How to Audit Proof A Tax Return

An article has appeared in Forbes on "Ten Ways to Audit Proof Your Tax Return". The articles advises one way is not to file electronically.

Taxpayer Cannot Rely on Google to Prove Reasonable Cause

Good-faith reliance on advice from an independent, competent professional as to the tax treatment of an item may meet the reasonable cause requirement for abatement of penalties. The Tax Court in Woodard v. Commissioner did not accept Mr. Woodard's argument that his research on the Internet using the Google search engine provided him with reasonable cause for the position he took when filing his 2004 tax return.

Tax Court Rules Cancellation of Debt Not Income

In the recent case of McCormick v Commissioner, the Tax Court held for the IRS to determine the amount of cancellation of indebtedness income properly attributed to the taxpayers, the Tax Court must determine the amount of the CitiFinancial and Chase debt that was definite and liquidated.


In this case, the Tax Court found that the IRS could not rely on the Forms 1099-C submitted by CitiFinancial and Chase as evidence of the amount of debt that was definite and liquidated. Section 6201(d) provides that in any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return and has fully cooperated, the IRS shall have the burden of producing reasonable and probative information concerning the deficiency in addition to the information return. In this case the taxpyaers asserted reasonable disputes with respect to the amounts reported by CitiFinancial and Chase. The IRSfailed to produce reasonable and probative information independent of the third-party information returns. Thus, the Tax Court held for the taxpayers.

Who Is Being Convicted of Tax Crimes

For those of you who may have an interest in who is being prosecuted for tax crimes here is a link from TIGTA with some interesting information.

Commissioner's Advice to Corporate Directors

IRS Commissioner Doug Shulman addressed the National Associaton of Corporate Directors Governance Conference and gave them certain advice. You can see the Commissioner's remarks here.

Annual Report to Congress on the Whistleblower Statute

The Department of the Treasury has published its annual report on the Whistleblower statute. The report can be found here.

Whistleblower Guidance from the IRS

The IRS has published guidance to provide procedures for processing and examining referrals received from the Whistleblower’s Office (WBO) regarding IRC 7623(b). Due to a change to IRC 7623, there are now two types of Whistleblower informant claim cases:

IRC 7623(a) discretionary award cases, “A” cases, and
IRC 7623(b) mandatory award cases, “B” cases.

The guidance can be found here.

IRS Statistics of Income

The IRS has published it 2009 Statistics of Income (SOI) Bulletin. This publication has a wide range of tables, articles, and data that describe and measure elements of the U.S. tax system. This publication is available here.

Tax Court Rejects Everyone is Doing It As Reasonable Cause Penalty Defense In Son-of-Boss case

In 3k Investment Partners v. Commissioner; 133 T.C. No. 6 (9/3/09), the taxpayer, an "investor" in a Daugerdas / Jenkens deal, sought to assert this defense to a penalty and, in support of the defense, sought discovery from the IRS of all the Son-of-Boss opinions in its bowels or wherever. In his typical straight-forward fashion, Judge Thornton opined:

Petitioner alleges and respondent does not dispute that in connection with many Son-of-BOSS transactions, one or more law firms or accounting firms wrote opinion letters to the investors supporting the claimed tax treatment. Petitioner alleges, and respondent does not dispute, that respondent has a large number of these tax opinion letters. Petitioner contends: "The availability of a large number of law firms and accounting firms issuing tax opinion letters determining that so-called 'Son of Boss' transactions * * * would produce the tax results as reported by Petitioner on its subject tax return would bolster Petitioner's position that it had reasonable cause and that Petitioner acted in good faith." Similarly, at the hearing petitioner's counsel argued that "based upon the general consensus of national law firms across the country that were issuing tax opinion letters that were taking the same position as the Petitioner in my case was taking, I wanted to show that reasonable cause does exist to take the position that we took on the tax return."

Petitioner's argument appears to be a variant of the refrain, familiar to parents of teenagers, that "Everyone's doing it." For the same reason that this does not constitute reasonable cause for teenagers, it would not constitute reasonable cause for petitioner. Petitioner must establish the reasonableness of its position on the basis of the facts and merits of its own case. n6 See Avedisian v. Commissioner, supra ("each individual must rest on the validity of his own position under the applicable taxing provisions, independently of others"). The legal analysis, conclusions, and recommendations that some tax advisers may have given other taxpayers are irrelevant to the reasonableness of the positions the partnership took on its return. See P.T. & L. Constr. Co. v. Commissioner, 63 T.C. 404, 414 (1974).

n6 We also reject any suggestion that the requested information, which appears to involve only a small subset of tax advisers, shows any "general consensus" of tax advisers regarding Son-of-BOSS transactions.

With a follow-up punch, the Court held that the opinions were not relevant or likely to lead to the discover of admissible evidence, as required by the discovery rules.

Finally, the court held that the opinions sought were in any event tax return information prohibited from disclosure under § 6103. The court held that redaction of taxpayer identifying information did not make it any the less tax return information subject to the strictures of § 6103. Reliance on cases dealing with § 6110 is misplaced because that code section specifically lifts the veil if § 6103, with appropriate redactions, for the types of IRS general legal interpretation documents that Congress said should be in the public domain once shorn, by redaction, of taxpayer identification information.

IRS Expands Use of Reported Interest on Mortgage Payments

Banks and other mortgage lenders provide annual statements to the borrowers and the IRS of the mortgage interest they paid. The IRS can use the data to confirm the amount of an interest deduction claimed by the borrower. The data can also be used to identify potential nonfilers. The Wall Street Journal reports here that the IRS is now poised to use the data to identify discrepancies between the reported interest paid and a taxpayer's income.

Are Tax Collectors Your Friends?

The Wall Street Journal has an article this morning here on tax collectors' use of various "friend" sites to gather information to assist in tax collection. The anecdotal instances discussed involved state tax collection, but "An Internal Revenue Service spokesman declined to say whether its agents use social-networking sites to pursue delinquent taxes or assist audits."

Commonly Asked Questions of Work Status

The IRS has issued Notice 989 , "Commonly Asked Questions When IRS Determines Your Work Status is Employee". Interesting questions that relate to employee and independent contractor issues. You can see the notice here.

Legal Advice Issued to Program Managers

The IRS has issued a list of legal advice, signed by attorneys in the National Office of the Office of Chief Counsel and issued to Internal Revenue Service personnel who are national program executives and managers. They are issued to assist IRS personnel in administering their programs by providing authoritative legal opinions on certain matters, such as industry-wide issues. See the list here.

Textron En Banc Decision -- Government Wins

The First Circuit has held that tax accrual workpapers disclosed to the outside accountants preparing the audited financial statements are not subject to the work product privilege. The decision, rendered en banc in a 3 - 2 split by the full court, reverses the prior panel's decision (a 2 -1 split). The opinion can be viewed here.

Tax talking heads had proclaimed loudly and often about this case for a long time and will now have something new to fulminate about. Much of the practicing bar will see the decision as taking from them some of the magic they offer clients for high fees and thus will complain loudly. Such magic and the fees it produces, after all, is as much their entitlement as, say, welfare for the indigent.

I think this quote from the majority en banc decision pretty much sums it up:

Textron apparently thinks it is "unfair" for the government to have access to its spreadsheets, but tax collection is not a game. Underpaying taxes threatens the essential public interest in revenue collection. If a blueprint to Textron's possible improper deductions can be found in Textron's files, it is properly available to the government unless privileged.

And, of course, the court held these documents were not privileged.

It is Not My Income - Is That Form 1099 Correct

The IRS matches third-party information reports with items reported on taxpayer’s tax returns. Typically this involves the IRS sending a CP2000 letter to a taxpayer advising that a W-2 or Form 1099 was not reported on the taxpayer’s tax return. We are now seeing many cases where in particularly Forms 1099 are being issued to taxpayers who did not work for the company shown on the Form 1099.


The United States Tax Court has recently addressed this issue in Martin v. Commissioner, T.C. Summary Opinion 2009-121, August 4, 2009. Pursuant to Section 7463(b), this decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.


On June 21, 1999, Steed A. Martin, Taxpayer, purchased a 1988 Toyota 4-Runner automobile. He financed the automobile through Heritage Community Credit Union (Heritage) by entering into a "Simple Interest Motor Vehicle Contract and Security Agreement" indicating that the price was $12,360.48, of which $8,872.34 was being financed with Heritage. Taxpayer stopped making payments on his loan with Heritage during 2001, and Heritage "charged-off" and "canceled" the $6,704.92 outstanding principal of Taxpayer’s loan.


Taxpayer was notified by Heritage in 2002 that his automobile was going to be repossessed, and soon thereafter a person came to his residence to repossess the automobile. Taxpayer turned over the keys for the automobile, and it was placed on a truck and transported from the vicinity of Taxpayer’s residence. Taxpayer did not subsequently see or have access to the automobile. During 2005 Heritage issued a Form 1099-C, Cancellation of Debt, to Taxpayer reflecting the cancellation of Taxpayer’s debt of $6,704.92. That information was also communicated to the Internal Revenue Service. Taxpayers did not report the $6,704.92 in income for 2005, and Respondent made an adjustment for increased income due to cancellation of indebtedness. The records of Heritage reflect that Taxpayer’s automobile was assigned for repossession.


At some point Taxpayer stopped making payments on the loan and was advised that the automobile would be repossessed. The automobile, which Taxpayer believed had a value equal to the outstanding principal on the loan, was taken from Taxpayer during 2002. Heritage had charged off the loan in 2001, but sent Taxpayer a Form 1099-C in 2005 reflecting cancellation of indebtedness income in the amount of the outstanding balance of the loan.


