Bench & Bar of Minnesota

Trammels of the Tax Tangle: What Every Lawyer Should Know About the IRS

With tax season in full swing, you never know when the troubled tax client will come through the door. There’s no substitute for adequate research, but here are
some pointers on where to begin.

By Theodore M. David

When clients have IRS problems, they turn to their attorneys — even if their attorneys have little or no experience confronting the IRS. This article will give such an attorney a survival kit for dealing with IRS problems. It is by no means a substitute for a more exhaustive discussion of the topics presented. It does provide a basic discussion in ten areas where client concerns are most often found:

1. Examination;
2. Statute of limitations;
3. Summons;
4. Appeals;
5. Collection;
6. Criminal;
7. Tax Court;
8. Claims;
9. Penalties/interest; and
10. Getting help from the IRS.

Examination

Although IRS audit rates in the last few years have dropped in some areas to below 1 percent of filed returns, the new IRS commissioner, Mark Everson, has declared a return to tax enforcement. Practitioners will likely see more clients with examination issues.

Tax returns are selected for audit by use of “DIF,” a computerized score given to each return filed. When the relationship between income and deductions, both their amount and nature, fit the formula, the return is selected for review. An IRS classifying officer will determine whether the return requires contacting the taxpayer for audit. Such audits can be done as correspondence or in-person examinations. IRS agents, called tax examiners, will work ordinary examinations from their offices, while IRS revenue agents will visit the taxpayer’s business to conduct the examination.

Returns are also selected randomly for IRS research purposes to gather information to refine the dif formula. These line-by-line examinations constitute only a small portion of the returns examined by the IRS (50,000) and are called the National Research Project (NRP). Audits may also result from the IRS matching tax information received with returns filed. Informants’ tips can also result in examination, but these cases are relatively rare. From time to time, the IRS establishes audit programs designed to target specific industries and taxpayers. Of current concern are high-income nonfilers, use of off-shore credit cards, and Schedule C filers.

Practitioners who represent clients in examination must have Form 2848, Power of Attorney, completed by the client to permit them to “practice” before the IRS without violation of tax disclosure laws. Such practice includes representation of the client before all levels of the IRS appeal system and subjects the practitioner to the IRS Rules of Conduct found in IRS Publication Circular 230, 31 C.F.R. Part 10. Violation of these rules can result in suspension of practice privileges before the IRS.

Federal tax law provides an appeal process whereby clients can challenge findings of IRS agents through the U.S. Tax Court without first paying the tax. Interest continues to run during the appeal process.

Appeals and Court Proceedings. Most examination disputes with the IRS are resolved short of litigation in the Tax Court at settlement conferences held at the IRS Appeals Branch. A second appeal procedure exists for taxes which have already been paid, which requires the client to seek refund of such taxes by filing a claim and proceeding, if necessary, in the Claims Court or federal district court. These cases are most often settled in the IRS Appeals Branch as well.

Before commencing any tax dispute matter, the client should formally retain the practitioner and sign Form 2848. The lawyer should send an engagement letter to the client to avoid any misunderstanding of the scope of the practitioner’s involvement. At the initial consultation with the client, a firm plan of action should be established which will be monitored and revised as the matter proceeds.

As a practical matter, most ordinary tax examinations are handled by accountants and tax return preparers, unless issues of concern exist — for example, unreported income, inflated deductions or credits, tax positions taken, etc. Practitioners in examination matters more likely will represent clients at the IRS Appeals Branch, which is the highest level of administrative appeal at the IRS or in the tax courts.

Statute of Limitations

At the conclusion of an audit, the client may agree to the IRS’s findings by signing waiver forms accepting the tax assessment. If there is no agreement, the agent will issue a 30-day letter permitting the client to protest the matter to the IRS Appeals Branch, or a 90-day letter which requires filing a petition in the U.S. Tax Court. The action taken by the agent will depend upon the time remaining under the statute of limitations for assessment.

Clients are often amazed to learn that statutory time periods control IRS actions. And those who are aware of this fact often labor under misconceptions generated by a mix of popular tv and law-related movies. The two most important Internal Revenue Code sections dealing with limitations periods are §§6501 and 6502. (All section references are to the Code unless otherwise indicated.) Section 6501 limits the period for additional tax assessments to:

Three years from the date of return filing; or
Six years from return filing if there has been a nonfraudulent omission of more than 25 percent of gross income; or
An unlimited period if no return has been filed or the filed return is fraudulent.

Often more surprising to clients is the limitations period for collection under §6502. In most cases, that period is ten years from the date of assessment. The time period for claiming a refund of taxes is provided in §6511 as:

Three years from the time a return is filed; or
Two years from the time a tax is paid, which ever expires later; or
If no return has been filed, two years from the time the tax is paid.

