Archive for the ‘ Taxes ’ Category

If the government can prove that you “willfully attempted in any manner” to “evade or defeat” a tax, then you cannot discharge that tax debt in bankruptcy. 11 U.S.C. 523(a)(1)(c).   I’ve always seen this as a very low bar for the IRS to prove, because the elements are simple: 1) the taxpayer had a duty to pay a tax; 2) the taxpayer knew that he had this duty; and 3) the taxpayer voluntarily and intentionally violated that duty. Payment of any expense beyond subsistence, such as a child’s college tuition, at a time when taxes remain unpaid, could meet the standard. That’s what the cases around the country teach.

The 9th Circuit, however, has changed the standard here in California and elsewhere in its domain. In Hawkins v. FTB, Case No. 11-16276, decided on September 15, 2014, the court has held that the taxpayer needs to have a specific intent of evading tax for this discharge exception to apply. Outside the 9th Circuit, a “willful attempt “ to intentionally violate the duty to pay tax means a deliberate act that results in nonpayment of tax. Here in the 9th Circuit, the “willful attempt” means a deliberate act with the intent of evading tax.

The facts in Hawkins are rather shocking to this former IRS attorney. The debtor-taxpayer made a fortune in Silicon Valley enterprises, and tried to shelter some of his capital gains through sophisticated yet dubious transactions. A large tax bill ensued, and then his enterprises lost a great deal of money. Yet he continued to live large: in the face of of a $25 million tax bill, he continued to maintain two residences worth a total of more than $6 million, and bought a fourth family car (in a two-driver family) for $70,000. The family spent between $17,000 and $78,000 more per month than its income for several years.

I think that the result in Hawkins is wrong. This kind of spending by a taxpayer who knows he owes $25 million in taxes is dishonest. As a taxpayer, I do not want my fellow Americans to get away with this by saying “gee, I wasn’t trying to avoid paying the taxes, but I just couldn’t stop myself from spending.  But I do salute the attorneys who reached this result. It is a good result for my clients, and I intend to use it until the Supreme Court reverses the 9th Circuit.

To the IRS, Every Tax Period Stands on Its Own

I received a call recently from someone already represented by a tax attorney, but who wanted my opinion on whether there was anything his attorney could have done to avoid the following, very unfortunate situation.  John Barrett owed a bunch of employment taxes on his own. He tried to make arrangements to pay them, and made good use of the Collection Due Process provisions in the Tax Code: he filed four cases against the IRS in the Tax Court to challenge the way the IRS was trying to collect almost $85,000. He settled those cases with an agreement that the IRS would place these liabilities “in a Currently Not Collectible status due to the petitioner’s financial hardship.” This is a good result, because it means that the IRS will go away and not try to collect these liabilities.

Unfortunately Barrett had other liabilities: he and his wife Carol owed $10,000 in joint income taxes for the 2002 and 2009 tax years. The IRS tried to levy on their bank accounts, so together the Barretts filed another Collection Due Process case (Tax Court case 1576-12L). They claimed that the legal doctrine of “res judicata” (“the thing has been decided”) required the IRS to make the joint income tax liabilities non-collectible too. After all, if financial hardship prevented John Barrett from paying the $85,000 in back employment taxes, that same hardship ought to extend to the $10,000 in income tax owed. When the IRS asked for financial documentation to determine collection alternatives, the Barretts produced only the signed settlement agreements from John’s employment tax cases.

The IRS disagreed that it had decided that the income tax liabilities were non-collectible, and so did the Tax Court (T.C. Memo. 2013-256). “A well-established principle is that the Commissioner [IRS] may challenge in a succeeding year what was accepted in a previous year,” according to Judge Cohen. End result: the IRS gets to levy on any accounts it finds belonging to John and Carol, and it doesn’t need to find the liabilities non-collectible.

