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Proving fraud proves difficult for IRS  
By Janet A. Meade, CPA, Ph.D.
March 2013

The Tax Court determined that the IRS was time-barred from assessing tax against the owner of several bankrupt entities for all but the last of several years at issue. Aside from the one year for which the taxpayer consented to extend the limitation period, the assessments were all outside the regular three-year period, and the unlimited limitation period for assessment did not apply because the returns were not fraudulent. The Tax Court did, however, impose an accuracy-related penalty for the open year, finding that the taxpayer failed to make a good-faith effort to assess the proper tax liability.

In 1984, after defaulting on bank loans, Theodore Gould and several entities in which he held interests filed voluntary Chapter 11 bankruptcy petitions. The bankruptcy court approved a consolidation plan, providing, among other things, for the establishment of a liquidating trust to which all assets of the bankruptcy estate were to be transferred. The plan was silent, however, on the trustee’s obligation to file tax returns or to pay taxes. To clarify this matter, the bankruptcy court subsequently determined that the liquidating trust was a grantor trust and not a taxable entity. On appeal, the Supreme Court reversed this determination, holding that the trust was not a grantor trust and that the trustee was responsible for filing returns and paying taxes (Holywell Corp. v. Smith, 503 U.S. 47 (1992), rev’g 911 F.2d 1539 (11th Cir. 1990), aff’g 85 B.R. 898 (Bankr. S.D. Fla. 1988)). The trustee, nonetheless, did not file timely returns for the taxpayer, leading to an IRS examination.

After remitting more than $6 million to the IRS, the trustee of the liquidating trust entered into a compromise and settlement agreement that provided for an additional $10 million payment. The agreement also stated that there would be no tax attribute carryovers available to Gould’s bankruptcy estate. In 1998, the liquidating trust was terminated, and the bankruptcy cases of Gould and the entities were closed.

On joint tax returns for 1995–2002, Gould reported net operating loss (NOL) deductions, capital loss deductions, and estimated tax payments belonging to the liquidating trust and one of the entities. Gould claimed that he succeeded to his bankruptcy estate’s NOLs upon its termination. But he did not report his distributive share of income generated by one of the entities. He also did not remit any of the estimated tax payments reported on the joint tax returns. And while he did amend some of the returns to report self-employment tax liabilities, he did not remit those amounts, either. The IRS subsequently disallowed the NOL and capital loss deductions and assessed a civil fraud penalty under Sec. 6663(a) for each year or, alternatively, an accuracy-related penalty under Sec. 6662(a) for 2002 (for which Gould agreed to extend the limitation period).

Sec. 671 provides for grantors who are treated as the owner of a trust to take into account all items of trust income, deduction, and credits when computing their personal income tax. Sec. 1398(i) allows a debtor who succeeds to the property of a bankruptcy estate upon its termination to take into account many of the tax attributes of the estate, including NOLs and capital losses.

Sec. 6501(a) generally requires the IRS to assess any tax within three years after a return is filed or due. One of several exceptions to the three-year assessment period is Sec. 6501(c)(1), which provides for an unlimited assessment period in the case of a false or fraudulent return with the intent to evade tax. Where the issue of fraud with intent to evade tax is raised in a noncriminal proceeding, the IRS must show by clear and convincing evidence that the taxpayer had an underpayment of tax and that at least some portion of the underpayment was due to fraud.

Gould argued that, based on the bankruptcy court’s holding, the IRS was collaterally estopped from asserting that he was not the grantor of the liquidating trust. The Tax Court, however, rejected that argument because of the Supreme Court’s reversal. The court then noted that the settlement agreement expressly provided for no carryover of tax attributes. Thus, the court determined that Gould was not entitled to take into account the trust’s NOLs in computing his taxable income. Additionally, the court rejected the claimed capital loss deductions for lack of substantiation. As a result, the court sustained the IRS’s determination that Gould had underpayments of tax for the years at issue.

