Abatement Versus Refund

 

I was contacted recently to inquire about my interest in a proceduralist opportunity.

That raises the question: what is a proceduralist?

Think about navigating the IRS: notices, audits, payment plans, innocent spouse claims, liens and so on.  One should include state tax agencies too. During my career, I have seen states become increasingly aggressive. Especially after COVID – and its drain on state coffers - I suspect this trend will only continue.

I refer to procedure as “working the machine.” This is not about planning for a transaction, researching a tax consequence or preparing a tax return. That part is done. You have moved on to something else concerning that tax return.

Less glamorously, it means that I usually get all the notices.

Let’s go procedural this time.

Let’s talk about the difference between an abatement and a refund.

Mr Porporato (Mr P) filed a return for 2009. He owed approximately $10 grand in taxes.

He did not file for 2010 or 2011. The IRS prepared returns for him (called a Substitute Return), and he again owed approximately $10 grand for each year.

COMMENT: He had withholding but he still owed tax for each year. He probably showed have adjusted his withholding, but, then again, he went a couple of years without even filing. I doubt he cared.

The IRS came a-calling for the money, and Mr P requested a Collection Due Process hearing.

COMMENT: I agree, and that is what a CDP hearing is about. Mind you, the IRS wants to hear about payment plans, but at least you have a chance to consolidate the years and work-out a payment schedule.

There was chop in the water that we will not get into, other than Mr P’s claim that he had a refund for 2005 that was being ignored.

So what happened with 2005?

Mr P and his (ex) wife filed a joint 2005 return on June 15, 2006.

Then came a separation, then a divorce, then an innocent spouse claim.

Yeeessshhh.

He amended his 2005 return on March 29, 2010. The amended return changed matters from tax due to a tax overpayment. The IRS abated his 2005 liability.

There you have the first of our key words: abatement.

Let’s review the statute of limitations (SOL). You generally have three years to file a tax return and claim your refund, if any. Go past the three years and the IRS keeps your refund. There are modifiers in there, but that is the general picture. We also know the flip side of the SOL: the IRS has three years to examine your return. Go past three years and the IRS cannot look at that year (again, with modifiers). Why is this? It mostly has to do with administration. Somewhere in there you have to close the matter and move on.

Let’s point out that Mr P amended his 2005 return after more than three years. The IRS still reversed his tax due.

Can the IRS do that?

Yep.

Why?

An IRS can abate at any time. Abatement is not subject to the restrictions of the SOL.

Abatement means that the IRS reducing what it wants to collect from you.

But the result was an overpayment.

Mr P wanted the IRS to refund his 2005 overpayment – more specifically, to refund via application of the overpayment to later tax years with balances due.

This is not the IRS reducing what it wants to collect. This is in fact going the other way: think of it as the IRS writing a check.

Wanting the IRS to write a check ran Mr P full-face into the statute of limitations. He filed the 2005 amended outside the three-year window, meaning that the SOL on the refund was triggered.

I get where Mr P was coming from. The IRS cut him slack on 2005, so he figured he was entitled to the rest of the slack.

He was wrong.

And there you have the procedural difference between an abatement and a refund. The IRS has the authority to reduce the amount it considers due from you, without regard to the SOL. The IRS however does not have the authority to write you a check after the SOL has expired.

Another way to say this is: you left money on the table.

Our case this time was Porporato v Commissioner (TC Summary Opinion 2020-24).

Use Certified Mail With The IRS

I am looking at Baldwin v U.S., at least as much as I can between the September and October 15^th due dates.

In the blog equivalence of cinematic foreboding, the case comes out of the Ninth Circuit.

The Baldwins filed a 2007 joint tax return showing an approximate $2.5 million loss from a movie production business.

They filed to carry the loss back to 2005 for a refund.

They had three years to file the refund claim. The three years started with the filing of their 2007 return – that is, the year that showed the loss. They filed their 2007 return on extension, so three years later would be October 15, 2011.

They filed the refund claim on June 21, 2011.

Seems plenty of time.

They filed using regular mail.

The IRS said they never received the refund claim.

Problem.

The three years expired. Sorry about your luck, Baldwins, purred the IRS.

You know this went to court.

It went to a California district court.

And we get to talk about the mailbox rule.

