Amending Your Way Into A Penalty

I have a set of tax returns in my office for someone who dropped off the tax grid for years. I suspect we will be fighting penalties and requesting a payment plan in the too-near future.

It reminded me of why not filing returns is a bad idea.

Here’s one: she has refunds she cannot use because the statute period has expired.

She could have used the refunds, as she has other years with tax due.

There is another reason.

Let’s say that you file a return, but you file it late. For example, you extend the return to October, but you don’t get around to filing until the following January or February. You have a refund so you do not care.

Many tax professionals would agree with you. Penalties apply on tax due. If there is no tax due, then – voila – no penalty (generally speaking).

But you later amend the return. Or the IRS adjusts the return for you. However it happened, you now owe tax.

Consider this:

          § 6651 Failure to file tax return or to pay tax

(a)  Addition to the tax.

In case of failure-

(1)    to file any return required under authority […]on the date prescribed therefor (determined with regard to any extension of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the amount required to be shown as tax on such return 5 percent of the amount of such tax if the failure is for not more than 1 month, with an additional 5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25 percent in the aggregate;

This is called the “late filing” penalty.

I am looking at a tax case from 1998. Greg Vinikoor (GK) married Melissa Vinikoor (MV). Best I can figure, her dad must have been loaded, as he was repeatedly transferring shares of stock to the newlyweds. GK graduated from college and took a job making $12 grand a year. They got everything out of that $12 grand, including:

·      trips to Hawaii, San Diego, Scottsdale and San Francisco

·      shopping trips to Saks Fifth Avenue, Neiman Marcus and Nordstrum

·      membership at the Tucson Country Club

We both know that they were not paying for this on that $12,000 salary. They were either borrowing against or selling stock that dad had transferred.

The IRS wanted to know why they were not reporting stock gains on their tax returns. There had been quite the run-up in value since dad had acquired the stock. In the case of a gift, dad’s low basis in the stock would carryover to the couple. Since gain = price – basis, that low basis meant a juicy gain, and the IRS wanted its cut.

Good question.

Uhhh…. Because we bought the stock from dad, they answered. Yeah, that’s it. We have a new – and higher! - basis because we bought the stock. We bought it on loan, and we have to pay dad back.

Fine, said the IRS. Show us the loan agreement.

Don’t have one, they replied.

Show us where you paid interest to dad.

We haven’t – not yet, they responded.

Is there a fixed repayment date?

Just an understanding, they susurrated.

How about security? Did you give any collateral for the loan?

No, not really, they murmured.

The Court was zero impressed.

After the stock rose, XXX [dad], the supposed creditor in these transactions never made any demand on petitioners for repayment, even though the value of the stock had increased substantially and petitioners were diminishing the stock with spendthrift habits.”

The Court decided this was a gift. There was gain, there was tax.

Guess who failed to file their tax return on time?

Yep, the Vinikoors.

Now they had penalties.

More specifically, that 25% penalty we talked about. It totaled over $38 grand.

And there is the trap. That late filing can haunt and hurt you if you later amend or the IRS adjusts the return to increase income. That penalty goes to back when, not the date you amended or the IRS adjusted.

File those returns on time, folks. Amend later if you do not have all the information, but at least you got the horse over the wire on time.

Our case this time – as you may have guessed – was Vinikoor v Commissioner.

Not Filing Because You Expect A Refund

I received a call from a client this past week. He is keen on getting his taxes caught-up.

Mind you, he is not a timely filer.  He files every two or three years, at best.

How does he get away with it?

He has the ultimate tax shelter: a net operating loss (NOL).

You have to have a business to have an NOL. It means a business loss so large that it overwhelms whatever other sources of income you may have. It leaves behind a net negative number, and you can use that negative to recoup taxes paid in a prior year (2 prior years, to be exact) or you can use it to reduce your taxes going forward (up to 20 years).

It makes tax planning easy.

Say you have a $1 million NOL carryforward. You anticipate earning $400,000 next year. What tax planning advice would you give?

Here’s one: stop the withholding on that $400,000, if you can.

