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.

Tax Preparer Gives Gambler A Losing Hand

 

I am looking at a bench opinion.

The tax issue is relatively straightforward, so the case is about substantiation. To say that it went off the rails is an understatement.

Let us introduce Jacob Bright. Jacob is in his mid-thirties, works in storm restoration and spends way too much time and money gambling. The court notes that he “recognizes and regrets the negative effect that gambling has had on his life.”

He has three casinos he likes to visit: two are in Minnesota and one in Iowa. He does most of his sports betting in Iowa and plays slots and table games in Minnesota.

He reliably uses a player’s card, so the casinos do much of the accounting for him.

Got it. When he provides his paperwork to his tax preparer, I expect two things:

(1)  Forms W-2G for his winnings

(2)  His player’s card annual accountings

The tax preparer adds up the W-2Gs and shows the sum as gross gambling receipts. Then he/she will cross-check that gambling losses exceed winnings, enter losses as a miscellaneous itemized deduction and move on. It is so rare to see net winnings (at least meaningful winnings) that we won’t even talk about it.

COMMENT: Whereas the tax law changed in 2018 to do away with most miscellaneous itemized deductions, gambling losses survived. One will have to itemize, of course, to claim gambling losses.   

Here starts the downward cascade:

Mr. Bright hired a return preparer who was recommended to him, but he did not get what or whom he expected. Rather than the recommended preparer, the return preparer’s daughter actually prepared his return.”

OK. How did this go south, though?

The return preparer reported that Mr. Bright was a professional gambler ….”

Nope. Mind you, there are a few who will qualify as professionals, but we are talking the unicorns. Being a professional means that you can deduct losses in excess of winnings, thereby possibly creating a net operating loss (NOL). An NOL can offset other income (up to a point), income such as one’s W-2. The IRS is very, very reluctant to allow someone to claim professional gambler status, and the case history is decades long. Jacob’s preparer should have known this. It is not a professional secret.

Jacob did not review the return before signing. For some reason the preparer showed over $240 grand of gross gambling receipts. I added up the information available in the opinion and arrived at little more than $110 grand. I have no idea what she did, and Jacob did not even realize what she did. Perhaps she did not worry about it as she intended the math to zero-out.

She should not have done this.

The IRS adjusted the initial tax filing to disallow professional gambler status.

No surprise.

Jacob then filed an amended return to show his gambling losses as miscellaneous itemized deductions. He did not, however, correct his gross gambling winnings to the $110 grand.

The IRS did not allow the gambling losses on the amended return.

Off to Tax Court they went.

There are several things happening:

(1)  The IRS was arguing that Jacob did not have adequate documentation for his losses. Mind you, there is some truth to this. Casino reports showed gambling activity for months with no W-2Gs (I would presume that he had no winnings, but that is a presumption and not a fact). Slot winnings below $1,200 do not have to be reported, and he gambled on games other than slots. Still, the casino reports do provide some documentation. I would argue that they provide substantiation of his minimum losses.

(2)  Let’s say that the IRS behaved civilly and allowed all the losses on the casino reports. That is swell, but the tax return showed gambling receipts of $240 grand. Unless the casino reports showed losses of (at least) $240 grand, Jacob still had issues.

(3)  The Court disagreed with the IRS disallowing all gambling deductions. It looked at the casino reports, noting that each was prepared differently. Still, it did not require advanced degrees in mathematics to calculate the losses embedded in each report. The Court calculated total losses of slightly over $191 grand. That relieved a lot – but not all – of the pressure on Jacob.

(4)  Jacob did the obvious: he told the Court that the $240 grand of receipts was a bogus number. He did not even know where it came from.

(5)  The IRS immediately responded that it was being whipsawed. Jacob reported the $240 grand number, not the IRS. Now he wanted to change it. Fine, said the IRS: prove the new number. And don’t come back with just numbers reported on W-2Gs. What about smaller winnings? What about winnings from sports betting? If he wanted to change the number, he was also responsible for proving it.

