Not Quite The Informal Claim Doctrine

 

I am looking at a district court opinion from Illinois.

I find the discussion of the numbers a bit confusing. It happens sometimes.

But there something here we should talk about.

We have recently discussed the tax concept of a “claim.” In normal-person-speak, it means you want the government to refund your money. The classic claim is an amended income tax return, but there can be claims for other-than-income taxes. It is its own niche, as using the wrong form can result in having your claim rejected.

Let’s look at the American Guardian Holdings case.

AGH filed its 2015 tax return on September 19, 2016.

Here are the numbers on the original tax return:     

	Original
Revenues	152,092,338
Taxable income	4,880,521
Tax	1,327,806

 The accountant found an error and amended the return on June 6, 2019.

			First
	Original		Original	Amended
Revenues	152,092,338		152,092,338	154,808,792
Taxable income	4,880,521		4,880,521	11,084,397
Tax	1,327,806		1,327,806	148,243
Refund				(1,179,563)

Let me see: The 2015 return would have been extended to October 15, 2016. The amended return was prepared June 6, 2019. Yep, we are within the statute of limitations.

Problem: AGH never sent the amended return.

Answer: AGH hired a new accountant.

The new accountant filed an amended return on September 19, 2019.

COMMENT: Still a few days left on the statute.

For some reason, the accountant incorporated the first amended (even though it had not been filed) into the second amended, resulting in the following hodgepodge:

		First		Second
		Original	Amended	Original	Amended
Revenues		154,808,792	141,773,572	154,808,792	?
Taxable income		11,084,397	7,446,746	11,084,397	?
Tax		1,327,806	148,243	1,327,806	0
Refund			(1,179,563)		(148,243)
Total refund					(1,327,806)

Huh? I would find that second amended confusing. On first impression it appears that AGH is filing a claim for $148,243, but that is incorrect. AGH was stacking the second amended on top of its first. AGH is filing a claim for $1,327,806, which is the entire tax on the original return.

Not surprisingly, the IRS also responded with “huh?” It could not process the second amended return because the “Original” numbers did not match its records.

AGH responded by filing yet another amended return (third amended). Mind you, at this point it was after October 15, 2019, and the statute of limitations was in the rear view mirror.

AGH did the following:

(1)  AGH explained that the new and shiny (third) amended return incorporated the previously (non-filed) first amended return and the second (actually filed) amended return. As a consequence, the “previously-filed amended return for 2015 should be discarded.”

COMMENT: NO! 

(2)  AGH further explained that it was filing Form 1120-PC (a specialized tax form for property and casualty insurance companies) as its third amended return rather than the Form 1120 originally filed because it had received permission to change its method of accounting.

COMMENT: NO!!

I am somewhat shocked at how deep a hole AGH had dug, and more shocked that it kept digging.

Let’s go through the wreckage:

(1)  AGH filed its (second) amended return/claim within the statute of limitations.

(2)  This creates an issue if the claim is imperfect, as one would be perfecting the claim AFTER the statute expires. Fortunately, there is a way (called the informal claim doctrine) that allows one to perfect a claim after the original filing date and still retain the benefit of that original date. 

(3)  The IRS immediately seized on the “previously-filed amended return for 2015 should be discarded” statement to argue that AGH had violated the informal claim doctrine.  If the second amended return was discarded, there was no timely-filed return to which the informal claim doctrine could attach. Fortunately, the Court decided that the use of the word “discard” did not actually mean what it sounded like. AGH dodged a bullet, but it should never have fired.

(4)  That leaves the third amended return, which was filed after the statute expired. AGH of course argued informal claim, but it had committed a fatal act by changing its method of accounting. You see, the informal claim allows one to clarify, document and explain whatever issue is vague or in dispute within the claim at issue. What one is not allowed to do is to change the facts. AGH had changed the facts by changing its method of accounting, meaning its third amended return could not be linked to the second via the informal claim doctrine.