Why?

$400,000 - $1,000,000 = ($600,000).

There is no tax on minus $600,000. There is no point in withholding.

And that is why my client is somewhat lackadaisical about filing his taxes.

Won’t there be penalties for late filing?

Most likely: No. Penalties are normally calculated on any taxes due. No taxes due = no penalties. This is not always true, but it is true enough in his case.

A more common variation on this theme is a taxpayer who always gets a refund. A refund = no taxes due = no penalties. One has to be careful with this, however, because once enough years go by (more specifically: 3 years), the government will keep your money.

I was looking at the Parekh case this week. Here is the Tax Court:

… we conclude that petitioners did not exercise ordinary business care and prudence and that they have not established reasonable cause for failing to file their 2012 tax return timely.”

COMMENT: if you see the words “ordinary business care and prudence” or “reasonable cause,” rest assured that someone is being penalized. Those are code words when one is trying to remove or reduce penalties.

What did Parekh get into?

Let’s see:

• Mr and Mrs Parekh filed 2009 only after the IRS prepared a substitute tax return for them.
• They were late in filing 2010 and 2011.
• They did not extend their 2012 return. They eventually filed it in 2014.

Wouldn’t you know the IRS decided to audit 2012?

Who cares, right? They are always overpaid.

There was something different in 2012: retirement plan distributions. The IRS determined that they owed over $8 grand of Alternative Minimum Tax (AMT).

Now that there was tax due the IRS also assessed a penalty.

Parekh went to Appeals. He wanted the penalty for late filing abated.

His reason?

He always had refunds. How was he supposed to know that 2012 was different?

Here is Parekh:

I figured, reasonably so I thought, that since I’d be getting a refund it was OK to file late ***. In fact, I had considered the de facto deadline for filing to be three years if one is getting a refund since after that the refund is forfeited. As I take a quick look at some tax advice websites that is pretty much what they say.”

Here is the IRS:

The Appeals officer noted that petitioners had also been delinquent in filing their 2009-2011 returns and that, as of […], they had not filed a return for 2013 or 2014 either.”

One they got to Tax Court – and hired an attorney - the Parekhs added another reason for filing late: his mom was ill and he was routinely travelling to India in 2013 and 2014 to help his father care for her.

The Court did not like the attorney slapping the India thing into the record at the last minute.

Even if we were to credit petitioner husband’s testimony about his heavy travel schedule, it is inconceivable that he could not have found two days in which to fulfill petitioners’ filing obligation, as opposed to filing that return 15 months late.”

The Court said no reasonable cause for not extending and not filing on time. They had to pay the penalty.

Did Parekh’s track record with the IRS hurt him with the Court?

No doubt.

And there is the risk if you routinely file your returns late – perhaps because you expect a refund or because you have always gotten refunds. Have your taxes spike unexpectedly, and it is unlikely you will avoid the penalties that will come with them.

What Does It Take To Get Reasonable Cause Around Here?

My partner has a difficult IRS penalty issue.

He expects a client to be penalized for more than one year. This complicates how we handle the first year.

The IRS has reorganized its penalty review function to a system called the Reasonable Cause Assistant (RCA). There however is a problem: the system does not work well. The Treasury Inspector General for Tax Administration (TIGTA) reported that RCA was inaccurate 89% of the time in 2012.

Step away from RCA and you still have the following:

 * It used to be that penalties were assessed as a means to encourage voluntary compliance. Many tax pros feel that is no longer the case, and penalties are being used as a means to raise revenue.  An example is the penalty assessed for late filing of a partnership return: $195 per month per partner. Take a 10-person partnership, file a week late and face a $1,950 penalty. There is little consideration for the size of the partnership, its total assets or revenues - or the fact that partnerships do not pay federal taxes.            

* Penalties are assessed even when taxpayers are trying to do the right thing. For example, enter into a reportable transaction, disclose it on your tax return but forget to file a copy with a second office and you will be assessed a penalty. Fail to disclose the transaction at all and you will be subject to the same penalty.