The Tax Court then reviewed the “badges of fraud” factors traditionally analyzed to determine fraudulent intent. Gould failed to keep adequate records, and his explanation of why he claimed losses but did not report income from one of the entities strongly indicated his intent to evade tax. But he cooperated with tax authorities and disclosed on his returns the reasons for claiming credit for unpaid taxes. Thus, the court determined that the IRS failed to clearly prove fraudulent intent. The unlimited assessment statute consequently did not apply, and the IRS’s determinations for 1995–2001 were time-barred.

For 2002, the open year, the court upheld the IRS’s disallowance of claimed NOL and capital loss deductions. It also found that Gould was not entitled to credit for payments made to the IRS by the liquidating trust. Last, the court determined that the accuracy-related penalty was applicable because Gould failed to prove that he had acted with reasonable cause in claiming the disallowed deductions or that he had a reasonable basis for his reporting positions.

  Gould, 139 T.C. No. 17 (2012)

By Janet A. Meade, CPA, Ph.D., associate professor, University of Houston.

File now or file later  
By Charles J. Reichert, CPA
March 2013

The U.S. District Court for the District of Massachusetts held that an estate was liable for a late filing penalty since its reliance on an accountant’s advice to file a late estate tax return rather than a timely estimated return was not reasonable cause for filing the return after the due date. That the estate had fully paid its estimated estate tax before an extended payment deadline (but after the original deadline) did not excuse the penalty, the court held. 

A taxpayer who files a delinquent tax return must pay a penalty of 5% of the tax liability per month or portion of a month, up to a maximum of 25%, unless the taxpayer can prove that the failure to file a timely return was due to reasonable cause and not due to willful neglect (Sec. 6651). In Boyle, 469 U.S. 241 (1985), the Supreme Court held that an estate did not have reasonable cause when an attorney it had hired to handle the estate failed to file a timely return. The Court contrasted the facts in Boyle to those in numerous prior cases where taxpayer reliance on an expert’s opinion on a matter of tax law, such as whether a return needed to be filed, was reasonable cause. The Court in Boyle referred to willful neglect as a “conscious, intentional failure or reckless indifference.”

Arthur Young was the executor of his mother’s estate, which was required to file an estate tax return and pay its tax by May 14, 2009. The estate properly extended the tax return’s due date and the tax payment date to Nov. 14, 2009, and May 14, 2010, respectively, and made tax payments of $760,000 on May 14, 2009, and $2.2 million on Aug. 31, 2009. When valuing its assets, the estate obtained real estate appraisals that it believed were much higher than fair market value. After considering an option to file a timely estimated return and later file an amended return after the real estate was sold, the estate’s accountants recommended that the estate should instead file only a late tax return after the sale of the real estate. The accountants thought this approach could simplify a possible future audit and that no late filing penalty would be assessed because the estate had paid an amount ($2,960,000) they believed would be, and ultimately in fact was, greater than its eventual tax liability. The estate followed this advice and filed a late return on Feb. 15, 2010. The IRS assessed a late-filing penalty of $259,326 plus interest of $20,774, since part of the estate tax liability was paid after May 14, 2009, the original filing deadline. The estate filed suit with the district court.

The court stated because the estate paid off its estimated tax liability after the original payment deadline, it was subject to a late filing penalty even though it paid off its liability before the extended payment deadline. Also, according to the court, waiting for more complete information does not give taxpayers reasonable cause to file a late tax return. The estate argued that a desire to avoid or simplify any subsequent audit was reasonable cause for filing a late return. However, the court disagreed, since the estate had followed advice on tax strategy, not tax law. Finally, the court held that the estate’s conscious decision that it would be better to file a late return rather than a timely estimated return constituted willful neglect.

  Estate of Nancy Young, No. 11-11829-RWZ (D. Mass. 12/17/12)

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.

Rules on use, disclosure of taxpayer information finalized  
March 2013

The IRS issued final regulations under Sec. 7216 that govern the circumstances in which tax return preparers can disclose or use certain limited tax return information (T.D. 9608). The regulations finalize with minor changes rules that were issued in 2010 as temporary and proposed regulations (T.D. 9478 and REG-131028-09). The final regulations were effective Dec. 28, 2012.