The only evidence in the record that supports Rrespondent’s determination of cancellation of indebtedness income is the Form 1099-C Heritage issued.


Section 6201(d) provides that in any court proceeding, where a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return (such as a Form 1099) filed by a third party, the Commissioner may have the burden of producing reasonable and probative information concerning the deficiency in addition to information on the information return.


Taxpayer disputed the correctness of the information return. Taxpayer testified that the automobile was repossessed by Heritage at a time when it had a value equal to the outstanding debt. That would mean that Heritage had received an asset with sufficient value to substantially reduce or eliminate the outstanding debt and would call in question whether the Form 1099-C was correct.


The Tax Court found that Taxpayer effectively called into question the validity of the Form 1099-C, and Commissioner did not placed in evidence any information that would rebut Taxpayer’s testimony, which is also supported by documentary evidence in the record. Therefore, the Tax Court found in accord with Section 6201(d), the Commissioner is not able to rely solely upon the Form 1099-C in support of the determination that Taxpayer has cancellation of indebtedness income.


Generally, a taxpayer must include income from the discharge of indebtedness. See Section 61(a)(12); sec. 1.61-12(a). Where indebtedness is being discharged, the resulting income would equal the difference between the amount due on the obligation and the amount paid, if any, for the discharge. See, e.g., Cronin v. Commissioner, T.C. Memo. 1999-22. This principle derives from the seminal case of United States v. Kirby Lumber Co., 284 U.S. 1 (1931), where the Supreme Court held that a taxpayer may realize income by paying an obligation at less than its face value.


Accordingly, income from cancellation of indebtedness would not include the entire amount of the outstanding debt if the creditor received payment or assets of value from the debtor. A cancellation of indebtedness generally produces income to the debtor equal to the difference between the amount due on the obligation and the amount paid for the discharge. If, however, no consideration is paid to or received by the creditor for the discharge, then the entire amount of the debt is considered income to the debtor. Section 61(a)(12).


The Tax Court accepted Taxpayer’s testimony on the value of the automobile, as an owner is presumed to know or have a good sense of the value of his property. There is no evidence in the record that is contrary to Taxpayer’s testimony. In addition, Taxpayer purchased the automobile during 1999 for $12,360.48. Two years later, when it was repossessed, a value of $6,704 would appear to be reasonable (one-half of its original value).


The Tax Court found under these circumstances, that the Form 1099-C has been refuted and discredited. Taxpayer showed that the debt was satisfied, and the Tax Court accordingly held that Taxpayer was not required to report cancellation of indebtedness income for 2005.


If there is any doubt that a taxpayer owes taxes as the result of an errouneous Form W-2 or Form1099, the taxpayershould challenge the IRS.

IRS Alerts Public to New Identity Theft Scams

The Internal Revenue Service reminds consumers to avoid identity theft scams that use the IRS name, logo or Web site in an attempt to convince taxpayers that the scam is a genuine communication from the IRS. Scammers may use other federal agency names, such as the U.S. Department of the Treasury. For more information click here.

Should Cancellation of Credit Card Debt Be Cancellation of Debt Income?

Should the cancellation of credit debt be treated as cancellation of debt income. For an article on this issue click here.

House Committee Approves Health Bill

The House Committee on Ways and Means approves America’s Affordable Health Choices Act. For more click. See the Bill.

Taxpayers Held Liable for the Accuracy-Related Penalty

The Court of Appeals for the Fifth Circuit has held a couple liable for the accuracy-related penalty under Section 6662 of the Internal Revenue Code. In Prudhomme v. Commissioner, the Court found that the Prudhommes could not avoid the penalty because they did not act in “good faith” and with “reasonable cause,” as required by Section 6664(c)(1). Generally, good faith and reasonable cause may exist when relying on an accountant to prepare a tax return. The Tax Court held that the Prudhommes did not meet this standard because they provided their accountants with insufficient information to prepare their tax return accurately and did not make a reasonable effort to assess their proper tax liability. The Fifth Circuit affirmed the decision of the Tax Court.

The Tax Court found the Prudhommes’ reliance on their accountant was not reasonable, because they did not fully inform the accountant of all facets of their finances.

If a taxpayer relies on an expert, all facts and circumstances regarding whether that reliance was reasonable and in good faith, including the taxpayer’s education, sophistication and business experience, must be taken into account.

IRS Issues Highlights of 2008 Tax Changes

The IRS has issued Publication 553, Highlights of 2008 Tax Changes. This publication highlights major tax law changes that take effect in 2008 and 2009. The seven chapters cover the following: (1) Tax Changes for Individuals; (2) Tax Changes for Businesses; (3) IRAs and Other Retirement Plans; (4) Estate and Gift Taxes; (5) Excise Taxes: (6) Foreign Issues; and (7) How To Get Tax Help.

Tax Court Again Disallows Unsubstantiated Expenses

In Kyne v. Commissioner, T.C. Summ. Op. 2009-98 (June 25, 2009), the Tax Court has ruled in favor of the IRS disallowing unsubstantiated expenses. We are seeing more and more cases from audit to appeals to the courts where taxpayers are losing, if expenses taken as a deduction cannot be substantiated. It is a good time to remind clients to improve record keeping and make sure documentation exists to prove deductions.

National Taxpayer Advocate Submits Mid-Year Report to Congress

National Taxpayer Advocate Nina E. Olson today delivered a report to Congress that identifies the priority issues the Office of the Taxpayer Advocate will address in the coming fiscal year. Among the key areas of focus will be working with the IRS to improve taxpayer services, enhancing IRS oversight of federal tax return preparers, improving the accessibility of the offer in compromise program, and working with the IRS to improve its ability to administer refundable tax credits effectively. See News Release IR-2009-63.

Among the key areas of focus for the Taxpayer Advocate will be working with the IRS (1) to improve taxpayer services, (2) enhancing IRS oversight of federal tax return preparers, (3) improving the accessibility of the offer in compromise program, and (4) working with the IRS to improve its ability to administer refundable tax credits effectively.

TIGTA Issues Trends in IRS Compliance Activities

The Treasury Inspector for Tax Administration (TIGTA) has issued a report that presents statistical information and trend analyses of the data for Collection and Examination activities of the IRS. Click here to review the full report.

The Will of Michael Jackson

So much hype about Michael Jackson. TaxProf Blog has published a copy of the will. See the will here.

Court declares Son of Boss Illegitimate

In Clearmeadow Investments LLC v. United States, ___ Fed. Cl. ___ (2009), decided 6/19/2007 [I will link to the decision when posted on website], the Court of Federal Claims (Judge Allegra) uses the parent-son metaphor to call a Son-of-Boss transaction the illegitimate child of an illegitimate father, although some might question the timing and use of the metaphor immediately before Father's Day (today). The opinion is long and very good. But, you'll get the key points from the following introduction from the decision (although I question Judge Allegra's inference that Son-of-Boss transactions present a sexy legal issue):

"When pondering sexy legal issues," one commentator recently noted, "it is doubtful that tax law crosses the minds of many." Yet, once in a while (alright, a long while), a tax dispute bursts into the mainstream. Take, for example, the legal controversy swirling around the so-called "Son of BOSS" transactions -- the quoted phrase being short for "sales option bond strategy," the legatee of the "bond and option sales" or "BOSS" strategy. While this case involves a Son of BOSS transaction, perhaps it is best to start by examining the earlier BOSS strategy -- "qualis pater talis filius," as the Romans used to say.

The BOSS strategy employed a series of transactions seemingly to increase the tax basis of an asset that would eventually be sold, supposedly at a loss. In its simplest form, it worked like this:

• Two companies are set up by a promoter -- Company A and Company B.
• Company A buys a bond with a market value of $50.
• Taxpayer X buys the bond from Company A for $1,000,050. However, Taxpayer X pays only $50 in cash, with the remainder of the purchase price taking the form of a promissory note payable by Taxpayer X to Company A for $1 million due in twenty years. Taxpayer X claims that his adjusted tax basis in the bond is $1,000,050.
• Taxpayer X then sells the bond to Company B for $50. Because Taxpayer X claims a basis in the bond of $1,000,050 and sells it for only $50, he argues that he has incurred a $1 million loss, which he promptly deducts to offset income that would otherwise be subject to tax.

In the Community Renewal Tax Relief Act of 2000 (the 2000 Renewal Act), Pub. L. No. 106554, § 309, 114 Stat. 2763A-587 to 638, Congress devitalized this strategy by modifying key provisions in the Internal Revenue Code (the Code) to prevent, in absolute terms, the increase in basis essential to generating the large loss deductions. n2 Even before the passage of the Act, however, tax planners had begun to direct their creative energies elsewhere, focusing, in particular, on the partnership provisions of the Code as a potential new engine for producing large tax losses.

Their efforts eventually led to the christening of the "Son of BOSS" strategy. Under this brainchild, the taxpayer typically would form a partnership and contribute to it an option he had purchased. The partnership would contemporaneously assume a second option that represented a liability of the taxpayer. The taxpayer would then claim that his basis in the partnership was increased by the cost of the purchased option, but not reduced by the partnership's assumption of the obligation. As in the BOSS transactions, this ultimately led the taxpayer to claim a sizable loss deduction when he sold either the partnership interest itself, or some asset whose tax basis was derivable therefrom. Though clothed in the partnership provisions of the Code, the Son of BOSS strategy shared a common aspiration with its forebear -- to generate large tax loss deductions with little in the way of capital outlays. And the Internal Revenue Service (the Service) reacted to the "son" much as it had to the "father" -- disallowing the claimed loss deductions and assessing a range of penalties.

