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Litigation and Administrative Cost Recovery EIC Overclaims Amending Tax Shelter Transactions Dispute Resolution Options
Editor: Mark
H. Ely, J.D., CPA
Editor's note: Mr. Ely is the former chair of the AICPAs Relations with the IRS Committee. Messrs. Blair, Welty and Monaco and Ms. Bauman are members of the AICPAs IRS Practice & Procedures Committee. Mr. Monaco is a former IRS Assistant Commissioner, Office of Examinations.
Recovering Litigation and Administrative Costs Taxpayers disorganized records cost them the opportunity to recover administrative and litigation costs. If taxpayers expect to be reimbursed for these costs, they must keep adequate records and cooperate with the IRS from the beginning. Proper recordkeeping with adequate upfront substantiation would eliminate the need to incur administrative and litigation costs at all.
How to Avoid Costs The rules for recovering reasonable administrative and litigation costs are not new or complex. To be eligible for reimbursement, taxpayers must prevail substantially, under Sec. 7430(c)(4)(A), either on the amount involved or on the most significant issues, and their net worth must fall below a stated threshold. According to Sec. 7430(c)(4)(B), the taxpayer fails to qualify as the prevailing party if the IRS establishes that its position was substantially justified under Sec. 7430(c)(4)(B). A finding of substantial justification might take into account the taxpayers behavior and condition of his or her records. Said another way, a finding of lack of substantial justification may require that the taxpayer provided adequate records and demonstrated cooperation in the examination process. If taxpayers meet the criteria, Sec. 7430(a) provides that they can obtain reimbursement of reasonable administrative costs incurred during an administrative proceeding for any procedure or other action before the IRS, and recover reasonable litigation costs incurred in a court proceeding. For the latter, taxpayers must also exhaust all administrative remedies available within the IRS, under Sec. 7430(b)(1). Administrative and litigation costs might be denied if, under Sec. 7430(b)(3), the taxpayer has un-reasonably protracted the administrative or court proceeding.
Authority In Pierce v. Underwood, 487 US 552 (1998), the Supreme Court held that the governments position would be substantially justified if, based on all the facts and circumstances and legal precedents, the government: 1. Acted reasonably; 2. Has a reasonable basis in both law and fact; and 3. Is justified to a degree that could satisfy a reasonable person. Taxpayers are required to maintain books and records in accordance with the prescribed rules and regulations and to bear the burden of proving and substantiating claims. On the other hand, the IRS may reasonably oppose a taxpayers claims until the taxpayer provides adequate information that the Service can verify. The Services position may be incorrect, but substantially justified, if a reasonable person could think it correct (Pierce at 566, n. 2). The question is whether the IRS knew or should have known that its position was invalid at the onset or when it took the position, given the facts and circumstances known at that time. The fact that the Service eventually loses or even concedes is relevant, but it does not establish that the position was unreasonable; see McIntosh, TC Memo 2001-144, and the authorities cited therein. In McIntosh, the taxpayers did not keep a set of books, nor did they provide an accounting of the expenses incurred in their business. They gave to the IRS folders containing receipts and canceled checks. The examining agent attempted to verify the amounts shown on the returns in question and to reconstruct costs incurred. The agent contacted third parties and submitted numerous Information Document Requests (IDRs). The taxpayers gave IDR information that was disorganized to the agent; they did not submit the final supporting documentation until after the Service issued a deficiency notice. The Service had several conferences with the taxpayers and their representative, who were adequately informed about the IRSs objections to the deductions claimed. The taxpayers argued that the Services positions on the adjustments were not reasonable in fact, based on the evidence they ultimately presented. Although the IRS agreed that the taxpayers had substantially prevailed on the amount in controversy, it contended that they failed to fully substantiate, or account for, certain items. The Service argued (and the court agreed) that taxpayers are responsible for substantiating the amounts and the purposes of deductions claimed. It is reasonable not to concede adjustments until adequate substantiation is received and the items in question are verified. Thus, the court concluded that the IRSs position was reasonable when taken and appropriately conceded within a reasonable time after suitable substantiation was provided. Because the Services positions on the disputed issues were reasonable and sufficiently supported by the facts and circumstances known at the time, the court held that they were substantially justified. Thus, even though the IRS conceded the substantive issues, the court found the taxpayers not to be the prevailing parties, because the Services position was substantially justified. As a result, it denied the administrative and litigation costs. From Ronald J. Blair, CPA, MBA, School of Management, University of Texas at Dallas, Dallas, TX
To address earned income tax credit (EIC) overclaims, the IRS is proposing to precertify 45,000 EIC recipients beginning in July 2003 and another two million taxpayers starting in 2004. Although the details of the precertification program are vague, the Service plans to use a combination of taxpayer education and enforcement to reduce EIC overclaims. According to John M. Dalrymple, Commissioner of the IRSs Wage and Investment Division, the EIC overclaim rate has reached $9.9 billion or 31.7% of EIC benefits, based on a Treasury study of 1999 returns. The Services precertification plan appears to be aimed only at EIC overclaims and does not attempt to bring the estimated 4.3 million taxpayers eligible for the EICbut who fail to claim the creditinto the tax system. According to IRS statistics, approximately 19 million taxpayers claim the EIC, and more than 70% use a return preparer. EIC overclaims are a result of intentional taxpayer fraud and unintentional taxpayer errors caused by the multiple complexities of claiming the EIC. The Service identified three specific problem areasineligible qualifying children, incorrect filing status and underreported incomeas the source of 80% of EIC overclaims.
