AI Practicing Tax Law

 

I was working with a younger accountant this busy season who is a fan of AI in tax research. He uses it quite a bit. He also has a client who in turn has used AI to review his work. This has not amused my friend, and I understand he intends to fire the client.

Irony, methinks.

There has always been research in tax practice, and AI is just the newest and shiniest model on the lot. My concern about AI is that previous research alternatives did not invent answers - that is, hallucinate. This can be a problem, especially for a young(er) practitioner learning the ropes. An experienced hand may recognize when AI leaves the pavement. That is small comfort, as I question whether an experienced hand would rely heavily on AI.

As we have commented before: you don’t know what you don’t know.

Let’s look at the Clinco case.

Peter Clinco was an attorney in California. He mostly practiced real estate and business law. He was also an entrepreneur and spent much of his time running MedCafe Westwood, a restaurant and bar near the UCLA campus. It started off as a partnership, but over the years Clinco wound up owning the place by himself. MedCafe had approximately 60 employees but did not have strong accounting for sales and tips. This would become an issue.

Clinco personally prepared his 2015 tax return, although he filed it late (2018). He reported restaurant gross receipts of approximately $1.6 million, with enough expenses to show a net loss of $400 grand. We do not know whether filing late was an issue, but 2015 got pulled for audit. There were two areas on that return the IRS clearly wanted to look at:

• The restaurant
• Two rental properties

Why do I say “clearly?”  See a tax return the way I do: where are your subtractions – that is, your deductions? More specifically, where are your biggest deductions? That is where an auditor would want to look, because that is where the dollars – and audit adjustments – are.

The exam started in 2019, when Clinco was already quite ill. The accountant stepped in for Cinco, but this was after Clinco commented to the revenue agent that an estimated 10% of the restaurant’s revenues were in cash.

Clinco planted a bug in the auditor’s ear. The auditor responded by using a common-enough technique: comparing known credit (and debit) card transactions to reported cash transactions. While the ratios can vary (in this case, 90/10), it is a starting point. Sure enough, the auditor decided something was off and expanded her audit.

What does it mean to “expand”? Easy. She requested Forms 1099 issued to MedCafe. The IRS would have those as a matter of routine.

She also requested copies of bank statements.

COMMENT: The bank deposit analysis is virtually de rigueur for all Schedule C audits at this point (MedCafe was a Schedule C because Clinco owned 100%). The concept is easy: all deposits are income unless proven otherwise. Fail to prove otherwise and you have a problem. I had an audit – with deposit analysis – a few years ago. A son (my client) intermingled his business deposits with his father’s (both were contractors). Why? Who knows. It is not normal business practice; I had a difficult time understanding why he did this; the auditor had a difficult time believing either of us; and his foolishness made the audit much more difficult than it needed to be.

The IRS thought actual revenues were about $3.8 million – approximately $2.2 million more than the $1.6 million reported on the tax return.

Yep, you can see that train a ‘coming.

What was Clinco’s first line of defense?

COMMENT: Somewhere during this Clinco passed away. Technically the matter would have been pressed by his estate and agents.

Clinco challenged whether one of the early procedural steps - the Notice of Deficiency – needed to be signed by the IRS in fresh ink.

This is well-trod road with (very) low risk of victory, but Clinco’s attorney (Mr. Wagner) brought novelties to the party:

He cites ‘Cacchillo v Commissioner’ … as a case where the taxpayer challenged the validity of the notice of deficiency because it lacked an official signature. He claims we held the IRS’s failure to issue a valid signed notice of deficiency ousted us out of jurisdiction.”

Mr. Wagner claims ‘Cacchillo v Commissioner’ … overturned ‘Miller v Commissioner’ and ‘Tefel v Commissioner’ ….”

Here is the Court:

Neither of these cases exist as cited.”

OK.

There is no case named “Tefel v Commissioner …”

Going down folks.

The bouillabaisse of case names, reporter citations and legal propositions suggests something cooked up by AI.”