That, in a nutshell, is what happened in the case sub judice, which is a partnership proceeding involving a Son of BOSS transaction, pending before the court on the parties' cross-motions for summary judgment. After carefully considering the parties' briefs and oral argument, the court grants defendant's motion for summary judgment and denies plaintiff's cross-motion for summary judgment. As will be described below, the court finds, as a matter of law, that the Son of BOSS transactions that led to the tax losses at issue did not, under the Code, generate the losses claimed and, at all events, lacked economic substance. It also holds that, aside from any defenses the individual partners may raise in later proceedings, the Service properly asserted the gross valuation overstatement penalty of section 6662 of the Code.

My only comment relates to Judge Allegra's "simplest form" illustration of the concept. I ask the readers to re-read the simplest form illustration. Judge Allegra describes nothing more or less than the exceedingly hokey -- and perhaps even fraudulent -- tax shelters of the late 1970s and early 1980s where all sorts of properties -- from paintings to plastic recylcing shelters -- were overvalued, purchased for the hyper-inflated values (usually with nonrecourse financing or some economic equivalent), and then purchaser-taxpayer or a flow-through entity claimed purchase price basis supported improper tax deductions. For an example of this type of earlier shelter, see Addington v. Commissioner, 205 F.3d 54 (2d. Cir. 2000).

Partner Level Adjustments without a Partnership TEFRA audit

In Muruelo v. Commissioner, 132 T.C. No. 18, here, the Court held that partnership affected items which are more properly determined at the partner level could be the subject of a notice of deficiency to the partner even without a TEFRA audit proceeding at the partnership level. The affected items that could be determined at the partnership level were (1) a partner's at risk with respect to the partnership, (2) the 704(d) limitation on partnership loss allocations to the partner's basis in his or her partnership interest, and (3) the accuracy related penalty. (Note that some courts hold that the good faith defense to the accuracy related penalty may be asserted at the partnership level in some cases, but that does not gainsay its application normally at the partner level).

The general progress of partnership tax contests starts with the partnership level audit and is thereafter followed with the partner level adjustments and further proceedings, if any, as to matters more properly determined at the partnership level. This case reminds practitioners that step 1 -- the partnership audit -- does not have to occur first.

The case is a cryptic as to why the IRS started with the partner level notice of deficiency. The tiered partnership whose activity was at issue had invested in a tax shelter that was a subject of a grand jury proceeding. Hence, I speculate, the IRS may not have wanted to move civilly via a partnership TEFRA proceeding. Alternatively, the IRS may have just recently learned of this particular shelter investment. It is clear that that partnership's and the partner's normal statutes of limitations absent fraud were about to expire when the IRS issued the notice of deficiency to the taxpayer-partner. The expiration of the partner's statute of limitation is irrelevant provided the IRS timely starts the partnership TEFRA proceeding, but the IRS had not done that here. Hence, it looks like the IRS was not certain that it would be able to prove fraud at the partnership level so as to extend the partnership level statute of limitations (thus automatically extending the partner level period for flow-through adjustments) and, rather than putting the bottom-line tax at the partner level at risk, it issued a notice of deficiency to the partner to use overlapping tools to deny the loss directly at the partner level.

Two Cases on Tax Shelter Exception to FATP-7525 Privilege

In Valero Energy Corp. v. United States, ___ F.3d ___ (7th Cir. 2009), available here, the Seventh Circuit blew the hopes of some taxpayers and professions that the tax shelter exception to the Federally Authorized Tax Practitioner ("FATP") privilege would apply only to mass-marketed, so called cookie-cutter tax shelters. Section 7525 confers the equivalent of attorney-client communications privilege for communications between a client and an FATP. SEction 7525(b)(2) excepts from the privilege "in connection with the promotion * * * in any tax shelter (as defined in section 6662(d)(2)(C)(ii))." Valero argued that the word "promotion" -- interpreted both literally and with recourse to the legislative history -- should confine the application of the exception to widely promoted tax shelters and not to one-on-one tax advice for a specific client for a special situtation. The Seventh Circuit disagreed. The opinion is straight-forward, well-written and short. I feel that would disserve the reader by trying to summarize the opinion beyond its bottom-line holding.

I will provide a short quote where the Court gives useful background and analysis for the FATP privilege that should serve as a guide for practitioners desiring to protect client communications:

We begin by noting that there is no general accountant-client privilege. United States v. Frederick, 182 F.3d 496, 500 (7th Cir. 1999). In 1998, Congress provided a limited shield of confidentiality between a federally authorized tax practitioner and her client. This privilege is no broader than the existing attorney-client privilege. It merely extends the veil of confidentiality to federally authorized tax practitioners who have long been able to practice before the IRS, see 5 U.S.C. § 500(c); 31 C.F.R. § 10.3, to the same extent communications would be privileged if they were between a taxpayer and an attorney. 26 U.S.C. § 7525(a)(1) (privilege does not apply in criminal proceedings). Nothing in the statute "suggests that these nonlawyer practitioners are entitled to privilege when they are doing other than lawyers' work. . . ." Frederick, 182 F.3d at 502; see also United States v. BDO Seidman, 337 F.3d 802, 810 (7th Cir. 2003) (BDO II). Accounting advice, even if given by an attorney, is not privileged.

This means that the success of a claim of privilege depends on whether the advice given was general accounting advice or legal advice. Admittedly, the line between a lawyer's work and that of an accountant can be blurry, especially when it involves a large corporation like Valero seeking advice from a broad-based accounting firm like Arthur Anderson. But we have set some guideposts to help distinguish between the two. For starters, the preparation of tax returns is an accounting, not a legal service, therefore information transmitted so that it might be used on a tax return is not privileged. In re Grand Jury Proceedings, 220 F.3d 568, 571 (7th Cir. 2000); Frederick, 182 F.3d at 500-01; United States v. Lawless, 709 F.2d 485, 487 (7th Cir. 1983). On the other side of the spectrum, communications about legal questions raised in litigation (or in anticipation of litigation) are privileged. In re Grand Jury Proceedings, 220 F.3d at 571; Frederick, 182 F.3d at 502. Of course, there is a grey area between these two extremes, but to the extent documents are used for both preparing tax returns and litigation, they are not protected from the government's grasp. In re Grand Jury Proceedings, 220 F.3d at 571; Frederick, 182 F.3d at 501. This circumscribed reading of the tax practitioner-client privilege is in sync with our general take on privileges, which we construe narrowly because they are in derogation of the search for truth. United States v. Evans, 113 F.3d 1457, 1461 (7th Cir. 1997).

I should also note to balance this discussion that the Tax Court recently gave a relatively taxpayer friendly application of the tax shelter exception to the FATP. In Countryside Limited Partnership v. Commissioner, 132 T.C. No. 17 (2009), here, the Tax Court held that, once the taxpayer establishes that the FATP privilege is applicable, the Government then bears the burden of showing that an exception -- there the tax shelter exception -- makes the privilege inapplicable. There, the long-time tax advisor merely responded to inquiries from the taxpayer and gave advice. The Tax Court held that the IRS had not established that these actions were a "promotion" of a tax shelter, reasoning:

Respondent has focused on Mr. Egan as "promoting the Countryside transactions." We read the conferees' statements quoted above as distinguishing tax advice given in the course of a relationship such as that between Mr. Egan and the Winn organization from the "promotion" of a client's participation in a tax shelter. There may be a point at which an FATP's actions cross the line, and will no longer be encompassed within the routine relationship between an FATP and his client and will amount to tax shelter promotion. Respondent has, however, failed to show us that Mr. Egan's communications with the Winn organization with respect to the partnership redemptions and associated transactions before us crossed that line. He rendered advice when asked for it; he counseled within his field of expertise; his tenure as an adviser to the Winn organization was long; and he retained no stake in his advice beyond his employer's right to bill hourly for his time. Respondent has failed to show us that he crossed the line from trusted adviser to promoter.

Relief from Joint and Several Liability - Two Year Rule Does Not Apply to Sec. 6015(f)

IRM 25.15.3.4.4(1) has added a note before the other note: Effective 6-8-09, until further notice, the Service will not disallow claims as being untimely under IRC § 6015(f). The Request for Innocent Spouse Relief will be reviewed based on the other factors under IRC § 6015(f). The Request for Innocent Spouse Relief under IRC § 6015(b) and IRC § 6015(c) will continue to be disallowed if not timely filed. This follows the recent Tax Court Case, Lantz V. Commissioner, 132 T.C. No. 8 (April 7, 2009). The Tax Court has ruled that the two year rule does not apply to IRC § 6015(f).

IRS Launches Tax Return Preparer Review

IRS Commissioner Doug Shulman has announced that by the end of 2009, he will propose a comprehensive set of recommendations to help the Internal Revenue Service better leverage the tax return preparer community with the twin goals of increasing taxpayer compliance and ensuring uniform and high ethical standards of conduct for tax preparers. For more see News Release IR-2009-57.

Interim Guidance On Return Preparer Penalty Procedures For Estate & Gift Preparer Penalty Cases

The IRS has issued Interim Guidance On Return Preparer Penalty Procedures For Estate & Gift Preparer Penalty Cases. The guidance advises that during every examination, estate tax attorneys should determine if further consideration of return preparer penalties is necessary. This determination will be made based on oral testimony and/or written evidence during the examination process. For more detailed information see SBSE-04-0509-009.