(5)  Standing on its own, the third amended of course failed as it was filed after the statute had expired.    

This case is a nightmare. I am curious whether there was a CPA or law firm involved; if so, a malpractice suit is almost a given. If the work was done in-house, then … AGH needs to tighten up its hiring standards. The case reads like there were no adults in the room.

All is not lost for AGH, however.

Remember that AGH filed its second amended return within the statute of limitations.  The matter then went off the rails and the Court booted the third amended return.

But that leaves the second amended. Can AGH resuscitate it, as technically the Court dismissed the third claim but not necessarily the second?  It would likely require additional litigation and associated legal fees, and I would expect the IRS to fight tooth and nail. AGH would have to weigh the cost-benefit.

Our case this time was American Guardian Holdings, Inc v United States of America, No. 1:2023cv 01482, Northern District of Illinois.

A Short Story About Connecticut Unemployment Reporting

I read that the Governor of Connecticut has signed a bill repealing certain additional payroll reporting requirements otherwise slated to start next year.

As background, all state quarterly unemployment returns include certain basic information, including:

·       Name

·       Social security number

·       Wages paid in the quarter

Prior to repeal, Connecticut employers were to report additional information with their quarterly unemployment returns. The reporting was to start in 2024, with the exact phase-in depending on the number of employees:

·       Gender identity

·       Age

·       Race

·       Ethnicity

·       Veteran status

·       Disability status

·       Highest education completed

·       Home address

·       Address of primary work site

·       Occupational code under the standard occupational classification (SOC) system of the federal Bureau of Labor Statistics

·       Hours worked

·       Days worked

·       Salary or hourly wage

·       Employment start date in the current job title

·       Employment end date (if applicable)

Ten of the above 15 data elements are not collected by any other state.

There was concern that the additional elements could negatively impact people filing for benefits – that is, the actual purpose of unemployment taxes.

“The Department of Labor would need to edit incoming reports against certain standards and reject employer wage/tax reports or suspend processing while seeking clarification of elements reported.   

“Rejected or suspended wage reports could make wage information unavailable when unemployment claimants apply for benefits.”

It appears a breath of sanity.

A Too Rare Taxpayer Win Over Foreign Reporting

I have become cynical about IRS penalties.

Like many accountants, I initially learned that penalties were in the system as a deterrent. If one complies with reporting responsibilities, penalties should not enter the picture. If they do, they surely would be for ministerial causes (think late payment of an estimated tax) and minor, and – if somehow major – waivable upon showing reasonable cause for the mistake.  

Poppycock.

Congress has been raising and creating penalties for decades to “pay for” their tax bills. I would also argue that the IRS has used penalties as a backstop to its funding, especially during Republican budget stringency after the Lois Lerner fiasco.  

The IRS often assesses penalties automatically, without anyone even glancing at your return. This transfers tax administration from the IRS to you – and then by extension – to me. Say that you have a reportable interest in a foreign corporation. The IRS says you must file a certain information report. I get it: the IRS wants to know what is going on. You file the report, but you file it late. Why late? Who knows. Your accountant was on health leave. You were misadvised. You were never advised because you did not recognize it as a tax-sensitive issue. You will – soon enough – get an automatic IRS notice for a $10,000 penalty – or more. You complied, but not fast enough.

Reasonable cause?

Depends on who defines reasonable. As a practicing tax CPA for decades, I am much more open to reasonable cause. Why? I am closer to the day-to-day, so I do not have the anesthesia of distance and disinterest. Things ... just … happen. No one likes paying, but let’s not use that same brush to accuse one of gaming the system.

Let’s take a look at Wrzesinski.

We will call him “W” to keep our sanity.

W was born in Poland. He moved to the United States when he was 19 years old.

A few years later his mom, who still lived in Poland, won the Polish lottery.

Sweet.

Mom gifted him $830,000 over a couple of years.

W knew about U.S. tax. He contacted his tax advisor to ask what the consequences would be. His advisor (G) correctly told him that the gift would not be taxable, but incorrectly told him that no further reporting was required.