The IRS had a point. It was being unfair and unreasonable but also technically correct.

Bottom line: the IRS was not going to permit Jacob to reduce his gross receipts number without some documentation. Since all he had was the casino reports, the result was that Jacob could not change the number.

Where does this leave us? I see $240 – $191 = $49 grand of bogus income.

My takeaway is that we have just discussed a case of tax malpractice. That is what lawyers are for, Jacob.

Our case this time was Jacob Bright v Commissioner, Docket No. 0794-22.

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.

Repaying a COVID-Related Distribution

Do you remember a tax break in 2020 that allowed you to take (up to) $100,000 from your IRA or your employer retirement plan? These were called “coronavirus-related distributions,” or CRDs in the lingo. In and of itself, the provision was not remarkable. What was remarkable is that one was allowed three years to return some, all, or none of the money to the IRA or employer plan, as one wished.

I was thinking recently that I do not remember seeing 2021 individual returns where someone returned the money.

Granted, we have a flotilla of returns on extension here at Galactic Command. I may yet see this beast in its natural state.

Let’s go over how this provision works.

To make it easy, let’s say that you took $100,000 from your 401(k) in 2020 for qualifying COVID-related reasons.

You had an immediate binary decision:

·      Report the entire $100,000 as income in 2020 and pay the taxes immediately.

·      Spread the reporting of the $100 grand over three years – 2020, 2021 and 2022 - and pay taxes over three years.

There was no early-distribution penalty on this distribution, which was good.

You might wonder how paying the tax immediately could be preferable to paying over three years. It could happen. How? Say that you had a business and it got decimated by COVID lockdowns. Your 2020 income might be very low – heck, you might even have an overall tax loss. If that were the case, reporting the income and paying the tax in 2020 might make sense, especially if you expected your subsequent years’ income to return to normal levels.

What was a COVID-related reason for a distribution?

The easy ones are:

·      You, a spouse or dependent were diagnosed (and possibly quarantined) with COVID;

·      You had childcare issues because of COVID;

·      You were furloughed, laid-off or had work hours reduced because of COVID.

Makes sense. There is one more:

·      You experienced other “adverse financial consequences” because of COVID.

That last one has an open-gate feel to me. I’ll give you an example:

·      You own rental cabins in Aspen. No one was renting your cabins in 2020. Did you experience “adverse financial consequences” triggering this tax provision?

You have – should you choose to do so – three years to put the money back. The three-year period starts with the date of distribution, so it does not automatically mean (in fact, it is unlikely to be) December 31^st three years later.

The money doesn’t have to return to the same IRA or employer plan. Any qualifying IRA or employer plan will work. Makes sense, as there is a more-than-incidental chance that someone no longer works for the same employer.

 Let’s say that you decide to return $50 grand of the $100 grand.

The tax reporting depends on how you reported the $100 grand in 2020.

Remember that there were two ways to go:

·      Report all of it in 2020

This is easy.

You reported $100 grand in 2020.

When you return $50 grand you … amend 2020 and reduce income by $50 grand.

What if you return $50 grand over two payments – one in 2021 and again in 2022?

Easy: you amend 2020 for the 2021 and amend 2020 again for the 2022.

Question: can you keep amending like that – that is, amending an amended?

Answer: you bet.

·       Report the $100 grand over three years.

This is not so easy.

The reporting depends on how much of the $100 grand you have left to report.

Let’s say that you are in the second year of the three-year spread and repay $30,000 to your IRA or employer plan.

The test here is: did you repay the includable amount (or less) for that year?

If yes, just subtract the repayment from the includable amount and report the difference on that year’s return.

In our example, the math would be $33,333 - 30,000 = $3,333. You would report $3,333 for the second year of the spread.

If no, then it gets ugly.

Let’s revise our example to say that you repaid $40,000 rather than $30,000.