Materials on Offshore Account and Entity Voluntary Disclosure (Including FBARs)

Readers are reminded that the Voluntary Disclosure program for offshore accounts and entities must be implemented by September 23, 2009. Because of the time it takes to receive account documents and other information from offshore sources, persons desiring to enter the program must move promptly. For further information on the initiative, see the blogs on our sister site, the Federal Tax Crimes Blog here. This link will automatically update for blog items added in the future.

Persons having the required signatory or other authority over an offshore account anytime in 2008 must file the 2008 FBAR by 6/30/2009. For further information on this filing see here.

Tax Court Training Video

The Tax Prof Blog has posted here the links to the Tax Court's new training video series. The series is particularly useful for taxpayers representing themselves in the Tax Court (referred to in the jargon as pro se taxpayers), but some tax professionals who do not practice regularly in the Tax Court may also find the videos useful.

Xilinx & Section 482's Arm's Length Standard

On May 27, 2009, The Court of Appeals for the Ninth Circuit rendered the long-awaited opinion in Xilinx, Inc. v. Commissioner, ___ F.3d ___ (9th Cir. 2009). The Court concluded that the "arm's length" test for the application of § 482 is not the ubiquitous standard that most of us thought it was. I think the court was wrong. Let me explain.

I, like most who have played around in this field, think that the arm's length standard was always the ultimate guide and that any specific rules as to methodology in the 482 regulations were simply ways of administering the arm's length standard in specific contexts. After all, the Regulations specifically state that "the standard to be applied in every case" is the arm's length standard. § 1.482-1(a)(b)(1). Yet, the Xilinx Court held that, although the arm's length standard may be the general benchmark for valid 482 adjustments, the IRS can by regulation change that benchmark even if it achieves a demonstrably non-arm's length result.

I do not doubt that the IRS has a great deal of authority to promulgate regulations that, under Chevron (not mentioned by the majority opinion but clearly in the background), will be the law so long as reasonable even when not commanded by the plain meaning of the statute being interpreted. So, you might ask, does the statute as interpreted not require the arm's length standard? The statute itself does no mention the arm's length standard. The statute merely says that the IRS may make the adjustment when it is "necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." Evasion of taxes is a term of art in the tax area, generally meaning the willful intent to violate a known legal duty applicable in order to convict under Section 7201. But, evasion as a separate concept has no discernible meaning in § 482, so the courts have focused on the "clearly reflect income" standard in the text. What does clearly reflect income mean? It too is not self defining in this context, but the overwhelming body of law, including the IRS's own regulations, says it means the income that would be reflected in a transaction between parties dealing at arm's length -- the arm's length standard.

You might ask about the legislative history. It is sparse and unhelpful given that it was enacted in 1928 with early revenue statute predicates, a time when Congress was less wordy. I cover the sparse legislative history in my earlier article John A. Townsend, Reconciling Section 482 and the Nonrecognition Provisions, 50 Tax Lawyer 701, 702-705 (1997). Until Xilinx, the arm's length standard has become the standard for resolving transfer pricing issues where it really matters -- in cross-border contexts where our treaties uniformly adopt some variation of language that is interpreted to mean that the arm's length standard applies. (The Court discusses the treaty context, and I have discussed in more detail in John A. Townsend, Tax Treaty Interpretation, 55 Tax Law. 219 (2001).)

Readers will forgive me if I digress for a moment on the arm's length standard. Back in the old (real old) days while I was with DOJ Tax Appellate I briefed and argued Liberty Loan Corp. v. United States, 498 F.2d 225 (8th Cir. 1973). In that case, the taxpayer was a parent corporation with numerous consumer finance subsidiaries. The parent-taxpayer borrowed at 5.55% and re-lent to its subsidiaries much, if not most, of the cash the subsidiaries needed to lend in their consumer finance businesses. Each of the loans to the subsidiaries was reflected in separate lending documents. The taxpayer lent its profitable subsidiaries at a 5.75% rate and its unprofitable subsidiaries at a 0% rate. These two rate structures produced overall interest income to the parent-taxpayer at its cost of borrowing rate -- 5.5%, so the parent-taxpayer had neither income or loss at its level. The parties stipulated that, had the subsidiaries borrowed from a third party unrelated lender, they would each have paid a rate exceeding 5.75%. Exercising its authority under § 482 to adjust the 0% interest rate loans to 5% (a safe harbor rate) without adjusting the 5.75% interest rate loans. The 5.75% interest rate loans were not adjusted because they were within the "safe harbor" provided in the regulations. The parent-taxpayer objected, paid the tax and sued for refund. the parent-taxpayer won at the trial level. The district court treated the subsidiaries as a group borrower who, as a group but not as individual corporations, could borrow at the 5.5% rate, thus in effect making the transaction between the parent-taxpayer and the "group" at arm's length. The Government appealed to the Eight Circuit. The Government argued, that the no-interest loans could be adjusted to the safe harbor rate because that was an adjustment toward the actual arm's length rate (exceeding 5.75%) but could not adjust the 5.75% rate downward to mitigate the effect of the first adjustment because a downward adjustment of the 5.75% rate would impermissibly move the interest rate away from the arm's length rate stipulated to exceed 5.75%. The Government won the appeal. The Court of Appeals in Liberty Loan held:

Thus, it would have been contrary to the regulations for the Commissioner to balance out the transactions at 5% (or 5.55%) when the stipulated arm's length rate was in excess of 5.75%. This limitation on the offset provision logically follows when one remembers that the purpose of a § 482 adjustment is to more clearly reflect income. The upward adjustments to the no-interest loans do just that. Downward adjustments to the 5.75% loans, however, would have the effect of moving those loans even further away from the actual arm's length rate. In adjusting the no-interest loans upwards to 5%, the Commissioner therefore made the only adjustment he could.

In Xilinx, the court did exactly what the Government argued was impermissible in Liberty Loan -- i.e. it forced the taxpayer under the guise of the regulations to move the stipulated arm's length transfer price away from the arm's length standard. It is true that the court did that under what it perceived as authority of the IRS to require § 482 adjustments by regulation under Chevron-type notions (although the court does not refer to Chevron).

I think the dissent got this right.

Predicting Appellate Results from Quantity (Not Quality) of Questions

The New York times today here has a very interesting article (here) addressing the thesis that: “The bottom line, as simple as it sounds, * * * is that the party that gets the most questions is likely to lose.” It is a short article and I recommend the reader link to it and read it in its entirety.

I decided to make a few brief comments based on my appellate experience while with the DOJ Tax Division Appellate Section in the early 1970s. My experience was before 3 judge panels that, in oral argument, functioned similarly to the way the Supreme Court works in oral argument. Hence, I observed the dynamics of oral argument and, even in some cases, understood them and applied them to my client's perceived advantage. My brief comments are:

1. To state the obvious, the quantity of questioning is not a perfect predictor (hence "likely" in an important qualifier). But quantity is more than just slightly statiscally significant (86% is quite good). Most of us would like odds that good in placing any type of bet (or just living life). See Leonard Mlodinow, The Drunkard's Walk: How Randomness Rules Our Lives (2008) and Mlodinow's recent comment on the New Times Happy Days Blog.

2. The article suggests that justices often ask questions for which they already know the answer and are just using the question and answer to convince one or more other justices. Often, it does not matter whether the responsive answer is consistent with the questioning justice's perception of the right result. Even wrong answers can be an important teaching tool, as many of us learned as we participated in the Socratic method of teaching in law school.

3. While serving as an appellate attorney, I was aware of the dynamic in a general sense. By way of background, judges who read the briefs or have been briefed by their clerks, in most cases, have an idea of what they will hold before oral argument. Their minds can be changed (and I experienced one known such significant instance), but usually they go out as they came in. This comment is directed to the odds of changing a panel's mind, and is a different, but related, issue to predictability from the quantity of questions asked.

4. My personal experience is that, across the board, counsel for the party appealing (appellant) usually get more questions than counsel for the party not appealing (appellee). Keep in mind that the party appealing has to change the status quo and given the dynamics of systemic deference to the result below (whether to the jury or to the judge) (perhaps, heaven forbid, a form of inertia), I think that the party appealing is statistically more likely to lose, wholly independent of how many questions the panel asks. (This observation is consistent with the following observation in the article that, "If the two sides receive the same number of questions, the likelihood of reversal is 64 percent, which is in line with the usual probabilities; the court reverses more often than it affirms.") But the judge's perception of need to test whether that party should really lose, perhaps drive the dynamic of a larger quantity of questions.

5. Further dynamics are at issue in tax cases. The Government wins more far more times in taxpayer appeals in tax cases than it loses. In tax cases, taxpayers do not generally exercise the same restraint that the Government does in taking appeals which must be authorized by the Solicitor General; hence, the universe of taxpayer appeals present statistically more ill-advised -- unpersuasive -- appeals than the universe of Government appeals. Focusing on the opposite circumstance -- a Government appeal -- Government appeals are generally more meritorious because, in part, they are preceded by fairly rigorous review before the Solicitor General is persuaded to even authorize the appeal. I don't know the statistic, but I would be stunned if, statistically, the Government did not win significantly more of its appeals than the taxpayers win of their appeals. But, the Government on its appeal faces the same dynamic of trying to change the status quo, and thus the Government is bound to lose a number of its appeals, regardless of the rigorousness of the internal DOJ review process. The dynamic noted previously of deference will inevitably give some tilt to Court of Appeals' results in favor of affirmance rather than reversal.