How It Works Under the EIC precertification initiative, the IRS is precertifying only specific aspects of EIC eligibilitythe relationship and residency status of qualifying children. Thus, a taxpayer could later be denied an EIC for failing another eligibility requirement (e.g., income) that is not being precertified. In the trial phase, the Service will select EIC recipients who are deemed high error EIC filers. These taxpayers will have until December 2003 to submit proof of relationship and residency for their qualifying children. The IRS has identified affidavits from a variety of sources (e.g., clergy, day-care providers, school officials and social service agencies) as acceptable documentation; thus, the burden of precertification will extend beyond the taxpayer. The proof-of-residency requirement will become an annual event for EIC claimants whom the Service classifies as being in the EIC high-error category. However, married taxpayers who file jointly or mothers who file as single or head-of-household will be exempt from the annual precertification filing requirements. To implement the EIC precertification program, President Bushs fiscal 2004 budget targets $100 million and an additional 650 IRS staff.
Program Wrinkles On April 8, 2003, the House Ways and Means Oversight Committee asked the General Accounting Office to examine the IRSs plans for EIC precertification, citing fears of significant taxpayer burden compared to other Federal programs for low-income taxpayers (such as food stamps). The Oversight Committee also expressed concerns that the Service is not allowing sufficient time to examine the results of the EIC precertification of 45,000 taxpayers planned for 2003, before broadening the precertification scope in 2004. Although the specific details of the precertification program have not been disclosed, the program has tremendous potential to cause confusion and panic among uncontacted EIC recipients, resulting in increased inquiries to the IRS and other tax professionals. Taxpayers may not understand why a relative or neighbor is being precertified for EIC, and they are not. Because only a portion of the taxpayers EIC eligibility is being precertified, it is unknown the type of assurance letters taxpayers will receive, and the recourse they will have if precertification is denied. It is also unclear how the Service will assure consistent treatment of taxpayers and their precertification documentation. The taxpayers financial burden associated with EIC precertification is another major concern. The cost of assistance from a CPA or other tax professional could substantially dilute the anti-poverty effects of EIC funds. Whether states with the EIC will accept any of the IRS precertification documentation in their audit process is unknown. EIC overclaim rates are high because taxpayers self-report their eligibility; EIC benefits represent one third or more of a taxpayers annual income, and the rules are complex. In the coming months, Congress and the Service will sort out whether an EIC precertification role is appropriate for the IRS. The CPA profession and IRS-funded (Sec. 7526) low-income taxpayer clinics will also need to identify the role that they can play in the proposed EIC precertification program, in identifying alternative solutions to reducing EIC errors and in encouraging eligible EIC nonfilers to file tax returns. From Christine C. Bauman, Ph.D., CPA, DirectorLow Income Taxpayer Clinic, University of WisconsinMilwaukee, Milwaukee, WI
Tax Shelter Transactions: To Amend or Not to Amend? In its ongoing efforts to crack down on promoters and taxpayers participating in tax shelters, the IRS has suggested that taxpayers should file amended returns to eliminate the shelter transactions tax benefits. Setting aside the question of whether the Service will allow taxpayers who voluntarily amend to participate in a global settlement offered to all taxpayers who entered into a particular transaction, the Services ambiguous regulations on qualified amended returns and its aggressive interpretation of the interest-suspension rules send mixed messages to taxpayers about whether to amend.
