Self-Sabotaging A Penalty Abatement

 

The opinion is two and a half pages.

It is one of the shortest opinions I have seen. That was – frankly – what caught my interest.

Francis Kemegue lost his job in 2017. I do not know details, but he experienced multiple personal and professional setbacks.

He extended his 2017 return.

Gotta be a late file/late payment case. If you are ever in a situation where you are unable to pay your tax, file the return nonetheless. Yes, the IRS will eventually contact you, but they are going to contact you anyway. The penalties for filing a late return are more severe than for filing but not paying.

Kemegue in fact never filed his 2017 return.

Sounds like that job loss debilitated him.

The IRS prepared a tax return for him. This a called a “substitute return,” and the IRS assumes that every known receipt (think computer matching) is taxable and that there are no deductions. The math is bogus, of course. The IRS is not so much trying to prepare your return as to catch your attention.  

He owed with that substitute return.

Of course.

Now he was late file and late pay.

Great.

Kemegue wanted a break.

Go for it.

More specifically, he wanted abatement of the late file and pay penalties.

I would do the same. There is a kabuki dance to this, however. Abating this penalty requires establishment of reasonable cause. The IRS has for a while been (in my opinion) very unreasonable about reasonable cause. However, if Kemegue was seeing a counselor or otherwise under professional care – even if intermittently - he has a decent chance. This would be a superb time to obtain exculpatory letters from his health professional(s) and to polish his storytelling chops.

Kemegue did not do any of this.

He did talk about his job search, including traveling to other states. He even tried to start his own company.

Kemegue, you are missing the plot here.

The Court wanted to know more about his story: shattering setback, evaporating self-confidence, needing help for depression. He fell behind on his tax return because he – you know – fell behind in all areas of his life.

Silence.

Not good.

The Court wanted to know: what was going on that he could travel and search for work but not file that tax return?

Again silence.

You know how this turned out.

Sheesshh.

Our case this time was Francis Kemegue v Commissioner, T.C. Summary Opinion 2023-5.

No Penalty Abatement When Taxes Not Paid For Years

 

I am looking at a case where the taxpayers wanted penalty abatement for reasonable cause.

I have been cynical for years about the IRS allowing reasonable cause, but let’s read on.

The Koncurats owed for years 2005, 2006 and 2010 through 2016.

CTG: There is a donut in there from 2007 through 2009. I wonder what happened?

For the years at issue Stephen Koncurat owned his own company in the insurance industry. Tamara Koncurat maintained their home and raised four children.

The interest and penalties added up, exceeding $670 grand. To their credit, the Koncurats did not argue the tax due. They did feel, however, that penalty abatement was warranted because “circumstances largely beyond his control” prevented them from meeting their tax obligations.

There were a lot of years involved, though. What were those circumstances?

·      Around 2007 or 2008 Stephen had six rental properties foreclosed.

COMMENT: Got it. That was the Lehman Brothers bankruptcy and the near implosion of the American housing market.

·      From 2010 to 2011 Stephen’s income dropped sharply from over $450K to about $96K.

·      There was a stretch where they could not even afford to make their house payment. Stephen’s father made the payments for them. 

OBSERVATION: This is years after 2005 and 2006, however. I can see going into a payment plan, then negotiating with the IRS to reduce or interrupt payments because of subsequent events cratering one’s income. It is not the easiest thing to do, but it can be done. 

·      Around 2014 or 2015 Stephen broke his back.

·      In 2018 he was diagnosed with cancer and a blocked artery.

·      He thereafter underwent three major surgeries and attended over 100 medical appointments.

He continued to work, as best he could., They reported the following income:

         2005          $274,359

         2006          $251,902

         2010          $462,455

         2011          $95,974

         2012          $71,847

         2013          $109,072

2014          $171,648

2015          $207,398

2016          $314,491                              

I get it. The 2011 through 2013 tax years were aberrant.

I am impressed how well he did during the broken back, cancer and surgery years, though.

Stephen voluntarily paid $1,500 a month to the IRS.

Good.

Starting January 2020.

What? Starting …??

I admit, this is going to be a problem. Unexpected circumstances can knock you off your feet. Maybe you don’t file or pay for a couple of years, but there is a beginning and end to the story. Somewhere in there the IRS – and reasonable cause – expects you to put on your big boy pants and try to comply. Hopefully you can file and pay, but maybe all you can do is file. Fine, then file and request a payment plan. Will the IRS be unreasonable? Of course. What if they want more than you can pay? Then request a Collections Due Process hearing.

The point is: get back into the system.