6. I now provide some anecdotal experience based on the some of the preceding observations. On some taxpayer appeals where I perceived from the dynamics of the opening appellant argument the panel understood the issues and the Government would win, my appellee argument was simply to invite questions if the panel had any but otherwise to present no argument at all when the panel had no questions. (I usually flattered or pandered the panel by saying that I perceived from the panel's questions that they understood the issues in the case (just a euphemistic way of saying I thought the Government would win).) Almost invariably, the panel asked no questions and the Government won. Sometimes I varied this approach if the dynamics of the opening argument were generally favorable but I felt that only one or two points needed clarification. I would make those one or two points (once less than 30 seconds with no panel questions after a 25 minute appellant opening argument) and sit down. I developed the strategy to do this type of limited appellee oral argument after my first case with the Government -- a taxpayer appeal to the Second Circuit. After the taxpayer's counsel used all his time, I got up with my canned argument (that I had rehearsed with a panel from the Appellate Section and went, as canned, for about 15-18 minutes), but realized within three minutes that each member of the panel was (i) not paying a lot of attention to what I said and (ii) indeed was reading something that I quickly surmised or guessed or speculated was related to the next argument. I already knew from the court's questions on the opening argument that the Government would win, so I quickly (but not abruptly) closed my argument out, covering only the major outline. Perhaps 5 minutes out of a total permitted of 30 minutes. I speculate that the panel really appreciated that I did not further occupy their and our time (but I could be wrong if the panel had anticipated having that time to further prepare for the next argument). I don't think this approach would work in the Supreme Court, although I could imagine it working if the opening argument isolated some single limited issue that was concerning the justices and then only addressing that issue (provided of court that the issue for which the Supreme Court accepted certiorari was clearly understood).

7. On Government appeals, I approached it differently. I did not perceive a bias in the quantity of questions asked. Since the Government had the burden to persuade the court to change the status quo, I felt that I wanted questions from the court. I felt that, as attorney for the Government appellant, fewer questions meant loss. Of course, the Government lost some, perhaps most of the Government appeals I argued (I really did not keep count), and in those cases, overall, I am certain that I got more questions than counsel for the appellee. And, as I now recall it, in those successful Government appeals, the taxpayer's counsel got more questions from the panel than I did. So this observation is consistent with the statistic.

8. I offer one more observation in trying to use such statistics at the Supreme Court level to extrapolate conclusions about the dynamics of Courts of Appeals. Appeals to the Courts of Appeals are of right. The Courts of Appeals must hear and decide them. Appeals to the Supreme Court through the certiorari process are not appeals of right. The Supreme Court must affirmatively decide to hear the case and determine which issues it will hear. I perceive that the Courts of Appeals now are much more stringent in determining which cases justify oral argument than they were in the days I was doing appellate work on a daily basis. This can be a process with a dynamic not dissimilar to the Supreme Court's determining which cases it will hear. Presumably, Courts of Appeals are much more likely to hear oral argument in cases which, in the review process for determining which cases will be scheduled for oral argument, are identified as involving important issues (important in their own right or involving some potential conflict with other circuits or even the own circuit) for which oral argument can be useful in understanding the bases and ramifications of whatever action the Court of Appeals ultimately takes. In this sense, the designation for oral argument in the Court of Appeals suggests some statistical correlation with the likelihood for some form of reversal or some type of revision to the result or reasoning below (i.e., if the lower court action were clearly correct, oral argument is not needed), just as the Supreme Court's acceptance of certiorari suggests a more than random statistical possibility of reversal or revision of the result or reasoning below (as noted in the article, "the [Supreme] [C]ourt reverses more often than it affirms."). The Supreme Court's rigorous selection process makes it much more likely that the Court perceive an importance in correcting errors in result or reasoning below than it just pronouncing that the lower courts got it right in result and reasoning. That dynamic in the Courts of Appeals in assigning cases for oral argument is, I suspect, much less pronounced, simply because I don't think that the selection process is nearly so rigorous. But, having said that, there might be some positive correlation that would be shown with empirical analysis.

TEFRA Partnership Rules -- IRS Protective Position at Partner Level

In Bausch & Lomb Inc. v. Commissioner, T.C. Memo 2009-112, decided yesterday, at the IRS's request, the Tax Court held that the notice of deficiency issued by the Tax Court was invalid which meant that the Tax Court had no jurisdiction since a notice of deficiency is a jurisdictional prerequest in cases where the taxpayer petitions for redetermination. What's the deal? Why would the IRS urge the invalidity of its own notice of deficiency?

The reason is that the TEFRA partnership provisions, enacted in 1982, leave many issues undecided and the courts have been working through them ever since. In the meantime, as to at least some of these undecided issues, parties must take protective positions -- going through some formal steps even when they believe the steps should not apply given the purpose of the TEFRA patnership provisions. Although the Court's background discussion is somewhat cryptic as to the precise reasons for the protective position, that appears to be what happened in Bausch & Lomb and is certianly what happened in other cases where the unnecessary steps are less visible.

Extrapolating from the decision,. the following is probably the type of fact background for the IRS issuing a notice of deficiency. As readers will recall, the TEFRA provisions mandate unified audit and litigation for partnership items and affected items and then creates a special statute of limitations independent of the partners' statutes of limitations so that the unified result can be imposed on the parters. In lay terms, this requires the IRS to conduct a single partnership level audit and litigation of partnership items affecting a partnership and then, in a relatively summary assessment action, impose the results on the partners without concern for the individual partners' statutes of limitations.

The system is commendable in its purpose and most of the times serves that purpose of having a single proceeding rather than multiple and potentially inconsistent partner level proceedings as to the same items or items arising from the partnership. One of the rubs was likely presented in Bausch & Lomb. What should the IRS do when the IRS's position is that the partnership is a sham? One way of viewing a sham is that the partnership is to be disregarded altogether so that the TEFRA partnership proceedings simply never apply. This would mean that, if the IRS wants to actually collect related tax from the partners for items on their returns related to the sham partnership, the IRS must move against the partners via the notice of deficiency procedure rather than through the TEFRA rules. On the other hand, if the partnership even though a sham, is subject to the TEFRA partnership rules (administratively a good position given the purpose of the TEFRA partnership rules, even if not necessarily commanded by the explicit text of the statutory provisions) the IRS must proceed under the TEFRA provisions to issue a FPAA and then, failing litigation that would change the result, impose the results on the partners via a direct assessment. Notwithstanding logic that suggests that the latter -- proceeding under TEFRA -- is the right result, the statute does not literally foreclose a taxpayer argument that proceeding under TEFRA is the wrong result. The IRS in such cases might protectively proceed under both potential avenues -- i.e., (1) issue a notice of deficiency directly to the taxpayer even while the partnership level audit is going on and (ii) proceed under TEFRA to issue the FPAA and, upon final resolution fo the FPAA, impose the results on the partners as allowed the the TEFRA provisions.

That type of protective position appears to be what happened in Baush & Lomb. The IRS thinks the second avenue -- use of the TEFRA provisions -- is correct and thus that its protective notice of deficiency is not correct. The taxpayer for some reason wanted to litigate via the notice of deficiency rather than via the TEFRA procedures. The Tax Court accepted the IRS's position. That is the right result although we cannot provide a statutory analysis that necessarily commands that result. Let's just say that it is the only one that makes sense. Maybe Justice Scalia would decry it because the statute does not expressly command it, but he would be the only one that would have such qualms.

Hat tip to the Tax Professor List Serv.

IRS Reminds Small Tax-Exempt Organizations to File e-Postcards

In certain cases small tax exempt organizations are required to file Form 990-N with the IRS. The IRS has issued a notice reminding these tax exempt organizations to file the form. The form was due by May 15. See the notice.

Interim Guidance from OPR for Sanctions

See the interim guidance published by OPR with respect to sanctions of tax representatives. Click here for the guidance.

IRS Position on Burden of Proving Penalty on Failure to Pay Estimated Tax

The IRS has issued a notice that describes procedures that should be followed in Tax Court cases in which the addition to the tax for failure to pay estimated tax under Section 6654 has been determined and the IRS has the burden of production under Section 7491(c). See IRS notice at this link.

IRS Frequently Asked Questions on Offshore Accounts

The IRS has published a list of frequently asked questions on voluntary disclosure concerning offshore accounts. See the questions at this link.

Beware of Form 4180

When companies get in a financial bind, the last debt they pay in some cases is employment taxes to the IRS. Many owners and officers of these companies do not know they can be personally liable for the trust fund portion of these taxes that are not paid to the IRS. Under Section 6672 a person can be personally liable for trust fund taxes if they can sign checks and pay other creditors while knowing the taxes are not being paid.

When the IRS does their investigation they require those they interview to complete Form 4180. This form is used to gather information from potentially responsible persons. In most cases a revenue officer will interview the potentially responsible person and complete the form and then ask that it be signed without allowing it to be read by the potentially responsible person.

We are seeing more and more cases where the potentially responsible person is afraid or not allowed to read the form. This form is basically a confession and a taxpayer should never, never sign one without reading it carefully and making any changes that are necessary.

The best way to handle this form is for the taxpayer's representative to help the taxpayer complete the form and give it to the IRS.

