In the last article, we focused on overcoming an accuracy penalty when the taxpayer uses and relies on tax preparation software.  Let’s see what the “rules of the road” are if he instead relies on professionals. 

            The case of Curcio v. Commissioner, T.C. Memo 2010-115, decided May 2010, provided a challenging situation.  It involved four taxpayers whose companies had participated in a “Section 419 Plan” where they claimed deductions as business expenses for significant life insurance premiums, and the Court rejected the deductions under the Plan.  The 419 Plan at issue was created by Daniel Carpenter, a lawyer with experience in tax and employee benefits law.  He designed the plan, drafted and approved all amendments, and secured a legal opinion by a separate lawyer.  These Taxpayers, however, did not just buy the Plan from him and rely upon his representations. 

            All of the taxpayers were experienced business people.  Mr. Curcio had an accounting degree, and his partner, Mr. Gelling, owned and operated a car dealership.  Before they enrolled in the Plan, they consulted an accountant for their dealerships.  He reviewed the opinion letters, and affirmatively advised his clients that the companies could claim deductions for the contributions.  However, the Court’s opinion stressed that that accountant was not “an expert” in welfare benefit plans.  Mr. Curcio also relied upon his insurance agent to review the Plan. 

            The next taxpayer, Samuel Smith, owned a construction business.  He and his financial adviser selected a particular variation of the plan.  The fourth Taxpayer, Stephen Mogelefsky, had a degree in real estate and finance and was the President of a company called Discount Funding Associates, Inc.  Before having his company invest in the plan, Mr. Mogelefsky consulted his accountant, who was also an accountant for the Company, but who conducted no research about the Plan and, according to the Court, had no particular expertise in welfare benefit plans, but relied upon the legal opinion provided when the Plan was presented to his client.

            The taxpayers claimed that they had both reasonable cause and, with respect to the substantial understatement facet of the penalty, substantial authority, but Judge Cohen found they had neither.  Before upholding the penalties against all of these individuals, Judge Mary Ann Cohen of the U.S. Tax Court observed that contributions to plans similar to this one were held not to be deductible in at least two other cases.  One was decided and reported before these individuals had invested, which is not a good fact, and the other decided after afterwards.    Substantial authority requires a demonstration that the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment, but is not as strict as “more likely than not.”  The Court found that the Taxpayers provided no such authority, and in particular noted that their reliance upon anyone’s professional opinion is not in itself substantial authority. 

            With respect to the professionals upon whom they relied, Judge Cohen noted that there was no evidence that their accountants had any particular expertise in employee benefit plans, or that they thought their accountants had such expertise.  There was no evidence that the accountants conducted anything more than cursory independent research on their deductibility, and one testified he relied only upon the opinion letter provided with the investment.  The Court further found that there was no evidence that the Taxpayers relied on tax advice from their insurance agents, and if they had, there is no evidence that their agents were educated in tax or held themselves out to be tax advisors, or that the Taxpayers even believed they were educated in tax law.  Finally, the Court stresses that these were all experienced business people presented with a program that was “too good to be true.”

            So what does all this tell you?  The Curcio case presents a standard that reflects the law but which will shock most taxpayers.  It is doubtful that most people go beyond skimming a legal opinion which appears to be thorough, or the advice of a trusted tax return preparer, one that was not the “salesman” for the promotion or tax deduction.  Curcio stands for the proposition that a significant level of due diligence is necessary beyond that with respect to anything but the most common, ordinary tax deductions that are claimed.  Perhaps the most essential part of any defense will be securing the review of the underlying transaction from a competent, knowledgeable, independent professional.

            The case probably also stands for the proposition that professionals should be wary in these situations, because their clients in all likelihood expect them to have a greater level of knowledge than they do, so that they should point out their own limitations and perhaps point the client in the direction of someone with greater expertise for fear that they will later be “blamed” for a deduction gone wrong.

            This is a two-part article intended to cover the challenges facing a taxpayer whose return is audited, producing a tax deficiency, on top of which the I.R.S. asserts a penalty. 

