Tuesday, November 23, 2010

New Duty Imposed on IRS: Find My Address!

            This office believes a recent Fifth Circuit Court of Appeals opinion may have a broad impact on the policies and procedures of the Internal Revenue Service.  As explained below, the IRS may have a duty to perform due diligence when corresponding with taxpayers through the mail. 

The Fifth Circuit Court of Appeals reversed a Tax Court decision that an individual’s petition challenging the IRS’s denial of innocent spouse relief was untimely because it was filed more than 90 days after the IRS issued its determination.  The Fifth Circuit reinstated the case because it found the IRS was on notice that its determination was sent to the wrong address.  The Fifth Circuit found that the IRS has a duty to search for taxpayer’s correct addresses when sending correspondence.  Because the taxpayer acted within 90 days of receiving the determination at her correct address, the petition was timely.  

            The taxpayer in this case was Pamela R. Terrell who received an assessment for over $660,000 in unpaid taxes.  She filed a Request for Innocent Spouse Relief (Form 8857) on September 20, 2006 with the IRS pursuant to section 6015 of the Internal Revenue Code.  Under Section 6015(e)(1)(A), the Tax Court has jurisdiction over an individual’s request for innocent spouse relief if a petition is filed at any time after the earlier of the date:  (a) the IRS mails a notice of its final determination of relief available to the individual, or (b) 6 months after the date the request is made, and, in either case, not later than the close of the 90th day after the date the IRS mails its notice of final determination.  

After Ms. Terrell submitted the Form 8857, she moved.  The IRS mailed two notices of determination to her old address denying relief and notifying Ms. Terrell she had 30 days to request a review from IRS Appeals.  The US Postal Service returned both notices as undeliverable.  After the IRS did not receive a request to review, it mailed to her old address a Notice of Final Determination on April 6, 2007 denying innocent spouse relief and stating she had 90 days to petition the Tax Court for review.  This notice was also returned to the IRS as undeliverable.  

On April 11, 2007, Terrell filed her 2006 tax return listing her new address.  After it received the returned Notice of Final Determination, the IRS searched its database and found her new address from her filed tax return. The IRS then re-mailed the Notice of Final Determination to her new address.  She then filed a petition with the Tax Court on July 13, 2007.

The Tax Court dismissed the petition because it was not filed within 90 days of the date of the Notice of Final Determination- April 6, 2007.  It held that Terrell had not carried her burden of demonstrating that the Notice was not sent to her “last known address.”  The Court stated Ms. Terrell had to file her petition by July 5, 2007, and because she did not file until July 13, 2007, it lacked jurisdiction to hear her claim.  Ms. Terrell appealed. 

The Fifth Circuit held that, absent a subsequent, clear and concise notification of an address change, the IRS may consider the address on the taxpayer’s most recently filed return as her “last known address.”  But this does not dispense with the requirement that the IRS must use reasonable diligence to determine the taxpayer’s address in light of all relevant circumstances. 

In this case, when the IRS sent its Notice of Final Determination on April 6, 2007, it should have already known that Terrell’s address on file was incorrect because three separate mailings had been returned as undeliverable.  Although the IRS had not received clear and concise notification that her address had changed, the Fifth Circuit found that the IRS could not rely on a lack of notification once it was on notice that its address on file was incorrect. 

Because the IRS failed to take any steps to determine Ms. Terrell’s address after receiving the undeliverable mail and before mailing the Notice, the Fifth Circuit found that the IRS did not exercise reasonable diligence.  It noted the IRS could have done a search through the Department of Motor Vehicles, contacted Ms. Terrell’s employer, searched using her social security number, or undertaken any number of actions that might have revealed her new address.  

The Court went on to hold that because the Notice was not sent to her “last known address,” the Notice was null and void.  The statutory petition period began only when the IRS re-sent the Notice to Ms. Terrell’s correct address on May 14, 2007.  Because Ms. Terrell filed her petition within 90 days of this date, the Tax Court erred in finding itself without jurisdiction to hear the merits. 

To read the complete opinion, see Terrell v. Commissioner of Internal Revenue, ---F.3d ---, 2010 WL 4276021 (5th Cir., November 1, 2010).

Tuesday, November 9, 2010

Economic Substance: A Strict Diagnosis

       The new Health Care and Education Reconciliation Act of 2010 passed this year may have some very unhealthy consequences for unwitting small businesses and individual taxpayers in the form of strict liability tax penalties. With close to 150 million federal income tax filers in the country, taxpayers are given no comfort in the revelation that Congress enacted yet another strict liability penalty for transactions that lack “Economic Substance.” The weight of the Economic Substance penalty is sure to be borne by small businesses and individuals, not the large corporations that can afford the costs of engaging in controversy with the IRS.

       With the enactment of the strict liability penalty, the IRS apparently seems unable to learn from its past mistakes. Section 6707A was enacted to impose strict liability for the failure to disclose and report tax shelters to the IRS. Although the penalties reaching $300,000 per year were intended for large corporations, Section 6707A victimized many small businesses for attempting to do good deeds such as establishing employee benefit plans. Laura Saunders, Small-Business Owners Fret Over Large IRS Fines, The Wall Street Journal, September 19, 2009 at B1.