When Is an Amended Return Qualified? An amended return may reduce or eliminate accuracy-related penalties if it qualifies. Sec. 6662(a) and (b) provide for a 20% penalty on an underpayment resulting from (among other things) negligence or a substantial understatement of income tax. Under Sec. 6662(h), this penalty can increase to 40% of an underpayment if a taxpayers adjusted basis is grossly misstated (i.e., overstated by 400% or more). In many tax shelter transactions, an assets basis can become enhanced by more than 400%, and the IRS has been proposing the 40% penalty. Regs. Sec. 1.6664-2(a) defines underpayment as the difference between the correct amount of tax and the amount shown as the tax by the taxpayer on his return. Under Regs. Sec. 1.6664-2(c)(2) and (3), the latter includes an amount shown as additional tax on a qualified amended return, except when an original return is fraudulent. Thus, a qualified amended return effectively eliminates accuracy-related penalties, by removing amounts shown on the amended return from the penalty calculation. A qualified amended return, according to Regs. Sec. 1.6664-2(c)(3)(i) and (ii), is an amended return, or administrative adjustment request, filed after the returns due date for the tax year (including extensions) and before the taxpayer or any person described in section 6700(a) (relating to the penalty for promoting abusive tax shelters) is first contacted by the IRS. Consistent with its promoter strategy, the Service has initiated a significant number of promoter examinations to obtain (among other objectives) tax shelter client lists. However, it is conducting most of the examinations under Secs. 6707 (failure to register penalty) and 6708 (failure to maintain investor list penalty), not under Sec. 6700 (promoting abusive tax shelters). A number of tax advisers (and at least one senior IRS executive) interpret the regulations as providing that an amended return would be qualified even if the taxpayer filed it after the Service has initiated a Sec. 6707 or 6708 promoter examination, as long as the promoter is not under a Sec. 6700 examination when the taxpayer filed the amended return. The qualified amended return regulations, however, do not appear to contain the temporal element suggested by this interpretation. Indeed, it appears that the IRS can nullify the penalty reduction or elimination effect of a putative qualified amended return filed after the initiation of a promoter examination under Secs. 6707 and 6708, simply by taking the position that the promoter is a person described in section 6700, even if the Service neither seeks nor imposes Sec. 6700 penalties against the promoter. Absent further IRS clarification of its position on amended returns filed in such situations, many practitioners are uncomfortable in advising clients that an amended return accomplishes anything, other than possibly reducing the likelihood that the IRS will seek penalties.
How Is Interest Calculated? Another consideration is the effect an amended return may have on calculating interest. Generally, interest accrues on any tax underpayment from the date tax was originally due. In 1998, Congress enacted Sec. 6404(g), which generally provides that interest stops accruing on an underpayment 18 months after the taxpayer filed the return, unless the Service provided a notice to the taxpayer specifically stating the taxpayers liability and the basis for it. This rule is supposed to protect a taxpayer from mounting interest when the IRS has not given the taxpayer notice about any return item that may be improper. Interest does not begin to accrue again until the Service provides such notice. Under Sec. 6404(g)(2)(C), interest is not suspended for any interest, penalty, addition to tax, or additional amount with respect to any tax liability shown on the return. The legislative history of this exception supports the conclusion that Congress did not want to suspend interest on underpayments self-assessed on an original return. This makes sense, as Congress did not want to give a break on interest to taxpayers who simply failed to pay the tax shown on their return. The IRS has been interpreting this self-assessment exception to interest suspension to apply to amounts shown on amended returns; see Memorandum for Commissioner, Small Business/Self-Employed Division Deputy Commissioner for Modernization/Chief Information Officer (Ref. No. 2002-10-187, September 2002) (available at www.ustreas.gov/tigta/2002reports/200210187fr.html). This would be true even if a taxpayer filed an original return in good faith, relying on the advice of competent tax advisers, but later filed amended returns after learning that the IRS considers a transaction in which the taxpayer participated to be an abusive tax shelter. Consequently, under the Services interpretation of Sec. 6404(g)(2)(C), a taxpayer who files an amended return loses the benefit of interest suspension, while taxpayers who play the audit lottery would get the benefit of interest suspension (whether the IRS examines them at all). Obviously, the Services current position on interest militates against filing amended returns.