            First, a little bit of history.  Until 1982, outside of situations where the I.R.S. could prove an affirmative attempt to evade tax, the only sanction for errors on returns was the negligence penalty of I.R.C. § 6653(a).  That penalty was imposed at the rate of five percent and did not bear any interest, so that in the view of many it was an encouragement for people to play the “audit lottery,” since owing the tax, that penalty and interest (for the use of the money) wasn’t a high risk operation.  As a result, the penalty has been transformed over the years into the current version of I.R.C. § 6662, which is the penalty statute presently in existence.  That penalty applies at the rate of 20% to negligence, including intentional disregards of rules and regulations; a valuation overstatement in excess of 150% of the correct value; or for a “substantial understatement of tax,” which means a deficiency in excess of 10% of the amount of tax which should appear on the taxpayer’s return, or $5,000, and the absence of either a disclosure statement filed with that return, or “substantial authority” for the reporting position.

            With that in mind, let’s focus on how this scheme works in practice.  In perhaps the most basic situation, we have a taxpayer who seeks to avoid the accuracy penalty because he relied on tax preparation software.  Recently, a gentleman named David Parker found himself liable for taxes and asserted that the penalty should be waived on the basis of “reasonable cause” for that reason, and even claimed to consult with experts at the software company.  Unfortunately, when the Tax Court reviewed the evidence, it was unpursuaded that Mr. Parker had in fact followed the protocols of the software, used it properly, and believed in the accuracy of what was produced. 

            He is not the first taxpayer whose claimed reliance on software has been rebuffed, several who lost their cases could not show that they used the software correctly and made no mistakes themselves, such as entering personal expenses as if they were deductions.  Ronald Thompson, whose case is reported at T.C. Memo 2007-174, prevailed on the “software defense” because he showed that he made no mistakes and reasonably relied on the product to prepare an accurate return.

            In other words, a “do it yourselfer” can avoid the accuracy penalty, but must do more than point to the software if something goes wrong as if it provides a complete defense. 

            This is a question I hear from a lot of clients who owe the IRS money, because either they were not able to pay everything on their tax return when it was filed, or they endured an IRS audit and adjustments were unfavorable to them.  The fact of the matter is that, outside the confines of an Offer in Compromise based on doubt as to collectability, which is governed by I.R.C. § 7122 and an analysis of the taxpayer’s ability to pay the liability in full, the IRS has a lot less discretion in this area than most people think.

            Let’s look at interest first.  Pursuant to I.R.C. § 6601, interest generally runs from the time a tax return is due until the time the tax is paid.  One exception is an “assessable” penalty, for which case the interest runs from the date the penalty is assessed.  Internal Revenue Code § 6404(g) permits the IRS to waive interest, but two circumstances must be present.  First, this only relates to interest on income tax, so that if we’re talking about estate tax, excise tax, or employment tax, there is no legal authority for the IRS to “waive” interest.  Second, there must be a showing that the interest ran as a result of some error or delay on the part of the Internal Revenue Service in the performance of a “ministerial” act.  As you can imagine, the IRS rarely admits that such a mistake has occurred, and there are disappointingly few cases in which taxpayers have successfully gone to Court and had this position overturned as an abuse of discretion.

            With respect to penalties, it all depends.  I.R.C. § 6404(f) permits the I.R.S. to abate any penalty when it provided erroneous written advice, in response to a written request for advice, and the taxpayer reasonably relied on it.  Telephone or in person advice does not qualify, and is almost impossible to prove anyway. 

            In most other situations, we are talking about the failure to pay estimated taxes, deposit employment taxes, file the return on time, or pay a tax after it has been assessed.  The failure to pay estimated taxes rules do not have a “reasonable cause” safety valve:  a taxpayer either meets certain safe harbors, based on the amount of tax on the return in question or the prior year’s return, or must pay the penalty.  All of the others have a “reasonable cause” defense.  Without belaboring the point, the IRS will not waive a penalty, and the courts will not overturn the IRS action, if the taxpayer failed to act as a reasonable prudent person trying to meet her obligations under the circumstance.  Relying upon a third party to perform an act like filing a return on time, securing an extension to file that return on time, or making a tax deposit, whether an employee or a professional, is not in and of itself a legal defense.  Responsibility to perform these acts is “on the taxpayer,” and cannot be delegated.