Hard landing imminent.

Their presence is unacceptable.”

So…  I would say that the IRS was not required to hard-sign the Notice of Deficiency.

On to the audit adjustments.

Cash deposit analysis is a long-standing technique. The Court granted an adjustment when Clinco could prove that a deposit was not income, but it was not going to reject the entire analysis.

Even money-losing businesses, however, can have unreported income.”

There was one more issue.

The IRS wanted some proof for depreciation expense on two rental properties.

Normally, this is not outrageous to provide. One gets a copy of the closing statement. Sometimes the municipality itself maintains those records. Granted, it may not show later improvements and whatnot, but it is a start.

Clinco went in a different direction. Clinco argued that the IRS could not challenge depreciation because they had allowed it in a different tax year.

Folks - with minimal exceptions - this is not the way it works. The IRS not asking about your “fill-in-the-box” deduction in year one does not mean they cannot ask about it in year three. This is long-standing practice and predates me being in school.

Even AI should have picked that up.

Our case this time was Peter L. Clinco, Deceased, C. M. Barone-Clinco, Successor in Interest, and C. M. Barone-Clinco, T. C. Memo. 2026-16

A Skeleton Return And Portability

 

The amount for 2025 is $13.99 million.

This is the lifetime exclusion amount for combined gift and estate taxes. You can give away or die with assets up to this amount and owe neither gift nor estate tax. This amount is per person, so – if married – you and your spouse have a combined $27.98 million.

Next year that amount resets to $15 million, or $30 million for a married couple.

Let’s say it: most of us do not need to sweat. This is a high-end issue, and congrats if it impacts you.

What I want to talk about is the portability of the lifetime exclusion amount.

Tax practice brings its own acronyms and (call it) slang.

Here is one: DSUE, pronounced Dee-Sue and referring to the transfer of the lifetime exclusion amount from the first spouse-to-die to the second.

Let’s use a quick example to clarify what we are talking about. 

• Mr. and Mrs. CTG have been married for years.
• They have not filed gift tax returns in the past, either because they have not made gifts or gifts made have been below the annual gift exclusion. The exclusion amount for 2025 is $19,000, for example, so only a hefty gift would be reportable.
• Mr. and Mrs. CTG have a combined net worth of $20 million.
• For simplicity, let’s assume that all CTG marital assets are owned jointly.

 At a net worth of $20 million, one might be concerned about the estate tax.

Except for one thing: we said that all assets are owned jointly.

Let’s say that Mr. CTG passes away in 2026 when the lifetime exclusion amount is $15 million. His share of the joint estate is $10 million ($20 million times ½), well within the safety zone. There is no estate tax due.

Let’s go further. Let’s say that Mrs. CTG dies later in 2026.

Her net worth would be $20 million ($10 million - her half - and $10 million from Mr. CTG).

Could she have an estate tax issue?

First impression: yes, she could. She exceeded the lifetime exclusion amount by $5 million ($20 million minus $15 million).

In income tax we are used to numbers being combined when filing as married-filing-jointly. This is estate tax, though. That MFJ concept … does not apply so neatly here.

We can even create our own tax headache by having the first-to-die leave all assets to the surviving spouse.

And there is the point of the DSUE: whatever lifetime exclusion amount the first-to-die doesn’t use can be transferred to the surviving spouse. In our example, $5 million ($15 million minus $10 million) could be transferred. If Mrs. CTG dies shortly after Mr. CTG, her combined exclusion amount would be $20 million (her $15 million and $5 million from Mr. CTG). Since combined assets were $20 million, there would be no estate tax due. It’s not quite the simplicity of married-filing-jointly, but it gets us there.

Moving that $5 million from Mr. CTG to Mrs. CTG is called “portability,” and there are rules one must follow.

The main rule?

          A complete and properly prepared estate return must be filed.

