Civil War Horses, Con Men and Lois Lerner

I think I have been insulted.

I am reading this morning that the Court of Appeals for the D.C. Circuit is hearing the IRS appeal of the Loving decision.  That decision concerned the recent effort by the IRS to regulate tax preparers, and the IRS lost the case. There were three parts to the IRS effort:

• a unique preparer identification number, called a PTIN (“pea tin”). The PTIN would allow – in theory - the IRS to track which individuals prepared which returns. I say “in theory” because it is not uncommon for larger returns to have two or more preparers and one or more reviewers. Traditionally the highest-ranking last person in the chain is considered the official preparer, but the IRS did not write its regulations that way.

• a competency test. CPAs, enrolled actuaries, attorneys and enrolled agents were exempt, as their credentialing already includes a competency test.

• a continuing education requirement. Tax laws change frequently, so the IRS thought that continuing education would be a good idea. It is.

Here is the rub: where does the IRS get the authority to make these proclamations? I know it sounds a bit quaint to talk about “government of laws rather than of men” in the current political environment, but there are a few sticklers out there who still believe in the concept. One of them was Judge Boasberg in the Loving decision.

Yesterday the IRS trotted out its attorneys, arguing that they have the right to regulate whatever they want under the “Horse Act of 1884.” Folks, that is “18” 84. 

Do you remember the following words?

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

This is the 16^th amendment, creating the income tax and ratified in February 1913. That is “19”13. Which comes after “18”84, for most people. Let’s be blunt here: how can a law from the 1800’s give the IRS any authority over income tax preparers when the income tax was not even created until 1913?

I have to admit, I had to look up the Horse Act of 1884. We must have missed that bright shiny in high school American History. After the Civil War, people brought claims against the U.S. for dead or missing horses. Makes sense, as horses were required to work the farm or for transportation, and their loss would have been keenly felt. Always seeking a vacuum, fraudsters soon appeared to help people press horse claims against the government. Soon all horses were thoroughbreds, and the government was facing more actions than there were horses lost in the Civil War. The government realized they were being scammed by con men and, in defense, starting regulating those people. The government even used the term “enrolled agent,” a term still used today for a class of preparer who has passed a competency examination given by the IRS itself.

So the IRS attorneys are arguing that tax CPAs like me are akin to fraudsters who inflated the value of dead or missing horses in action against the government following the Civil War?

As I said, I think I have been insulted.

I am also reading that Lois Lerner, the former head of the IRS Exempt Organizations Division, is retiring. You may remember that she invoked the Fifth Amendment when appearing before Congress on May 22, 2013. She was the political hack from the Federal Elections Commission who somehow wound up at the IRS reviewing and delaying applications from conservative groups, especially Tea Party organizations, seeking 504(c)(4) status in time for the 2012 presidential election. Good thing she was there too or the election may have gone a different way. She was quite happy to initially throw a few Cincinnati IRS employees under the bus, saying they had gone “rogue.” Later investigation, including e-mails, put a rest to that lie. Congress could have instead spoken with a few practicing tax CPAs, and we could have told them the same thing.  

She has been on “administrative” leave since then, drawing an approximate $170,000 salary. Now she gets to retire. It’s a nice retirement too, as she able to look for another government position and still collect her retirement pay, estimated over $50,000 annually. 

I would love a deal like that. Unfortunately, the IRS thinks of me as a con man.

Smackdown On IRS Regulation of Tax Preparers

In 2009 the IRS commissioned a study of the tax preparation industry. Some of the findings were obvious: as the tax law becomes more complex, taxpayers are increasingly relying upon tax preparers or tax software (think TurboTax) in preparing accurate returns. The study then went on to look at the preparers themselves, from attorneys and CPAs to big-block preparers (such as H&R Block) to someone who prepares a few returns for compensation from their kitchen table.