The result is tragic, because the Barretts probably could have gotten their joint income tax liabilities into non-collectible status by providing the same documentation that John produced to find the $85,000 non-collectible. The appeals officer considering their situation had already proposed an installment agreement of $340 a month, and offered to do more for them if they provided a financial statement (Form 433A). Had I represented the Barretts, I would have had them complete the Form 433A and provided all requested documentation, while also sending the information from John’s employment tax collection effort to show how the IRS had dealt with the same taxpayer on a different liability. In truth, they may have the chance to do that now, but the IRS will have the legal right to reject their offers to pay on their terms.

The moral of this case: cooperate with the collection officer. If he asks for specific documentation, show it to him. The argument that the IRS had already considered his situation and reached a decision does not hold water, because the IRS treats each individual tax liability as a separate item – each year, each type of tax – as a separate item.

It’s Not Easy Dealing with the Franchise Tax Board

My clients owed the California Franchise Tax Board (FTB) $8,000 for the  2011 tax year; they filed their return late, and couldn’t pay it all at once.

The FTB sent a notice that it was about to levy – standard procedure, it wants to get paid, let’s scare the taxpayers into making an agreement to pay it over time.

If you look at the FTB website, it really discourages people from calling up to make an installment agreement, and my clients feared doing this themselves. So, armed with their banking information, I went online and made the installment agreement for them.  The FTB spat back a confirmation number and thanked me for making these arrangements. The client was going to pay $300 per month until the debt was paid off.

Just to be sure that the levy was going to be stopped, I called the FTB. The collection officer had no record of an installment agreement. I said “but I’ve even got a confirmation number from your website.” The officer told me that this meant nothing, that the FTB wouldn’t do an online installment agreement for an old tax year. But it looked like everything was okay on the installment agreement; if I hadn’t called him, how would I have found this out? The officer said that I would have found out when my client got levied.

I set up the installment agreement with the collection officer over the phone. It costs $34 to do this; I asked if the FTB was going to charge that fee twice, once for the online agreement and once for the phone agreement. He said no, that the online agreement didn’t exist, my clients aren’t being charged for it, and even though the FTB has all their banking records from that interaction, it won’t make automatic withdrawals based on the online agreement.

I don’t quite trust it.

The state taxation system is dysfunctional, fraught with cronyism and unfair laws. There is little oversight. If the FTB goes ahead and levies on my clients, there is little recourse; the clients owe the tax money, and they aren’t legally damaged if they pay that amount quicker through a levy than peacefully through an installment agreement.

So I’m asking my clients to watch their accounts very carefully: if they see the FTB removing two automatic payments, then I’ve got more work to do.

Investment Activity and Your Tax Return

Have your Investment Expenses Been Disallowed on Your Tax Return?

Most people know that they can’t claim losses incurred by a hobby – say, for instance, their side hobby of breeding and raising Great Pyrenees dogs.  No profit motive, no deduction of losses.

Despite the profit motive in investing, the same rule goes for investment activities that are not a “trade or a business.”  If an investor claims a loss on a Schedule C business whose sole purpose is lending and collecting money, IRS auditors will almost automatically disallow the expenses.  Even though most of us know better, the auditors see investment activities as something less than a business.

What, then, makes an investment activity a business in the eyes of the taxman?

Courts look for continuous and regular involvement in the activity, as well as a profit motive, to turn any activity into a trade or business.  When it comes to money-lending, the activity is a trade or business in those “exceptional” situations where the involvement is so continuous and extensive as to “elevate” the activity to that of a separate business.  Imel v. Commissioner, 61 T.C. 318, 323 (1973).

How do you prove this?

This question generally comes up in an audit, so the first person to convince about the “trade or business” is the IRS auditor.  An investor being challenged on these expenses should produce any documentation and explanations of the business that show continuous and extensive involvement in managing the investments, such as timesheets, advertising, loan agreements, and so forth.

IRS audits start with low-level employees who have little discretion, and who are likely to just deny the expenses.  When a taxpayer doesn’t just agree with the audit results, the audit gets handed to people who have successively more discretion than the prior person. Expect to rehearse the same story not only to the auditor, but also to the auditor’s manager, the appeals officer, the IRS docket attorney, and eventually the Tax Court judge.  The longer and further you escalate the audit, the better the odds of having your investment losses deducted.