There is a provision in the tax Code that timely-mailing-equals-timely filing with the IRS. That is the reason you hear (not as much now in the era of electronic filing) of people heading to the post office on April 15^th. Folks want to get that “April 15” stamped on the envelope, as that stamp means the return is considered timely filed with the IRS.

By the way, that provision did not enter the Code until 1954.

What did folks do before 1954?

They relied on common law.

Common law allows one to presume that a properly-mailed envelope will arrive in the ordinary time required to get from here to there. One would have to prove that one mailed the envelope, of course, but once that was done the presumption that the mail arrived in normal time would kick-in.

In 1954 Congress added the following:

§ 7502 Timely mailing treated as timely filing and paying.

(a)  General rule.

(1)  Date of delivery.

If any return, claim, statement, or other document required to be filed, or any payment required to be made, within a prescribed period or on or before a prescribed date under authority of any provision of the internal revenue laws is, after such period or such date, delivered by United States mail to the agency, officer, or office with which such return, claim, statement, or other document is required to be filed, or to which such payment is required to be made, the date of the United States postmark stamped on the cover in which such return, claim, statement, or other document, or payment, is mailed shall be deemed to be the date of delivery or the date of payment, as the case may be.

Section (c) is important here:

(c)  Registered and certified mailing; electronic filing.

(1)  Registered mail.

For purposes of this section , if any return, claim, statement, or other document, or payment, is sent by United States registered mail-

(A)  such registration shall be prima facie evidence that the return, claim, statement, or other document was delivered to the agency, officer, or office to which addressed; and

(B)  the date of registration shall be deemed the postmark date.

Section (c) is why accountants encourage the use of certified mail with tax returns.

But the Baldwins did not certify their mailing.

They instead argued that they met the common-law standard for timely filing.

Seems a solid argument.

The IRS went low.

There are Court cases out there (Anderson, for example) that decided that the common law standard continued to exist even after the codification of Section 7502. It makes sense – at least to me - as that is what common law means.

The IRS argued that Section 7502 did away with the common-law standard, and the cases deciding otherwise were decided erroneously.

Sounds like a truckload of fine-cut bull manure to me.

Let’s load the truck.

There was a case in 1984 called Chevron. From it came the Chevron doctrine, an administrative law principle that a government agency’s interpretation of an ambiguous or unclear statute should be respected by a court.

I get the concept.

The first thing the agency has to do is show that the statute is ambiguous or unclear.

Does Section 7502 appear ambiguous or unclear to you?

We are going to need a jump to get this truck going.

Let’s introduce National Cable & Telecommunications Association v Brand X. That case has to do with the internet and whether it is an information service or a telecommunication service.

Sounds boring.

Let’s look at the Ninth Circuit’s take-away from Brand X:

But [a] court’s prior judicial construction of a statute trumps an agency construction otherwise entitled to Chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion.”

Let me translate that word salad:

Since the prior Court decisions (let’s use Anderson as an example) did not specifically say that the statute was unambiguous, the statute is therefore ambiguous.

Huh?

So, if I do not make clear that I am not a Robert Howard sword-and-sorcery, skilled, powerful and fearless giant weapon-wielding barbarian, then it can be deduced that I am that very said barbarian?

Cool!

Brand X lets me say that Section 7502 is ambiguous, at which point Chevron kicks-in and allows me to argue that the underlying statute means anything I want it to say.

There is an aisle for this at Borders. It is called “Fiction.”

The Baldwins did not get to rely on common-law. Since they could not meet requirements of Section 7502(c), they lost out altogether. No carryback refund for them.

Can You Have Cancellation Of Debt Income If You Are Still Paying On The Debt?

Harold is a native Hawaiian. He has worked in the telecommunications industry for more than 40 years. In 1996 he founded Summit Communications, Inc (Summit), which he served in the capacity of president, chief executive officer and director.

Al has a background similar to Harold's, but his company was called Sandwich Isles Communications, Inc (SIC). In 1997 he desperately needed a telecommunications executive. Al met Harold and wanted Harold to come work for him.

Harold was already involved with Summit, which was having business issues. Harold felt a commitment to the company and his employees.

But Al was not going to let go easily.