            This article could be three times as long without covering all possible situations where penalties are asserted.  The point to take away, however, is that the Internal Revenue Service does not create the penalties:  Congress has created all of them, as well as generally defined what is “reasonable cause” with respect to each of them.  From time to time, Congress asks the IRS to report on the imposition of penalties–how many and how well they are being sustained–with the expectation that they will be imposed in appropriate cases and not routinely waived.  Very often, by not waiving the penalty, the IRS is simply following the rule that Congress has asked it to follow, so that a taxpayer who feels she is unfairly penalized should consider some sort of correspondence or communication with her elected representatives, rather than simply cursing the IRS for being unreasonable. 

            As my readers know, I focus my practice on representing people who have “misunderstandings” with the Internal Revenue Service.  I can’t count the number of clients who have made a comment along the lines of “get me Geithner’s deal” since it came to light that he had some significant and frankly embarrassing tax problems while working for the International Monetary Fund.  In point of fact, making a statement like that to an IRS employee is probably one of the worst things a taxpayer could say, because the rank and file IRS employees realize that if they did what Mr. Geithner did, they would be fired on the spot.

            That said, someone recently tried this, and he is the subject of Parker v. Commissioner in TC Summary Opinion 2210-78.  Like Mr. Geithner, David Parker worked for the International Monetary Fund, and also like Mr. Geithner, he received income subject to self-employment tax, but did not report it on his 2005 and 2006 income tax returns, or pay it.  He got a W-2 from the IMF that showed that no federal income tax, Social Security or Medicare had been withheld from his earnings.  When he filed his tax returns, the lines for self-employment tax were left blank.  The Internal Revenue Service determined that this behavior warranted what is known as the accuracy related penalty (20% of the tax deficiency), and asserted it against him for both 2005 and 2006.

            Mr. Parker took his case to the U.S. Tax Court and lost.  Interestingly enough, he asked the Court for the same “favorable treatment” which Mr. Geithner had received, claiming that his case was “incredibly similar” and that “there should not be different or favorable rules for the well-connected.”  Tax Court Judge Carolyn Chiechi was not amused, and devoted an entire footnote to explaining that the record does not establish any special treatment that Mr. Geithner received, but also noting that such facts would be irrelevant to her resolution of the issues presented in Mr. Parker’s case.

            There is a further interesting aspect of this case.  In 2006, the Internal Revenue Service was aware of the IMF practice and created a “settlement initiative” for all employees at foreign embassies, foreign consultant offices and international organizations in the United States.  Before taking this case to the Tax Court, Mr. Parker made an effort to take advantage of this settlement initiative – it was not an amnesty – but for a variety of reasons he and the IRS never reached a meeting of the minds on it.  Unfortunately, the record in the case does not explain what that settlement initiative would have allowed him to do, but this writer suspects that it would have provided very favorable terms with respect to the penalties.

            What is the morale of this story?  Don’t count on getting the same break you think someone else got.

            It is a virtual certainty that higher personal income tax rates are in the cards for Americans.  Even if the United States Congress does not raise rates to pay for the health care proposals or to shrink the deficit, inaction by Congress would return us to the rates that were applicable in 2002, when the Bush tax cuts were enacted.  Although there are many factors that will determine whether and if so when the economy recovers or stalls, it is worth a quick “trip down memory lane” to examine what top marginal tax rates were at various times since 1913, when the first income tax was enacted. 