I know that G was wrong, but how could the IRS expect W to know that?

Fast forward a few years and W wanted to make a gift to his godson in Poland. He did an internet search, at which time he realized that – while not taxable – reporting was still required. He realized this situation as his own years before, and he contacted an attorney with expertise in foreign tax matters.

W got into an IRS program for late filing of certain foreign-related returns. The IRS would tread lightly if one had reasonable cause, and both W and his attorney thought he had reasonable cause to spare.

I agree.

The IRS came back with its automatic penalties: they wanted $87,500 for one year and $120,000 for the second.

Their reason?

The Notices stated that …

… ignorance of the tax laws was not a basis for penalty abatement under the “reasonable cause” standard and that ordinary business care and prudence require that the taxpayers be aware of their obligations and file or deposit accordingly.”

I would argue the opposite: good faith “ignorance” of tax laws is exactly the basis for the reasonable cause standard. We have more than once huddled here at Galactic Command analyzing tax consequences, especially if planning a transaction. We sometimes disagree. We have run into gaps in tax law, as Congress is churning out this stuff faster than the IRS and the profession can interpret. We have run into contradictions in tax law, especially when the aforesaid gaps are working their way through the courts system. Did I mention that we are all CPAs with varying tax backgrounds? I am, for example, a tax specialist. It is all I do and have done for years.

Consider that there was no tax shelter here, no attempt to avoid reporting income or of claiming bogus deductions. There was a gift from a mother to a son. A gift unfortunately involving some of the most arcane reporting rules embedded in the tax Code. There was no need for the IRS to flog the guy.

W and his attorney protested the penalties.

The IRS lost W’s protest.

Yes, they “lost” his protest.

It took the Taxpayer Advocate to find it.

The IRS abated all but $40 thousand or so of penalties.

W paid it.

And he immediately filed claims for refund.

I like this guy.

The IRS bounced the first claim, saying he did not establish reasonable cause.

You may be figuring out the IRS schtick when in this situation. It is a one-play gamebook: nothing is reasonable. Boyle. Go away.

The IRS bounced the second claim, saying that it was “frivolous.”

Folks, never ever tell a tax practitioner that his/her position is “frivolous.” That is a loaded word in tax practice.

This thing … NO SURPRISE … went to Court.

Let’s fast forward.

In a too-rare taxpayer win, the DOJ conceded the case on February 7, 2023, and requested six to eight weeks to refund W his remaining penalties.

But look at the effort it took.

Our case this time was Krzysztof Wrzesinski v The United States, U.S. District Court, Eastern District of Pennsylvania.

Self-Sabotaging A Penalty Abatement

 

The opinion is two and a half pages.

It is one of the shortest opinions I have seen. That was – frankly – what caught my interest.

Francis Kemegue lost his job in 2017. I do not know details, but he experienced multiple personal and professional setbacks.

He extended his 2017 return.

Gotta be a late file/late payment case. If you are ever in a situation where you are unable to pay your tax, file the return nonetheless. Yes, the IRS will eventually contact you, but they are going to contact you anyway. The penalties for filing a late return are more severe than for filing but not paying.

Kemegue in fact never filed his 2017 return.

Sounds like that job loss debilitated him.

The IRS prepared a tax return for him. This a called a “substitute return,” and the IRS assumes that every known receipt (think computer matching) is taxable and that there are no deductions. The math is bogus, of course. The IRS is not so much trying to prepare your return as to catch your attention.  

He owed with that substitute return.

Of course.

Now he was late file and late pay.

Great.

Kemegue wanted a break.

Go for it.

More specifically, he wanted abatement of the late file and pay penalties.

I would do the same. There is a kabuki dance to this, however. Abating this penalty requires establishment of reasonable cause. The IRS has for a while been (in my opinion) very unreasonable about reasonable cause. However, if Kemegue was seeing a counselor or otherwise under professional care – even if intermittently - he has a decent chance. This would be a superb time to obtain exculpatory letters from his health professional(s) and to polish his storytelling chops.