Practitioners who work in this area know how burdensome a complete and properly prepared estate tax return can be. The return requires full disclosure of assets and liabilities, including descriptions and values, not to mention documentation to support the same. Here are a few examples:

•  Do you own stock? If yes, then each stock position must be valued at the date of death (or six months later, an alternative we will skip for this discussion). How do you do this? Perhaps your broker can help. If not, there is specialized software available.
•  Do you own 401(k)s or IRAs? If so, one needs to know who the beneficiaries are.
•  Do you own a business? If so, you will need a valuation.
•  Do you own real estate? If so, you will need an appraiser.

Let’s be blunt: there are enough headaches here that someone could (understandably) pass on filing that first-to-die estate tax return.

Fortunately, the IRS realized this and allowed a special rule when filing an estate tax return solely for DSUE portability.

Yes, we see the usual tax gobbledygook, but the IRS is spotting us a break when preparing the Form 706. 

• You can use (good faith) estimates. You do not have to hire appraisers and valuation specialists, for example.
• However, the special rule only applies if all property goes to the surviving spouse (the marital deduction), to charity (the charitable deduction), or a combination of the two.

Can you fail the special rule?

Yeppers.

Let’s look at the Rowland case.

Fay Rowland passed away in April 2016. She did not have a taxable estate.

The surviving spouse (Billy Rowland) passed away in January 2018. He did have a taxable estate.

Note the fact pattern: they will want to transfer Faye’s unused lifetime exemption (that is, the DSUE) to Billy, because he is in a taxable situation.

Fay’s Trust Agreement (effectively functioning as a will) instructed the following:

• 20% to a foundation
• 25% to Billy
• The remainder to her grandchildren

Fay filed an estate tax return reporting everything under the special rule: showing zero for individual assets but a total for all combined assets.

Billy’s estate return reported a DSUE (from Fay) of $3.7 million.

The IRS bounced Billy’s DSUE.

Off to Tax Court they went.

The Court agreed with the IRS.

Why?

Take a look at the special rule again.

• Assets passing to Billy qualify as a marital deduction.
• Assets passing to the foundation qualify as a charitable deduction.
• Assets passing to the grandchildren …. do not qualify for the special rule.

Fay’s estate tax return showed all assets as qualifying for the special rule. This was incorrect. The return should have included detailed reporting for assets passing to the grandchildren, with simplified reporting for the assets passing to Billy or the foundation.

Fay did not file a complete and properly prepared estate return.

The failure to do so meant no DSUE to port to Billy.

Considering that the estate tax rate reaches 40%, this is real money.

What do I think?

I have seen several DSUE returns over the last year and a half. Some have been straightforward, with all assets qualifying for the special rule. We still had to identify assets and obtain estimated values, but it was not the same amount of work as a full Form 706.

COMMENT: Practitioners sometimes refer to this special-rule Form 706 as a “skeleton” return. Skeleton refers to one providing just enough information on which to drape a portability election.

Then we had returns with a combination of assets, some qualifying for the special rule and others not. This is a hybrid return: nonqualifying assets are reported in the usual detail, while assets qualifying for the special rule are more lightly reported.

Fay’s estate tax return should have used that hybrid reporting.

Our case this time was Estate of Billy S Bowland v Commissioner, T.C. Memo 2025-76.

Filing A Zero-Income Tax Return

Here’s a question:

Would you file a tax return if you have no income – or minimal income - to report?

I would if there was a refund.

I also lean to filing if one has a history of tax filings.

The former is obvious, unless the incremental cost of filing the return is more than the refund.

The latter is because of my skepticism. I do not want a letter from the IRS stating they have not received a tax return for name-a-year. Granted, the issue should be easily resolved, but I have lost track of how many should-be’s have turned out to not-be.

Another reason is a rerun of Congress’ decision to automatically send advance payments back in 2021 – specifically, the child tax credit.       

You were ahead of the game by having filed a prior year return.

Ruben Varela filed a 1040EZ for 2017. It showed a refund of $1,373.

OK.