The criminal statute of limitations under §6531 is six years from the prohibited act for most tax crimes. The time period during which the IRS can assess the trust fund recovery penalty in employment tax cases under §6672 is three years from the April 15 following the close of the tax year. These limitations periods can be extended both by agreement and specific actions taken by the client.

Extending the Statute of Limitations. By filing Forms 872 or 872-A, the assessment statute can be extended to either a date certain or one depending on action taken by the IRS. Contract law controls the validity of such extensions. Seeking judicial review in the U.S. Tax Court also suspends the assessment statute.

The collection statute cannot be extended by agreement unless the agreement is part of an installment plan to pay taxes over a longer period. However, the period is automatically stayed by the filing of a bankruptcy, submission of an offer in compromise, the client’s presence outside the country, or by seeking either administrative or judicial review of IRS-enforced collection action. The statute of limitations is a complete bar on the IRS and can result in a tax liability being no longer either assessable or collectable.

Special rules do exist under sections 1311 to 1314 to “mitigate” the statute of limitations under very specific circumstances to avoid abuse. They are technical and narrowly applied.

Summonses

All agents of the IRS can issue summonses. Section 7602 provides that summonses can be issued to:

Ascertain tax liability;
Prepare a tax return;
Determine transferee or fiduciary liability;
Determine the correctness of any filed tax return; and
Correct any tax liability.

Summonses can be issued at any time during a civil or criminal investigation up until the time when the IRS refers a criminal case to the Justice Department. They may be served personally or left at the taxpayer’s residence. Mailing is permitted to third-party recordkeepers by certified or registered mail. Special procedures for notification in third-party recordkeeper summons situations is found in §7609. These procedures provide a right for the taxpayer to move in federal district court to quash the summons within 20 days after required notice to the taxpayer is given. The IRS may also issue “John Doe” summonses when the identity of the taxpayer is not known. Such summonses can be served, for example, upon tax shelter promoters to ascertain the names of client customers.

The summons is not self-enforcing and an action must be brought by the IRS to compel compliance in the U.S. District Court. Few summonses are enforced but those that do go to court must satisfy these requirements:

The summons has been issued for a legitimate purpose;
The information sought is relevant;
The IRS does not already have the information.

The summons may request the production of documents or things (duces tecum) or actual testimony of the person summoned or the giving of a handwriting exemplar. Whether a client should comply with a summons is a legal strategy and must be carefully considered in the scope of the examination. The most common defenses raised in moving to quash or to defend against the summons are:

Attorney-client privilege;
5th amendment privilege;
Work product doctrine
Procedural defects in the summons.

Appeals Branch

Most tax disputes with the IRS, whether in the prepayment appeal process, where the taxpayer has been issued either a 30-day or 90-day notice, or the post-payment refund procedure, when a client is seeking the return of tax money paid, end up at the highest level of administrative appeal — the IRS Appeals Branch.

The Appeals Branch is staffed with seasoned IRS employees called appeals officers or settlement officers. Their function in tax administration is to settle cases and 85 percent or more are settled. Since the IRS Restructuring and Reform Act of 1998, the settlement authority extends to innocent spouse cases, lien and levy due process collection matters, as well as the traditional Collection Appeals Program to review action taken by IRS district offices. The appeals function is to review matters with a fresh look at the hazards of litigation in cases involving income, estate, gift, and employment taxes and the many discretionary actions the IRS may take, including offers in compromise, abatement of interest, and penalty waiver appeals.

Appeals officers conduct conferences with practitioners in an informal setting, without transcription. Appeals officers consider all available evidence, even if otherwise not admissible in court. Though the role is similar to an administrative law judge, no formal opinion is issued and no practitioner briefs are required. Caution, however, must be exercised in requesting Appeals review, since officers are permitted to raise new issues and may have significant experience in complicated matters that may have eluded the examining agent.

To invoke Appeals consideration, some form of protest is filed. When less than $10,000 is in dispute, a letter will suffice. In larger matters, the formality of a protest is required. The protest will include: Preliminary Statement of the Dispute, Statement of Facts, Legal Argument, Conclusion, and Certification under oath by the client or practitioner.

Numerous other filings, including Refund Claim Form 843, Innocent Spouse Application 8857, or Lien or Levy Form 12153, will trigger Appeals jurisdiction.

Programs now exist, such as Fast Track Mediation, to move matters quickly from the IRS district offices to Appeals in an effort to settle cases earlier in the process. Cases can be settled based on various approaches:

Percent of tax;
Swap of issues;
Split issues;
Flat tax allowance; and
Waiver of penalties.