It was on that last point that the IRS had an issue. It noted that anyone could enter the tax preparation business and that that ill-equipped preparers were making numerous errors that were costly to the Treasury. The IRS was unsure even of the number of tax preparers out there, guessing there were between 900,000 and 1.2 million preparers.

The IRS observed that:

...the American public overwhelmingly supports efforts to increase the oversight of paid tax return preparers.”

Sorry, that one sounds like self-serving flourish. I doubt the American public is barely aware of this issue.

The IRS, then under Commissioner Shulman, instituted a three-part program to oversee individual income tax preparers:

(1) A specific identification number for each preparer

           

This is called the “preparer tax identification number” (PTIN), and every preparer is required to obtain one and use it on every return he/she signs. Before January 1, 2011, use of a PTIN was optional.

(2) The competency test

The IRS mandated that preparers had to take an exam and then went on to exempt categories of preparers, such as attorneys, CPAs and EAs. There were reasonable grounds for these exceptions, as each of these groups has its own licensing system. 

After much wrangling, the IRS also exempted preparers supervised by an  attorney, CPA or EA. If you worked for me, for example, you could be exempt by working under my supervision.

(3) Continuing education

           

Preparers had to complete 15 hours of continuing education each year. Again, attorneys, CPAs and EAs were exempt because of their own education requirements.

The government being what it is, a new unit was created within the IRS – the Return Preparer Office – to administrate all this activity. The government also created a new designation, the "registered tax return preparer," for those passing the competency exam.

So far, this sounds reasonable (or, at least, not unreasonable), right?

There was deep cynicism right away about what the IRS was actually up to. For example, the PTIN cost $63. Every year. Many practitioners, including some I have worked with, believe this to be a back-door effort by the IRS to pad its own budget. The facts seem to bear this out, as the IRS has collected more than $106 million from the preparer registration and testing system. It has spent approximately $50 million and assigned 167 employees to the program.

What about the testing? No one is truly certain how many tax preparers have to go through the testing, given that so many (like me) are exempted. The number I have seen most often is 350,000.

Let’s go with 350,000. As of December 31, 2012, only 48,000 of 350,000 had finished the certification process. Sheeeshh. No one is knocking down that door.

That leaves continuing education. The cost of those 15 hours could vary significantly. For many preparers, the number of returns prepared might not justify the cost of the education. Preparers were required to obtain their first 15 hours in 2012. After complaints, the IRS wound-up allowing preparers to make-up their 2012 hours in 2013.

Fueling the cynicism was the program’s open support by H&R Block and Jackson Hewitt. Those big guys are better positioned to comply with these new rules. The former CEO of H&R Block – Mark Ernst – was made deputy commissioner of the IRS and drafted many of the new rules for tax preparers. No conflict there, it appears. The investment firm UBS advised "the new regulations should help (H&R) Block" to put their smaller competitors out of business.

This is the United States, so you know someone sued. Three independent tax preparers did, with the assistance of the Institute for Justice.

The case is Loving v Internal Revenue Service, decided on January 23, 2013 by the District Court for the District of Columbia. Judge Boasberg wrote the opinion and he is – given that tax can be boring – quite the hoot. Let’s summarize what he said.

The Court immediately observed that the IRS was interpreting an 1884 statute as giving it authority for its actions. That statute gives the Treasury Secretary authority to regulate preparers who “practice” before it. The Court immediately noted that:

... attorneys, CPAs, enrolled agents or enrolled actuaries are otherwise regulated by the IRS and thus have no bone to pick with the new regulations.”

That leaves the other hundreds of thousands of preparers who are not attorneys, CPAs, EAs or enrolled actuaries. They comprise the 350,000 preparers we discussed previously. Sabina Loving, of the eponymous case, is a bookkeeper and tax preparer from Chicago. She is one of those 350,000.

So, is Sabina Loving “practicing” before the IRS?

Here is the Court:

Under ..., originally enacted in 1884, the Treasury Secretary has authority to regulate people who practice before the Treasury Department. This is so even though the casual student of history knows that the Sixteenth Amendment authorizing the modern federal income tax was not ratified until 1913.”