Sec. 7216 prohibits a tax return preparer from “knowingly or recklessly” disclosing or using tax return information. A violation could result in a preparer’s being charged with a criminal misdemeanor involving a maximum penalty of $1,000 or one year in prison, or both, plus costs of prosecution.

The final rules were generally already in effect because they had been issued as temporary regulations that were effective Jan. 4, 2010. The final regulations retain the provisions in the proposed and temporary regulations that require return preparers to obtain written consent to use taxpayer information for any purpose not expressly allowed in the regulations.

When it issued the temporary regulations, the IRS said they were intended to provide additional flexibility to tax return preparers and to provide benefits to taxpayers without compromising taxpayers’ rights to control the use or disclosure of their tax return information. They expanded the information that tax return preparers may use without taxpayer consent and include in lists for soliciting tax return business.

The final regulations clarify that lists used to solicit tax return business may not be used to solicit non-tax return preparation services, including accounting services. The IRS noted in the preamble to the final regulations, however, that a tax return preparer may, without taxpayer consent, compile a list of specified taxpayer information that can be used to contact taxpayers on the list to provide tax information and general business or economic information or analysis “for educational purposes.” The IRS also said that the regulations do not attempt to describe every scenario that may constitute permissible (or prohibited) use of a list, and that return preparers must “carefully consider, on a case-by-case basis, the specific content of a particular newsletter article to ensure that the content meets the requirements of §301.7216-2(n).”

Solicitation of tax return business. Under Regs. Sec. 301.7216-2(n), return preparers may compile and maintain a list of their clients’ names, addresses, email addresses, and phone numbers for the sole purpose of offering tax information or additional tax return preparation services to those taxpayers. The temporary regulations expanded the list of permissible information to include the taxpayer’s entity classification or type, including “individual” status, and the taxpayer’s income tax return form number (e.g., 1040).

The final regulations replace the phrase “tax information” in former Regs. Sec. 301.7216-2(n) with “tax information and general business or economic information or analysis for educational purposes” (Regs. Sec. 301.7216-2(n)(1)).

The examples in the final regulations were modified to clarify that any delivery method that facilitates direct contact with taxpayers on a list is authorized. The temporary regulations had provided examples using U.S. mail and email. The IRS said the examples were not intended to limit the scope of the rule under Regs. Sec. 301.7216-2(n)(1).

The IRS also clarified, in response to a comment, that nontax information cannot be included in a list along with allowed items of tax return information.

Sale of a tax return business. Tax return preparers are allowed to transfer lists or statistical compilations “in conjunction with the sale or other disposition of the compiler’s tax return preparation business” (Regs. Sec. 301.7216-2(n)). This phrase includes due diligence performed in contemplation of a sale or other disposition of a tax return preparation business. The regulations also clarify that tax return information made available to a potential purchaser for due-diligence purposes constitutes a disclosure of that information and not a transfer of that information.

Providers of auxiliary services. The regulations explain that persons who meet the definition of a tax return preparer solely because they provide auxiliary services to another tax return preparer may not, under Regs. Sec. 301.7216-2(n), use the tax return information they receive from the other tax return preparer to compile and maintain a list of taxpayers for their own use.

Statistical compilations. The regulations add new exceptions to the general rule that a tax return preparer may not disclose or use statistical compilations of tax return information without taxpayer consent. However, under the final regulations, tax practitioners may not, in the context of marketing or advertising, use or disclose, in whole or in part, statistical compilations that identify dollar amounts of refunds, credits, or deductions associated with tax returns, or percentages relating to them, even if the data are statistical, averaged, aggregated, or anonymous.

