The IRS And Bull

One thing with a blog by a practicing tax CPA: you get a feel for whatever is going across my desk at the moment.

Let’s get historical and look at a Supreme Court case from 1935.

The case is Bull v United States. I kid you not.

Mr. Bull died in 1920.

He was a partner in a partnership.

His share of the partnership profits through his date of death was $24,124. His share of the profits for the rest of the year was $212,719.

The executor filed an estate tax return (that is, the tax return on the net assets Mr. Bull died with). That return included both the $24,124 and the $212,719. The executor paid whatever the estate tax was.

The executor then filed an income tax return for the estate.

COMMENT: Mr. Bull would have had a personal income tax return up to the day of his death. His estate would also have an income tax return, starting the day after he died. The estate would pay income tax until the assets were distributed (by will, contract or whatever). Whoever received the assets would pick-up their income tax consequence from that point on.

The executor did not include the $212,719 representing Mr. Bull’s share of the profits after his death.

COMMENT: The quirky detail here is that the partnership agreement allowed Mr. Bull to participate in profits for the year even after he died. I interpret that to mean that his estate would participate, as Mr. Bull could not do so personally. After all, he died.

The IRS threw a conniption, arguing that the estate should have reported the $212,719 on its income tax return. The IRS assessed income taxes.

I think the IRS is right: the partnership income after Mr. Bull’s death is (income) taxable to his estate.

But I think the IRS was wrong to include that same income on the estate (that is, his net assets at death) tax return. Why? Simple: That income could not have been an asset to Mr. Bull at death as it did not exist as of the date of his death.

I say that the executor paid too much estate tax.

The executor agreed and wanted the taxes back.

Problem: too much time had elapsed. The refund was barred under the statute of limitations. The IRS had zero intention of refunding even a penny.

What to do?

There was nothing in the tax law per se for a situation like this. Folks, this was the 1930s.

But we had a tradition of English common law and equity. The Supreme Court acknowledged that what was happening here was unfair.

The Supreme Court reasoned:

·      There is one transaction underlying both tax situations.

·      The IRS claim for a deficiency allows for an argument of recoupment, since the overpayment and deficiency arose from the same transaction.

·      Recoupment as a defense is never barred by the statute of limitations. It cannot, as it is a doctrine of equity.

If the Supreme Court could not get to this result using the tax statutes available, it would get to the result by introducing what has come to be known as “equitable recoupment.”

The IRS had to allow the estate to offset one tax against the other. Allowing two bites at the same apple was inequitable. The key is that one transaction – the same transaction – is triggering two or more taxes

Bull was – from what I understand – the first time we see the equitable recoupment doctrine in tax law. In Bull it mitigated the otherwise severe absolutism of the statute of limitations.

OK, this was not a particularly thrilling day at my desk.

Mental Illness And The Statute Of Limitations

Many people and most tax practitioners (hopefully) know the statute of limitations on refunds from the IRS:

§ 6511 Limitations on credit or refund.

(a)  Period of limitation on filing claim.

Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires the later, or if no return was filed by the taxpayer, within 2 years from the time the tax was paid. Claim for credit or refund of an overpayment of any tax imposed by this title which is required to be paid by means of a stamp shall be filed by the taxpayer within 3 years from the time the tax was paid.

We can shorthand this as the “3 and 2” rule.

Then there was the Brockamp case in 1997, which many felt was unfair and which led Congress to write this beauty:

§ 6511 Limitations on credit or refund.

(h)  Running of periods of limitation suspended while taxpayer is unable to manage financial affairs due to disability.

(1)  In general.

In the case of an individual, the running of the periods specified in subsections (a) , (b) , and (c) shall be suspended during any period of such individual's life that such individual is financially disabled.

(2)  Financially disabled.

(A)  In general. For purposes of paragraph (1) , an individual is financially disabled if such individual is unable to manage his financial affairs by reason of a medically determinable physical or mental impairment of the individual which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months. An individual shall not be considered to have such an impairment unless proof of the existence thereof is furnished in such form and manner as the Secretary may require.

Like so much of the tax Code, the heavy lifting is in the details. Brockamp had been senile. Congress addressed the issue by introducing the phrase “medically determinable,” and then handed the baton to the IRS to define what that verbal salad meant.