First step: You would offset the current-year includable amount entirely. There is nothing to report the second year, and you still have $6,667 ($40,000 – 33,333) remaining.

You have a decision.

You have a year left on the three-year spread. You could elect to carryforward the $6,667 to that year. You would report $26,666 ($33,333 – 6,667) in income for that third and final year.

You could alternatively choose to amend a prior year for the $6,667. For example, you already reported $33,333 in 2020, so you could amend 2020, reduce income by $6,666 and get an immediate tax refund.

Which is better? Neither is inherently better, at least to my thinking. It depends on your situation.

There is a specific tax form to use with spreads and repayments of CRDs. I will spare us the details for this discussion.

There you have it: the ropes to repaying a coronavirus-related distribution (CRD).

If you reflect, do you see the complexity Congress added to the tax Code? Multiply this provision by however many times Congress alters the Code every year, and you can see how we have gotten to the point where an average person is probably unable to prepare his/her own tax return.

 

Literacy And Tax Penalties

I am looking at a Tax Court case.

It does not break any new ground, but there is a twist I do not remember seeing before.

Michael Torres and Elizabeth Ruzendall founded an S corporation (Water Warehouse).

In 2016 Michael found himself in a bad way health-wise. Elizabeth was around, though, even though she was no longer an owner. She ran the company in Michael’s absence.

It must have been a sweet gig, as Water Warehouse issued her a $166,494 Form 1099 for 2016.

Here is the oddball fact: Michael could not read or write. He was sick for so long, however, that he had time to learn.

Good for him.

In 2017 he came across the Form 1099. He could now read.

In 2018 he filed civil suit against Elizabeth.

Both the company’s and Michael’s personal 2016 tax returns were due in 2017. That did not happen, and both returns were filed in 2018.

Remember that an S corporation normally does not pay its own taxes. Instead, the S income would be included on Michael’s personal return, and he would pay tax on the sum.

Michael amended the 2016 S corporation return to subtract the $166,494 paid Elizabeth. Amended returns take an explanation, and it appears that the word “theft” may have come up.

As the corporate income went down, Michael’s personal income would simultaneously go down. Michael was now expecting a refund for 2016.

The IRS told him to pound sand.

And off to Court they went.

Embezzlement or theft are maddening topics in the tax Code.

A key question was whether a theft even occurred. When Elizabeth was running the show in 2016, Michael told her to take “what she felt was her pay.”

Be fair: Elizabeth could easily argue that she had done that.

Except she testified to taking the funds without Michael’s authorization.

And then you have the hurdles of the tax law itself.

The Code says that a theft is deductible when discovered.

Matthew discovered the theft in 2017.

He amended the 2016 corporate and personal tax returns.

That were due in 2017.

But filed late in 2018.

When was the theft discovered?

That would be 2017.

It cannot go on a 2016 return. It could go on a 2017 return, though.

Michael struck out. He claimed the theft a year early.

COMMENT: Once tax year 2016 became an issue with the IRS, he should have filed a protective claim for 2017. The purpose of the claim would be to keep the 2017 tax year open if the theft deduction in 2016 went against him.

The IRS however marched on: it wanted penalties.

I get it: he failed to file those 2016 returns on time.

However, the penalty can be abated for reasonable cause.

The Court said the IRS had reached too far. Michael had been sick for an extended period of time. He hired a new accountant upon learning of the 2016 issues. He taught himself to read and write. e taught himself to read and writeHe could now review his own accounting records rather than having to rely on others.

 

It sounded reasonable to the Court.

To me too.

This is the first time I can remember somebody receiving penalty abatement citing illiteracy.

However, it is probably more correct to say that Michael received abatement for becoming literate. I would say the Court liked him.

Our case this time was Torres v Commissioner, T.C. Memo 2021-66.

A CPA’s Signature And The Informal Claim Doctrine

 

I am looking at case where the CPA signed a return on behalf of a client.

Been there and done that.