Ruben attached four Forms 4852 Substitute for Form W-2.

This form is used when an employer fails to send a W-2, among other situations. It happens and I see one every few years. But four …? That is odd.

The 4852’s that Ruben prepared showed zero wages.

And the $1,373 included Social Security and Medicare taxes., taxes which are not refundable.

Ruben, stop that yesterday. This is common tax protestor nonsense.

Let’s read on. There was third party reporting (think computer matching) for wages of $11,311 and cancellation of indebtedness income of $1,436.

Not surprisingly, the IRS considered it a protest filing and assessed a Section 6702(a) penalty.

§ 6702 Frivolous tax submissions.

(a)  Civil penalty for frivolous tax returns.

A person shall pay a penalty of $5,000 if-

(1)  such person files what purports to be a return of a tax imposed by this title but which-

(A)  does not contain information on which the substantial correctness of the self-assessment may be judged, or

(B)  contains information that on its face indicates that the self-assessment is substantially incorrect, and

(2)  the conduct referred to in paragraph (1) -

(A)  is based on a position which the Secretary has identified as frivolous under subsection (c) , or

(B)  reflects a desire to delay or impede the administration of Federal tax laws. 

That caught Ruben’s attention, and he disputed the penalty. On to Tax Court they went.

How can I owe a penalty if there was NO TAX, argued Ruben.

On first impression, it seems a reasonable argument.

But this is tax. Let’s look at that Code section again. 

              Such person files ….                                                      OK

              What purports to be a tax return …                                OK

      Does not contain information on

   which the substantial correctness …                             ?

 

Let’s talk about this last one. The Tax Court has a history of characterizing “zero” W-2s as both substantially incorrect and not containing sufficient information allowing one to judge the self-assessment of tax.

We have a third “OK.”

Back to Section 6702.

Is there any reference in Section 6702 to whether the return did or did not show tax due?

I am not seeing it.

The Court did not see it either.

They upheld the Section 6702 penalty.

The IRS wanted more, of course. They also wanted the Section 6673 penalty.

§ 6673 Sanctions and costs awarded by court

This penalty can be imposed when somebody clogs the Court in order to impede tax administration. The penalty can be harsh.

How harsh?

Up to $25 grand of fresh-brewed harsh.

The Court noted they had not seen Ruben Varela before nor was it aware of him previously pursuing similar arguments. They declined to impose the Section 6673 penalty, but …

We caution petitioner that a penalty may be imposed in future cases before this Court should he continue to pursue these misguided positions.”

The Court was warning him in the strongest legalese it could muster.

Our case this time was Ruben Varela v Commissioner, T.C. Memo 2024-92.

 

Losing A Refund: Revisiting The Statute(s) of Limitations

 

I am thinking she got hosed.

I am looking at a district court decision. It involves Michelle Moy, and it remarkably bridges 2011 to the 2020 COVID year.

Let’s talk about it.

In May 2011 Moy was assessed $32,507 by the IRS because she failed to file a 2008 tax return. In this situation, the IRS may prepare a return for you (called a substitute for return) and proceed accordingly with collections activity.

COMMENT: It is rare that a substitute for return (SFR) will be to your advantage. The IRS will throw in all the positive numbers it can find, but it will not include negative numbers with the same zeal. It is almost always to your advantage to file a return rather than accept an SFR.

QUESTION: Here is an obscure practice question: when you file the 2008 return with an SFR already on file, is it considered an amended return? The answer is below.

Turns out that Moy had $20,447 in 2008 U.K. foreign taxes available for credit. Assuming that the foreign tax credit was available dollar-for-dollar, Moy owed $12 grand rather than the $32 grand the IRS wanted.

Seems easy enough. File the return. Pay the $12 grand plus interest and penalties and move on.

It appears Moy instead paid the $32 grand. She did not realize and overpaid.

I say that because she filed a claim for refund in April 2018. I presume the claim was for the $20 grand of foreign taxes.