COMMENT: And there you have a capsule summary of how the Code has gotten away from us over the years. Congress writes words and then leaves it to the IRS and courts to determine what they mean. Congress did the pooch again with the Tax Cuts and Jobs Act.  Google “qualified business income” and tell me that isn’t an elmore waiting to happen.

           

The IRS issued its interpretation of “medically determinable” in Rev Proc 99-21:

SECTION 4. PROCEDURE Unless otherwise provided in IRS forms and instructions, the following statements are to be submitted with a claim for credit or refund of tax to claim financial disability for purposes of § 6511(h).

(1)   a written statement by a physician (as defined in § 1861(r)(1) of the Social Security Act, 42 U.S.C. § 1395x(r)), qualified to make the determination, that …

The IRS is pointing to the Social Security rules to define what a physician is. Methinks this is poor work. Why not reference Beat Bobby Flay to define meal expenses or Car Talk to define transportation expenses?

Let’s look at the Green case.

Richard Green and his wife (Hae Han) went to Tax Court in 2009. There were taxes due and tax refunds and quite the debate about offsetting one against the other.  The case eventually got to Sec 6511(h), and here is what the Court had to say about it:

An individual will not, however, be considered financially disabled unless proof of a medically determinable physical or mental impairment is provided in such form and manner as the Commissioner may require. More specifically, the Commissioner requires a written statement from a physician. Ms. Han, however, did not establish that she was financially disabled. In addition, she was treated by a clinical psychologist, not a physician, and thus could not and did not provide the requisite documentation.

Ms. Han’s letter was written by a psychologist. 

COMMENT: I am thinking: why is a psychologist not considered a “physician?” An optometrist is considered one for this purpose, although an optometrist has an O.D. and not an M.D.

There was no relief for Green and Han.

A number of practitioners considered this decision to be nonsense. The IRS had grafted a Medicare definition concerning payment for services onto Sec 6511(h), which was supposed to be a relief provision in the tax Code.

Enter the Estate of Stauffer, which is presently in Court.

Carlton Stauffer died in 2012 at the age of 90. His son is administering the estate. He discovered that his dad had not filed tax returns for 2006 through 2012. He filed those returns on behalf of his dad. One year alone – 2006 – had a refund of approximately $137,000.

The IRS denied the refund as outside the 3-year window.

The son appealed and pointed at Sec 6511(h).

His father had been seeing a psychologist, who treated him from 2001 until his death in 2012. The psychologist wrote a persuasive letter explaining how Carlton had suffered from psychological problems in addition to ailments including congestive heart failure, chronic obstructive pulmonary disease, leukemia, and chronic pneumonia. He explained how all these factors negatively impacted Carlton’s mental capacity, cognitive functioning, decision making and prevented him from successfully managing his affairs.

The IRS said: show us the “M.D.”

Why wouldn’t they? They had won with that play before.

The estate sued in District Court.

The IRS motioned to dismiss, order boneless chicken wings and watch the NBA over a pitcher of beer.

The District Court denied the IRS motion.

The Court pointed out that – for all the IRS’ power – that it could still review Rev Proc 99-21 under the “arbitrary and capricious” standard that government agencies are held to. The IRS had to articulate a rational connection for its standard, as well as explain why it rejected any reasonably obvious alternatives to the challenged rule.

The Court pointed out that Social Security does not restrict the types of professionals who may opine on whether someone has a disability qualifying for disability benefits. In fact, the opinion of a psychologist is given great weight in such a determination.

The Court did not see how the IRS dismissal of a psychologist’s letter passed the “arbitrary and capricious” standard.

Mind you, the Estate of Stauffer won a motion only; this does not mean that it will win the overall case.  

I for one hope it does.

The IRS Could Not Collect When Limitations Period Expired

Let’s talk a bit about the tax statute of limitations.

There are two limitations periods, and it is the second one that can lead to odd results.

(1) The first one is referred to as the limitations on assessments. This is the three-year period that we are familiar with. The IRS has three years to audit your return, for example. If they do not, then – in general – the opportunity is lost to them.

There are a number of ways to extend the three-year period. When I was young in the profession, for example, tax practitioners would “hold back” certain tax deductions until the client was closing-in on the three years. With a scant few and breathless days remaining before the period expired, they would file amended tax returns, thereby obtaining a refund for the client and simultaneously kneecapping the IRS’ ability to look at the return.