Conflict-of-interest reviews. The regulations add an exception to the written consent rules to allow disclosures of tax return information by a tax return preparer without taxpayer consent for the purpose of conducting conflict-of-interest reviews, but only to the extent necessary to accomplish the reviews. They clarify that tax return preparers may use and disclose tax return information to the extent necessary to accomplish a conflict review undertaken to comply with the requirements of any federal, state, or local law, agency, board, or commission, or by a professional association ethics committee or board (Regs. Sec. 301.7216-2(p)). Such a conflict-of-interest review must be undertaken to identify, evaluate, and monitor actual or potential legal and ethical conflicts of interest that may arise when a tax return preparer or tax return preparation business is employed or acquired by another tax return preparer or tax return preparation business, or when a tax return preparer is considering engaging a new client.

Mandatory language for consents to disclose, use taxpayer information modified  
March 2013

In Rev. Proc. 2013-14, the IRS provided guidance to tax return preparers about the format and content of taxpayer consents to disclose and consents to use tax return information and modified the mandatory language required on each taxpayer consent. The guidance applies to individuals filing a return in the Form 1040 series. The revenue procedure also lists specific requirements for electronic signatures when a taxpayer executes an electronic consent to the disclosure or consent to the use of the taxpayer’s tax return information.

Rev. Proc. 2013-14 modifies and supersedes rules issued in 2008 (Rev. Proc. 2008-35) and was effective Jan. 14, 2013.

Taxpayers who do not file a return in the Form 1040 series may use language prescribed in the revenue procedure or may use consents whose formats and content do not conform to the revenue procedure, as long as those consents otherwise meet the requirements of Regs. Sec. 301.7216-3.

In the revenue procedure, the IRS said that some taxpayers have expressed confusion over whether they must complete consent forms to engage a tax return preparer to perform tax return preparation services. The modified language required in consent forms clarifies that a taxpayer does not need to complete a consent form to engage a tax return preparer to perform only tax return preparation services. One example in the revenue procedure provides that if a tax return preparer makes provision of tax preparation services contingent on the taxpayer’s signing a consent, the consent is not valid because it is not voluntary. However, a taxpayer must complete a consent form as described in the revenue procedure to allow a tax return preparer to disclose or use tax return information in providing services other than tax return preparation.

Each separate consent to disclosure or use of tax return information must be contained on a separate written document (either paper or electronic). The separate written document may be provided as an attachment to an engagement letter furnished to the taxpayer.

The revenue procedure prescribes formats for consents on paper and in electronic form, as well as general statements and statements that must be included in various circumstances. All consents must require the taxpayer’s affirmative consent to a tax return preparer’s disclosure or use of tax return information. An “opt-out” consent that requires the taxpayer to remove or deselect disclosures or uses that the taxpayer does not wish to be made is not permitted. For an electronic consent to be valid, it must be furnished in a manner that ensures the taxpayer’s affirmative, knowing consent to each disclosure or use. A tax return preparer may not alter a consent form after the taxpayer has signed the document, including by filling in blank spaces.

All consents to disclose or use tax return information must be signed by the taxpayer. Taxpayers may sign electronic consents by any method prescribed in the revenue procedure.

Voluntary Classification Settlement Program expanded  
March 2013

The IRS significantly modified its Voluntary Classification Settlement Program (VCSP). In Announcement 2012-46, in effect until June 30, 2013, the IRS is temporarily permitting employers who have not filed Forms 1099 for their workers to participate in the program by paying a larger amount of past-due tax than under the normal VCSP (see previous Tax Matters coverage, Dec. 2011, page 59). In Announcement 2012-45, which modifies and supersedes Announcement 2011-64, the IRS said it is liberalizing the program’s rules.

Liberalized VCSP rules. After a year of experience with the program and in response to feedback from taxpayers and their representatives, the IRS made the following changes or clarifications:

  • A taxpayer under IRS audit other than an employment tax audit is now eligible to participate. Formerly, employers could not be under audit by the IRS for any issue.
  • A taxpayer is no longer required to agree to extend the limitation period on employment tax assessment as part of the VCSP closing agreement with the IRS. Formerly, employers were required to extend the period for three years for each of the three calendar years beginning after the date of the agreement.