Settlements are effectuated by signing Forms 870-AD, entering into closing agreements, or by issuance of a notice of determination. Some of the actions taken by Appeals are statutorily reviewable in the U.S. Tax Court.

Collection

The IRS collects $3 trillion in tax revenue annually and does so with a relatively small collection force. All collection procedures of the IRS are designed to maximize tax collection and minimize personal contact and enforced collection. Although armed with administrative tools like levies to compel tax payment, the IRS counts on the system of voluntary compliance. In recent years, IRS tax account receivables have grown to a staggering extent, exceeding $300 billion. Renewed efforts at enforced collection are now under way.

Once proper tax procedures have been satisfied, the IRS may assess a tax and then begin tax collection of that assessment. IRS service centers bill taxpayers, then dun them with increasingly harsh correspondence. If unsuccessful at obtaining payment, the IRS will issue its Notice of Intent to Levy, which gives the client 30 days to arrange an acceptable collection plan or face loss of assets, including bank and stock accounts, retirement accounts, wages, etc.

Accounts that cannot be collected from the service center are sent to field offices where IRS revenue officers will personally work the case. A revenue officer is a collection specialist whose job it is to both collect delinquent tax accounts and to solicit unfiled tax returns. The primary powers of such agents include the authority to:

Seize and sell assets of the taxpayer;
Recommend waiver of penalties for reasonable cause;
Do the investigative work for offers in compromise; and
Monitor the collection statute of limitations and file necessary federal tax liens.

Practitioners who represent clients in the collection area will have various options to consider in dealing with unpaid tax liabilities which include:

Installment agreements — either formal or informal, based on financial disclosure Forms 433-A for individuals and 433-B for businesses;
Offers in compromise — the IRS can compromise tax, penalty, and interest. Practitioners must file Form 656 along with Forms 433-A and 433-B. Grounds for consideration include doubt as to collectability (client can’t pay), doubt as to liability (client is not liable for the tax), or effective tax administration (fairness requires the relief);
Bankruptcy — Under certain circumstances, tax liability may be discharged in a bankruptcy. Trust taxes cannot be discharged; and
Suspension of collection activity — the practitioner may be able to show current uncollectability.

The collection statute of limitations, found in §6502, is ten years. Seeking procedural relief will suspend and extend the collection statute and no such action should be recommended until its impact on the collection statute is considered and discussed with the client.

To protect the IRS’s position, revenue officers will routinely file federal tax liens. The priority of this lien is determined under §6323(a). A “first in time, first in right” rule applies in most situations. Procedures exist to seek discharge and subordination of filed tax liens.

Levying Assets. After proper notice, the IRS can levy taxpayer assets. Exemptions from levy are found at §6334(a) and include:

Wearing apparel;
Books;
Personal effects (maximum $6,250);
Unemployment benefits;
Child support payments;
Workers compensation;
Welfare payments; and
Tools of trade (maximum $3,125).

A residence of the taxpayer is exempt when tax liability is less than $5,000. In other cases, in order to seize and sell a taxpayer’s residence, a court order is required. To seize assets of a business, the approval of the IRS Area Director — and not court approval — must be obtained.

Innocent Spouse Relief. Section 6015, called the innocent spouse provision, provides a defense to liability for tax, penalty, and interest in income tax cases. Relief can be granted under three situations:

Traditional grounds (§6015(b)) — where the spouse shows lack of knowledge or benefit;
Separate liability (§6015(c)) — the spouse meets mechanical tests and tax liability can be assigned to the responsible spouse when separation, divorce, or death have occurred
Equitable grounds (§6015(f)) — when taking into consideration all the facts and circumstances, the spouse should be released from liability.

Spouses claim relief by filing Form 8857 and have an appeal procedure available through the Appeals Branch. Since the IRS Reform and Restructuring Act of 1998, many IRS collection procedures are reviewable in the Tax Court.

Criminal

The purpose of the criminal tax system is to bolster voluntary compliance by deterring taxpayers from violating the tax laws. With deterrence and not tax collection as its object, the Criminal Investigation Division (CID) makes cases most often in the tax evasion area with an eye to the publicity it can achieve. Clients are often amazed to find themselves in the grip of a four-year criminal tax investigation for an amount of tax dollars which would appear to be comparatively small.

CID agents have backgrounds in law enforcement and are never involved in routine audit examinations. They will frequently work with examination revenue agents who assist them in the preparation of schedules and issues of technical tax law.