 * The IRS is automatically asserting penalties. For example, for fiscal year 2015, the IRS assessed over 40 million penalties on individuals and businesses. To put that in context, there were approximately 243 million returns filed for the period.

* Many penalties can be waived if the taxpayer can show "reasonable cause," but many tax professionals believe the IRS has so narrowed the definition as to be almost unreachable, unless you are willing to die. To aggravate the matter, the IRS has also instructed its personnel to substitute "first time abatement" (FTA) for reasonable cause as a matter of policy. While the IRS argues that FTA is easier to review and administer than reasonable cause, there exists a high degree of skepticism. Why would a taxpayer automatically burn a "get out of penalty-jail free" card if the taxpayer otherwise has reasonable cause? Wouldn't a taxpayer want to keep that card available just in case?

My partner - by the way - has that last situation: burning his FTA chip without a reasonable-cause backup for the second year. Ironically, he may have reasonable cause for the first year, but that sequence does not follow IRS policy. I anticipate going to Appeals to obtain reasonable cause and preserve the FTA for the second year.

Let's talk about the Carolyn Rogers (Rogers v Commissioner) case.

Carolyn lived in New York. In 2006 she had a small business (Talk of the Town Singles) which she operated from her cooperative. In 2006 there was a fire which rendered the place uninhabitable.

She moved. In 2007 there was another fire, one she appears to have caused herself. The local newspaper called her out, and she was thereafter harassed by people in her neighborhood.

She moved to the YWCA until 2010. She did not have a pleasant time there, and in 2009 she fell off a subway platform and fractured her skull on the rails. She was in the hospital for days, and she continued to suffer from dizzy spells thereafter.

Prior to this period, she had a record of filing timely returns. She also made significant efforts to correctly prepare her tax returns, consulting books and references and more than once contacting the IRS. She did not use a paid preparer.

The IRS penalized her for not filing a 2009 return.

She explained that the insurance company settled the second fire in 2009, and she lost a bundle. According to her research, the casualty loss would wipe out her income, and she was therefore below the filing threshold. She did not need to file.

The IRS then trotted technical guidance on a casualty loss. While the layperson might think that the loss would be deferred until the insurance is settled, the tax Code uses a different test:

* If an insurance claim is not paid in the year of casualty AND there is a reasonable prospect of recovery, then the loss is deferred until one can determine the amount of recovery.

* If there is no hope for insurance - or the prospect of recovery is unreasonable - then the loss is deductible in the year of the casualty.

 The IRS said that she came under the second rule. She knew that insurance would not cover the full loss from the 2007 fire. The loss was therefore deductible in 2007.

COMMENT: There is enough "what if" to this rule that even a tax professional could blow it.

The IRS wanted penalties for not filing that 2009 return.  

The Tax Court reviewed her filing history and her chaotic life. It noted:

Petitioner's error (regarding the proper year of deduction of the portion of a casualty loss for which there is no reasonable prospect of recovery from insurance) is considerably different from the errors made by a taxpayer whose failure to file, late filing, or late payment is chronic. Erroneously deducting a loss in a year later than the correct year is not usually considered to be a blatant tax avoidance technique ..."

Ouch. The Court did not appreciate the IRS wasting its time.

Taking into account all of the facts and circumstances, we conclude that petitioner exercised ordinary business care and prudence under the difficult circumstances in which she was living at the time leading up to the due date of her 2009 return...."

The Court found reasonable cause. She owed the tax, but she did not owe the penalties.

The IRS should have found reasonable cause too. It is troubling that it didn't.

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.

An Expat Tax Horror Story

I acquired a client last week. He was an expat living in Scotland for more than a decade. He recently returned to the US and is now working the in the oil industry.  Yep, based in Cincinnati and working the oil fields of west Texas. While in the UK he worked in the North Sea, went to college, met his wife and started and closed a restaurant, losing quite a bit of money along the way.  He is in the process of immigrating his wife into the US. He has not filed US tax returns since he left the US way back when.

What does a tax guy see here?

(1)    The first is obvious: he hasn’t filed individual tax returns.