The IRS reiterated the previous eligibility requirement that a taxpayer that is a member of an affiliated group under Sec. 1504(a) is not eligible to participate in the VCSP if any member of the affiliated group is under employment tax audit. The IRS also emphasized that a taxpayer is not eligible to participate in the VCSP if the taxpayer is contesting in court the classification of the class or classes of workers from a previous IRS or U.S. Labor Department audit.

Temporary expansion of VCSP eligibility. In response to requests from taxpayers that requested VCSP relief but did not qualify for the VCSP program because they had not filed Forms 1099 for their workers, the IRS announced a temporary program. To participate, taxpayers must submit applications to the IRS by June 30, 2013. The temporary eligibility expansion is available for taxpayers who want to voluntarily change the classification of workers from independent contractors to prospectively treat the workers as employees.

To be eligible to participate in the temporary expansion, before executing the temporary eligibility closing agreement, the taxpayer must furnish to the workers being reclassified and electronically file with the IRS all required Forms 1099 consistent with nonemployee treatment for the previous three years.

If the IRS approves a taxpayer’s application, the taxpayer will:

  • Pay 25% (compared with 10% in the regular VCSP) of the employment tax liability that would have been due on compensation paid to the workers being reclassified for the most recent tax year if those workers were classified as employees for that year, determined under the reduced rates of Sec. 3509(b); and
  • Pay a reduced penalty for unfiled Forms 1099 for the previous three years for the workers being reclassified.

Furthermore, approved taxpayers will not be liable for any interest and penalties on the liability and will not be subject to an employment tax audit for the worker classification of the class or classes of workers for prior years. 

Line items  
March 2013

Proposed Regs. Issued on Net Investment Tax

The IRS released proposed regulations (REG-130507-11) governing the 3.8% net investment income tax imposed under Sec. 1411 that was added to the Code by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152. Taxpayers can rely on the proposed regulations for purposes of complying with the tax until final regulations take effect. The IRS has also posted FAQs explaining the tax and how it operates.

Starting in 2013, Sec. 1411(a)(1) imposes a tax equal to 3.8% of the lesser of an individual’s net investment income for the tax year or the excess (if any) of the individual’s modified adjusted gross income (AGI) for the tax year over a threshold amount. The threshold amounts are $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for other taxpayers. The tax also applies to estates and trusts on the lesser of (1) the estate’s or trust’s undistributed net investment income or (2) the excess of the estate’s or trust’s AGI over the threshold of the highest income tax bracket applicable to estates and trusts under Sec. 1(e) ($11,950 in 2013).

Prop. Regs. Sec. 1.1411-2(a)(2) provides that nonresident aliens (who are otherwise exempt from the tax) are subject to the tax if they elect to file a joint return with a resident or citizen spouse under Sec. 6013(g).

Prop. Regs. Sec. 1.1411-3 contains the rules for trusts and estates, including the types of trusts to which the tax does not apply (business trusts under Regs. Sec. 301.7701-4(b), certain state law trusts, pooled income funds, cemetery perpetual care funds, qualified funeral trusts, etc., as well as tax-exempt trusts--the latter exclusion applies to unrelated business income of those trusts).

Grantor trusts pay the tax at the level of the grantor, not at the trust level. Electing small business trusts, which are usually treated as two separate trusts, have their AGI determined as if they were one trust for purposes of this tax. Charitable remainder trusts (CRTs) are not subject to the tax, but distributions to noncharitable beneficiaries are (Prop. Regs. Sec. 1.1411-3(c)(2)). Foreign trusts and estates are not subject to the tax unless their net investment income is earned or accumulated for the benefit of U.S. persons. If a debtor is an individual, his or her bankruptcy estate is treated as an individual for purposes of computing the tax.

Prop. Regs. Sec. 1.1411-4 defines net investment income and its components. It also explains the exception for income received in the ordinary course of a trade or business. This section also describes the calculation of net investment income, describing the deductions that are properly allocable to the investment income.

Prop. Regs. Sec. 1.1411-5 provides definitions and examples regarding the trades or businesses to which the tax applies, which include trades or businesses that are passive activities with respect to the taxpayer. A trade or business of trading in financial instruments or commodities is subject to the tax.