There is a hard-and-fast rule when you do this.

Let’s go through it.

The Mattsons were working in Australia for the Raytheon Corporation.

In April, 2017 they timely filed their 2016 individual tax return, paying $21,190 in federal taxes.

COMMENT: This immediately strikes me as odd. I would have anticipated a foreign income exclusion. Maybe they were over the exclusion limit, meaning that some of their income was exposed to U.S. tax. Even so, I would then have expected a foreign tax credit, offsetting U.S. tax by taxes paid to Australia.

Turns out they had signed a closing agreement when they went to Australia. The agreement was with the IRS, and they waived their right to claim the foreign income exclusion.

Ahh, that answers my first question.

Why would they do this?

In return for agreeing not to claim the 911 exclusion, the government of Australia has entered into an agreement with the United States Government not to subject the income earned by the taxpayer to Australian taxes."

Yep, there are advantages to working with the big company. It also answers my second question.

Seems to me that we are done here. Taxpayers paid taxes on their Australian wages solely to the United States. In exchange they forwent the foreign income exclusion. Makes sense.

The Mattsons changed CPA firms. The new firm prepared an amended 2016 return for – you guessed it – the foreign income exclusion.

COMMENT: I presume the new firm did not know about the closing agreement.

A CPA at the firm signed the amended return on behalf of the Mattsons.

No problem, but she did not attach a power of attorney authorizing the CPA to sign the return.

Not good, but there is time to fix this.

The IRS held the amended return and sent a letter wanting to know why the Mattsons had taken a position contrary to the closing agreement.

Me too.

In May, 2019 the CPA firm requested an Appeals hearing.

OK.

In July, 2019 the IRS sent a letter that they were disallowing the refund.

The taxpayers filed suit in Court.

To me, the controversy was done with discovery of the closing agreement. There is a Don Quixote quality to this story once that fact came to light.

There is a requirement in the tax Code and a list of cases as long as my arm that taxpayers have to sign a return, especially a claim (that is, a return requesting a refund). A CPA can sign the return on behalf of a client, but the CPA is charged with attaching a copy of a power of attorney to the return.

Hold on, argued the CPA. We sent a power of attorney to the IRS in November, 2018.

This is new information.

And it introduces the “informal claim” doctrine to our discussion.

The idea is that the taxpayer can correct the defect in a claim. That is what “informal” means in this context – think of the first claim as a placeholder until it is perfected. The CPA firm had failed to initially attach a power of attorney, but it subsequently corrected this error in November, 2018.

Issue: the claim has to be perfected BEFORE the start of a lawsuit.

Fact One: the lawsuit was filed in July, 2019.

Fact Two: the power was sent to the IRS in November, 2018.

Reasoning: the dates work.

Question: did the taxpayer correct their claim in time?

I sign powers of attorney all the time. I doubt I go a week without filing at least one with the IRS. I like to explain to clients (unless they have been through the process before) what the limitations are to a standard tax power of attorney. I can call the IRS, request and/or agree to adjustments or stays, and so forth.

However, what our standard power does not do is allow me to sign the return. A client can give me that authority, true, but is has to be separately stated on the power. Our routine powers here at Galactic Command, for example, do not include the authority to sign a return on behalf of a client. In truth, unless there are exceptional circumstances, I do not want that authority. I don’t want to receive a client’s refund check, either.

I can almost visualize what happened.

The CPA signed the return. She knew that she needed a power, so she – or a staff accountant – generated one from their software. It was a default power, the one they – like we – use in almost all cases. No one paused to consider that the default power was not appropriate in this instance.

There was still time to fix this. The firm could revise the power to allow the CPA authority to sign, collect the appropriate signatures and record the power with the IRS.

But they had to do this before bringing suit.

Which they did not.

The informal claim doctrine did not apply, because the placeholder claim was not perfected before filing suit.

Our case this time was Mattson v U.S., 2021 PTC 110 (Fed Cl 2021).