I have been
thinking about IRS penalties. I had a
client that racked up payroll tax penalties, and we tried to get them waived.
The IRS thought otherwise. Many tax practitioners will tell you that penalty
abatement rests as much on drawing a sympathetic IRS officer as any technical argument
the practitioner can offer. I am increasingly a member of that camp.
Let’s
briefly discuss my client, and then let’s discuss the Arthur and Cheryl
English Tax Court decision.
I acquired a
new client from a sole practitioner. He had been their accountant for a number
of years, and it was his usual routine to go out, review the books, prepare a
payables listing, run payroll and whatnot. Fairly routine stuff. The client then
bought a business. In addition to more complicated accounting, the accountant now
had some additional payroll tax issues to address.
It did not
go well. The accountant miscalculated certain third-quarter payroll tax
deposits. Others he simply deposited late. He continued this into the fourth quarter.
The client sensed something was wrong, and then decided something was in fact wrong.
This took time, of course. By the time my client hired me, the prior accountant
had affected two tax quarters.
The IRS –of
course – came back quickly with penalties.
I disagreed
with the penalties. My client – relying on a tax professional – paid as and
when instructed. Granted, my client eventually realized that something was
amiss, but surely there is permitted a reasonable period to investigate and replace
a tax advisor. Payroll can have semiweekly tax deposit requirements, which
timeframe may be among the most compressed in the tax Code. It does not mesh at
all with replacing a nonperforming professional.
We got the
third quarter penalties waived.
Then the IRS
came after quarter four. I once again trotted out my reasonable cause request.
The IRS denied abatement, in response to which we requested an Appeals
hearing. My heart sank a bit to learn
that our case went before a newly minted Appeals officer. She could not understand
why the client had not “resolved” the payroll issue by the end of quarter three.
Surely, she insisted, my client “must have known” that there was a problem, and
he should have done an “investigation” or something along those lines. She
trotted out the well-worn trope that is the bane to many a reasonable cause request:
a taxpayer is not allowed to “delegate” his tax responsibility to another, even
if that other is a tax professional.
At what
point does reliance on a tax professional extend to “delegation” of responsibilities?
Apparently, my scale was quite different from that of this brand-new Appeals
officer.
We lost the
appeal.
Sigh. I
suspect that – in about ten years – she would decide the same case differently.
Let’s talk
about Cheryl English.
Cheryl
became disabled in 2007. She carried a private disability policy with Hartford
Insurance, and Hartford paid while she filed and waited on her social security
disability claim. There was a catch, however. If Cheryl were successful in receiving
social security, her Hartford benefits would be reduced by any social security
benefits she received.
In 2010 she won her social security claim. She
received a check of approximately $49,000, from which she forwarded approximately
$48,000 to Hartford. She netted approximately $1,500 when the dust cleared.
And there is
a nasty tax trap here.
If one
purchases a private disability policy and pays for it on an after-tax basis,
then any benefits received on the policy are tax-free. It is one of the reasons
that many tax advisors – including me – frown on using a cafeteria plan to purchase
disability coverage.
Cheryl
received tax-free benefits from Hartford.
Then she
received social security.
She
consulted with two CPAs. Both assured her that – since the social security was
being used to repay nontaxable benefits – it would be nontaxable.
There is symmetry
to their answer.
However, taxes
are not necessarily symmetrical. The Code states what is taxable. Both CPAs were
wrong.
Social
security can be taxable. The same is true for social security disability.
The IRS
wanted tax of approximately $10,500. They also wanted an “accuracy” penalty of
approximately $2,100.
OBSERVATION: Remember that Cheryl only cleared approximately
$1,500 from the transaction. The IRS wanted approximately $12,600 in taxes and
penalties. There clearly is lunacy here.
Cheryl took
the case pro se to the Tax Court.
NOTE: “Pro se” means she represented
herself.
The Court
reviewed the Code, where it found that social security benefits could be
nontaxable if one repays the benefits. That is not what happened here, however.
Cheryl received social security benefits but repaid an insurance company, not
the Social Security Administration. The Court looked for other exceptions, but
finding none it determined that the benefits were taxable.
She owed the
tax.
The Court
struck down the “accuracy” penalty, though, observing that she sought the
opinion of two CPAs and acted with reasonable cause and in good faith. The
Court commented on the complexity of the tax law in this area, stating:
The disparate treatment of private and public disability
benefits for tax purposes is curious and somewhat confusing,”
I am
curious why Cheryl made no claim-of-right argument. There is a provision in the
Code for (some) tax relief when a taxpayer recognizes something as income and
later has to pay it back. I presume the reason is that Cheryl did not have tax
(or much tax) in the Hartford years, so the tax break would have been zero or
close to it when she repaid Hartford.
Cheryl won
on the penalty front, but she still had to pay taxes of $10,500 on
approximately $1,500 of net benefits. Frankly, she may have been better off not
having the Hartford policy in the first place.