In 1998 Al sweetened the offer by including a $450,000 loan. He knew that Harold would immediately loan the monies to Summit. In fact, that is why Al offered the deal. He wanted to loan to be to Harold so that he and SIC did not have to deal with Summit's board of directors.

SIC also wanted to contract with Summit for operations and technical support.

Harold signed on with SIC, and Al let him stay on as Summit's director and chief executive officer.

They signed a note, stipulating that Harold had to repay the loan if he ever left SIC's employment.

The relationship went well, and by the end of 1999 Summit was booming, although - granted - SIC represented 60% of its revenues. It was growing so much that it need Harold back. Al, basically being a good guy, agreed that Harold should return.

No one remembered that Harold had to repay the loan.

SIC then received a large loan from the U.S. Department of Agriculture, which it used to upgrade its operations and technical staff. As it did, SIC's reliance on Summit decreased. By 2002 Summit filed a bankruptcy petition. By 2005 Harold had gone back to work for Al.

In 2010 the IRS audited SIC.

In 2011 Al met with Harold and reminded him that the loan was still due. Harold arranged for payroll deductions - first for $300 per month, then $600 and finally a $1,000 a month - to repay the loan.

The IRS sent a notice to Harold. The IRS said that SIC had discharged his loan, and he had cancellation of indebtedness income.

Think about this for a moment. The IRS wanted taxes from Harold because he had been let off the hook for a $450,000 loan. The problem is that Harold was still paying on the loan. Both cannot be true at the same time, so what was the IRS' reasoning?

It primarily had to do with how many years SIC had to pursue collection before the statute of limitations ran out. Remember: Harold did not start paying the loan until 2011. According to the IRS, there was no enforceable loan at that time, as SIC had gone too long without any evident collection activity. That was the triggering event for income to Harold: when the debt was no longer enforceable.

The IRS had a good point.

The IRS also argued that Harold starting repaying on the loan because it had noticed the defaulted loan on audit and Harold did not want to pay taxes on it.

Harold and Al appeared before the Court and testified that they both considered the loan outstanding, and the Court found them both to be "honest, forthright, and credible."

The Court could not help but notice that Harold and Al were on separate sides with respect to the loan.

 ... respondent argues that any repayment activity taken after the commencement of the examination should be discounted. We disagree. The testimony suggests instead that [Harold] sought to repay the SIC loan because he understood that it was his obligation to repay it. Additionally, a reasonable person in this case would not agree to pay an unenforceable debt to save a fraction of that debt on taxes. Repayment, in other words, is against [Harold's] economic interests."

The Court agreed that cancellation of income requires a triggering event, but it disagreed that the expiration of the statute automatically rose to that level.

... the expiration of the period of limitations generally does not cancel an underlying debt obligation but simply provides an affirmative defense for the debtor in an action by the creditor."

The Court decided that Harold owed the debt. He did not have income.

Why did the IRS pursue this? It certainly did not put a smiley face on their public persona.

I suspect the IRS considered themselves backed into a corner. If the loan really was uncollectible AND the IRS did not pursue, then the regular three-year statute on tax assessments would close on Harold's tax year. At that point, the IRS could not reach Harold again if it wanted to. If however the IRS went to Court - even if it lost - it would mean that the loan was either still in place or discharged in a later year. In either case, the IRS could reach Harold.

So What If You Do Not File A Gift Tax Return?

Let’s talk a little federal estate and gift tax.

It is unlikely that you or I will ever be subject to the federal estate tax, as the filing exemption is $5,430,000 for decedents passing away in 2015. If I was approaching that level of net worth, I would reduce my practice to part-time and begin spending my kid’s inheritance.

Let’s say that you and I are very successful and will be subject to the federal estate tax. What should we know about it?

The first thing is the $5,430,000 exemption we mentioned. If you are married, your spouse receives the same exemption amount, resulting in almost $11 million that you and your spouse can accumulate before there is any federal tax.

The second thing is that the federal estate tax is unified with the federal gift tax. That means that – at death - you have to add all your reportable lifetime gifts to your net worth (at death) to determine whether an estate return is required. As an easy example, say that you gift $5,400,000 over your lifetime, and you pass away single and with a net worth of $1 million.

·        If you just looked at the $ 1 million, you would say you have no need to file. That would be incorrect, however.