Kemegue did not do any of this.

He did talk about his job search, including traveling to other states. He even tried to start his own company.

Kemegue, you are missing the plot here.

The Court wanted to know more about his story: shattering setback, evaporating self-confidence, needing help for depression. He fell behind on his tax return because he – you know – fell behind in all areas of his life.

Silence.

Not good.

The Court wanted to know: what was going on that he could travel and search for work but not file that tax return?

Again silence.

You know how this turned out.

Sheesshh.

Our case this time was Francis Kemegue v Commissioner, T.C. Summary Opinion 2023-5.

You Must Give The IRS Time

I understand the court’s decision, but I suspect the most interesting part is how this case even got to court.

The issue is almost prosaic:

Somona Lofton filed a 2021 Form 1040X (that is, an amended individual tax return) on May 18, 2022. She requested a refund of $5,362.

The dates strike me as odd. The 2021 return was due April 18, 2022. Lofton filed an amended return one month later. Does it happen? Sure and usually because someone left something out – maybe a W-2 or a broker’s account. That would normally increase tax though, so I am expecting a story.

The IRS did not immediately process the return.

I am not surprised. This was IRSCOVID202020212022, and you were lucky to get someone over there to even answer the phone.

Lofton filed a refund case against the IRS on September 14, 2022.

That was a waste.

Let’s talk about it.

Like any large organization, the IRS has policies and procedures to follow. I would argue that sometimes the rules approximate self-inflicted wounds, but I understand that coordinating that many people and processing that much data requires standardization.

And right there is a reason that many practitioners got upset during IRSCOVID202020212022. The system broke down. One side of the IRS was inadequately processing returns, correspondence, penalty appeals or whatnot, while the Collections side continued undeterred and unhindered.

Why was it broken? Because much of the Collections side is automated. Those notices go out without passing human eyes. If the IRS fails to match a 1099-whatever to your return, bank on receiving a CP2000 notice. Ignore it – or submit a response and then have the IRS ignore it - and you have entered automated hell. A tax practitioner can usually obtain time, allowing a break for response and processing, but the practitioner likely needs to speak with someone to obtain that time.

Yeah, no. Didn’t work when the IRS wasn’t answering the phone.

Back to Lofton.

May, September. I would have advised her to chill.

She however was not using a tax practitioner. She filed the case pro se, meaning she was representing herself. I am – frankly – impressed. Filing pro se with the Tax Court is one thing (and bad enough), but she filed pro se with the US Court of Claims. At first, I thought a tax clinic may have helped, but – no - that couldn’t be. A tax clinic would have told her to wait.

Why?

Look at this Code section:

§ 6532 Periods of limitation on suits.

(a)  Suits by taxpayers for refund.

(1)  General rule.

No suit or proceeding under section 7422(a) for the recovery of any internal revenue tax, penalty, or other sum, shall be begun before the expiration of 6 months from the date of filing the claim required under such section unless the Secretary renders a decision thereon within that time, nor after the expiration of 2 years from the date of mailing by certified mail or registered mail by the Secretary to the taxpayer of a notice of the disallowance of the part of the claim to which the suit or proceeding relates.

The IRS has six months to respond to your request for refund. Six months should be sufficient time for the IRS to adequately review a refund claim (at least in normal times). The flip side is that Congress did not want the IRS parking on a refund claim, effectively denying a refund by never processing it.  

Lofton filed suit within six months.

The Court immediately dismissed the suit. Easiest decision they made that week.

I find the rest of her story more interesting.

For example, she complained that the California Department of Social Services harassed her and withheld her benefits.

She was swinging hard.

… Civil damages for Certain Unauthorized collection action 1,000,000”

… Emotional distress $250,000”

I am not certain how that involves the Federal Court of Claims. The Court noted the same and dismissed her allegations.