COMMENT: Heh.

           

Section 330(a) authorizes the Treasury Secretary to ‘regulate the practice of representatives.... In dispute is the IRS’s interpretation that tax-return  preparers are ‘representatives’ who ‘practice’ before the IRS.”

The IRS hurries through..., arguing that the statute is ambiguous because it defined neither ‘representative’ nor ‘practice’.... That simplistic approach will not fly, however.”

The Court goes on to observe that the statute refers to a “representative” advising and assisting persons in presenting their cases. Here is the Court again:

           

Filing a tax return would never, in normal usage, be described as ‘presenting a case.’ At the time of filing, the taxpayer has no dispute with the IRS; there is no ‘case’ to present.”

COMMENT: I like this judge. He likely has blown his chance to be on the Supreme Court, though.

With an invalid regulatory regime on the IRS’s side of the scale and a threat to the plaintiff’s livelihood on the other, the balance of hardship tips strongly in favor of plaintiffs.”

The Court permanently enjoined the IRS from enforcing its tax preparer program.

Yes, the little guy won, at least for the moment. In a motion filed January 24 with the Court, the IRS argued that it has a “reasonable likelihood” of winning its appeal and that the public will suffer “irreparable harm.” The IRS argued that it would incur “substantial costs” to restart the preparer program if the injunction is not lifted. The IRS also noted that that “thousands of return preparers who have already submitted their users fees would demand refunds, and the United States would likely face numerous lawsuits—including class action lawsuits.”

My Take: I am both happy and uncomfortable with the decision. I agree that the IRS went a bridge too far. I also understand that a rapidly-changing tax code requires ongoing education and that unscrupulous preparers fueling fraudulent deductions and tax credits have become a cottage industry.

I point out how much of this trouble has been caused by Congress introducing what most parties agree are welfare or transfer payments into the tax code. Congress could remove a lot of steam from unscrupulous preparers just by eliminating refundable tax credits, such as the earned income credit, for example. Here is a currently out-of-vogue idea:  why not have a national debate on whether the purpose of a tax system is to – you know – collect taxes?

The District Court will either lift its injunction or not. If not, expect an appeal from the IRS to the Circuit Court. It seems to me a tremendous expenditure of talent and resources by an over-tasked agency.

A Tax Crook Story

I have previously argued against draconian laws to protect against the morally unscrupulous. The key concept here is draconian: the little good the law does is far outweighed by its burden on society. Sometimes I believe that recent tax regulation is approaching this line.

And then I read about Todd Halpern, a tax preparer in New Jersey.

In 2008 Halpern purchased a tax preparation business from the widow of the prior owner. He received all the computers and client records in the purchase. Makes sense: the widow didn’t need them. The new practice required a new electronic filing number, but Halpern did not obtain one. He kept the previous owner’s number. Why? Because Halpern’s criminal record would keep him from getting a new number.

Then he prepares a tax return for the mom of a client. The problem is that the mom had no income. She collected social security and was claimed as a dependent on her son’s return.  Halpern falsified her return, using fake income and deductions, to generate a refund. To complete the loop, he had the refund deposited to his account.

He kept doing this. After all, what could go wrong? The IRS estimates that he received approximately $375,000 in diverted refunds between July and August, 2009.

The guy is a crook. There exist enough laws to put him in jail.

Or maybe he can run for Congress.

Do Tax Preparers Get Penalized On Their Own Returns?

Do tax preparers ever get penalized by the IRS on their own returns?

We are going to look at one today: Joyce Anne Linzy (JAL). She is party to a Tax Court Memorandum Decision issued on November 7, 2011.

JAL is a tax preparer with more than 15 years’ experience. During 2007 she operated an income tax return preparation business. She owned an apartment building in which she both lived and worked: the business was on the first floor and she lived on the second floor. She also rented out second-floor space that she did not use as a residence.