IRS Releases 2006 Corporate Tax Data

The IRS report on 2006 corporate tax data report contains data by industry on assets, liabilities, receipts, deductions, net income, income subject to tax, tax, and credits. Data is also classified by size of total assets, by size of business receipts, and by size of income tax after credits. Other classifications include returns with net income, return types and other selected subjects. See the full report.

IRS Strategic Plan Released

The IRS has released its strategic plan for 2009 to 2013. Click here to see the plan.

Is it So? Is the IRS Working with Taxpayers Who Owe?

We have previously posted that Commissioner Shulman of the IRS stated that the IRS will work with taxpayers who cannot pay their taxes. Shulman said: "If they can't pay, they should attach a note" to the tax return, and either contact the IRS or wait for the agency to call." Click here to see full story.

In practice we are not seeing this. We are seeing the IRS serving levies and refusing to release them even though they are causing a hardship.

E-mail us with your thoughts and views about the IRS. Send you comments to larry@tjtaxlaw.com.

Tax Alliance Conference

June 17 & 18, 2009

Register By May 15, 2009 for $275.
Visit the website for a full list of speakers and topics.

Optional Bootcamp

June 16, 2009

Choose Tax Preparation or Tax Controversy
Register by May 15, 2009 for $80.

IRS Stepping Up International Enforcement

The IRS says it will improve tax administration to deal more effectively with the increase of globalization of individual and business taxpayers. This will be accomplished through Service wide cross-functional cooperation in addressing emerging international issues. The priority will be to improve voluntary compliance with the international tax provisions and to reduce the tax gap attributable to international transactions. See the Approach of the IRS.

2008 IRS Enforcement Statistics

Interesting statistics on IRS enforcement activities in 2008. See the statistics.

Statistical Portrayal of CI Released

The Treasury Inspector for Tax Administration has issued the Statistical Portrayal of the Criminal Investigation Division’s Enforcement Activities for Fiscal Years 2000 Through 2008. This report presents the results of the Inspector's review of statistical information that reflects activities of the Criminal Investigation Division. The overall objective of this review was to provide statistical information and trend analyses for the Division’s enforcement activities for Fiscal Years (FY) 2000 through 2008.

Five-Year Anniversary of TaxProf Blog

Congratulations to TaxProf Blog on its fifth anniversity. This is one of the best and most interesting tax blogs that exist. This is the first place many tax practitioners go each day to get an update and we are one of them. See some interesting facts about TaxProf Blog. Paul Caron does an excellent job in publishing this blog.

Beware of IRS’ 2009 “Dirty Dozen” Tax Scams

The IRS has released what it is calling the "Dirty Dozen" or tax scams for 2009. As we all practice tax law there are more and more thing to consider. See IR-2009-41.

Tax Court Puts Another Nail in the Coffin of Helmer Tax Shelters

In New Phoenix Sunrise Corp., et. al. v. Commissioner, 132 T.C. No. 9 (4/9/09), the Tax Court rejected a Helmer tax shelter claim. In Helmer v. Commissioner, T.C. Memo. 1975-160, at the IRS's request, the Court held that contingent liabilities contributed to a partnership do not enter the basis reduction calculation. Taking Helmer at face (taking anything at face is often dangerous in the tax context), tax shelter promoters created many variations of a gambit that would permit a large artificial basis upon which to claim a large artificial loss. New Phoenix involved one of the variations (the so-called digital option), masterminded (if that is the right word) by the Daugerdas-Jenkins & Gilchrist team.

In beginning its discussion of his conclusions, the Tax Court moved quickly to the core point:

We note at the outset that neither Mr. Wray, New Phoenix, nor Capital actually
suffered a $10 million economic loss during 2001. The loss claimed as a result
of the stepped-up basis in the Cisco stock was purely fictional.

From that core observation, the result surely followed:

Absent the benefit of the claimed tax loss, there was nothing but a cash flow that was negative for all relevant periods -- the "'hallmark[] of an economic sham'" as the Court of Appeals for the Sixth Circuit has held. Dow Chem. Co. v. United States, 435 F.3d at 602 (quoting Am. Elec. Power Co. v. United States, 326 F.3d 737, 742 (6th Cir. 2003). Such a deal lacks economic substance. Id. Because we find that the transaction at issue lacked economic substance, we do not consider Mr. Wray's and Capital's profit motive in entering into the transaction. Id. at 605; Rose v. Commissioner, 868 F.2d at 853; Illes v. Commissioner, 982 F.2d at 165. Pursuant to the aforementioned cases, the BLISS transaction must be ignored for Federal income tax purposes. Accordingly, the overstated loss claimed as a result of the sale of the CISCO stock is disregarded, as is the flowthrough loss from Olentangy Partners.

Not only did the Court disallow the loss, the Court also disallowed the attorneys fees the taxpayer incurred in undertaking the transaction. Then, piling at least penalty, if not insult, to the substantive injury, the Court made the following key points on penalties:

1. The 40% gross valuation / basis misstatement penalty applies, specifically rejecting the notion that, because the deductions were denied on the basis of lack of economic substance. In doing so, the Court distinguished and rejected Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990). Any notion derived from Heasley and its progeny that this penalty does not apply is quickly losing ground in the circuits.

2. The 20% substantial understatement of tax penalty applies. The Court found that the position lacked substantial authority and that the transaction was a tax shelter. Returning to his opening theme, The Court quoted Jade Trading, LLC v. United States, 80 Fed. Cl. 11, 58 as follows: "At bottom, the fictional nature of the transaction and its lack of economic reality outweigh Helmer in the substantial authority assessment."

3. The 20% negligence and intentional disregard penalty applies. The taxpayer urged in effect that Helmer and its progeny were substantial authority, and that authority had not been eroded below reasonable basis. In so holding, the Court noted that the IRS had already issued a statement of its position in Notice 2000-44 on Helmer and the taxpayer did not seek independent advice.

4. The taxpayer did not have reasonable cause and good faith for all the obvious reasons and some special twists unique to the facts.

5. Important to the penalty holdings was Jenkins & Gilchrist's clear conflict of interest that the taxpayer simply chose to ignore, thus eroding the reasonableness of reliance of the tax shelter opinion.

6. These penalties may not be stacked. Accordingly, the 40% penalty applies to the portion of the underlying tax attributable to the basis overstatement, but 20% penalty (either substantial understatement or negligence) applies to the balance.

Altogether, given the shift in the winds and prior precedents, this is not an altogether surprising opinion. Players in this area should note that interest on these penalties apply from the date the tax is due, so the cumulative cost of the tax, the penalties and the interest can be quite substantial.

TEFRA Tax Matters Partner Consents to Extend the Statute of Limitations

In United States v. Martinez, ___ F.3d ___ (5th Cir. 2009), decided 4/3/09, the Fifth Circuit held that actions taken by the tax matters partner in a TEFRA partnership were not ineffective to toll the statute of limitations because of an alleged disabling conflict between the tax matters partner and the other partners. The specific actions involved executing consents to extend the statute of limitations and filing a Tax Court proceeding. Under the TEFRA scheme, both of these actions result in the extension of the statute of limitations at the partnership level and thus extension of the statute of limitations for the TEFRA partnership adjustments at the individual partner level.

The Fifth Circuit distinguished an earlier Second Circuit case which had found a disqualifying conflict between the tax matters partner and the partners that made it unreasonable and inappropriate for the IRS to rely upon consents given by the tax matters partner. The Fifth Circuit concluded that (i), unlike the facts in Transpac Drilling, the IRS had not sought consents from the partners and been denied the consents, (ii) the IRS did not have a pending criminal investigation against the tax matters partner, (iii) the tax matters partner’s request for a quid pro quo via relief from the preparer penalties was not disabling because the IRS had already determined not to seek the penalty, and (iv), although the IRS believed the tax matters partner was dishonest, that alone did not create a per se conflict between his interests and the limited partners’ interests sufficient to put the IRS' reliance unreasonable under the circumstances.

A Loser on Avoiding the 6 Year Statute for 25% Omissions

Our readers will recall that Section 6501(e)(1)(A) gives the IRS a six year statute for a “substantial omission” – defined as an omission from gross income in an amount exceeding 25% of the amount of gross income stated in the return. An exception to this extended statute of limitations is provided if the omitted income is disclosed on the return even though it is not included in gross income on the return.

Consider this discussion from Benson v. Commissioner, ___ F.3d ___, ___ (9th Cir. 2009) where there was a 25% omission and no disclosure:

The Bensons also argue that Colony can be read to preclude the application of the extended limitations period because the Commissioner was able to discover the unreported income, despite their omissions. For this proposition, the Bensons cite the Court's language stating that the extended limitations period was meant to give the Commissioner additional time to "investigate tax returns in cases where, because of a taxpayer's omission to report some taxable item, the Commissioner is at a special disadvantage in detecting errors." Colony, 357 U.S. at 36. The Bensons argue that the Commissioner was at no such special disadvantage here, as evidenced by the fact that the Commissioner actually detected the errors, and therefore the six-year period should not apply. However, the Supreme Court's gloss on the statutory language does not alter the statute's plain language, which simply provides that the Commissioner is afforded extra time whenever a taxpayer “omits” a certain amount from his or her gross income. 26 U.S.C. § 6501(e)(1)(A). The Bensons omitted the constructive dividends from their tax returns.

The taxpayer’s argument was, of course, circular. If the IRS did not discover the omission, then the statute was six years but would be meaningless because the IRS did not discover the omission even in the six years. If the IRS did discover it in the six year period, then the six year period would not apply because the IRS discovered it.