This gauntlet of decision-makers will look for certain factors: the number of loans made by the taxpayer (more is better); the time period over which the loans were made (again, more is better); the quality of the taxpayer’s books and records relating to this activity (a trade or business will have good books and records); the time the taxpayer spends on the lending activity (it doesn’t need to be full-time, but the lender should seem committed to spending time at the activity); how the taxpayer sought out lending business, including word-of-mouth referrals and advertising (more aggressive marketing suggests a trade or business); whether the taxpayer had a separate office for the business (again, a devoted office looks more businesslike); the taxpayer’s general reputation as a lender (someone in the trade of lending will be known as a lender); and the relationship of the debtors to the taxpayer-lender (borrowers who are not relatives help this factor).  U.S. v. Henderson, 375 F.2d 36, 41 (5th Cir. 1967).

Interestingly, the failure to claim the activity as a trade or business for some time, even decades, does not prevent the lender from starting to do so.

If any one of the series of decision-makers agrees with the taxpayer, the audit closes with no change to the taxpayer’s return.  Because it gets more expensive to fight the IRS the longer the fight lasts, a taxpayer has a good incentive to show up with as much documentation and argument as possible from the beginning.  In some situations, taxpayers may recover part of their attorney fees from the IRS if they can show that the IRS took an unreasonable position, such as when an auditor completely ignores documentation of the Henderson factors.

Taxpayers seem to do very well according to the case law: most reported cases show the IRS losing on this issue.  However, every case turns on its own unique facts, and we don’t know how many lenders decided to agree with the IRS and not fight the “trade or business” battle.  What the case law does tell lenders is that it is often worth fighting the IRS on this issue.

Is it true that there is no law requiring payment of income tax?

My tenure as an IRS attorney caused me to think deeply about taxes, courts, and government. And it helped me see how I can help individuals who face the tax system.

There are people – common in the San Fernando Valley – who believe that the government does not have the right to collect taxes. At the IRS offices, we called them “constitutionally challenged.” We weren’t allowed to call them “tax protestors.” A common assertion they made: there is no law that requires them to pay income tax. Oh, they’ll say that the 16th Amendment wasn’t properly ratified because Ohio wasn’t a state in 1916, or that the term “person” in I.R.C. § 6012 isn’t defined, therefore doesn’t include them, or that receiving “cash” isn’t “income.” Debating them made me think about the IRS’s mission. It also made me think about what a mentally healthy person does.

Someone recently showed me a case involving a bankruptcy debtor who filed Uniform Commercial Code Financing Statements against federal employees because he didn’t like the way the federal employees were doing their jobs. It brought me back five years, to a case where the taxpayer didn’t like the IRS collecting taxes from him, and didn’t like that I was helping the IRS collect taxes from him. He filed a UCC-1 financing statement against me in the amount of $41 million (or was it billion?). I wasn’t alone; the statement also named 10 other IRS personnel and a Tax Court judge. It’s a good thing I had already gotten a home loan.

That particular taxpayer had used a novel argument against the IRS: he was not only a “natural-born, 13th Amendment citizen,” but also a “U.S. Vessel.” As such, he had a prior lien against his earnings under the Tax Court’s maritime jurisdiction that trumped the federal government’s contractual right to payment from him.

This argument, of course, was not seaworthy, and the judge did not even dignify it with comment beyond the word “frivolous.” (The IRS has identified a host of other arguments that are “frivolous;” the kindest word I can use is “creative.”)

My sometime-vessel taxpayer left the bounds of mental health when he adopted an extravagantly unrealistic statement: “I am a U.S. vessel.” Yes, there are legal fictions (corporations are persons), but they are few and widely-accepted.

More importantly: the taxpayer made a grave mistake when he said that the government had a contractual right to taxes.

Attorneys and the general public must be clear about this. There is nothing “contractual” about taxes. Taxation is extortion. It is only legal because all three branches of the government, which controls the legitimate use of power and violence, say it is legal. Regardless of its morality and justice, the income tax exists. It’s mentally healthy to recognize this and deal with it, rather than claiming that some tortured loophole rescues me from its obligations.