Then we learn that she initially filed her 2021 federal tax return claiming a refund of $6,668. The IRS adjusted it for one of the refundable credits, reducing her refund to $3,918.

OK. She already received some of her refund as the IRS sent those monthly child tax payments.

Still, let’s do math. $3,918 plus $5,362 from the amended totals refunds of $9,280. Her original refund request was $6,668.

The woman is a tax Houdini.

Our case this time was Lofton V United States. U.S. Court of Claims, No 1:22-cv-01335.

A Ghost Preparer Story

 

I came across a ghost preparer last week.

I rarely see that.

A ghost preparer is someone who prepares a tax return for compensation (me, for example) but who does not sign the return.

This is a big no-no in tax practice. The IRS requires all paid tax preparers to obtain an identification number (PTIN, pronounced “pea tin”) and disclose the same on returns. The IRS can track, for example, how many returns I signed last year via my PTIN. There are also mandates that come with the CPA license.

Why does the ghost do this?

You know why.

It started with a phone call.

Client: What do you know about the employee retention credit?

Me: Quite a bit. Why do you ask?”

Client: I had someone prepare refunds, and I want to know if they look right.”

You may have heard commercials for the ERC on the radio These credits are “for up to $26,000 per employee” but you “must act now.”

Well, yes, it can be up to $26,000 per employee. And yes, one should act soon, because the ERC involves amending tax returns. Generally, one has only three years to amend a return before the tax period closes. This is the statute of limitations, and it is both friend and foe. The IRS cannot chase you after three years, but likewise you cannot amend after the same three years.

The ERC was in place for most of 2020 and for 9 months of 2021. If you are thinking COVID stimulus, you are right. The ERC encouraged employers to retain employees by shifting some of the payroll cost onto the federal government.

Me: I thought you did not qualify for the ERC because you could not meet the revenue reduction.” 

         Client: They thought otherwise.”

         Me: Send it to me.”

He did.

I saw refunds of approximately $240,000 for 2020. I also remember our accountant telling me that the client could not meet the revenue reduction test for 2020. Revenues went down, yes, but not enough to qualify for the credit.

COMMENT: There are two ways to qualify for the ERC: revenue reduction or the mandate. The revenue reduction is more objective, and it requires a decrease in revenue from 2019 (50% decrease for the 2020 ERC; 20% decrease for the 2021 ERC). The second way – a government COVID mandate hobbling the business – does not require revenue reduction but can be more difficult to prove. A restaurant experiencing COVID mandates could prove mandate relatively easily. By contrast, a business experiencing supply-chain issues probably experienced COVID mandates indirectly. The business would likely need its suppliers’ cooperation to show how government mandates closed their (i.e., the suppliers’) doors.

I had our accountant locate the 2020 accounting records. We reviewed the revenue reduction.

The client did not make it.

I called.

Me: Did they say that you qualified under the mandate test?"

         Client: They said I qualified under revenue reduction."

         Me: But you don’t. How could they not tell?"

         Client: Because they never looked at it."

         Me: Then how ….?"

Client: They asked if I had a revenue decline and I said yes. They took my answer and ran with it."

Why would someone do this?

Because that someone works on commission.

There is incentive to maximize the refund, whether right or not.

I was looking at a refund of almost a quarter million dollars.

That would have been a nice commission.

No, the client is not filing those amended returns. He realized the con. He also realized that he had no argument upon IRS audit. He would have to return the money, plus whatever penalties they would layer on. I could no more save him than I could travel to Mars.

He now also understands why they never signed those returns.

Ghosts.

When A Tax Audit Is Not An Audit

 

I am cleaning-up files here at Galactic Command. I saw an e-mail from earlier this year chastising someone for running business deposits through a personal account.

I remember.

He wanted to know why his extension payment came in higher than expected.

Umm, dude, you ran umpteen thousands of dollars through your personal account. I am a CPA, not a psychic.

Let’s spend some time in this yard.