·        You have to add your lifetime gifts and your net worth at death. In this example, that would be $6,400,000 ($5,400,000 plus $1,000,000). Your estate would have to file a federal estate tax return.

Q: How would the IRS know about your lifetime gifts? 

A: Because you are required to file a gift tax return if you make a gift large enough to be considered “reportable.”

Q: What is large enough?

A: Right now, that would be more than $14,000 per person. If you gifted $20,000 to your best friend, for example, you would have a reportable gift.

Q: Does that mean I have a gift tax?

A: Nah. It just means that you start using up some of the $5,430,000 lifetime exemption.

Q: Does that mean that gifts under $14,000 can be ignored?

A: Not quite. It depends on the gift.

Q: Do you tax people take a course on hedging your answers?

A: Hey, that’s not…, well …. yes. 

Many advisors will separate a straightforward gift (like a check for $20,000) from something not so straightforward (like an interest in a limited partnership) valued at $20,000. 

The reason has to do with discounts. For example, let’s say I put $2 million in a limited partnership. I then give 100 people a 1% interest in the partnership. Would you pay $20,000 for a 1% interest?

Let me add one more thing: any distribution of money would require a majority vote. Therefore, if you wanted to take money out, you would have to get the approval of enough other partners that they – combined with your 1% - represented at least 51%. 

Would you pay $20,000 for that?

I wouldn’t.  Life would be easier to simply stash the money in a mutual fund. I could then access it without having to round up 50 other people and obtain their vote. The only way I would even think about it would require a discount. A big discount.

That discount is referred to as a minority discount. 

Let’s go a different direction: what if you just sold that interest instead of rounding-up 50 other partners?

Then the buyer would have to round-up 50 other partners. If I were the buyer, I would not pay you full price for that thing. Again, mutual fund = easier. You are going to have to offer a discount.

That discount is referred to as a liquidity discount.

Normal practice is to claim both control and liquidity discounts when gifting non-straightforward assets such as limited partnership interests or stock in the family company. 

Let’s use a 15% minority discount, a 15% liquidity discount and a gift before any discount of $20,000. The gift after the discount would be $14,000 ($20,000 * (15% + 15%)). No gift tax return is required unless the gift is more than $14,000, right?

Well, yes, but consider the calculus in getting to that $14,000. If the IRS disagreed, perhaps by arguing that the discounts should have been 10% +10%, then the gift would have been more than $14,000 and should have been reported.

Q: This is getting complicated. Why not skip a return altogether unless the gift is clearly more than $14,000?

A: Why? Because if you prepare the return correctly, there is a statute of limitations on the gift. If you file a return and describe that gift in considerable detail, the IRS has 3 years to audit the gift tax return. If the 3 years pass, that gift – and that discounted value – is locked in. The IRS cannot touch it.

Do not report the gift, or do not report it in sufficient detail, and there is NO statute of limitations.

Q: If I am dead, who cares?

A: Let’s return to the estate tax return. The gift is being added-back to your estate. Without the statute of limitations, the IRS can reopen the gift and revalue it, even if the gift was made a decade or two earlier. That is what NO statute of limitations means.

Q: Is this a bogeyman story told just to frighten the children?

A: Let’s take a look at Office of Chief Counsel Memorandum 20152201F.

NOTE: This type of document is internal to the IRS. A revenue agent is examining a return and has a question. The question is technical enough to make it to the National Office. An IRS attorney there responds to the agent’s question.

The donor (now deceased) made two gifts to his daughter. There were some problems with the gift tax return, however:

1.  The taxpayer did not give the legal names of the partnerships.
2. The taxpayer gave an incorrect identification number for one partnership.
3. The taxpayer gifted partnership interests, requiring a valuation. The taxpayer got an appraisal on the land, but did not get a valuation on the partnership containing the land. 
4. Failure to get a valuation on the partnership also meant the taxpayer failed to document any discounts claimed on the partnership interest.

What was the IRS conclusion?

The Service may assess gift tax based upon those transfers at any time.”

The IRS concluded there was no statute of limitations. No surprise there. Granted, if there is enough money involved the estate has no choice but to pursue the matter. It however would have been easier – and a lot cheaper - to prepare the gift tax return correctly to start with.

Q: What is my takeaway from all this?

A: If you are gifting anything other than cash or publicly-traded stock, play it safe and file a gift tax return. Ignore the $14,000 limit. 