            In 1913, the highest marginal tax rate on earned income was 7%, and it only applied to taxable income over $500,000.  Ah, how we all long for the good old days!  However, by 1918, when the United States was involved in World War I, the top marginal tax rate had grown to 77%, although it was only applicable to incomes over $1,000,000.  In 1929, when the stock market crashed, the highest marginal tax rate was 24%, and it applied to taxable incomes over $100,000.  When Franklin Roosevelt was elected in 1932, the highest marginal rate was 63% (up from 25% in 1931), and it applied to taxable incomes over $1,000,000.

            Some people argue that the recovery from the Great Depression was stalled by raising federal income tax rates.  In 1936, the highest marginal rate was pushed to 79%, but it only applied to taxable income over $5,000,000.  That is the time, however, when the real growth in rates began.  In 1941, the top marginal rate was 81%, but it only applied to taxable incomes over $5,000,000.  In 1942, the rate rose to 88%, but it applied to taxable incomes over only $200,000.  The highest rate during the war years was 94% during 1944 and 1945.  After a short drop in the mid-50’s, the marginal rate rose to 91% in 1951, on taxable incomes over $400,000.

            At this point, it is worth reflecting upon a story attributed to Ronald Reagan.  At the height of his career, Reagan is said to have turned down a project that might have been perfect for him, and when asked why he supposedly stated that it was because his income tax rate was over 90%, so that he’d get to keep virtually no part of the income earned from the project.  We don’t know what that project was, and we don’t know whether it was offered to Reagan the following year, but there is no question that when rates reach a certain point, they do stifle people’s willingness to continuing working and earning more money.  The 91% rate at the $400,000 level continued through 1963.  I think most Americans who lived through that era will state that despite that impediment, the U.S. economy was strong for most of that period.

            Shortly after coming into office, the Kennedy administration is given credit for reducing taxes.  After President Kennedy passed away, the rates fell to 77% on incomes over $400,000 in 1964, and to 70% on incomes over $200,000 in 1965.  In 1968, the rates began rising, but returned to 70% in 1971, with a limit on the rate applicable to earned income of 60%.  That fell to 50% in 1972, and those rates continued until 1980, when Ronald Reagan was elected, at which point the highest marginal income tax rate was 70%, the highest rate on earned income was 50%, but the top marginal rate applied only to taxable income over $215,400. 

            President Ron began reducing taxes almost immediately.  In 1981, the top rate fell to 69.125% on taxable income over $215,400, but the top rate on earned income was only 50%.  In 1982, the top rate was 50% on all kinds of income, but it only applied to incomes over $85,600.

            The 50% rate stayed in effect until 1987, and at the end of 1986 it applied only to incomes over $175,250.  In 1987, the marginal rate was reduced to 38.5% and it applied only to taxable income over $90,000.  In 1988, the 28% rate was imposed on all kinds of income – compensation, dividends, capital gains, interest, whatever – and it cut in at taxable income of only $29,750.  What those alive 21 years ago will also remember is that as part of the deal with Congress to reduce rates, President Reagan agreed to reduce or eliminate many deductions that had been an integral part of the Internal Revenue Code for as long as anyone could then remember.  The 28% rate remained in effect until the middle of the first Bush administration, when the top marginal income tax rate rose to 31% for everything but capital gains, which remained at 28%, but applied only to taxable income over $82,150.

            The arrival of the Clinton administration signaled the highest rates since the Reagan reductions.  The highest marginal rate was raised to 39.6% in 1993, although the capital gains rate was frozen at 28%, and the top rate applied to what has been called the “millionaire’s” level, taxable income of over $250,000.  I have met many people who earned $250,000 in a year that never considered themselves “millionaires”.  The rates remained at 39.6% until the end of 2000, but the level at which those rates cut in rose with inflation to taxable income over $288,350 in 2000.  However, long term capital gains were reduced to 20% and shorter term gains were left at 28%.

            In 2002, the top rate dropped to 38.6%, with a 20% long term capital gains rate, and the top marginal rate applied to taxable income over $307,050.  It is then, during the second Bush administration, where the top marginal income tax rate was reduced to 35%, but the capital gains rate was reduced to 15% in 2003 and that same rate applied to dividends for the first time.  Those rates remained, with the highest rate applying only to taxable income over $357,700, through 2008.