Prop. Regs. Sec. 1.1411-7 provides details on determining the gain or loss on the disposition of interests in partnerships or S corporations.

The regulations are proposed to be effective for tax years beginning after Dec. 31, 2013, except for Prop. Regs. Sec. 1.1411-3(c)(2) (special rules for CRTs), which is effective for tax years beginning after Dec. 31, 2012.

Rules Proposed for Partial Identifying Numbers

The IRS issued proposed regulations (REG-148873-09) that permit filers of information returns to use truncated taxpayer identification numbers (TTINs) when issuing payee statements in the Forms 1099, 1098, and 5498 series (with the exception of Form 1098-C, Contributions of Motor Vehicles, Boats, and Airplanes, because it is an acknowledgment). The regulations make permanent a pilot program under Notice 2011-38.

A TTIN is an individual’s Social Security number (SSN), individual taxpayer identification number (ITIN), or adoption taxpayer identification number (ATIN) that is truncated by replacing the first five digits of the nine-digit number with X’s or asterisks. The TTIN program is voluntary for filers. It permits filers to truncate numbers on payee statements but not on forms filed with the IRS. It also does not allow the use of a TTIN on Form W-2, Wage and Tax Statement, because Sec. 6051(a)(2) requires that form, when furnished to employees, to show the name of the employee “and his social security account number.” However, filers may now use TTINs on electronically furnished payee statements.

The regulations will be effective when published in the Federal Register as final; however, affected filers may rely on the proposed regulations until final regulations are published.

Proposed Regs. Issued on Employer Health Coverage

The IRS issued proposed regulations (REG-138006-12) providing guidance on the large employer “shared responsibility” provisions in Sec. 4980H. Taxpayers can rely on the proposed regulations until the IRS issues final regulations or other applicable guidance. The IRS also posted FAQs on its website explaining how the shared-responsibility provisions work and who is subject to them.

The 144-page proposed regulations follow up on four notices the IRS issued in 2011 and 2012 that outlined possible approaches and asked for public comments (Notices 2011-36, 2011-73, 2012-17, and 2012-58). The proposed regulations generally incorporate the provisions of Notice 2012-58, as well as many of the provisions of Notices 2011-36, 2011-73, and 2012-17, with some changes in response to comments received.

Under Sec. 4980H, an applicable large employer is subject to a penalty if its employer-sponsored health coverage does not provide “minimum essential coverage” or is not affordable relative to the employee’s household income and at least one full-time employee (FTE) has been certified as having enrolled in a qualified health plan with respect to which an applicable premium tax credit or cost-sharing reduction is allowed or paid with respect to the employee. An employer is an “applicable large employer” for a calendar year if, during the preceding calendar year, it employed on average at least 50 FTEs. An employee is an FTE for any month if he or she was employed, on average, at least 30 hours per week.

The proposed regulations contain various definitions (Prop. Regs. Sec. 54.4980H-1) and rules for determining:

  • Status as an applicable large employer and applicable large employer member (Prop. Regs. Sec. 54.4980H-2);
  • FTEs (Prop. Regs. Sec. 54.4980H-3);
  • Assessable payments under Sec. 4980H(a) (Prop. Regs. Sec. 54.4980H-4); and
  • Whether an employer is subject to assessable payments under Sec. 4980H(b) (Prop. Regs. Sec. 54.4980H-5).

They also provide rules relating to the administration and assessment of assessable payments under Sec. 4980H (Prop. Regs. Sec. 54.4980H-6).

The proposed regulations adopt the position outlined in Notice 2011-36, which determines who is an employee and an employer under the common law standard. The IRS declined to adopt the definition of employer used in the Fair Labor Standards Act.

For purposes of determining who is an FTE, the proposed regulations adopt a commenter’s suggestion that the regulations use the term “hours of service” rather than “hours worked” (which had been used in Notice 2012-58).

Employers can rely on the proposed regulations pending the issuance of final regulations or other guidance. Sec. 4980H is effective for months after Dec. 31, 2013.

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