The rules have been revised allowing the IRS additional time when this happens. I have no problem with this change, as I consider the previous practice to be unacceptable. 

(2) The second one is the collections period, and this one runs ten years.

Say you filed your return on April 15, 2014. You got audited and the IRS assessed $15,000 on December 15, 2015. The IRS has ten years – until December 15, 2025 – to collect.

There are things that can extend (the technical term is “toll”) the collections period. Make an offer in compromise, for example, and the period gets tolled. 

Sometimes tax practice boils down to letting the ten-year period click-off, hoping that the IRS does not initiate action. It happens. A few years ago I had a client who had moved to Florida, remarried and had her new husband involve her in an unnecessary tax situation. It was extremely unfortunate and she was extraordinarily ill-advised. He passed away, leaving her as the remaining target for the IRS to pursue. She had a fairness argument, but that meant as much as a snowball in July to IRS Collections. They have a different mind frame over there.

So I am looking at a case where a taxpayer (Grauer) had an issue with his 1998 tax return. He filed it late (in 2000).  That was his first problem. He owed around $40 grand, which quickly became almost $58 grand when the IRS was done tacking-on interest and penalties. That was his second problem. He could pay that much money about as easily as I can fly.

In 2001 he signed a waiver, extending the ten-year collections period.

What makes this point interesting to a tax nerd is that someone would not (knowingly) sign a waiver without something else going on.  In fact, Congress disallowed this in the late nineties, responding to perceived IRS abuses - especially in Collections.

Sure enough, the IRS said that he signed an installment agreement in 2001 (around the time of that waiver), but that he broke it in 2006

Grauer said that he never signed an installment agreement.

It was now 2013, and off to Tax Court they went.

The Court looked at the account transcript, which showed that the IRS had issued an earlier Notice of Intent to Levy.  This was an immediate technical issue, as the Court would not have jurisdiction past the first Notice. The IRS persuaded the Court that the transcript was wrong. 

COMMENT: Your transactions with the IRS go to your “account.” That account is updated whenever a transaction occurs. The posting will include a date, a code, and sometimes a dollar amount and perhaps a meaningful description.  Some codes are straightforward, some are cryptic. 

The Court next observed that Grauer asserted that he had not signed a payment plan. In legal jargon, this was an “affirmative defense,” and the IRS had to prove otherwise. The IRS argued that its transcript was correct and that Grauer was incorrect.

The Court was a bit flummoxed by this response. The IRS was having it both ways.

The Court told the IRS to “show us the installment agreement.” 

The IRS could not.

The Court went on to describe the IRS account transcript as “indecipherable and unconvincingly explained.”

The Court decided for the taxpayer.

Remember: ten years had passed. The waiver needed to attach to something. In the absence of something, the waiver fizzled and had no effect.

The statute had expired.

Did the taxpayer get away with something?

I don’t know, but think about the alternative. Let’s say that the IRS could post whatever it wanted – to speak bluntly, to make things up – to your account. You then get into tax controversy. You are required to prove that the IRS did not do whatever it claimed it did. Good luck to you in that scenario. I find that result considerably more unacceptable than what happened here.

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. 

Can The IRS Collect From You After 31 Years?

What were you doing 31 years ago? 

Me? I was living in South Florida. I probably had a nice tan. 

Let’s return to tax talk: do you think that the IRS can chase you down after 31 years?

One wouldn’t think so. There is a three-year statute of limitations on assessment, which generally means that the IRS has three years to audit you. If there is tax due, the IRS will then “assess” the tax, which means that they post the tax due to your master account. They have ten years (after assessment) to lien, levy or otherwise collect from you. The ten years is the statute of limitations on collection.  

NOTE: You can see there are two statutes at play: one on assessment and another on collection. The two can – and frequently – overlap, so that many times the effective statute of limitations is ten years.

There are specialized situations where tax representation involves exhausting the ten-year period. I had a client from Florida, for example, who inherited a nasty tax problem from her deceased husband.  Exhausting the collection period was part of our strategy.

Let’s talk about Beeler, which the Tax Court decided last month. 

There used to be a company called Equidyne Management, Inc, which failed to remit payroll taxes thirty-one years ago. That would be 1982.