Conclusion If the IRS sincerely wants taxpayers to file amended returns, it should first clarify its position as to the definition of a qualified amended return, including whether it will (1) consider a promoter a person described in Sec. 6700 if the taxpayer files an amended return when the promoter is under examination under Secs. 6707 and 6708, and not Sec. 6700; or (2) disqualify the amended return because the promoter is a person described in Sec. 6700, even if the IRS never imposes a Sec. 6700 penalty. Second, the Service should modify its current interpretation of Sec. 6404(g)(2)(C), so that interest suspension applies to amended returns, as long as the taxpayer filed the original return in good faith. From Todd Welty, J.D., CPA, Meadows, Owens, Collier, Reed, Cousins & Blau, LLP, Dallas, TX
The Many Faces of Dispute Resolution A complex tax law, global economy, international competition and the financial penchant for improving after-tax income will cause disagreements between taxpayers and tax administrators. This is costly to both the government and taxpayers; time and human resources are expensive. With less than 25% of large corporate audits and only 1% of proposed audit dollars agreed on in the late 1980s, the IRS has recognized the need to improve the dispute resolution process and has developed several programs.
Background The Service made changes in the early 1990s that encouraged examiners to resolve factual disputes and obtain agreements with taxpayers. By 1995, the large corporate audit case agreement rate increased from less than 25% to over 75%; the percentage of audit dollars agreed on improved to 25%. Today, roughly 65% of large corporate audits and 23% of large corporate proposed adjustments were agreed on in 20012003. The Service continues to struggle with agreements and the time span of audits. Although agreement rates have improved, the time needed to complete examinations has not. Large corporate audits still take an average of five years to complete; the Office of Appeals (Appeals) process to finalize them takes an average of more than two yearsvery similar to the timeframes of the early 1990s. The Service has introduced a variety of initiatives intended to bring disputes to a prompt conclusion. Their success, while dramatic for individual corporate taxpayers, has not significantly improved the overall system. The corporations that take advantage of the initiatives receive prompt attention, but apparently at the expense of others, as the average timeframes have not changed significantly.
Programs Industry Issue Resolution (IIR) program (Rev. Proc. 2003-36). This program intends to identify contentious industrywide issues and resolve them with specific guidance. IRS and Treasury personnel solicit the public to identify issues that arise frequently and to recommend resolutions. They study and analyze each issue and produce guidance in the form of a revenue procedure. While, thus far, they have released about 10, the process is time- and resource-consuming for both the Service and industry representatives. Considering the views of many parties and trying to satisfy everyones needs have proved to be a challenge, and outcomes are not always perceived as improvements. The volume of issues (about 150 IRS coordinated issues alone) far outstrips resources. The program accepts fewer than 10 issues a year. It has successfully resolved the few studied, but needs to produce much more guidance. The IIR program has potential, but IRS resource limits prevent it from having a significant effect. Pre-Filing Agreements (PFAs) (Rev. Proc. 2001-22). This program allows taxpayers to identify issues and reach agreement with the IRS before filing. The program has merit, because both sides accept the return, potentially saving a lot of time. A number of successful PFAs have been completed, but strict criteria for eligibility have limited this program. It has accepted fewer than 100 issues, a very small part of the thousands examined each year, and is time-consuming. Overall, while interesting, provocative and beneficial to those who use it, the PFA program has not yet made substantial changes to the audit process. Limited Issue Focused Examination (LIFE) (IR 2002-133). As the newest initiative to accelerate the audit process, LIFE is supposed to limit the scope of audits and obtain cooperative agreements for conducting them. This includes limiting the kind and number of issues based on materiality, and identifying and agreeing to the documents and records required, in advance. If the IRS accepts that every issue and document does not need to be examined and that every dollar of tax does not need to be assessed, LIFE has a potential for success. However, the Service must permit and support the process in most audits. Delegation Orders 236 and 247. The IRS delegated formal settlement authority to Office of Examinations (Examinations) managers in limited circumstances. Although a managers authority is restricted, the delegation orders provide avenues for resolving cases at a lower level. The managers can settle recurring issues that have already been settled in Appeals and settle coordinated issues based on Appeals settlement guidelines. Both issues are troublesome; delegation orders provide a sensible way of resolving them more quickly. However, the authority has been sparsely used, perhaps because of factual differences between years and evolving legal positions. Early referral to Appeals (Rev. Proc. 99-28). This procedure (in place since 1992) allows taxpayers under examination to request the transfer of a developed, unagreed-on