So the question is Shakespearean - to disclose or not to disclose. For taxpayers who pay close attention to odds (viewing tax reporting like gambling), disclosing solely to avoid a six year limitations period is not generally a recommended option. Providing that the taxpayer is reasonably certain he or she can avoid civil and criminal penalties for the omission, the taxpayer may want to take the risks involved in having a six year rather than a three year statute of limitations. The IRS hardly ever commences audits of returns that are over 2 ½ years old anyway, so that the additional three year risk may not be that great. Thus, for each year during the first three years when the statute is open under the general rule, the odds of an IRS audit of the return are far greater than in the succeeding three years (Years 4 through 6). Nevertheless, even with the decreased odds in the “out years,” the IRS will sometimes stumble upon an out year problem while auditing years within the normal statute of limitations and will seek to invoke § 6501(e). And, of course, a disclosure will likely eliminate the far worse risk than a 6 year statute of limitations – a criminal investigation and prosecution.

Tax Court Invalidates Two Year Rule for Innocent Spouse Relief

In the past the IRS has contended that someone asking for innocent spouse relief under Section 6015(f) of the Internal Revenue Code would have to file for innocent spouse relief within two years of the first collection action taken by the IRS. The IRS has consistently disallowed claims that were not filed within this two year period.

In the case of Lantz v. Commissioner, 132 T.C. No. 8 (Apr. 7, 2009), the Tax Court has held that the two year rule imposed by the Regulation Section 1-6015-5(b)(1) is invalid. If request for innocent spouse relief has been denied by the IRS based on the two year rule, it should be requested again.

Enrolled Agent Suspended

An enrolled agent has been suspended from practice before the Internal Revenue Service by the Office of Professional Responsibility for not performing services related to offers in compromise paid for by taxpayers. In IR 2009-35 the IRS states that the enrolled agent admitted a lack of due diligence in representing the taxpayers. The announcement also states: "The IRS is taking a closer look at tax resolution companies, and is also litigating known OIC abuses to ensure that tax professionals fulfill their legal and ethical obligations to their clients in dealing with IRS tax matters".
It is time more action is taken against those who represent taxpayers before the IRS and do not perform work in a competent and professional manner.

Tips for Choosing a Tax Preparer

The IRS offers some points for taxpayers when someone else prepares their return.
In addition see: FS-2009-7, How to Choose a Tax Preparer and Avoid Preparer Fraud

Not Tax But Time

Jim Calloway in his blog writes about some interesting websites dealing with time. There are sites that give official US time, the world clock, on line stop watch, and others.

Something to review when you have TIME!

Amnesty to Those Who Evaded Tax Through Offshore Accounts

The TaxProf Blog has announced the IRS policy for reducing penalties for those who have evaded taxes on offshore accounts. See TaxProg Blog for more.

Addendum 3/27/09 9:50 am: Jack Townsend has posted the key points of the initiative on his Federal Tax Crimes Blog here.

AT&T Attorneys Offer Advice to Small Business Clinic Clients

Larry Jones is Director of the Tax Clinic and Small Business Clinic at the SMU Dedman School of Law. Today the Dallas Morning News has featured the Small Business Clinic. See the Article. For clients who cannot afford attorneys in tax and small business matters, these clinics at the Law School may be able to help. The number to arrange an appointment is 214-768-2562 or go to the website.

IRS to Announce Today Inducements on Offshore Accounts

The Wall Street Journal announces that the IRS will announce today the inducements for taxpayers with offshore accounts to come clean and avoid some of the draconian downside of past sins with respect to foreign accounts. Jack Townsend will be following this in more detail on his federal tax crimes blog, so we point our readers there.

Ask IRS For A Closing Letter

Clients will often ask for something in writing from the IRS that their collection case has been closed. The IRS has now issued a procedure for taxpayers to receive letters when their collection case is closed. This letter will be helpful and reassuring to the taxpayer when the IRS has classified a case as currently non collectible. See the IRS Memorandum with more detail.

It's Not Over Until the First Circuit Sings

The Tax Prof Blog reports that the First Circuit has granted rehearing in the infamous Textron Case denying the Government's attempt to summons tax accrual workpapers -- the tax mother lode for the IRS. The Tax Prof Blog report may be reviewed here (along with links to the opinion and some commentary on the opinion). Prediction: The Government will get the workpapers. Perhaps we'll write more on this later; perhaps not.

Questions on Preparing Partnership Tax Returns

Patti Logan, EA, in Colorado and our good friend has advised that the IRS recently added a page (See Link) providing answers to frequently asked partnership return questions to its website. The page provides nearly two dozen detailed questions and may be of assistance to accountants who file partnership tax returns.

Controls Over IRS Employee Telephone Calling Cards

TIGTA has issued a report on its review of whether the IRS has established effective controls to identify and address instances of waste, fraud, and abuse relating to the use of employee telephone calling cards. See the Report. Tghe report states: "Overall, the IRS lacks effective controls over telephone calling cards issued to employees. Specifically, telephone calling card charges are not routinely reviewed for waste, fraud, and abuse, and a comprehensive inventory of telephone calling cards is not completed annually".

It is interesting to note that the IRS is being stricter in taxpayer's keeping records, but not in their own house. Even the courts are enforcing the requirement of substantation. See: Freddy W. Fuentes v. Commissioner; T.C. Summ. Op. 2009-39; No. 16020-07S.

Less Inserts in Some IRS Mailings

The IRS has announced that nearly a dozen inserts that go into a notice informing businesses that they owe additional tax will no longer be included. This change affects the CP 161 notice, which is mailed to business taxpayers who underpay their taxes. See News Release IR-2009-24.

Hopefully, the IRS will expand this to copies of notices received by those of us who represent clients before the IRS. I often wonder why representatives need all of the inserts that are included in our copy of notices. Also, why does the IRS send two copies of the same letter?

Settling with IRS - Make Sure Procedure Is Followed

In Burton v. Commissioner, T.C. Memo. 2009-60, March 18, 2009, the issue was whether the taxpayers had entered into a binding settlement agreement with the IRS Appeals Office relating to taxpayers’joint income tax liability for 2000.

Taxpayers asserted a final binding settlement was entered into under which they were to pay a single lump sum of $60,000 without any further liability to pay statutory interest. The IRS asserted, among other things, that no final binding agreement was ever reached-particularly with regard to tapayers’ statutory interest.

In the letter the IRS Appeals officer explained that the tax due under the proposed settlement would be $60,000 and that interest would "continue to accrue" thereon until paid. The taxpayers’ attorney notified the Appeals officer that he agreed on behalf of taxpayers to the revised closing agreement, and the Appeals officer sent to the attorney the closing agreement along with the Form 870-AD for signature.

Taxpayers and the attorney signed the closing agreement and the Form 870-AD and mailed them, along with a check for $60,000, back to the Appeals officer. On taxpayers’ $60,000 check the words "paid in full" were written in the lower left corner.

The Appeals officer mailed a letter to taxpayers’ attorney acknowledging receipt of the closing agreement, the Form 870-AD and the $60,000 check. The Appeals officer explained that he could not process taxpayers’ $60,000 check because the check and payment did not include an additional $23,684 in statutory interest.

Not having received a response from taxpayers, the Appeals officer returned taxpayers’ $60,000 check, and the IRS issued a notice of deficiency. No one on behalf of the IRS ever signed the closing agreement that taxpayers had signed.

The Court in the case of Dormer v. Commissioner, T.C. Memo. 2004-167, explained the law applicable to administrative settlement offers involving Federal income taxes is well established. Regulations establish the procedures for closing agreements and compromises under sections 7121 and 7122. Secs. 301.7121-1, 301.7122-1, Proced. & Admin. Regs. These procedures are exclusive and must be satisfied in order to effect an administrative compromise or settlement which will be binding on both a taxpayer and IRS. The regulations and procedures under section 7122 provide the exclusive method of effectuating a compromise. Regulations under sections 7121 and 7122 require that any closing agreement or offer-in-compromise be submitted and/or executed on or in the specific form prescribed by the IRS. Secs. 301.71211(d), 301.7122-1(d), Proced. & Admin. Regs.

The Court in this case found that no final closing agreement was signed by an individual authorized to bind the IRS. This is not an issolated situation. We have seen other cases where the taxpayer's representive has not made sure the settlement was completed.

Joint Committee Releases Explanation

The Joint Committee has released the General Explanation of Tax Legislation Enacted in the 110th Congress.

Strategic Concessions - Government Outmaneuvered

The Code imposes:

1. A 20% penalty for tax due that is attributable to return reporting positions based on negligence or substantial understatement.

2. a 40% penalty applies to tax due that is attributable to return reporting positions based on gross valuation or basis misstatements. Gross valuation or basis misstatements are those that exceed 200%.

A split among the courts has developed as to whether, if the tax is disallowed in a judicial proceeding for some threshold reason (such as lack of economic substance or simply failing to meet some other requirement of the code), the 40% gross valuation or basis misstatement penalty can apply. In holding that the 40% penalty cannot apply, courts reason that the tax due is attributable to the threshold disqualifier and not to the gross valuation or basis misstatement. See e.g., Keller v. Commissioner, ___ F.3d ___ (9th Cir. 2009). Other courts reject that if the gross valuation or basis misstatement was an essential ingredient of the originally claimed reporting position. See e.g., Long Term Capital Holdings, Inc. v. United States, 338 F.Supp.2d 122 (D. Conn. 2004), aff’d by unpublished order (2nd Cir. 9/27/05).