If you don’t, then reasonable cause – hard to obtain under regular circumstances – takes a step up the difficulty ladder. You now have to present “unavoidable obstacles” to your compliance.

Short of being in a coma or Marvel Universe superheroes destroying your city, that “unavoidable” threshold is going to be near-nigh impossible to meet.

Here is the Court:

·      They have alleged no details sufficient to support a finding that any of the hardships they experienced actually presented unavoidable obstacles.”

·      Further, the Koncurats have not alleged … that they ‘didn’t have [the money] or couldn’t keep [the installment plan] going…’”

·      While the family’s financial troubles were significant at times, the record reflects that they have had consistent access to financial resources throughout the years at issue.”

·      They were … contributing tuition, housing and wedding expenses to children….”

That last one doesn’t make sense for broke people.

·      Stephen Koncurat earned more than one million dollars in income in 2019, and again in 2021.”

So we are not talking about broke people. Broke people do not make a million dollars a year.

The Court wanted to know why – with that million dollars – they did not clean-up their tax debt – or at least a chunk of it – rather than delaying payment and tying up the Court’s time.

There was no reasonable cause for the Koncurats. Heck, one could have looked at the extended failure to pay and instead concluded that there was willful neglect.

Meaning no penalty abatement.

No surprise there.

The Koncurats dug themselves a hole by letting the matter go on long enough to attend high school. The likelihood of reasonable cause over that much time was minimal, but I do think that there was something they could have done to improve their odds.

What would that have been?

Take that $1 million dollars and pay the IRS.

They would then have gone before the Court and argued that they had a bad stretch, causing them to fail in their obligations and run afoul of the tax system. However, when their fortune improved, the first party they took care of was … the IRS.

Would this have allowed reasonable cause? Financial difficulties generally do not lead to eligibility for reasonable cause relief.

But it would not have hurt. It also would have lifted the needle off zero and given the Court something specific to support a taxpayer-favorable determination.  

Our case this time was United States v Koncurat, USDC MD, Case No 1:21-cv-00676.

When Your Employer Bungles Your Retirement Plan Loan

I admit that I am not a fan of borrowing from an employer retirement plan, except perhaps as a next-to-last step before being evicted.

Things go wrong.

Lose your job, for example, and not only are you looking for work but you also have a tax bill on a loan you cannot pay back.

You do not even have to lose your job.

Ms. Frias participated in her company’s retirement plan. She was getting ready to go on maternity leave when she borrowed $40,000 from her 401(k). Her employer was to withhold from her paycheck (to be paid biweekly), and there was a make-up provision allowing her to correct any shortfall by the end of the following month.

COMMENT: Retirement plan proceeds are normally tax-free if repaid over a period of five years or less.

She went on leave on or around August 1^st.  She was drawing on her accumulated vacation and sick time.  Sounds pretty routine.

She returned to work October 12th.

In November, she learned that her employer had failed to withhold any monies for her 401(k) loan.

She immediately wrote a $1,000 check and increased her withholding to get caught-up.

Nonetheless, at the end of the year the plan administrator (Mutual of America Life) sent her a $40,000 Form 1099R on the loan.

They however sent it to her electronically. Having no reason to expect one, she did not realize that she had even received a 1099. Goes without saying it was not on her tax return.

You know the IRS matched this up and sent her a notice.

What do you think: does she have a tax issue?

No question her employer messed up.

And that she tried to correct it.

However, the law is strict:

Although a loan may satisfy the section 72(p) requirements, “a deemed distribution occurs at the first time that the requirements … of this section are not satisfied, in form or operation.”

Her first payment was due in August, the month following the loan. If she had a deemed distribution, it would have occurred then. A distribution – even a “deemed” one – would be taxable.

There remained hope, though:

The plan administrator may provide the plan participant with an opportunity to cure the failure, and a deemed distribution does not occur unless the participant fails to pay the delinquent payment within the cure period.”

This is a nice safety valve. If the employer gives you a “cure” period, you can still avoid having the fail and its associated tax.

What was her cure period?

The end of the following month: September.

When did she write a check?

November, when she realized that there was a problem.

Too late.

She had one last long shot: a “leave of absence” exception.

Which is Code section 72(p)(2)(C), and it provides for interruption in a loan repayment schedule if one is not drawing a paycheck or not drawing enough to meet the minimum loan payment.

Her argument? She was not receiving her “regular” paycheck. She instead was drawing on her vacation and sick time bank.

Problem: she nonetheless received a check, and the Court was unwilling to part-and-parcel its source. She was collecting enough to make the loan payments.

She was hosed.

She did nothing wrong, but her employer’s negligence cost her somewhere near $15 grand in unnecessary taxes.

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.