            What does all this prove?  Perhaps nothing, as top individual rates are only one variable, but if one reflects on the economic activity of the country at various points in time, it is obvious that even confiscatory rates did not prevent the recovery of the United States economy in the late ’40s and ’50s, prosperity in the 1960’s or 1970’s.  Nor did a top rate or 39.6% during the Clinton years.  Nor did top capital gains and dividend rates of 28% in 1988.  However, as Mr. Reagan reminded us, there does come a point where a high rate can impact our decisions.  It is refreshing to see, however, that the proposals that are presently being made by this administration do not anticipate a marginal tax rate higher than the ones imposed during the Clinton administration, which were historically low.  Hopefully, they will not be a greater drag on the economy than they were in the 1990’s.

            I suspect that the answer of most readers will be “why would I want the IRS to find me in any event?”  In fact, I can recall one client who actually asked me to have him removed from what he described as “the IRS mailing list.”

            Believe it or not, while it’s always nice to be left alone, there are situations where it is important that the IRS have your correct address.  For instance, what if there’s a refund you’re due, and the IRS is about to send you a check?  Similarly, if you are in an audit or owe the IRS money, there are a variety of notices that the Internal Revenue Code requires the IRS to send to your “last known address,” and if it sends them to that address,  but you do not receive them, you will miss the opportunity to respond, as the law does not require that you actually receive the documents for them to be effective.

            Prior to 1988, nothing short of an affirmative, written statement to the IRS that your address had changed was satisfactory.  During that year, in the case of Barbara Abeles v. Commissioner, 91 T.C. 1019 (1988), the United States Tax Court held that where the Taxpayer had filed a return showing a new address, the IRS should search its computer system for that address before sending the Taxpayer critical correspondence such as a Notice of Deficiency, determining an additional amount of tax and giving the Taxpayer 90 days to file a Tax Court Petition.  Since that time, the validity of any number of other IRS letters – such as a Final Notice of Intent to Levy or a Notice of the Filing of Federal Tax Lien, both of which give rise to the right to request a Collection Due Process Hearing – similarly depend on having been sent to the Taxpayer’s last known address. Most IRS correspondence is not routinely forwarded by the U.S. Postal Service to a new address, and in this regard certified mailings are returned to the IRS if they are not claimed.  These documents contemplate that the IRS will send them by certified mail, but there is no requirement for the IRS to secure a return receipt card, and the way the law has been interpreted, there is no requirement that the Taxpayer receive them (which is a good reason why Taxpayers should never decline to accept a certified mail package from the Internal Revenue Service).

            The best approach is to be on the safest side, and always file a Form 8822, Change of Address when you move, and send that to the IRS by certified mail, to insure there is no confusion.  This is particularly important if you have moved since filing your last return.  But even in that situation, there is hope:  recently, the IRS issued Revenue Procedure 2010-16, in which it announced that it will automatically update a Taxpayer’s address of record based on a new address that the Taxpayer provides to the United States Postal Service, so long as it is retained in the USPS’s National Change of Address Database.  However, it is not clear how long it takes for that database to be updated and “dumped” into the IRS’ system, so this writer recommends that you take the extra step and send the Form 8822, rather than rely on the Government data bases talking to one another.

            Because our Internal Revenue Code contains so many grey areas, and in some situations the potential tax consequences from even a good faith mistake can be devastating, taxpayers often wish they could go to the IRS “in advance” and find out what the tax consequences of a transaction would be.  Well, they can.  Interestingly enough, the Internal Revenue Service has developed what is known as the Private Letter Ruling system to provide guidance to taxpayers on the tax impact of specific transactions.  As you might expect, however, this is not simply a matter of writing a letter to IRS Commissioner Douglas Shulman and asking “what do you think about this?”  In fact, as explained in Treas. Reg. § 301.7601—through 7 and Rev. Procs. 2007-4 and 2010-1, there is a great deal of information which must be submitted with any request for a Private Letter Ruling. 