The IRS investigates all violations of the Code, as well as money laundering and Bank Secrecy Act violations. The process of investigation begins with the special agent’s investigation, and the writing of a report which is forwarded to IRS counsel for review. When a case is sufficient, it is forwarded to the U.S. Department of Justice with IRS recommendation for prosecution. The trial of a criminal case is handled by the U.S. Attorney in the federal district court.

Like civil cases, most criminal matters are negotiated to settlement. Having effective counsel early in the investigation may result in no prosecution. For cases that are prosecuted, the Federal Sentencing Guidelines apply and often result in almost mandatory incarceration. Judges are required to consider offense levels and criminal history, with supporting reports by the U.S. Probation Office, in determining a final sentence. Offense levels are determined based on tax loss, the calculation of which is done by the IRS.

The IRS may also investigate criminal tax matters, in conjunction with the U.S. Attorney’s Office, through the Grand Jury.

Defense of a criminal tax case requires proof of a lack of willfulness. Willfulness for this purpose means a voluntary intentional violation of a known legal duty. A tax crime cannot be committed by negligence or oversight.

Most criminal tax cases accepted for prosecution are based on simple evasion schemes that can be readily understood by juries. Prosecutors will often avoid complicated issues for fear of confusing and clouding the jury’s mind. Typically, prosecutors will show “badges of fraud” which include:

False documents;
Use of cash;
Double set of books and other accounting irregularities;
Destruction of records; and
Hiding of assets.

The government’s success ratio in most criminal cases which are prosecuted requires that only experienced counsel attempt to represent clients charged with tax crimes. The gravity of the criminal tax investigation must never be confused with the activity the IRS conducts in its ordinary examination and collection function.

Tax Court

The Tax Court permits taxpayers to challenge IRS findings without first paying the IRS proposed tax. It is this feature, as well as the high level of tax sophistication of Tax Court judges and the counsel who practice there, that makes this court central to tax administration.

The court sits in Washington, D.C. but hears cases in cities throughout the country. All petitions for review of IRS action must be filed in Washington with the clerk of the court. The court has its own rules of practice, with specific forms. A copy of the court rules may be requested of the court clerk or found on its extensive Web site at www.ustaxcourt.gov. Counsel must be admitted before the Tax Court in order to practice there.

Most of the Tax Court’s work is in the income tax area, and petitions must be filed with the court within 90 days of the date of the IRS’s formal notice of deficiency. The IRS is represented in the Tax Court by IRS Area Counsel. Cases are heard before judges without juries. The court maintains a nonappealable “small case procedure” for cases under $50,000, and can impose penalties of up to $25,000 for the filing of frivolous petitions designed only for delay.

Appeals of Tax Court cases are heard by the federal Court of Appeals for the Circuit of the taxpayer’s residence at the time of filing the petition. Petitions to the Tax Court must include:

Taxpayer’s identification information;
Date of the notice of deficiency, copy attached;
Statement as to the nature and amount in dispute;
Clear and concise statements of error; and
Statement of facts.

The petition must be signed by the petitioner or admitted counsel and the required filing fee of $60 paid. The Tax Court may also review other IRS actions, including:

Innocent spouse relief;
Collection due process determinations;
Abatement of interest;
Declaratory judgment jurisdiction; and
Transferee liability.

In Tax Court, the burden of proof is on the taxpayer since a presumption of correctness attaches to the IRS’s statutory notice. Though burden shifting may occur when the taxpayer offers credible evidence in court, most cases are settled without trial.

Claims

A separate appeal process exists when the client has overpaid a tax. This post-payment appeal process begins with the filing of a claim, either on Form 843 for taxes other than income, or 1040X for income taxes. The IRS will review the claim request and either accept or reject it. If the claim is rejected, the practitioner may file a protest to request Appeals Branch review. If such review is denied, resort can be had to either of the post-payment courts: U.S. District Court or Federal Claims Court. Like most tax disputes, these matters are usually brought to resolution through settlement at the IRS Appeals Branch.

To constitute a valid claim that can begin the appeal process, the claim itself must:

Be in writing;
Set forth the facts;
Indicate the specific grounds for refusal;
Request a refund be paid; and
Be signed by the taxpayer or his/her representative under penalty of perjury.

The federal tax law requires that the IRS be put on notice of the client’s demand for refund. Completion of IRS Forms 843 or 1040X will satisfy the notice requirement, but other written communications may be considered acceptable if the requirements for notice are otherwise met.

Claim filing and the payment of refunds by the IRS are controlled by §6511, which sets forth the statute of limitations to be:

Three years from the filing of a tax return or two years from the payment of a tax, whichever expires later, or
If no return is filed, within two years of the time the tax was paid.

Cases have held that claims “embedded” in delinquent returns may satisfy the §6511 time period.