Skipping out on payroll taxes is a bad idea. Somebody will not only be responsible for the taxes, interest and penalties but also for a 100 percent penalty to boot. This is the “responsible person” penalty, and this is one case where you do not want to be responsible.

NOTE: We have previously called this the “big-boy” penalty. It is one of the most gruesome penalties in the tax Code, as it imposes personal liability for a business debt.

Equidyne had three responsible persons: Beeler, Ross and Liebmann.

Ross filed for bankruptcy almost right away – in 1983. During his bankruptcy, he sent $80,860 as part of a “global settlement” with the IRS. “Global” means that he was paying off various taxes, not just the responsible person penalty.

Per the statute of limitations, the IRS had three years to assess. Right on schedule, in 1985 the IRS assessed the responsible person penalty against the three Equidyne officers. It could not assess against the company, as Equidyne itself had gone out of business.

Beeler lawyers up and contests the penalty. 

OBSERVATION: Litigation will “toll” the statute. This means that the ten-year period is suspended until the toll comes off.

The litigation is not resolved until 1995 - 10 years later. Beeler loses.   

Beeler contacts the IRS in 1997. The IRS fails to list the big boy penalty on his transcript.  

In 2001 the IRS releases liens on Beeler’s properties in New York and Sarasota. 

Even better, the IRS makes entry in Beeler’s master account that the statute of limitations on collections had expired.

Beeler wonders what is going on. More likely, Beeler’s tax CPA wonders what is going on. What the IRS did could be correct. The trust fund penalty is “joint and several.” The IRS could go against any of the three officers, but it does not have to go against the three proportionally. If the IRS had collected from one of the other two officers, then Beeler would be off the hook. The IRS cannot collect the penalty more than once, regardless of the number of responsible persons. 

In 2005 an IRS employee reviewing Beeler’s account notices that a “pending” code had been entered into the master file when Beeler litigated in 1986. This is standard procedure, and it indicates the “tolling” of the account. Problem is that the IRS failed to remove the code when the litigation ended in 1995. 

The IRS corrects the file. The judgment against Beeler is recorded. 

NOTE: One way to override the collection period is for the IRS to obtain a judgment, which requires the IRS to go to Court. Beeler was considerate enough to do this on his own power. 

Beeler is hopping mad. Wouldn’t you be? He sues the IRS - again. He has two arguments:

(1) The lien release discharged his trust fund obligation.

COMMENT: It did not. The lien secures a debt; it does not pay a debt. Relinquishment of a lien has nothing to do with the enforceability of the underlying debt.

(2) The big-boy penalty had been satisfied by payment.

COMMENT: This caught the Appeals Court’s attention, especially since the file went back to when some of the judges were probably entering law school. The Appeals Court sent the case back to the Tax Court to look into this matter.

The Tax Court determined the following:

(1)  Equidyne never paid anything.

(2)  Liebmann never paid anything.

(3)  Beeler never paid anything.

(4)  Ross paid $80,860 as part of a global settlement.

Beeler argues that Ross paid another $64,000. The Court finds record of a $64,000 but it believes that this was a bookkeeping entry reflecting a transfer among bankruptcy trustees and not a payment to the IRS.

But there was an IRS entry for $60,773. There was some dispute as to what it meant, as decades have gone by. The Court concluded that the IRS was correcting a prior entry, that this was not cash received and therefore not the $64,000 payment Beeler wanted.

Since there is no better information, the Court assumes that all of the $80,860 was paid toward the responsible person penalty and reduces Beeler’s liability accordingly. But Beeler is still on the hook for the balance.

Let us speculate. What if Beeler had not litigated the big-boy penalty? There would have been no judgment, and the statute of limitations would have eventually expired. Would the IRS have let that happen? Who knows? Sometimes the IRS will send a 90-day notice (called a “SNOD”) to get the case into Tax Court before the statute expires. You know what the IRS wants, of course: it wants the Court to transmute the assessment into a judgment. The IRS does not always send a SNOD, though. Perhaps it decides the likelihood of payment is low, or the amount due is inconsequential, or maybe the file just gets lost in the system. 

If he could go back, I wonder if Beeler would have litigated the penalty. It is the reason he is still on the hook, thirty- one years later.