            Each request must contain a complete statement of all facts related to the transaction, an analysis of the material facts including the business reasons for it, along with copies of all pertinent documents and any relevant authorities that the taxpayer relies upon to secure this position.  One must also expect the IRS reviewers to ask for more information.

            Unfortunately, the IRS is not required to issue such a letter, so all your efforts may be for naught.  In fact, the IRS has an expanding list of issues on which it says it will not rule.  If that weren’t bad enough, the IRS could disagree with you and issue a negative ruling.  If the IRS agrees with your requested position, you have achieved a great victory, but if the IRS does not agree, bad things (like an audit, where the IRS has already dug in its heels on the issue and is guaranteed to make an adjustment) can occur. 

            Is there any other downside to making such a request?  Well, the information is “confidential” pursuant to I.R.C. § 6103, except in situations where the IRS actually provides a written ruling, in which case I.R.C. § 6110 provides that a background file be open and available for public inspection, although information specifically identifying the taxpayer is not to be provided.  Practitioners have known for years that the PLR process is a double edged sword, one which can occur whether one is successful or unsuccessful:  because the IRS is required by law to make the PLR public, there is the hopefully distant concern that a more than casual reader can surmise the identity of the requestor.

            This “downside” was illustrated earlier this year (2010) in the case of Anonymous v. Commissioner of Internal Revenue, 134 T.C. 2.  Anonymous was a company which requested a Private Letter Ruling, but did not like the IRS ruling (negative to the company’s request), and brought an action in the United States Tax Court to prevent the IRS from revealing the Ruling whatsoever.  One reason was that it disagreed with the IRS reasoning, but the other was the contention that the underlying facts were so obviously specific to its situation that even if its name were not revealed, its identity was unmistakable. 

            Here, Tax Court Judge Joseph Goeke carefully reviewed the statutory and regulatory scheme before giving the IRS a partial victory.  He held that the persons in the IRS who issued the PLR can reveal it (and presumably their entire file) to other IRS personnel.  That is black letter law, and no surprise.  In another holding against the taxpayer, he held that the conclusion of the IRS in the PLR could not be attacked as being arbitrary, capricious and an abuse of discretion in a § 6110 proceeding.  The latter challenges to the IRS’ conclusions will have to await actual litigation if Anonymous proceeds in spite of the Ruling and the IRS chooses to audit the transaction and makes an adjustment.  We thus may see Anonymous back in court at a later date.

            Finally, however, Judge Goeke held against the IRS on what is probably the most important point, at least for now:  the factual question of whether the IRS has deleted all information which could identify the taxpayer.  He left the case open for further proceedings and fact finding on that issue.  That process will be the more interesting battle.

            My initial reaction to the Opinion was that Judge Goeke’s holdings could cause taxpayers to avoid the PLR process if they had an “identity problem,” but on reflection do not think it should. Here, Anonymous could have sidestepped the problem by “withdrawing” the request when it learned the IRS would rule adversely and thus disposed of most if not all of the potential ill effects.  I do not enjoy being second guessed by my colleagues, so I will not wonder why Anonymous and its advisors declined that offer.

            Getting a Notice of Levy from the IRS is never fun, especially if you are the taxpayer.  However, it can be even more perilous when you receive one with respect to someone you employ that owes the IRS money, seeking to garnish the worker’s compensation.

            An employer would be making a serious mistake to simply ignore the levy, whether she tells the worker about it or not.  Any person who receives a levy but fails to honor it faces personal liability under I.R.C. § 6332(d) (1) in the amount of each payment that should have been turned over to the IRS.  Thus, the employer who ignores the levy could pay the worker the compensation, as well as have to pay the IRS a second time.  In addition, Subsection (d) (2) creates a second tier “penalty,” up to 200% of the amount that should have been paid to the IRS, if the failure to do so was willful.