Section 6511(h) permits suspension of this limitation period if an individual is “financially disabled,” meaning that:

The taxpayer is unable to manage his or her financial affairs;
The taxpayer has a medically determinable physical or mental impairment;
The impairment can be expected to last for a continuous period of not less than 12 months, or the impairment is expected to result in death; and
Medical certification is provided to the IRS.

The actual amount the IRS may refund to a client depends upon the tax paid during the prior two- or three-year period of the limitations statute.

Penalties & Interest

The Code is chock-full of penalties for failure to follow its many tax rules and procedures. Chief among these numerous penalties are the following:

§6662 accuracy-related penalties — 20 percent of tax underpayment. Includes negligence, substantial understatement, substantial valuation understatement, and substantial estate or gift tax misevaluation;
§6663, civil fraud — 75 percent of the portion of the understatement attributed to fraud;
§6651(a)(1), failure to file — 5 percent per month, maximum 25 percent;
§6651(a)(2), failure to pay — 5 percent per month, maximum 25 percent;
§6651(f), fraudulent failure to file — 15 percent per month, maximum 75 percent;
§6656, failure to timely deposit — 2 percent to 15 percent;
§6672, trust fund recovery — Penalty equal to 100 percent of the trust fund social security and income tax withholding.

Penalties are assessed as tax and are, therefore, subject to interest accumulation until paid.

Numerous Code sections dealing with penalties make “reasonable cause” a defense. Such a defense can be made if the practitioner can show circumstances beyond the taxpayer’s control caused the imposition of the penalty. Examples of such causes can be:

Natural calamities such as fire or other casualties;
Reasonable reliance upon tax advice given;
Loss of records; and
Illness of taxpayer or accountant/preparer.

Unavailability of funds to pay a tax is not reasonable cause.

Other penalty sections permit the IRS to assess penalties against those other than the taxpayer:

Tax preparer penalties. §§6695 (sign), 6107 (copy), 6109 (preparer ID); and
Aiding and abetting an understatement of tax ($1,000 for individual returns, $10,000 for corporate tax returns).

Criminal sanctions exist in: §§7201 (tax evasion) and 7207 (submitting false documents).

Interest is charged pursuant to §6601, which provides interest to be paid from the time a return is due until the date the tax is paid. It is compounded daily and is on the entire balance of tax, penalty, and interest. The IRS pays interest on tax overpayments, except refunds paid within 45 days after the last day prescribed for filing of a return. Interest rates are set quarterly by the federal short-term note, plus three percentage points. A procedure exists to request abatement of interest, but only by demonstrating IRS managerial or ministerial mistakes.

To claim relief from penalties, practitioners can seek a penalty appeal by filing Form 843 with stated grounds. A request for penalty relief should be made from the first IRS notice assessing such penalties. The IRS Appeals Branch has review jurisdiction in penalty appeal matters.

Obtaining Information From IRS

IRS pronouncements in the substantive and procedural tax areas include:

Revenue rulings — IRS positions on substantive tax issues;
Revenue procedures — IRS statements of procedural rules;
Private letter rulings — letters issued to specific taxpayers on substantive tax issues;
Determination letters — issued by IRS area directors on completed tax transactions; and
Treasury regulations — both legislative and interpretive pronouncements by the IRS on most Code sections.

Revenue procedures outline how to go about obtaining these rulings for clients. Currently, user fees are imposed from $150 to $2,500, depending on the type of request.

Practitioners can obtain client information through both informal and formal requests. Client tax account information can be requested from IRS service centers. Transcripts can be obtained by filing Form 4506. (Copies of returns require a $39 user fee.) Formal Freedom of Information Act requests for specific client records held in IRS files must be filed with the IRS district disclosure officer.

The IRS Web site at irs.gov is a source of IRS forms and publications and a professional section permits access to numerous programs of use to the practitioner. The IRS maintains a toll-free practitioner hotline at (866) 860-4259. Many fee-based (LEXIS, WESTLAW) and some free (www.findlaw.com) Web sites offer computer research tools for practitioners seeking tax information.

The IRS Taxpayer Advocate’s Office can assist practitioners when cases seem to bottleneck without resolution. Advocate offices are located in each state and can be additional sources of information in client matters as well as substantive help in resolving disputes.

Conclusion

Practitioners who meet with clients with IRS tax problems are expected to know the basics of tax procedure. No substitute for adequate research exists, but this article at least points the way to where one should start.

THEODORE M. DAVID has practiced exclusively in the tax dispute area in all IRS branches for more than 25 years. He is Professor of Law and Taxation at Fairleigh Dickinson University.