       As word spread of the damage being caused to small businesses by Section 6707A’s strict liability, senators and congressmen from around the country pleaded with the IRS to cease its imposition. What resulted was a moratorium on the collection of the penalty until Congress created a solution. Letter from Max Baucus, Chairman, Senate Committee on Finance, Charles Grassley, Ranking Member, Senate Committee on Finance, John Lewis, Chairman, House Committee on Ways & Means, and Charles W. Boustany Jr., Ranking Member, House Committee on Ways & Means, to Douglas H. Shulman, Commissioner, Internal Revenue Service (June 12, 2009) (available at the U.S. Senate Committee on Finance website). Even the National Taxpayer Advocate Nina Olson accused the fine of being unconstitutional in her yearly report. Taxpayer Advocate Service, 2008 Annual Report to Congress, vol. 1, p. 421. Congress has not fixed 6707A’s unintended damages but, nonetheless, the IRS marches forward with strict liability penalties for transactions that it unilaterally deems to lack economic substance.

       By way of reference, a strict liability penalty is one for which there exists no reasonable cause defense under Section 6664. Even if the taxpayer had a reasonable basis for the position by relying on a tax professional in good faith and discloses the transaction to the IRS, the penalty still applies. See 26 U.S.C. §6707A(a); Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (to codify “economic substance” at 26 U.S.C. §7701(o)(1)). Thus, the only defense is to convince the IRS that the transaction in fact has economic substance. Good luck.

       In theory, the IRS’s stated policy is against strict liability. Policy Statement 20-1 provides that the “Service will demonstrate the fairness of the tax system to all taxpayers by … providing every taxpayer against whom the Service proposes to assess penalties with a reasonable opportunity to provide evidence that the penalty should not apply; giving full and fair consideration to evidence in favor of not imposing the penalty, even after the Service’s initial consideration supports imposition of a penalty; and determining penalties when a full and fair consideration of the facts and the law support doing so.” Perhaps Congress should reexamine the IRS stated policies when deciding whether to enact strict liability penalties that strip the taxpayer’s right to full and fair consideration. In addition, the penalties are not insignificant.

       The Economic Substance penalty is 20 percent of the taxpayer’s understatement if the transaction is disclosed and 40 percent if the transaction is not disclosed under Section 6662. In addition, the Section 6662A penalty is also stacked on top of it, which is another 20 percent. Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (to be codified at 26 U.S.C. §6662(b)(6)).  

       If a potential 60 percent penalty is not daunting enough, the economic substance doctrine is one of the most fluid and facts-and-circumstances based “test” in the Code and is a judicially created vehicle whose standard varies from circuit to circuit. In general, the Economic Substance Doctrine stands for the idea that anticipated tax benefits from a transaction may be denied, even if the transaction completely complies with the technical aspects of the Internal Revenue Code, if the transaction otherwise does not result in a meaningful change to the taxpayer’s economic position other than a reduction in federal income tax. See Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89 (4th Cir. 1985); see also ACM P’ship v. Comm’r, 157 F.3d 231 (3d. Cir. 1998). The codification does not provide further clarity.

       Section §7701(o) states that “[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.” The only defined term relating to Section 7701(o) is “economic substance doctrine,” which is defined as the “common law doctrine [under which certain tax treatment may be disallowed if the transaction does not have economic substance].” Simply adopting a common law doctrine that varies from circuit to circuit implants ambiguity in the statute.

       Congress also failed to define terms such as “transaction to which the economic substance doctrine is relevant”; “changes”; “meaningful way”; “taxpayer’s economic position”; and “substantial purpose.” The codification provides no further assistance in determining any red flags that may trigger a transaction’s disallowance. In fact, Congress seems to have codified the judicial doctrine and inserted some new, undefined terminology that will keep the litigation lively.

       The issue with the application of the Economic Substance doctrine is that it is usually applied to transactions that occurred many years ago, and then the IRS makes a decision to aggressively attack the transaction. One such transaction of late would be stock loan transactions consisting of non-recourse loans individuals and businesses took on a stock portfolio. Many taxpayers’ advisors agreed with the loan treatment under the Internal Revenue Code. Even though law existed to support the loan treatment and the taxpayer did actually transfer stock to the lending entity, the courts agreed with the IRS that the transactions lacked economic substance. Nagy v. United States, Slip Copy, 2009 WL 5194996 (Dec. 22, 2009). These taxpayers would be subject to a 60 percent penalty because the loan proceeds would not have been disclosed on the return, and the return preparer may be subject to preparer penalties.

       In the future, what could keep the IRS from taking the position that the discounts related to the transfer of Family Limited Partnership interests funded with stock, bonds and other liquid assets lack economic substance?  I am sure that every tax practitioner could think of a client who engaged in a transaction in the past that may lack economic substance.

        By codifying this ambiguous, strict liability economic substance penalty, Congress is undoubtedly placing an insurmountable burden on small businesses and individuals. The IRS will not consider any documentation, CPA’s advice, tax opinions or other facts and circumstances that could support a reasonable cause defense before imposing this penalty. There is no defense to this penalty on the administrative level unless you can convince the IRS that the transaction does have economic substance. Should the IRS remain unconvinced, the only option left is to litigate the economic substance issue, which is a fact intensive and expensive process, especially when facing the litigation resources of the United States. Jasper L. Cummings, Jr., Making Litigation Complex, Tax Notes, June 28, 2010.  

       Congress seems intent on implementing harsher and harsher penalties to raise revenue at the expense of small businesses and individual taxpayers.

       Check out this article on the web, along with other publications from South Carolina Tax Reports Fall 2010.