            An organization named Mission Primary Care Clinic learned this lesson the hard way.  It received a levy on the compensation of one of its members, and failed to pay.  A lawsuit followed in the United States District Court for Southern District of Mississippi.  The Clinic argued that the amounts paid to the member were not compensation covered by the levy, and the Court disagreed.  In rejecting this argument, the Court upheld the primary liability for failure to honor the levy.  The additional penalty for willfulness was not at issue.  In March this year, the Clinic’s appeal of this ruling was rejected by the Fifth Circuit Court of Appeals.  If you are an employer facing this situation, you do not want to relive this experience.

            With that in mind, the first step any employer should take is to call in the worker and have a heart-to-heart talk about the problem.  It is possible that the old, creaky IRS computer issued the levy by accident, and if the employee tells you that, you and he should call the number on the levy to verify that.  More often, Notices of Levy are issued because the IRS is unable to work out a payment arrangement with the taxpayer, often because the person is not responding.  In those cases, serving a levy is almost a matter of desperation on the part of the IRS, which needs to get the taxpayer’s attention, and does so by serving a Notice of Levy.  Needless to say, this tactic usually works!  It may be a situation where all the worker needs to do is to complete financial statements and submit them with supporting documents as a prelude into entering into an installment agreement with the Internal Revenue Service.  If the worker and IRS reach an agreement, the IRS will “release” the notice of levy, and so notify the employer.  However, until the employer receives that release, she pays the worker at the peril of her business.

            Therefore, whatever the situation happens to be, the employer should counsel the worker to deal with this problem and not let it continue, as the levy – so long as it remains outstanding – is going to take a huge chunk out of the worker’s compensation.  There are exemptions for such things as child support orders and amounts equal to the monthly equivalent of standard deduction and exemptions, but the worker must affirmatively establish his entitlement to those exemptions, and they do not leave much to live on.  And no matter how sympathetic she feels about the worker’s plight, failure to honor the levy could make things worse for both the worker and the employer.

            It is said that before the tsunami hit the Pacific a few years ago, the animals on the various islands ran from the shoreline toward higher ground.  If you are a return preparer, you ought to consider the signs that a similar tsunami is on its way.

            The most recent signal, and one of the more serious, involves the IRS’ annual listing of its “Dirty Dozen” scams for 2010.  What’s the first “scam”?  Return Preparer Fraud, suggesting that “dishonest return preparers can cause trouble for taxpayers who fall victim to their ploys.”  That this item belongs on the list is not in dispute, but putting it at the top of the hit parade, ahead of hiding offshore income, filing false or misleading forms, making frivolous tax protest arguments, disguising ownership of businesses, and other offensive activities, has to send a very clear message.

            The second signal has to do with the plan of the Commissioner of Internal Revenue, applauded by both the Director of Professional Responsibility and the Taxpayer Advocate herself, to begin “licensing” return preparers who are not presently lawyers, CPAs, or “enrolled agents.”  The Office of Professional Responsibility has been looking for a basis for regulating such unlicensed preparers for a long time, and the Commissioner has finally taken the big step.  Each such return preparer will now be issued an identification number that must appear on each return which she is paid to prepare, and will be required to take a test, beginning in September 2010.  Until she passes, she will not be eligible to prepare returns. 

            The reason for excluding lawyers and CPAs is most likely that those groups are already regulated by state agencies as well as the Office of Professional Responsibility.  However, this writer can honestly say that when he received his law degree, and subsequently passed his first bar exam, that he was hardly qualified to prepare anything more complicated than his own Form 1040A.  Moreover, when one looks at some of more serious and abusive tax shelters that have come to light in the last ten years, each and every one of them was created by a lawyer from a prominent firm, a CPA from a prominent firm, or a combination of the two. 

Not mentioned in the IRS announcements of this plan is when this test will be administered to IRS Agents, Revenue Agents, Office Auditors, Tax Examiners, or Special Agents with the Criminal Investigation Division.  It would probably be best not to hold one’s breath until that takes place, but it would be interesting to see what kind of passing rate they earned.  In the meantime, while the Commissioner said that there is no plan “at the present” to require CPAs, lawyers and enrolled agents to take this test, the likelihood that they will someday be tested is waiting in the wings.

