A Rant On IRS Penalties

I am reading that the number one most-litigated tax issue is the accuracy-related penalty, and it has been so for the last four years.

The issue starts off innocently enough:

You may qualify for relief from penalties if you made an effort to comply with the requirements of the law, but were unable to meet your tax obligations, due to circumstances beyond your control.

I see three immediate points:

(1)  You were unable to file, file correctly, pay, or pay in full

(2)  You did legitimately try

(3)  And it was all beyond your control

That last one has become problematic, as the IRS has come to think that all the tremolos of the universe are under your control.

One of the ways to abate a penalty is to present reasonable cause. Here is the IRS:

Reasonable cause is based on all the facts and circumstances in your situation. The IRS will consider any reason which establishes that you used all ordinary business care and prudence to meet your federal tax obligations but were nevertheless unable to do so.

How about some examples?

·       Death

Something less … permanent, please.

·       Advice from the IRS

·       Advice from a tax advisor

That second one is not what you might think. Let’s say that I am your tax advisor. We decide to extend your tax return, as we are waiting for additional information. We however fail to do so. It got overlooked, or maybe someone mistakenly thought it had already been filed. Whatever. You trusted us, and we let you down.

There is a Supreme Court case called Boyle. It separated tax responsibilities between those that are substantive/technical (and reasonable cause is possible) and those which are administrative/magisterial (and reasonable cause is not). Having taken a wrong first step, the Court then goes on to reason that the administrative/magisterial tasks were not likely candidates for reasonable cause. Why? Because the taxpayer could have done a little research and realized that something – an extension, for example - was required. That level of responsibility cannot be delegated. The fact that the taxpayer paid a professional to take care of it was beside the point.

So you go to a dentist who uses the wrong technique to repair your broken tooth. Had you spent a little time on YouTube, you would have found a video from the UK College of Dentistry that discussed your exact procedure. Do you think this invites a Boyle-level distinction?

Of course not. You went to a dentist so that you did not have to go to dental school. You go to a tax CPA so that do not have to obtain a degree, sit for the exam and then spend years learning the ropes.      

·     

• Fire, casualty, natural disaster or other disturbances
• Inability to obtain records
• Serious illness, incapacitation or unavoidable absence of the taxpayer or a member of the taxpayer’s immediate family

I am noticing something here: you are not in control of your life. Some outside force acted upon you, and like a Kansas song you were just dust in the wind.

How about this one: you forgot, you flubbed, you missed departure time at the dock of the bay? Forgive you for being human.

This gets us to back to those initially innocuous string of words:

          … due to circumstances beyond your control.”

When one does what I do, one might be unimpressed with what the IRS considers to be under your control.

Let me give you an example of a penalty appeal I have in right now. I will tweak the details, but the gist is there.

·   You changed jobs in 2015 

·   You had a 401(k) loan when you left

·   Nobody told you that you had to repay that loan within 60 days or it would be considered a taxable distribution to you. 

·   You received and reviewed your 2015 year-end plan statement. Sure enough, it still showed the loan.  

·   You got quarterly statements in 2016. They also continued to show the loan. 

·    Ditto for quarter one, 2017. 

·   The plan then changed third-party administrators. The new TPA noticed what happened, removed the loan and sent a 1099 to the IRS.

o   Mind you, this is a 1099 sent in 2017 for 2015.

o   To make it worse, the TPA did not send you a 1099.     

•  The IRS computers whirl and sent you a notice.
•  You sent it to me. You amended. You paid tax and interest.
•  The IRS now wants a belt-tightening accuracy-related penalty because ….

Granted, I am a taxpayer-oriented practitioner, but I see reasonable cause here. Should you have known the tax consequence when you changed jobs in 2015? I disagree. You are a normal person. As a normal you are not in thrall to the government to review, understand and recall every iota of regulatory nonsense they rain down like confetti at the end of a Super Bowl. Granted, you might have known, as the 401(k)-loan tax trap is somewhat well-known, but that is not the same as saying that you are expected to know.  

I know, but you never received a 1099 to give me. We never discussed it, the same as we never discussed Tigris-Euphrates basin pottery. Why would we?

Not everything you and I do daily comes out with WWE-synchronized choreography. It happens. Welcome to adulthood. I recently had IRS Covington send me someone else’s tax information. I left two messages and one fax for the responsible IRS employee – you know, in case she wanted the information back and process the file correctly – and all I have heard since is crickets. Is that reasonable? How dare the IRS hold you to a standard they themselves cannot meet?

I have several penalty appeals in to the IRS, so I guess I am one of those practitioners clogging up the system. I have gotten to the point that I am drafting my initial penalty abatement requests with an eye towards appeal, as the IRS has  convinced me that they will not allow reasonable cause on first pass - no matter what, unless you are willing to die or be permanently injured. 