Because I know the way the IRS works, and the workings of the income tax, I can help most people live with and, sometimes, even defeat the IRS. But not if that person also thinks he’s a boat.

IRS and the Tea Party

A few months ago, the United States saw the political theater of Congress outraged at the IRS’s targeting of Tea Party organizations for special scrutiny on determinations of whether they qualified for tax-exempt status. It looked like the IRS was politically biased against conservative causes.
The IRS, however, had a great defense that it didn’t use. It’s the same defense that Colonel Jessep (Jack Nicholson) uses in the movie A Few Good Men: “You want me on that wall!”
The Internal Revenue Code grants tax-free status to “social welfare” organizations. What is a “social welfare organization?” Congress left that unclear, so the IRS cleared it up somewhat with a regulation 40 years ago: among other criteria, these organizations can’t spend more than 50 percent of their time on political campaigns for candidates (as opposed to ballot initiatives).
In the absence of congressional guidance, and with the regulation standing the test of time, the IRS chose recently to devote its scarce resources to organizations that it thought were most likely to be spending more than 50 percent of their time on political activities. After all, many Tea Party entities loudly and publicly proclaim anti-government, smaller-government, and anti-tax sentiments. From the IRS enforcement side, this probably seemed like sensible profiling.
So why didn’t the IRS provide this defense? Because the IRS engages in a dysfunctional relationship with Congress. Congress didn’t worry itself with giving the IRS any guidance on what a “social welfare” organization is. This allows Congress to occasionally step in, showing public outrage at the IRS overstepping its ill-defined bounds, and rescuing freedom from the jaws of the bureaucratic beast it created.
Members of Congress always want to show their constituents that they side with the common man against the big, bad government. And yet congress members depend on the IRS to collect the money that pays their salaries and funds the government the congress members are a part of. Congress needs the IRS, but doesn’t want to admit it. The IRS, of course, needs Congress; the IRS gets almost but not quite all the funding it needs to function (so Congress members can show that they control the IRS, not the other way around).
In a showdown with Congress, the IRS will almost always appear submissive, because everyone wants it that way.

Misleading Radio Ads

I heard a radio ad about solving IRS problems. “It’s a fact that when you owe $10,000 or more, the IRS can take your car, your house . . . even your freedom.” The advertiser went on to say that its professionals reduce tax liabilities in amounts of “70, 80, even 90 percent of what’s owed.”
This is good marketing at one level: it creates anxious images and thoughts in the listeners’ minds and points them to relief. But the message is misleading.

IRS Won’t Arrest You For $10,000 Owing
Is it a “fact” that the IRS can put you in jail if you owe $10,000 or more? Not entirely. The IRS can prosecute you for tax crimes, the jury can convict you, and federal marshals will put you in jail. And there is no lower dollar limit to tax crimes. So yes, it’s possible to go to jail with only $10,000 owing. But tax crimes always involve some other behavior than merely owing taxes. You won’t go to jail just because you owe $10,000; you might go to jail because of how you came to owe $10,000, and what you did to avoid paying it.
The IRS doesn’t usually spend resources prosecuting crimes on such small liabilities. This doesn’t mean it can’t. It’s just very unlikely.
Similarly, the IRS isn’t about to take your car or house for owing $10,000. Those actions require a lot of bureaucratic review, and only occur as a last resort after the taxpayer refuses to speak to the IRS reasonably.

Percentage Of Tax Reduced Means Nothing
I’m sure the tax-resolution service touting the “70, 80, even 90 percent of what’s owed” gets results like that on occasion. The IRS will compromise your liability if you can show that you can’t pay it – that process is the Offer in Compromise. And comparing the original liability to the amount paid through the offer might result in a 90 percent reduction.
But the IRS doesn’t care how much liability is being written off. It cares how much you can pay. For instance, when I was at the IRS, I approved an Offer in Compromise that wrote off a $500 million tax debt in exchange for a $500 payment – more than a 99.99 percent reduction! Of course, that’s difficult to replicate: the taxpayer had been a president of a Savings and Loan in the 1980s, living large until the feds brought down his financial institution, and the government figured that collecting $500 from his nephew was preferable to keeping the assessment open until he died in jail.
People who listen to these ads call me to ask by what percentage I can reduce their tax, and I can’t answer. I need to study their financial situation before suggesting amounts. And that just doesn’t sound as gripping on a radio ad. But, please remember, if radio ad promises sound too good to be true for your particular situation, they probably are.