In addition to these signals, the IRS has established a new program, involving “educational visits,” to tax return preparers on an allegedly random basis.  In January, 10,000 tax return preparers received a letter from the IRS reminding them of the importance of filing accurate returns, and a smaller number from that group were “selected” for personal visits from Revenue Agents who pointed out “common errors” in filed returns.  During the tax season, the last thing a tax return preparer needs is a distracting visit from an IRS agent like this.  Many CPAs have criticized this approach as “heavy handed,” but the Commissioner apparently intends to continue with the program.

If the foregoing weren’t enough, the IRS recently explained in Announcement 2010-17, that it is proposing mandatory reporting of “uncertain tax positions” on the returns of business taxpayers which have assets over $10,000,000 and financial statements prepared under FIN 48 or similar accounting standards.  There are three categories where the companies would be mandated to disclose their position – situations where they have reserves established on an issue, cases where it is the IRS’s examination practice not to audit an issue, or situations where the taxpayer expects to litigate the position.  Needless to say, the response from the accounting and legal professions has been uniformly negative, since this is in all likelihood a situation where the IRS is asking taxpayers to say “come audit me.”  The fact that it relates to large taxpayers, rather than smaller companies and individuals, indicates that the breadth of the IRS net is going to reach return preparers who work for “big” taxpayers.

If you are a return preparer at any level, the implications of all this are obvious.  But what if you are just an ordinary taxpayer, one who doesn’t feel competent to prepare her own return?  The Internal Revenue Code, large as it is, and notwithstanding all of the words it contains, is comprised of a lot of “black and white”, but also contains a lot of grey area as well.  Not only will it now be imperative for a taxpayer to find a competent and honest return preparer, but also one who will not be intimidated by all of these IRS machinations so as to begin working for the IRS, but will instead never lose sight of who her client is.

            The homebuyer’s tax credit that was effective in 2009 and 2010 has received a lot of attention.  It is just the latest example of the Internal Revenue Code favoring home ownership.  Historically, that practice involved giving deductions for interest on mortgages as well as real estate taxes.  Prior to the recent credit, in 1997, as part of the alleged Tax Relief Act of 1997, Congress enacted an exception to the normal rules of Internal Revenue Code § 72, which imposes an additional tax of 10% on amounts prematurely withdrawn from certain kinds of retirement accounts when the money withdrawn was used for a home purchase.  During the last year, Mr. and Mrs. Robert Bailey and Mr. John Armbrust discovered to their dismay that the latter provision was not what it originally seemed.

            I.R.C. § 72 imposes a 10% penalty tax on premature withdrawals from those accounts.  The specific exception of IRC § 72 to that penalty tax is focused upon withdrawals from individual retirement accounts.  Ms. Bailey and Mr. Armbrust did not have IRAs, but instead they withdrew the funds from 401(k) plans established and operated by their respective employers.  One would think that both kinds of plans would receive the same treatment under the Internal Revenue Code, but that proved not to be the case.  In both instances, the Tax Court rebuffed the efforts of these taxpayers to avoid the penalty tax stating that Congress intended only to permit the exemption from the penalty tax with respect to withdrawals from IRAs, and had no intention of exempting them from 401(k) plans.

            There is no indication from the Opinions issued by the Tax Court that either taxpayer hired a return preparer or consulted a tax professional about the issue.  Both taxpayers represented themselves before the Tax Court, but it is doubtful that hiring a lawyer would have made a difference here.  When you hear of a “tax benefit” you want to secure, the old adage about “not trying this in your own home” is excellent advice.  On its face, this appeared to be a situation where Congress would have treated withdrawals from the two kinds of tax deferred retirement plans the same, but simply demonstrates the importance of securing professional advice before assuming that logic plays any part in our tax system.