I have practiced long enough that I remember when the IRS was more reasonable on such matters. But that was before political misadventures and the resulting Congressional budget muzzle. The IRS then seemed to view penalties as a relief valve on its budget pressures. Automatically assess. Tie up a tax advisor’s time. Implement a penalty review software package in the name of uniformity, but that package's name is “No.” The IRS has become an addict.

Penalties And Reliance On A Tax Professional

I am working a penalty appeal case. The owner was fortunate: the business survived. There was a time when his fate was uncertain.

The IRS is being … difficult. The IRS considers “reasonable cause” when considering whether to mitigate or abate many penalties. The idea is simple enough: would a “reasonable” person have acted the same way, knowing his/her responsibility under the tax law?

That is a surprisingly high standard, considering that there are professionals who spend a career mastering the tax law. There is stuff in there that no reasonable person would suspect. I know. I make a living at it.

Back to my appeal case: take an overworked and overstressed business owner. He is facing the more-than-unlikely possibility of bankruptcy. It is the end of the year and his accountant mails him W-2s for distribution to employees. He does so and puts the envelope on a stack of paperwork. He forgets to send the employer copies to the IRS. Granted, this is not as likely to happen today with electronic filing, but it did happen and not so many years ago.

The IRS nails him. Mind you, he distributed the W-2s to the employees. He filed all the quarterly reports, he made all the tax deposits. He had a bad day, a messy office and forgot to put a piece of paper in the mail.

Do you think he has reasonable cause – at least to reduce the penalties - considering all the other factors in his favor?  I think so. The IRS thinks otherwise.

Here is another one: you hire me to prepare an estate return. These things are rare enough. First of all, someone has to die. Second, someone has to have enough assets to be required to file. I tell you that the return is due next March. It turns out I am wrong, and the return is actually due in February.

The IRS sends a you a zillion-dollar penalty notice for filing the estate return late.

Do you have reasonable cause?

You might think this is relatively straightforward, but you would be wrong.

Let’s go through it:

(Q) Did you hire a professional?

(A) Yes

(Q) Was the professional qualified?

(A) I presume so. He/she had initials after their name.

(Q) Did you disclose all facts to the professional?

(A) I think so. Someone died. I presume the professional would prompt and question me on matters I would not know or have thought of.

(Q) Did you rely on the professional for matters of tax law?

(A) Uh, yes. Do you know what these accountants charge?

(Q) I mean, as opposed to something you can look up yourself.

(A) What do you mean?

That last one is alluding to a “ministerial” act. Think signing a return, putting a stamp on the envelope and dropping it in the mailbox. All the hard lifting is done, and it is time to break down and throw away the moving boxes.

Sounds easy enough.

Until someone pulls the rug out from underneath you by changing the meaning of “ministerial.”

That someone was the Supreme Court in Boyle, when it decided that a taxpayer’s reliance on a tax professional for an estate return’s due date was not enough. The taxpayer knew that a return was required. The taxpayer could not “delegate” the responsibility for timely filing by …. accepting the tax professional’s advice on when the return was due.

If that sentence makes no sense, it is because Boyle makes no sense outside the fantasy world of a tax zealot.

If you go to see a dentist, are you required to study-up on dental compounds, as the decision to use silver rather than composite could be deemed “ministerial?”

The IRS, sniffing an opportunity to ram even more penalties down your throat, has taken Boyle and characterized it to mean that reliance on a tax professional can never rise to reasonable cause.

As a tax professional, I take offense at that.

The IRS gets occasionally stopped in its tracks, fortunately, but not often enough.

I practice. I am only too aware that “it” happens. It is not a matter of being irresponsible or lacking diligence or other snarky phrases. It is a matter that one person – or a very small group of people – is multitasking as management, labor, owner, analyst, financier, ombudsman and so on. Perhaps you are a business owner thinking that you waited too long on replacing that employee who left…  did you call the insurance agent about the new business vehicle … you have to find time to talk to the banker about increasing your credit line… hey, did you see something from the accountant in the mail?

Yes, I get frustrated with the IRS and its unrealistic “reasonable” standard. Reasonable should be real-world based and not require pilgrimage to a Platonic ideal. Life is not a movie. “It” happens, even in an accounting firm. Yes, accountants make mistakes too.

Rounding back, though, there is one thing you must show if you are arguing that you relied on a tax professional.

I am reading the recent Keenan case. This thing has to do with Section 419 plans, which are employee welfare plans that were unfortunately abused by charlatans. The abuse is simple enough. Set up a welfare plan, preferably just for you. Stuff the thing to the gills with life insurance. Deduct everything for a few years. Then close the plan, buy the insurance for a pittance and meet with a financial planner about retirement.

The IRS got cranky – understandably - and starting looking at these things as tax shelters.

Which means outsized penalties.

So Keenan was in a penalty situation. He points at the accountant and says “Hey, I relied on you to keep me out of trouble.”

Problem: the taxpayer did whatever the taxpayer was going to so. There was sweet money at the end of that rainbow. Accountant? Please.