In August 2018, the IRS bounced the claim as being outside the statute of limitations.

COMMENT: The statute for a refund claim is generally the latter of (a) three years from assessment date or (b) two years from the date of payment. Assessment here was in 2011, so the first period would have expired in 2014. Assuming she paid the $32 grand before April 2016, the second period would have also expired before she filed in April 2018.

Moy filed a protest with Appeals.

Appeals stalled, responding three times (in December 2019, February 2020, and March 2020), each time asking for another 60 days.

I think we all remember what happened in March 2020, so I withhold blame.

The IRS dismissed her appeal in January 2021, arguing that the statute of limitations for refund had expired.

In June 2023, Moy filed a lawsuit against the United States.

Confused yet?

Let’s sort this out.

What is happening is that there are two statutes of limitations coming into play here. In fact, it would be more accurate to say two and a half.

The first is the standard 3 years/2 years. This is the statute for filing a refund claim. In this context, Moy filing a 2008 return showing that foreign tax credit counts as a refund claim.

NOTE: In answer to our question above, Moy would file an original – not a an amended – 2008 return. The SFR is not considered a return for this purpose, so the first filing by the taxpayer would be considered the original filing.

Mind you, her 2008 filing was likely outside the 3/2 combo, so how did Moy argue that the statute for refund was still open?

Look at this pearl:

        § 6511 Limitations on credit or refund.

(d)  Special rules applicable to income taxes.

(3)  Special rules relating to foreign tax credit.

(A)  Special period of limitation with respect to foreign taxes paid or accrued. If the claim for credit or refund relates to an overpayment attributable to any taxes paid or accrued to any foreign country or to any possession of the United States for which credit is allowed against the tax imposed by subtitle A in accordance with the provisions of section 901 or the provisions of any treaty to which the United States is a party, in lieu of the 3-year period of limitation prescribed in subsection (a) , the period shall be 10 years from the date prescribed by law for filing the return for the year in which such taxes were actually paid or accrued.

 

Yep, the foreign tax credit gets its own 10 year statute of limitations. Let’s see, the 2008 return was due April 2009. Add ten years and we get April 2019. She filed a refund claim in April 2018. She appears to be within the statute period for filing a refund claim.

So why did the Court say she was out of statute?

There is one more statute of limitations to consider.

        § 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.

 What does this mishmash mean?

This statute applies to the IRS and authorizes the IRS to pay a refund up to two years after disallowing a claim for refund.

When did the IRS disallow Moy’s refund claim?

In August 2018.

Add two years and you have August 2020.

When did Moy file suit?

In 2023.

The IRS is prohibited from issuing a refund.

To recap, the familiar 3/2 statute of limitations applies to a taxpayer filing a refund claim.

The second statute (2 years, no more, no less) applies to the IRS paying the refund claim.

Moy cleared the first.

She did not clear the second.    

Are there administrative options?

None that excites me.

Could she have done something differently?

While a long shot, she could have asked to extend the refund statute. The difficulty is that both sides must sign, and it can be difficult to find someone at the IRS with authority to sign.

Realistically, her best option was filing a refund suit with the district court or U.S. Court of Claims. I would much rather go to Tax Court – as that court has procedures for pro se taxpayers – but the Tax Court does not accept refund suits. You must owe the IRS to get your ticket punched on the Tax Court Express.

Moy was hosed. She went into COVID with a two year window to get her refund. Little could she anticipate IRS employees being sent home - meaning no access to correspondence mailed to IRS addresses, unprocessed returns and mail accumulating in trailers, the later shredding of such returns and mail, and the agency becoming near unreachable for extended periods “due to a high volume of calls.”

And those IRS letters asking for “another 60 days”?

You would have to get a court to allow equitable tolling. Notice that the IRS did not do so on its own power. They were quick to ask for another six months while processing Moy’s appeal, but they did not toll a single minute on the Section 6532 limitation on her refund.