A decision reported just yesterday shows how a taxpayer skillfully exploited this split in authority. Alpha I, L.P., v. United States, ___ Fed. Cl. ___ (3/16/2009), denying the Government's motion for reconsideration in Alpha I, L.P., v. United States, 84 Fed. Cl. 622, 634 (2008). Basically, in this TEFRA proceeding, the partnership conceded a threshold legal disqualifier to the tax benefits in issue and then moved for summary judgment on the gross valuation misstatement issue because the valuation was no longer relevant and hence the tax due (conceded for other reasons) was not attributable to the gross valuation misstatement. The Government opposed the motion. The Court granted the motion. Alpha I, L.P., v. United States, 84 Fed. Cl. 622, 634 (2008). The Government then moved for reconsideration. The Court rejected the motion for reconsideration essentially because it did not raise any matters not previously considered as to the proper interpretation and application of the penalty. The Court reasoned (such as it is) in this regard (which I quote in its entirety because I don't understand it),

According to plaintiffs, however, "Defendant has lost sight of the different policy underlying the valuation misstatement penalty from other penalties designed to punish and deter taxpayers from taking negligent, aggressive, or fraudulent positions." Pls.' Resp. to Def.'s Mot. for Recons. 16. The court addressed the policy behind the § 6662(e) penalties in its Opinion of November 25, 2008. See Alpha I, 84 Fed. Cl. at 632-33. The court concluded that "forcing a 'trial on alternative grounds for adjustments plaintiffs have already conceded violates the purpose and policy behind the valuation misstatement penalties and is simply a waste of the Court's and the parties' resources.'" Id. at 632 (quoting Plaintiffs' Reply in Support of Plaintiffs' Motion for Partial Summary Judgment 5).

Apparently, the Court thought that was the end of it from a legal analysis perspective.

But the Court proceeded to dispatch a Government policy consideration not relevant to the interpretation and application of the penalty. This policy related to how the Government induces taxpayers into settlement without trial by holding out the prospects of a worse result at trial. The Government argues that the partners of the Alpha I partnership making this strategic maneuver would be better off than other similarly situated taxpayers who settled. Adopting Alpha I's position on this matter, the Court held that whether or not the taxpayer partners in Alpha I were better off is not relevant and in any event not certain. And that was the end of that.

The bottom line takeaway for practitioners whose clients may be subject to the gross valuation misstatement penalty in an overly aggressive shelter or other return reporting position is to find some threshold disqualifier and go to a jurisdiction (such as the Fifth, Ninth, or Court of Federal Claims) and concede the tax on the basis of the disqualifier.

American Recovery & Reinvestment Act (ARRA) of 2009

The new American Recovery and Reinvestment Act of 2009 is the subject of many conversations and is generating many questions. Many of these questions center on how this will affect taxpayers this filing season and next. IRS has placed information to help answer that question and others, on a special website. Click here.

Judge / Professor Lynch on the Blue Book

The New York Times reports that Judge / Professor Gerard Lynch is slotted for elevation to the Second Circuit Court of Appeals. Judge Lynch has written more than a few memorable opinions, but the one that comes immediately to my mind is his pronouncement on the relevance of the Blue Book to interpretation of a tax statute. Those in the plain meaning school of statutory interpretation (e.g., Justice Scalia) do not like such aids to interpretation, but this is what Judge Lynch had to say (Sequa Corp. v. United States, 350 F.Supp.2d 447, 454 (S.D. N.Y. 2004)):

However, as other federal courts around the country have noted, the Blue Book, as an interpretation of the statute by experts involved in the drafting process and very familiar with the problems being addressed, plainly has some value, particularly where the statute is ambiguous and the only available legislative history is limited to expressing broad policy goals. See Estate of Wallace v. Commissioner, 965 F.2d 1038, 1050 n.15 (11th Cir. 1992) (Blue Book is "a valuable aid to understanding"); McDonald v. Commissioner, 764 F.2d 322, 336 n.25 (5th Cir. 1985) (Blue Book is "entitled to great respect"); Hutchinson, 765 F.2d at 669 (although not legislative history, Blue Book can be "highly indicative" of Congressional intent); Ravenswood Group v. Fairmont Assoc., 736 F. Supp. 1285, 1287 (S.D.N.Y. 1990) (citing to Blue Book explanation). Where, as here, the explanation offered by the Blue Book accords both with the explicit statements of broad Congressional intent and with the most logical and consistent reading of somewhat ambiguous statutory provisions, that explanation is entitled to some weight. That weight simply tips the scales further in the direction of the Government's position. n6
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n6 Sequa argues on reply that the Blue Book is no more than a treatise, equivalent to any other academic commentary. (P. Rep. 10.) As part of its efforts to discredit the Blue Book's interpretation and advance its own, Sequa cites three academic commentaries that it claims support its view of the statutory language. (P. Mem. 22-24, citing Daniel J. Lathrope, The Alternative Minimum Tax P 6.11[3][f] (1994); Robert M. Brown, "Corporate Alternative Minimum Tax" § 28.04[4], 50 N.Y.U. Institute on Fed. Tax'n (1992); Robert M. Brown and Donald J. Massoglia, "Corporate Alternative Minimum Tax" § 7.07, 45 N.Y.U. Institute on Fed. Tax'n (1987).) First, two of the three are authored by the same person, so it is misleading to suggest that "three [separate] analyses ... amply negate[]" the Blue Book. (P. Rep. 10.) Second, Sequa selectively quotes from Professor Lathrope's treatise to make his analysis appear more favorable. (P. Mem. 23.) Lathrope does note that the Blue Book's approach "has been criticized," and offers some additional bases for questioning the position. However, Lathrope follows the quoted section with the following: "On the other hand, the transition rules do permit a corporation's pre-1987 net operating losses to carry over, with modifications, to post-1987 taxable years as AT NOLS. Perhaps offset of AT NOL carrybacks can be justified as a balanced approach." He then footnotes to the academic and practitioner commentary both for and against the Blue Book's interpretation. See Lathrope, 6-94 n.431 (citing Brown, supra, and Brown & Massoglia, supra, as critical of the Blue Book; and Hriszko, Schott & Stevens, "Reduction of Corporate AMT NOL Due to Regular Tax NOL Carrybacks," 19 Tax Adviser 778, 779 (1988), as in accord with the Blue Book.) The only reasonable conclusion to be drawn from the academic writing on this issue is that all observers agree that the statute is ambiguous. Beyond this unremarkable observation, the treatises offer little additional insight.

Now, I suspect that Judge Lynch would probably not rank this brief discussion among his more important judicial pronouncements but this one does resonate with tax procedure afficionados. And, moving to the broader issue of finding context for words to assist in meaning, I am reminded of the following article of faith that I learned as a first year law student from a tax opinion by Justice Oliver Wendell Holmes that is a good guide in the law and in life (Towne v. Eisner, 245 U.S. 418, 425 (1918)):

A word is not a crystal, transparent and unchanged, it is the skin of a living thought and may vary greatly in color and content according to the circumstances and the time in which it is used.

When Is Compensation Reasonable?

Few reasonable compensation cases have existed in the past few years. However, a few are surfacing in audits by the IRS. Section 162(a)(1) of the Internal Revenue Code allows for a deduction for “a reasonable allowance for salaries or other compensation for personal services actually rendered.”

What is reasonable compensation is a factual issue. The mistake most businesses make is failing to document how compensation is determined. Executive compensation should be reviewed each year and documented in corporate minutes.

In the recent case of Menard, Inc. v. Commissioner, No. 08-2125 (Mar. 11, 2009), Judge Posner reversed the Tax Court’s holding that compensation was unreasonable. The Tax Court only allowed the corporation a deduction of $7 million of the $20.6 million paid to the majority stockholder and CEO and deducted by the corporation. The opinion points out that when comparing the compensation of Mr. Menard with other executives, all of the compensation paid to the other executives must be considered and not just salaries.

Income Tax Data by Zip Code

The TaxProf Blog has advised of an interesting site. The site is Income Tax and Data List in Your Zip Code. This site could have some usefullness in dealing with certain issues in IRS audits and collections matters.

No More Private Debt Collectors

After conducting an extensive review of the private debt collection program, including the cost effectiveness of the effort, the Internal Revenue Service will not renew its contracts with two private debt collection agencies, the agency announced today. See IR-2009-19.

The IRS determined that the work is best done by IRS employees who have more flexibility handling cases, which is particularly important with many taxpayers currently facing economic hardship.

IRS Will Work With Taxpayers In Trouble

Commissioner Shulman of the IRS states that the IRS will work with taxpayers who cannot pay their taxes. Shulman said: "If they can't pay, they should attach a note" to the tax return, and either contact the IRS or wait for the agency to call." Click here to see full story.

See The “What Ifs” of an Economic Downturn on the IRS website.

Who Pays the Cobra Premium

As a follow-up to the First Wednesday Tax Forum on the Cobra premium issue, Peter Anastopulos, an attorney with The Roberts Law Firm, advises that the federal government will be paying the tab. The government will reimburse the coverage provider via a tax credit against certain employment taxes. The Department of Labor FAQ states:

"The premium reduction (65 percent of the full premium) is reimbursable to the employer, insurer or health plan as a credit against certain employment taxes. If the credit amount is greater than the taxes due, the Secretary of the Treasury will directly reimburse the employer, insurer or plan for the excess."