If you are self-employed – think gig worker – and are audited, the IRS is almost certain to ask for copies of your bank accounts. Not just the business account(s), mind you, but all your accounts, business and personal.

I have standard advice for gig workers: open a separate business account. Make all business deposits to that account. Pay all business expenses from that account. When you need personal money, draw the needed amount from the business account and deposit to your personal account.

This gives the accountant a starting point: all deposits are income until shown otherwise. Expenses are trickier because of depreciation, mileage, and other factors.

Is it necessary?

No, but it is best practice.

I stopped counting how many audits I have represented over the years. I may not win the examiner’s trust with my record-keeping, but I assure you that I will win their distrust without it.

Does the examiner want to pry money from you? You bet. Examiners do not like to return to their managers with a no-change.

Will the examiner back-off if all the “i’s” are dotted? That varies per person, of course, but the odds are with you.

And sometimes unexpected things happen.

Let’s look at the Showalter case.

Richard Showalter (RS) owned a single-member LLC. The LLC in turn had one bank account with Wells Fargo.

This should be easy, I am thinking.

RS did not file a tax return for 2013.

Yep, horror stories often start with that line.

The IRS prepared a substitute for return (SFR) for 2013.

COMMENT: The IRS prepares the SFR with information available to it. It will add the 1099s for your interest and dividends, the sales price for any securities trades, any 1099s for your gig, and so forth. It considers the sum to be taxable income.

         Where is the issue?

Here’s one: the IRS does not spot you any cost for securities you sold. Your stock may have gone through the roof, but the odds that it has no cost is astronomical.

Here is another. You have a gig. You have gig expenses. Guess what the IRS does not include in its SFR? Yep, you get no gig expenses.

You may be thinking this has to be the worst tax return ever. It is leaving out obvious numbers.

Except that the IRS is not trying to prepare your tax return. It is trying to get your attention. The IRS throws an inflated number out there and hopes that you have enough savvy to finally file a tax return.

So, RS caught an SFR. The IRS sent him a 90-day notice (also known as a statutory notice of deficiency or SNOD), which is the procedure by which the IRS can move your file to Collections. You already know the tender mercies of IRS Collections.

RS responded to the SNOD by filing with the Tax Court. He wanted his business expenses.

Well, yeah.

RS provided bank statements. The IRS went through and – sure enough – found about $250 grand of deductions, either business or itemized.

That turned out rather well for RS. He should have done this up-front and spared himself the headache.

Then the IRS looked at his deposits. Lo and behold, they found another hundred grand or so that RS did not report as income.

It is not taxable, said RS.

Prove it, said the IRS.

RS did not.

COMMENT: It is unclear to me whether this disputed deposit was fully or partially taxable or wholly nontaxable. The deposit came from a closing statement. Maybe I am being pedantic, but I expect a cost for every sale. The closing statement for the sale is not going to show cost. Still, RS did not argue the point, so ….  

Now think about what RS did by getting into IRS dispute.

RS filed with the Tax Court because he wanted his deductions. Mind you, he could have gotten them by filing a return when required. But no, he did this the hard way.

He now submitted invoices and bank statements to support his deductions.

However, using bank statements is an audit procedure. Why is the IRS using an audit procedure?

Well, he is in Tax Court and all. He picked the battleground.

Had RS filed a return, the IRS might have processed the return without examination or further hassle. Since bank statements are an examination step, the IRS would never have seen them.

Just saying.

Was this this fair play by the IRS?

The Court thought so. The IRS cannot run wild. There must be a “minimal evidentiary showing” tying the taxpayer to potential income. The IRS added up his deposits; that exceeded what he reported as income. Seems to me the IRS cleared the required “minimal” hurdle.

By my reckoning, RS should still come out ahead. The IRS bumped his income by a smidgeon less than a hundred grand, but they also spotted him around a quarter million in business and itemized deductions. Unless there is crazy in that return, this should have improved his tax compared to the SFR.

Our case this time was Richard Showalter v Commissioner, T.C. Memo 2022-114.