There were a number of proposed IRS adjustments for the Court to consider:

1.    JAL omitted $2,500 of gambling income.

This is actually the least of her problems.

2.    JAL claimed almost $35,000 of contract labor.

There is no problem with claiming this deduction, but the IRS expects one to maintain documentation to substantiate the deduction upon examination. Here is the Court’s language on this matter:

“Petitioner presented canceled checks, bank account statements, receipts and invoices purporting to substantiate various items claimed as business expenses deductions. These records are not well organized, and have not been submitted to the Court in a fashion that allows for easy association with the portions of the deductions that remain in dispute. Nonetheless, we make what sense we can with what we have to work with…”

The Court is trying to work with JAL. They are referring to the Cohan rule: if the Court knows that a taxpayer incurred an expense, it can (with some statutory exceptions) allow estimates of the actual expenses. JAL must be quite the tax adept, though, as the Court goes on…

“None of the numerous receipts petitioner offered in support of her claimed contract labor expense were for contract labor.”

“The checks are photocopied such that the dates are missing or incomplete, and the full amount cannot be determined…”

Oh, oh.

“These records are incomplete, and there is not enough information to permit a reasonable estimate. Accordingly, respondent’s complete disallowance of petitioner’s … deduction for contract labor is sustained.”

3.    Mortgage interest

JAL used one-third of the building for her tax return business. She deducted one-half of the mortgage interest as a business expenses.

Seems like simple math.

4.    Depreciation

During 2007 she purchased several depreciable items. She did not depreciate the cost of these items but instead claimed the costs as contract labor expenses.

Some of these items could not be immediately expensed under Section 179 because they related to building improvements. These items included siding and tuck pointing. Buildings of course have a long depreciation life, so the swing between immediately expensing and depreciating over many years is magnified.

There was no fallback position here for JAL.

5.    Charitable contributions

You may be aware that you are required to get a timely statement from the charity describing the contribution and that you received nothing of monetary value in return, or to estimate the amount if there was monetary value. You are supposed to have this in hand before you file your return.

JAL seems to have forgotten this.

She deducted a $2,500 donation to Schneider School.

Here is the Court:

               

“Although petitioner received a receipt from the Chicago Public Schools, it does not qualify as a contemporaneous written acknowledgement because it does not state whether she received any goods or services in return for her contribution.”

She deducted a $7,500 donation to Faith Deliverance.

Again, here is the Court:

               

“The letter does not state whether petitioner received goods or services in exchange for contribution and was not received by the earlier of her return’s filing date or its due date…. Thus there is no contemporaneous written acknowledgement from the donee that would permit petitioner to deduct the contributions.”

6.    The substantial understatement penalty

This is a “super penalty” if you misstate your taxable income by too much. The IRS defines “too much” as more than 10% of the final tax but at least $5,000.

JAL had no problem leaping over this hurdle.

The IRS can waive this penalty if one has “reasonable cause.” There are a number of factors that constitute reasonable cause, but a common one is reliance on a tax professional. In fact, I drafted a letter this week requesting abatement of this very penalty, and the reason I gave was their reliance on a tax professional. What happens, however, when you are a tax professional and it is your OWN tax return?

Here is the Court:

“Petitioner’s records were insufficient to substantiate several of her claimed deductions, and she failed to keep adequate books and records. Furthermore, petitioner, a tax return preparer with more than 15 years experience, improperly deducted….Petitioner offered no evidence that she acted with reasonable cause and in good faith. Accordingly, we hold that petitioner is liable … due to negligence or disregard of rules or regulations.”

The penalty alone was over $3,100.

What can I say about JAL?

A lesson here is that the Tax Court is going to hold a professional preparer to a higher standard. Now, JAL was not an attorney, CPA or enrolled agent, but when she stepped into “professional preparer” shoes the Court was going to be less lenient. It is not unreasonable, as others pay you for knowing more about the tax system than the average person. It seems to me that JAL did not rise to the occasion.