Indiana Blows It But Taxpayer Has To Give Back Refund

Our ongoing search for bad state tax laws and policies takes us this time to Indiana, which is almost next door to our offices. Generally Indiana is a solid, common-sense Midwest state, but they dived into the pool of bad tax administration with Zoeller v Aisin USA Manufacturing.

Aisin filed its 2001 corporate income tax return in October, 2002. It showed the following:

                Tax due                               $1,300,367

                Payments                           $1,457,000

                Applied                               $   156,633

The Indiana Department of Revenue (“Department”) worked its voodoo and in September, 2003 issued Aisin a refund of $1,146,062.

Aisin cashed the check.

Two more years go by. In October, 2005 Aisin amends its 2001 return to show the following:

                Tax due                               $1,051,099

                Payments                           $1,457,000

                Applied                                $   156,633

                Refund                                 $   249,268

Whoa Nellie!! This is different. Normally when an accountant prepares an amended return – and there was a refund on the original return – the accountant adjusts something to show the refund. Aisin is not associating the $1,146,062 refund with its 2001 payments at all. That is aggressive.

The Department starts taking a look at Aisin’s file. Good idea. In April, 2006 the Department wanted to issue a Proposed Assessment to Aisin. It wants its money back.

                Question:            Can you see the problem a tax person would have?

I’ll give you a hint. Under Indiana Code 6-8.1-5-1(b) “… the department may not issue a proposed assessment  … more than three (3) years after the latest of the date the return is filed, or … the due date of the return.”

OK, when was the return filed? That was in October, 2002. Three years from that is … October, 2005. Can the Department even issue this Proposed Assessment? But first …

               

                Question:            Does filing an amended return affect the 3-year Indiana statute?

Here is something that will surprise you; The filing of an amended return in Indiana does not restart the limitations period (UACC Midwest, Inc n v Indiana Department State Revenue). Aisin was very slick by filing the amended within days of the statute expiring.

Back to our question. Indiana could not issue the Proposed Assessment. Indiana recognized this and pulled the assessment before it could be mailed.

Seems to me that Aisin is up by $1,146,062. It is oily, I grant you, but it is the technical reading of the law. Indiana just blew it. Or did they?

The Department next files a nontax claim against Aisin on grounds of unjust enrichment. The trial court dismisses the case and the Court of Appeals affirms. Why? Because this was a tax case, and in Indiana tax cases are heard in the Indiana Tax Court, not in Superior (that is, trial) Court.

But the Department will not be deterred. It files an appeal to the Indiana Supreme Court … which decides to hear the case! There is only one issue before the Indiana Supreme Court: is this a tax case or not?

The Court states:

“Had Aisin neither paid nor owed any income taxes but still received the check because of clerical error, the State’s action to recover would not be an action to recover any unpaid “tax” because Aisin would not have owed any tax.”

To hold that this “refund,” issued solely because of accounting or clerical errors, represents part of a tax would not serve the legislative purpose of ensuring the uniform interpretation and application of the tax laws because the tax laws are not implicated.”

Huh?

Am I to believe that Aisin left the west side of Cincinnati for a leisurely two-hour drive to Indianapolis where – like a gift from the heavens - a check in the amount of $1,146,062 floated in through an open car window? Were these the winnings from a fantasy football league? Did Aisin discover the long-lost Harry Potter manuscript at a Saturday morning yard sale? Of course this money was tax-related. The only reason that the Department even knew that Aisin existed is because Aisin was filing its taxes.

I agree with the Justices Rucker and Dickson in the dissent:

What is really at stake in this case is that the State apparently acted under the assumption that it missed a statute of limitations deadline in a tax proceeding. The State does not contest Aisin’s assertion. Instead it is reasonable to conclude that acting under the assumption that it could obtain no relief in the Tax Court by reason of a statute of limitation, the State attempted an end-run and filed this action in Superior Court. Given the lengths to which the majority was required to analyze Aisin’s various tax filings and the resultant repercussions, I agree that this a tax case and would affirm the judgment of the trial court.

It is difficult to side with Aisin, but they were right and Indiana was wrong. We all lose something when a judge or court unilaterally decides to trump the law. What we lose is predictability and the right to rely on the law.