Looking back, IRS Appeals should have included Form 907 with any refund claims assigned during the COVID era. Unfortunately, the IRS still has no policy or practice of doing this, so any responsibility for this tax obscurity falls fully on the taxpayer (and his/her tax representative). 

Our case this time was Moy v United States, Case No 23-cv-03151-PP (Northern District of California 2024).

The EV Tax Credit

I was reading an article recently that approximately 40% of Americans have not heard about the EV tax credits.

EVs are battery powered cars. We used to have hybrids, which sometimes used a motor and other times a battery. EVs by contrast are 100% battery powered.

If you are thinking about buying one for personal use, here are a few markers to keep in mind:

(1)   There was an OLD tax credit and now there is a NEW tax credit.

a.     The OLD credit went through April 18, 2023.

b.    The NEW credit of course is after April 18, 2023.

Both credits can get up to $7,500, so what changed was the measuring stick.

Before April 19, the EV had to be assembled in North America.

After April 18, one test became two tests:

·       The battery itself has to be manufactured in North America, and

·       Then critical minerals in the battery (cobalt and lithium, for example) must be extracted or processed in the U.S. or in a country with which the U.S. has a free trade agreement.

Notice that OLD $7,500 credit (assembled in North America) has become two NEW credits of $3,750 each. You can get to $7,500, but along a different route.

It matters. For example, the new Ford Mustang Mach-E only qualifies for one of the credits – only $3,750 – because its battery comes from abroad.

Some – like the Genesis GV70 – used to qualify for the old $7,500 credit but no longer qualify for anything under the new rules.

If you are considering an EV, please double check whether the vehicle qualifies. Here is the Department of Energy’s website:

https://fueleconomy.gov/feg/tax2023.shtml

(2)   Congress included some price caps on qualifying vehicles. These things are expensive, and Congress was trying to exert downward pressure.

To qualify,

·       A van, SUV or pickup truck must cost $80 grand or less.

·       Any other vehicle (a sedan, for example) must cost $55 grand or less.  

(3)   Starting in 2024, you will have the option of using the credit immediately when you purchase the vehicle. It would make for an easy down payment, I suppose.  

The heavy lifting is done behind the scenes, as the dealerships will register on a new website to initiate and receive the credits. If you are curious, that website is: 

https://www.irs.gov/credits-deductions/register-your-dealership-to-enable-credits-for-clean-vehicle-buyers  

(4)   For the first time, used EVs will qualify for a credit. This credit will not be as large as the one for new EVs, but it is not insignificant either. Here are the ropes:

·       The price must be $25 grand or less.

·       The car must be at least two years old.

·       The car qualifies only once in its lifetime.

·       The credit is up to $4 grand, limited to 30% of the price.

·       You can claim the used EV credit once every three years.  

(5)   There are income limits on both the new EV and used EV credits. Make too much money and you will not qualify.  

For example:

New EV

           Married        income < $300,00

                                       Single          income < $150,000

                            Used EV

                                        Married       income < $150,000

                                        Single         income < $75,000  

You can test for income either in the year of purchase or the immediately preceding year. I am thinking – to be safe – that one should generally go with the preceding year. It would be no fun to apply a $7,500 credit against the purchase of an EV and then give it back because you reported too much income on your 2024 tax return.  

(6)   Up to now, we have been talking about buying an EV for personal use. There is a similar credit if you lease rather than buy, but some rules are different.

·       Since the leasing company (and not you) owns the vehicle, the income test does not apply.

·       The credit requires the EV be manufactured by a “qualified manufacturer” rather than the two-step qualification discussed above for a purchased vehicle. This should result in a wider selection.

·       Mind you, the leasing company is not required to pass (all or any of) this credit on to you. Education is important here - and expect negotiation.  

The reason the rules are different is that this second credit is designed for businesses – rather than individuals – buying an EV. By bringing in a leasing company, we flipped from the first to the second credit.  

I am not in the market for a car myself.  If I were, though, I would go in a very different direction.