A Failed E-Filed Return Hit With Penalties

 

I have noticed something about electronic filing of tax returns, especially state returns: there is a noticeable creep to demanding more and more information. I can understand if we are discussing tax-significant information, but too often the matter is irrelevant. We received a bounce from Wisconsin, for example, simply because there was a descriptor deep in the state return without an accompanying number.

How did this happen? Perhaps there was a number last year but not one this year. Could an accountant have scrubbed it out? Yes, in the same way that I could have played in the NFL. Work on a return of several hundred pages, add a few states in there for amusement, tighten the screws by closing in on a 15^th deadline and you might miss a description on a line having no effect on the accuracy of the return.

Why is this an issue?

Because if a state – say Wisconsin - bounces a return, then it is the same as never having filed a return. The penalties for not filing a return are more severe than – for example - filing a return but not paying the tax. Does it strike you as a bit absurd for a state to argue that one never filed a return when an accountant prepared (and charged one for) that state return?

The US Tax Court has reviewed the issue of what counts as a federal tax return in a famous case called Beard v Commissioner. The Court looks at four items, each of which has to be met:

·      It must purport to be a return;

·      It must be signed under penalty of perjury;

·      It must contain sufficient information to allow the calculation of the tax; and

·      It must be an honest and reasonable attempt to satisfy the requirements of the tax law.

Let’s look at a case involving the Beard test.

John Spottiswood (let’s call him Mr S) filed a joint 2012 tax return using TurboTax. He made a mistake when entering a dependent’s social security number. He submitted the electronic return through TurboTax on or around April 12. Within a short period, TurboTax sent him an e-mail that the IRS had rejected the return.

Problem: The e-mail was sitting in TurboTax. Mr S needed to log back in to TurboTax to see the e-mail. A professional would know to check, but an ordinary individual might not think of it.

Another Problem: Mr S owed almost $400 grand with the return. Since the return was never accepted, the bank transfer never happened. He did not pay the tax until almost 2 years later.

The IRS tagged him over $40 grand for late payment of tax.

I have no issue with this. Think of the $40 grand as interest.

The IRS also tagged him over $89 grand for late filing of the return.

I have an issue here. Mr S did try to file; the IRS rejected his return. I see a significant difference between someone trying and failing to file a return and someone who simply blew off the responsibility to file. It strikes me as profoundly unfair to equate the two.

Mr S protested the late filing penalty.

He had two arguments:

(1)  He did file (per the Beard standard).

(2)  Failing that, he had reasonable cause to abate the penalty.

I like the first argument. I would advise Mr S to provide a copy of the return to the Court and request Beard.

COMMENT: I suppose the issue is whether the return would meet the third test – sufficient information to calculate the tax. I would argue that it would, as the IRS could deny the dependency exemption and recalculate the tax accordingly. If Mr S objected to the loss of the exemption, he could investigate and correct the social security number.

FURTHER COMMENT: The IRS argued that it could not calculate the tax because it had rejected the return. I consider this argument sophistry, at best. The IRS could simply reject a return ... some returns … all returns … and make the same argument.

But Mr S could not provide a copy of the return.

Why not? Who knows. I suppose he never kept a copy and later lost the username and password to the software.

The Court cut him no slack. To conclude that the return met the Beard standard, the Court had to … you know … look at his return.

That left his second argument: reasonable cause.

The Court again cut him no slack.

The Court said that he should have logged back into TurboTax and yada yada yada.

Seems severe except for one thing: how could Mr S fail to realize that he never got dinged with an almost-$400 thousand bank transfer? I get that he carried a large bank balance, but reasonable people would pay attention when moving $400 grand.

Mr S could not provide a copy of his return nor could he explain how he could blow-off $400 grand. The Court was not buying his jibe.

There was no Beard for Mr S, nor was there reasonable cause to abate the penalty.

OBSERVATION: It occurs to me that Mr S may have received no advantage from the dependency exemption. This case involves a 2012 tax return, and for 2012 it is very possible that the alternative minimum tax (AMT) applied to this return. The AMT serves to disallow selected tax attributes to higher-income taxpayers – attributes such as a dependency exemption (I am not making this up, folks). The Court did not say one way or the other, but I am left wondering if he was penalized for something that did not affect his ultimate tax.

Our case this time was Spottiswood v US.

Abatement Versus Refund

 

I was contacted recently to inquire about my interest in a proceduralist opportunity.

That raises the question: what is a proceduralist?

Think about navigating the IRS: notices, audits, payment plans, innocent spouse claims, liens and so on.  One should include state tax agencies too. During my career, I have seen states become increasingly aggressive. Especially after COVID – and its drain on state coffers - I suspect this trend will only continue.

I refer to procedure as “working the machine.” This is not about planning for a transaction, researching a tax consequence or preparing a tax return. That part is done. You have moved on to something else concerning that tax return.

Less glamorously, it means that I usually get all the notices.

Let’s go procedural this time.

Let’s talk about the difference between an abatement and a refund.

Mr Porporato (Mr P) filed a return for 2009. He owed approximately $10 grand in taxes.

He did not file for 2010 or 2011. The IRS prepared returns for him (called a Substitute Return), and he again owed approximately $10 grand for each year.

COMMENT: He had withholding but he still owed tax for each year. He probably showed have adjusted his withholding, but, then again, he went a couple of years without even filing. I doubt he cared.

The IRS came a-calling for the money, and Mr P requested a Collection Due Process hearing.

COMMENT: I agree, and that is what a CDP hearing is about. Mind you, the IRS wants to hear about payment plans, but at least you have a chance to consolidate the years and work-out a payment schedule.

There was chop in the water that we will not get into, other than Mr P’s claim that he had a refund for 2005 that was being ignored.

So what happened with 2005?

Mr P and his (ex) wife filed a joint 2005 return on June 15, 2006.

Then came a separation, then a divorce, then an innocent spouse claim.

Yeeessshhh.

He amended his 2005 return on March 29, 2010. The amended return changed matters from tax due to a tax overpayment. The IRS abated his 2005 liability.

There you have the first of our key words: abatement.

Let’s review the statute of limitations (SOL). You generally have three years to file a tax return and claim your refund, if any. Go past the three years and the IRS keeps your refund. There are modifiers in there, but that is the general picture. We also know the flip side of the SOL: the IRS has three years to examine your return. Go past three years and the IRS cannot look at that year (again, with modifiers). Why is this? It mostly has to do with administration. Somewhere in there you have to close the matter and move on.

Let’s point out that Mr P amended his 2005 return after more than three years. The IRS still reversed his tax due.

Can the IRS do that?

Yep.

Why?

An IRS can abate at any time. Abatement is not subject to the restrictions of the SOL.

Abatement means that the IRS reducing what it wants to collect from you.

But the result was an overpayment.

Mr P wanted the IRS to refund his 2005 overpayment – more specifically, to refund via application of the overpayment to later tax years with balances due.

This is not the IRS reducing what it wants to collect. This is in fact going the other way: think of it as the IRS writing a check.

Wanting the IRS to write a check ran Mr P full-face into the statute of limitations. He filed the 2005 amended outside the three-year window, meaning that the SOL on the refund was triggered.

I get where Mr P was coming from. The IRS cut him slack on 2005, so he figured he was entitled to the rest of the slack.

He was wrong.

And there you have the procedural difference between an abatement and a refund. The IRS has the authority to reduce the amount it considers due from you, without regard to the SOL. The IRS however does not have the authority to write you a check after the SOL has expired.

Another way to say this is: you left money on the table.

Our case this time was Porporato v Commissioner (TC Summary Opinion 2020-24).