issue to Appeals, while Examinations continues to develop the other issues in the case. This intends to permit earlier resolution of individual issues and audits. Although several hundred issues have been successfully resolved through this program, it has had a minimal effect on expediting the overall audit process. Accelerated Issue Resolution (AIR) agreement (Rev. Proc. 94-67). This program allows issues raised, developed and agreed to during a corporate audit to be finally resolved for all open years through a closing agreement. It almost seems self-evident: if a taxpayer and the Service resolve an issue, why should it be raised and disputed again in the future? AIR agreements have been used advantageously a number of times, but the number of issues resolved with them is very few relative to the many examined. Both taxpayers and the IRS appear unsure of agreements for any years not currently on the table, perhaps because the facts and law continually change. The Service has also placed restrictions on the process by limiting the eligible issues. Fast-Track Mediation (FTM) (Notice 2001-67). In this process, an Appeals Officer is introduced into the examination process to bring the examiner and the taxpayer to agreement on the facts while the issues and case are still under Examinations jurisdiction. The Appeals Officer can also propose a settlement (under hazards of litigation), to which both sides must agree. A very short time frame (120 days) exists to reach agreement. FTM has been successful in quickly resolving issues and bringing cases to prompt conclusions. Resources devoted to achieving 120-day resolutions under FTM, however, are taken directly away from traditional Appeals cases, causing the time spans of those cases to increase, perhaps correspondingly. Mutually Accelerated Appeals Process (MAAP) (IR 2000-42). This process expedites the movement of large cases through the Appeals process via a formal agreement for both sides to devote additional resources (e.g., primarily staffing) to the work plan. MAAP can work as envisioned only if the IRS has resources to devote to increase staffing activity, which it does not. The programs practical effect is that cases electing MAAP move more quickly, while others move more slowly. Comprehensive Case Resolution Program (Notice 2001-13). This program was a creative, but failed, initiative designed to resolve unagreed-on issues at all levels of the audit/appeals/litigation process, in one effort. It was supposed to bring together all IRS functions (Examinations, Appeals and the Office of Chief Counsel) and all of the tax years in their combined jurisdictions to one resolution table, to jointly work out a settlement for all years and issues. Although the IRS extended the program, it did not approve any participants. It placed strict rules on the process, which limited the programs potential. Other programs. Some of the processes to expedite case resolution hold promise, but their current form has been limiting their reception. For example, Mediation (Rev. Proc. 2002-44) and Arbitration (Ann. 2002-60) are available at the end of unsuccessful appeals. Both of these programs are supposed to bring third parties into the resolution process in a final effort to avoid even more lengthy litigation. There have been too few successes and, overall, resolution of disagreements has been very minimal. Both programs suffer from strict rules and limits that need liberalizing.
Barriers to Success Additional authority given to examiners to resolve cases was by far the most successful approach to improve overall audit agreement rates. However, when large amounts of money are at issue, significant improvement has been lacking, Further, contrary to expanding examiners decision-making authority, issue coordination and counsel involvement have diminished success. The restriction of examiner authority should cause taxpayers to look for other avenues of resolution; the initiatives described above may present opportunities. Many creative procedures are available, with admirable goals of reducing contention and bringing disagreements to fast and acceptable ends. Successes, however, have been elusive so far and limited to taxpayers that actively seek ways to resolve their disputes with the IRS. The reasons for limited success are varied and include:
The many IRS initiatives introduced, tested and adopted over the last 10 years have not yet improved agreement rates for the audit system as a whole or affected the average time of resolving disputes; they have only provided relief for taxpayers actively pursuing them. To change the time-consuming and unpleasant system of never-ending audits and dispute may require a simpler tax system, an adequately staffed and risk-oriented tax organization and an open-minded public. The bottom line for the IRS dispute resolution process is that it works very well in getting the Service and taxpayers to agree on more issues at lower levelsbut only when taxpayers know their options and how to use them. The IRS audit process needs to embrace resolution programs more fully and expand the benefits across the board. Programs that have shown success should be integrally incorporated into the system. In the meantime, taxpayers and their representatives should aggressively pursue the opportunities made available by the Service to increase agreements and reduce the time needed to reach them. The dispute resolution system is still slow, but it is better. From John J. Monaco, CPA, PricewaterhouseCoopers LLP, Washington, DC, and Timothy Dreyer, J.D., PricewaterhouseCoopers LLP, Jacksonville, FL |
