seek to interview taxpayers near the commencement of an examination. Unfortunately, at that time the representative typically does not have sufficient information to determine the nature and scope of the examination. IRS examinations are typically focused and occur because of a specific reason. Determining that reason, especially following the good faith filing of a QAR, is the foundation of every representation.
Practitioners can not effectively represent their clients without knowing the nature and scope of any examination. During every examination involving an amended return (and otherwise), consider submission of a Freedom of Information Act (FOIA)[x] request seeking a copy of the IRS administrative file, which would include the internal memoranda and documents prepared by the examining agent or received from third parties. In the event the IRS Disclosure Office might determine that an exemption applies to some or all of the requested information, the FOIA request should include a request that a privilege log be provided in the form of a Vaughn Index.[xi] There may be meaningful surprises lurking within the FOIA response. Also, request information regarding any third parties the IRS may have contacted at any time regarding the examination of the taxpayer.[xii]
Efficient tax administration should seek to encourage, rather than restrict, the filing of QAR in a resource-challenged environment. Taxpayers and practitioners must carefully consider whether submission of a good faith QAR is actually in the best interest of the taxpayer. Code § 6664 and Treas. Reg. § 6664-2 specifically preclude the IRS from asserting the Code § 6662 accuracy-related penalties following the filing of a timely QAR. The informal IRS voluntary disclosure practice mostly precludes a criminal referral to the Department of Justice if a taxpayer has come into compliance in a timely manner.[xiii] Although the IRS has the burden of proving civil fraud by clear and convincing evidence, taxpayers must now be advised that it can be anticipated that the IRS will use the purported QAR as a roadmap in attempting to determine whether to assert the 75% fraud penalty under Code § 6663. Examinations of QARs for the stated or unstated purpose of determining a civil fraud penalty are simply inappropriate and do anything but promote the desired perception of the fairness of tax administration within the United States.
Examinations of amended returns are appropriate if to determine the accuracy of the amended return. However, the current QAR examinations are targeting items reflected on the original return that were changed in the amended return for the sole purpose of determining the possibility of a civil fraud penalty. The government should graciously accept the amended return and payment of the tax and interest deficiencies, determine whether it is substantially accurate, and thank the taxpayer for their contribution to the continued operations of the U.S. government. It is not good policy to shoot the fish in the barrel simply because the others are more difficult to catch.
As a result of RRA ‘98, we should have learned that inappropriately allocated enforcement resources may only serve to foster future non-compliance. If your neighbor filed a good faith QAR and then had to defend a civil fraud examination associated with the originally filed return there is no chance you or others would similarly consider filing a QAR. Those who amend returns in a timely and voluntary manner should be treated fairly and with respect. Burning down the village in an effort to save it is bad policy for future tax compliance.
The complexity found within the Code will long continue to be a significant problem for effective tax administration. We live in a country founded by smugglers and those resisting the exercise of government powers in England. Inappropriately asserting penalties will not improve tax compliance. Penalties only impact those who are actually penalized. Notwithstanding a strong, wide-ranging international enforcement effort and an increasingly significant possibility of detection and potential punishment, enforcement efforts alone will not reduce the Tax Gap. Fairness or at least the perception of fairness in enforcement will have a significant impact on the future of tax compliance in the United States. Compliant taxpayers and supportive practitioners will reduce the Tax Gap.
Taxpayers who are aware of questionable issues within their returns and are not presently under examination should seriously consider filing a QAR to avoid the exposure to the accuracy-related penalties. When representing a taxpayer considering or following submission of a good faith QAR, the representative should proceed with extreme caution. Next time they ask “Who’s the chump?”…make sure it is not while defending the assertion of a civil fraud penalty on behalf of a taxpayer who attempted to come into compliance by timely filing a good faith QAR….
[i]. Under Code §6662(h), this penalty can increase to 40% of an underpayment if a taxpayer’s adjusted basis is grossly misstated (i.e., overstated by 400% or more). In many tax shelter transactions, an asset’s basis can become “enhanced” by more than 400%, and the IRS has been proposing the 40% penalty.
[ii]. Code §6664(a) and Treas. Reg. §§ 1.6664-2(a), (b) and (c).
[iii]. Treas. Reg. Sec. 1.6664-2(c)(2).
[iv]. Bergmann v. Commissioner, T.C. Memo. 2009-289 (February 16, 2009).
[v]. See Treas. Reg. §1.6662–4(f)(5).
[vi]. See Treas. Reg. §1.6662–4(f)(5).
[vii]. See Code § 7609(f). A “John Doe” summons does not identify the specific person with respect to whose liability the summons is issued but must relate to the investigation of a particular person or an ascertainable group.
[viii]. Treas. Reg. § 6664-2(c)(3).
[ix]. Code § 7521(c).
[x]. 5 U.S.C. §552
[xi]. In Vaughn v. Rosen, 484 F.2d 820 (D.C. Cir. 1973), cert. denied, 415 U.S. 977 (1974), the court rejected an agency’s conclusory affidavit stating that requested FOIA documents were subject to exemption. Id. at 828. “A Vaughn Index must: (1) identify each document withheld; (2) state the statutory exemption claimed; and (3) explain how disclosure would damage the interests protected by the claimed exemption.” Citizens Comm’n on Human Rights v. FDA, 45 F.3d 1325, 1326 n.1 (9th Cir. 1995). A Vaughn Index ” ‘permit[s] the court system effectively and efficiently to evaluate the factual nature of disputed information.’ ” John Doe Agency v. John Doe Corp., 493 U.S. 146, 149 n.2 (1989) (quoting Vaughn, 484 F.2d at 826).
[xii]. See Code §7602(c).
[xiii]. See Internal Revenue Manual (IRM) 18.104.22.168 (June 26, 2009) available at irs.gov