Not that the accountant was without fault. He should have researched these things harder. If he then had reservations, he should have either insisted on the correct tax reporting or have fired Keenan as a client.

The correct reporting is not hard. You can take the deduction, but you have to flag it for the IRS. The IRS can then pursue or not, but you met your responsibility. I have done so myself when a partner has brought in a hyper-aggressive client. By doing so I am protecting both my license and the client from those outsized penalties.

That was not going to happen with Keenan.

Keenan lost the case for the most obvious reason: to argue reliance on a professional you have to actually rely on a professional.

A Baseball Player Gets Hit By A Penalty

I have a question for you: let’s say you are a professional athlete. You have hired a financial advisor and an accountant. You give the financial advisor a durable power of attorney, allowing him/her to pay your bills, manage your money and grow your investments. You ask your accountant to prepare tax returns as necessary keep you out of trouble.

These services are not cheap. They cost you an upfront fee of $150,000 and an ongoing $360,000 annually.

            COMMENT: I am available and open to relocation.

You get robbed for millions of dollars. Tax returns do not get filed.

The IRS now wants big penalties from you.

QUESTION: Do you have “reasonable cause” to have the IRS remove those penalties?

We are talking about Mo Vaughn, who played baseball with the Red Sox, the Anaheim Angels and the New York Mets in the nineties and aughts.  He was the American League MVP in 1995.

In 2004 he hired Ra Shonda Kay Marshall to handle his money matters. She wound up leaving her employer, Omni Elite, and set up her own company, RKM Business Services, Inc. He also hired David Krebs with CPA Advisory Group, Inc. for the preparation of his tax returns.

Something happened, and in 2008 he fired both of them. Vaughn was going through his bank statements when he realized that Marshall had been embezzling. He hired forensic accountants, who determined that from 2004 to 2008 she had embezzled more than $2.7 million.

He then learned that his 2006 taxes were not paid.

Even that was better news than 2007, when his taxes were not even filed, much less paid.

He sued Marshall and RKM Business Services.

He hired new CPAs to get him caught up. The IRS – in that show of neighborliness that we have come to expect – hit him with penalties of $1,037,158 for 2006 and $102,106 for 2007. He had filed and/or paid late, and there were penalties for both.

He owed the tax, of course, but he had to contest the penalties. He went the administrative route – meaning appealing and working within the IRS itself. Striking out, he then took his case to court. He went to district court and then to appeals.

His main argument was simple: he was paying people to keep him out of tax problems. There was a lot of money leaving his account, so he had every reason to believe that a good chunk of it was going to the IRS. He was robbed. The IRS was robbed. Surely robbery is reasonable cause.

The IRS and the court pretty much knew his story at this point, and they knew that he was suing to get his millions back. The court however decided the government was due its money. There was no reasonable cause.

How is this possible?

There is a tax case (Boyle) where the Supreme Court addressed the issue of penalties assessed a taxpayer for his/her agent’s failure to file and pay taxes. The Court stated:

“It requires no special training or effort to ascertain a deadline and make sure that it is met. The failure to make a timely filing of a tax return is not excused by the taxpayer’s reliance on an agent, and such reliance is not ‘reasonable cause’ for a late filing under [Section] 6651(a)(1).”

The Court was addressing deadlines, and it set a fairly high standard. The Court distinguished relying on an attorney or accountant for advice from relying on an attorney or accountant to actually file the return itself. Reliance on an agent did not relieve the principal of compliance with statutory deadlines, except in extremely limited circumstances.

Vaughn could not clear this standard. He had delegated too much when he turned over responsibility for both preparing and filing his taxes to Marshall and Krebs.

Vaughn had a backup argument: the malfeasance of his agents rendered him unable to pay. He did not have enough money left to pay taxes by the time Marshall was done with him.

He was referring to a tax case (American Biomaterials Corp) where two corporate officers defrauded their corporation, including failing to file and pay taxes. Those two were the only officers with the responsibility to file returns and make payment. The Court held that the corporation was not vicariously liable for the acts of its officers and therefore was not liable for penalties.

There is a limit on American Biomaterials, though: a corporation is not entitled to relief if – by act or omission – its internal controls are so lax that that there was no reasonable expectation that malfeasance would be detected in the ordinary course of business. In other words, the corporation cannot willfully neglect normal checks and balances and expect to be relieved of penalties.

Vaughn got smacked on his second argument. The Court noted the obvious: in American Biomaterials there was no one left in the company to file and pay the taxes. This was not Vaughn’s situation. While he had delegated responsibility, there was someone left who could and should have stepped in: Mo Vaughn himself. He did not. That was his decision and provided both reason and cause to impose penalties.

And so Vaughn lost both in the district and the appeals courts. He owed the IRS enough penalties to allow either you or me to retire. He lost because he delegated the one thing the tax Code does not allow one to delegate, except in the most extreme cases: the duty to file the return itself.