The Goose And Gander Tax Bill

Here is something that will catch your eye:

It is undisputed that the Debtor failed to file its tax returns for the years 2006 to 2008; and that for such failure, the Debtor incurred penalties totaling $3,662,000."

It is a bankruptcy case from Delaware.

COMMENT: You may wonder how a tax case wound up in bankruptcy court. Bankruptcy law keeps its own beat, and a bankruptcy court can have near-extraordinary powers. For example, the court can determine the amount or legality of any tax, any fine, or any penalty relating to a tax. That is what happened here. The IRS assessed a penalty, the taxpayer protested, the IRS decided it was right (surprise) and submitted the penalty as a claim to the bankruptcy court.

And I find the IRS position so extreme as to constitute bad faith. I further think the IRS should be required to reimburse the professional fees incurred defending against its reckless behavior. You miss a filing deadline by a day or two and one would think the Treasury underpinnings of the nation are in mortal throes. Have the IRS bankrupt you while enforcing some capricious tax argument, however, and you are expected to be a good sport.

I would like to someone (ahem, US Senator Paul) take up the cause. It could be called the Good For The Goose, Good For The Gander - Time For The IRS To Take Responsibility - Act. If the IRS can penalize you for unreasonable positions, then the IRS should also be subject to penalties for unreasonable conduct.  The penalty would be paid to the affected taxpayer.

Our protagonist (Refco Community Pool) formed in 2003 as a partnership. It was an investment group, and their thing was to track the S&P Managed Futures Index. To do this, they needed an investment advisor. They found one in the Cayman Islands (Sphinx Managed Futures Fund). The advisor (Sphinx) in turn used a clearinghouse (Refco, LLC) to execute trades and whatever.

OBSERVATION: Right off the bat, we have two Refco's going - "Pool" and "LLC." Set this aside, as it is not relevant to our story.

Here is what happened:

1. In 2005 Refco LLC filed for bankruptcy. This caused a run, meaning that ...
2. Sphinx yanked out $312 million. However, ...
3. Sphinx had to return $260 million as was deemed a "preference" action.
4. In 2006 Sphinx went into liquidation. As part of the process, the Court appointed two liquidators.  
5. The liquidators soon found very serious accounting issues. They in fact advised that they could not assure the accuracy of tax and accounting information provided investors.
6. Refco Pool wanted its money from Sphinx, but all they received was something called "special situation shares." They were special because no one knew what they were worth until the liquidation was complete, a process which stretched into 2013. 

The IRS noticed that Sphinx was not filing tax returns and issuing K-1s. The Sphinx liquidators explained that it would cost between $5 and $7 million to reconstruct records to even approach a tax return. The two sides came to an agreement, and Sphinx was absolved of filing K-1s from 2005 to 2007.

Let's back up a bit. Who invested in Sphinx? It was Refco Pool. The IRS next went after Refco Pool for not filing its tax return and issuing K-1s.

COMMENT: Here we have a conundrum. Refco Pool has one main asset - special situation shares (whatever that means) in a bankrupt entity with accounting problems severe enough that its liquidators advise against using any numbers. A tax return requires numbers. What to do?

           

Refco Pool argued reasonable cause for abatement of the penalty. You may as well have Refco Pool discover a new planet as get a tax return out of whatever information they could pry from Sphinx.

No, no, no, said the IRS. Refco Pool could have used selected files and summaries and reports and disbursement statements and a receipt from its last visit to Dairy Queen to reconstruct records that Sphinx should have provided but did not because the IRS said it was OK not to and then Refco Pool could have filed its own partnership tax return....

Well ... yes, Refco Pool could. However, the information was unreliable if not completely inaccurate. In fact, the matter went further than that. Even if Refco Pool could do some Harry Potter alchemy, it would not know how to separate the separate tranches, meaning it could not determine its share. And, since we are talking about it, Refco Pool would have no idea what to do with the "special" part of its share - which was certainly less than 100% but not certain to be more than 0%.

The Bankruptcy Court explained:           

As an accrual method taxpayer, the Debtor cannot recognize income until 'all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.'"

One could persuasively argue that Refco Pool could not meet this threshold.

The IRS persisted that Refco Pool could have assembled numbers - however fragile - and filed a tax return had it really wanted to.

ANALYSIS: The judicial standard however is not whether Refco Pool exhausted all possible alternatives. The standard is whether Refco Pool exercised the level of care that a reasonably prudent person would under the same circumstances. 

The Court pointed out the tax risk that Refco Pool would have assumed by filing a tax return:

By knowingly filing inaccurate returns, the Debtor had a reasonable cause for concern given the specter of accuracy-related penalties it might incur ...."

The IRS could have penalized Refco Pool if the numbers proved to be substantially inaccurate.

Wait, there is more.

Refco Pool had approximately 1,600 partners to whom it was obligated to issue K-1s. Had those K-1s gone south, the partners too could have gone after Refco Pool.

The Court was unconvinced whether Refco Pool could even sign a tax return:           

Based on this knowledge, a reasonable person would likely be concerned with signing the jurat clause at the bottom of Form 1065..." 

COMMENT: The jurat clause is the one at the bottom of the tax form that reads "... to the best of my knowledge and belief, it is true, correct, and complete."

The Court concluded: 

Based on the evidence presented, the Debtor proved that it carefully considered its filing obligations and undertook appropriate steps in an effort to avoid the failure. Accordingly, the Court holds that the debtor acted in a responsible manner both before and after the failure to file occurred."

The Bankruptcy Court disallowed the IRS penalties.

I grant you, this is an extreme case, but perhaps it takes the extreme case to spotlight outrageous government behavior.

Tax penalties can generally be abated for "reasonable" cause. The problem is that the IRS has redefined "reasonable" in a completely unreasonable way. Why? Many suspect that it wants to keep the penalties to supplement its Congressional funding. Is that really what we want: for the IRS to self-fund by automatically assessing penalties and then imperiously decreeing that any request for abatement of said penalties is not "reasonable"?

I propose a compromise if we cannot get the Goose & Gander bill passed: all IRS penalties are to be returned to Treasury. They are then to be re-budgeted as Congress determines, with no assurance that the monies would return to the IRS.  Perhaps that would cool the IRS jets a bit.