There are two saving graces: he will receive foreign income exclusion while working in the UK. That should remove all or almost all his income from taxation. As the UK tax rates are higher, he may also receive a foreign tax credit for tax paid on income in excess of the exclusion.

(2)    He hasn’t filed FBARs.

This is the annual report one sends to Treasury if one has more than $10,000 in an overseas bank account. He made pretty good money while in the North Sea, so he would have exceeded the $10,000 threshold.

This is where it becomes unfair. After the UBS episode, the IRS has taken a very tough stance with overseas accounts.  Some of this is understandable, as the IRS is pursuing the “fat cats.”  This fellow is not a fat cat. He is an ordinary guy who lived in Scotland, and while there he made a couple of dollars. If you have previously read my blog, you may know that I have in-laws overseas. His situation is not disparate to my brother-in-law.

The IRS has an initiative (the Overseas Volunteer Disclosure Initiative) which was to close yesterday (August 31) but was extended to September 9^th because of Hurricane Irene. We considered the OVDI.

Here is the IRS:

A penalty for failing to file the Form TD F 90-22.1 (Report of Foreign Bank and Financial Accounts, commonly known as an “FBAR”).United States citizens, residents and certain other persons must annually report their direct or indirect financial interest in, or signature authority (or other authority that is comparable to signature authority) over, a financial account that is maintained with a financial institution located in a foreign country if, for any calendar year, the aggregate value of all foreign accounts exceeded $10,000 at any time during the year. Generally, the civil penalty for willfully failing to file an FBAR can be as high as the greater of $100,000 or 50 percent of the total balance of the foreign account. See 31 U.S.C. § 5321(a)(5).  Nonwillful violations are subject to a civil penalty of not more than $10,000.

I spoke with an attorney in the IRS unit yesterday afternoon, and he informed me that – because of the favorable facts – the IRS would not penalize my client more than 12.5% for not filing his FBARs timely. The penalty might even be reduced to 5%. So if my client had $50,000 in a Scotland bank, he could be facing a fine of $6,250.

(3)    He owned a business in Scotland.

This business was organized as a private limited company. Had he made a timely US election, we would have treated this entity as an LLC and folded the numbers into his personal return. As the returns are late, that avenue is not available. The entity is therefore treated as a foreign corporation. Since the corporation is controlled by a US citizen, it has to file Form 5471 with the IRS.

Take a look at these penalties from the IRS Voluntary Disclosure website:

A penalty for failing to file Form 5471, Information Return of U.S. Person with Respect to Certain Foreign Corporations. Certain United States persons who are officers, directors or shareholders in certain foreign corporations (including International Business Corporations) are required to report information under sections 6035, 6038 and 6046.The penalty for failing to file each one of these information returns is $10,000, with an additional $10,000 added for each month the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.

(4)    He funded a business in Scotland.

There is additional reporting here. He is required to file Form 926 disclosing his outbound investment into the restaurant. Now, it wasn’t really “outbound” as he lived in Scotland at the time, but because he is a US citizen it is considered “outbound.”

Let’s look again at the IRS:

A penalty for failing to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. Taxpayers are required to report transfers of property to foreign corporations and other information under section 6038B.The penalty for failing to file each one of these information returns is ten percent of the value of the property transferred, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.

Now, does this appear reasonable to you?

As a long-standing tax practitioner I have very firm opinions on desirable attributes of a fair and efficient tax system. One is that a citizen should be able (in most cases) to prepare his/her tax return without the need of someone like me.  Second is that the system should not be random and arbitrary, either in its laws or regulations or in its enforcement of the same. Third is that the system should not mete out draconian punishment for matters representing less-than- extreme abuse or disregard of the system. I cannot help but feel that the Treasury has violated the third precept. This fellow is a driller, not a hedge fund manager. To me his noncompliance is roughly equivalent to me not knowing the holidays in Peru.

If you wonder how my client turned out, there was another way to file. He loses the certainty of the OVDI penalty structure, but when the penalty is that severe can you blame a taxpayer for preferring an unknown to the known?