Editor: Alan Wong, CPA
Procedure & Administration
Recent IRS actions suggest a movement away from granting penalty relief. The IRS has modified its first-time abate (FTA) administrative waiver policy, making an FTA more difficult to obtain. Moreover, a number of recent court cases suggest that the IRS will be less willing to resolve penalty issues when there is an underpayment of tax from undisclosed financial assets. Recent budget cuts, furloughs, and negative press have exacerbated the trend by significantly decreasing IRS resources, resulting in slower responses to taxpayer inquiries.
Failure-to-File and Failure-to-Pay Penalties and FTA
The FTA is established in Internal Revenue Manual (IRM) Section 188.8.131.52.6.1. IRM Section 184.108.40.206.2.2(2)(B) contains this FTA policy:
Check the preceding tax years (at least three) for payment patterns and the taxpayer’s overall compliance history. The same penalty, previously assessed or abated, may indicate that the taxpayer is not exercising ordinary business care. If this is the taxpayer’s first incident of noncompliant behavior, weigh this factor with other reasons the taxpayer gives for reasonable cause.
As a practical matter, the IRS has routinely granted FTAs for a variety of failure-to-file, failure-to-pay, and failure-to-deposit penalties. It is worth noting that the IRS generally applies FTA on a penalty-by-penalty basis. That is, a taxpayer’s FTA for failure to file in one year does not preclude that taxpayer from obtaining an FTA for failure to pay in the next year. Practitioners, however, must always be mindful that FTA is a discretionary policy. That is, FTA is not required by law.
On April 5, 2013, the IRS updated the FTA policy, stating, “Penalty relief under FTA will be limited to those taxpayers that are current with filing and payment requirements” (IRM Procedural Update, SBSE-20-0413-0690 (4/5/13)). Thus, taxpayers must be current with all filing and payment obligations to obtain an FTA. It is noteworthy that the procedural update considers a taxpayer current with payment obligations if that taxpayer has established an installment agreement. It is more noteworthy that many front-line IRS employees apparently conclude that a taxpayer whose return is on extension is not current with filing requirements.
Accuracy-Related Penalties and FTA
The IRS generally will not apply an FTA to Sec. 6662 accuracy-related penalties, even though the fact that a taxpayer has never made an error on a tax return suggests that this first error was an honest mistake and an FTA is appropriate. Unfortunately, these types of arguments have fallen on deaf IRS ears. Indeed, some practitioners have been told that an FTA does not apply to accuracy-related penalties, and the IRM procedural update specifically excludes Sec. 6662 from the penalty Code sections eligible for an FTA.
Taxpayers that seek to abate accuracy-related penalties should establish reasonable cause using other reasons than that it is a first-time occurrence. These taxpayers may still point to a clean compliance history when requesting penalty abatement; however, an FTA should not be strictly relied upon. Taxpayers may instead point to a variety of other factors to show reasonable cause, including but not limited to the use of ordinary business care, reliance on written IRS advice, and death or serious illness. Each of these factors can establish reasonable cause without any reference to FTA.
Civil Penalties and Recent Case Law
The IRS has recently increased its pursuit of civil penalties for taxpayers who fail to file various international tax forms, such as Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR). The Fourth Circuit Court of Appeals and the District Court of Utah recently upheld civil penalties for willful failure to file FBARs in Williams, 489 Fed. Appx. 655 (4th Cir. 2012), and McBride, No. 2:09-cv-378 DN (D. Utah 11/8/12), respectively. Question 7a of Schedule B on Form 1040 asks taxpayers whether they have an FBAR filing requirement. In both cases, the courts pointed to the fact that the defendants had signed Forms 1040 under penalties of perjury and incorrectly answered “no” to Question 7a.
The Fourth Circuit referred to the concept of “willful blindness,” “where a defendant was subjectively aware of a high probability of the existence of a tax liability, and purposefully avoided learning the facts [that] point to such liability” (quoting Poole, 640 F.3d 114 (4th Cir. 2011)). The IRS now uses willful blindness to support the proposition that any individual who fails to file an FBAR and answers “no” to Question 7a is subject to civil penalties (IRM §220.127.116.11.5.3). Whether Williams and McBride support this strict proposition is questionable. The defendants in Williams and McBride engaged in egregious conduct in addition to answering “no” to Question 7a, as both defendants conceded that they intentionally took steps to evade the payment of tax.
For instance, the defendant in Williams was an international tax attorney who set up bank accounts in Switzerland. The defendant stated:
I also knew that I had the obligation to report to the IRS and/or the Department of the Treasury the existence of the Swiss accounts, but for the calendar year tax returns 1993 through 2000, I chose not to in order to assist in hiding my true income from the IRS and evade taxes thereon.
Likewise, the defendant in McBride admitted to creating a financial plan designed to hide foreign assets. Courts have not yet ruled on a case in which the defendant was truly unaware of the FBAR and mistakenly answered “no” to Question 7a. The IRS nonetheless maintains its position that Williams and McBride dictate that civil penalties should apply to the “oblivious taxpayer.”
Fraud Penalties and Recent Case Law
Two recent Tax Court cases, Vanover, T.C. Memo. 2012-79, and Bohannon, T.C. Memo. 2013-122, can serve as measuring sticks for situations in which courts will uphold fraud penalties. The Tax Court upheld fraud penalties in Vanover, a case in which the petitioner deducted, on a business tax return, a number of personal expenses, including an automobile collection, a home mortgage, and personal utilities. The petitioner provided incomplete documents to his tax return preparer, did not cooperate during the IRS’s examination, and had extensive dealings in cash.
The petitioners in Bohannon also deducted a number of personal expenses on a business tax return, including personal architectural services, cabinets, and a baby sitter. However, the Tax Court did not uphold fraud penalties, noting that the petitioners kept meticulous records and were fully cooperative with the IRS examination. The Tax Court stated, “Simply put, petitioners made mistakes recording their expenditures, did not intend to evade tax, and are not liable for fraud penalties.”
It is significant that the IRS pursued fraud penalties in Bohannon, a case in which the petitioners seemingly did not engage in any egregious activity. Moreover, in Bohannon, the Tax Court made clear that failure to cooperate with IRS examinations suggests fraudulent intent.
The above-mentioned changes to the FTA policy and recent cases suggest that the IRS has increased its pursuit of penalties. As the federal government continues to experience furloughs and budget cutbacks, the IRS may view penalties as an important source of revenue. At a minimum, these changes mean increased costs to work with the IRS to abate penalties. Practitioners should be mindful of these recent changes when advocating for clients.
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP, in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986, ext. 986, or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.