Statutes of Limitation, the IRS, and the FTB

A potential client called me last week for help in dealing with the IRS.

It seems he owed a lot of taxes for tax years from 1992 to 1996. Had he filed the returns on time? Yes. Had he filed bankruptcy in the meantime? No. Had he filed an offer in compromise? No. Has he heard anything from the IRS in the last three years? No, but he thought that was because he had moved and not written to the IRS collection department to tell them about the move. Has he filed a tax return from his new address? Yes.

I told him not to worry, that he probably didn’t owe the taxes anymore because it took more than 10 years for the IRS to collect those taxes. And it occurred to me that I should explain how statutes of limitation can work to the taxpayer’s advantage.

Audit and Assessment – Three Years IRS, Four Years FTB

The IRS has a three-year limitation period on assessment from the time of the return’s filing. That means that if three years pass from the time you, the taxpayer, filed your return, the IRS can no longer audit you for that tax year.

Sounds simple, right? But when did you actually “file the return?” Let’s take a return for the 2011 tax year. If you filed it before April 15, 2012, the law says that the return was filed on April 15. If you had an extension until October 15 and filed the return on September 1, the limitation period starts on October 15.

If you filed the return late, the law says that it was filed on the day the IRS received it.

In California, the Franchise Tax Board generally enjoys more liberal state laws than the federal IRS. The FTB has four years to assess more taxes on a filed return.

There is a big difference between how the IRS and the FTB go about “assessing” a tax, and how their audit procedures work. For the IRS, assessment occurs at the end of the audit process. Thus, the IRS generally tries to reach potential audit targets within a one-to-two-year window after the return is filed. If the three-year clock has been ticking for two years and ten months, and you haven’t heard from the IRS, you are unlikely to get audited for that year – although there are relatively uncommon exceptions. The IRS has to start its audit soon enough that it can complete the process and issue a Statutory Notice of Deficiency more than four months before the end of the limitation period, for reasons that are too complicated to mention here.

The relatively uncommon exceptions? The IRS gets six years to audit you if it can show a large understatement of income, and if it can show that your return is fraudulent, it can open the audit and assess at any time; there is no statute of limitations on a fraudulent return.

The FTB, on the other hand, assesses the increased tax as soon as it smells a problem. Like a deputized posse member who shoots first and asks questions later, the FTB starts its process with a Notice of Proposed Assessment; this counts as the “assessment” for purposes of the statute of limitations. This notice can be mailed on the last day of the four-year clock, and it’s still effective.

If the taxpayer gets audited by the IRS and agrees to a higher assessment, the taxpayer has a duty to inform the FTB within six months. The FTB then has two years to make its assessment. If the taxpayer doesn’t make the six-month deadline, there is no limitation period – the FTB has an infinite amount of time to make the assessment.

These assessment clocks can be tolled (and often are) by agreement between the taxpayer and the taxing authority. Sometimes this is a good idea, especially if the taxpayer just needs a bit more time to gather records to show to the auditor. Sometimes it’s a bad idea, if the tax authority’s case is not very strong.

Obviously, the laws strongly favor the taxing authorities: our legislatures want to make sure that people do not get out of taxes owed by skillful procedural. And while the FTB’s laws sound even more tilted against the taxpayer, there is a counterbalance: the FTB is generally less effective at opening and closing audits, and investigating a taxpayer’s affairs, than the IRS. “Generally,” of course, doesn’t mean that it can’t be extraordinarily effective if it wants to be.

Collection – Ten Years IRS, Twenty Years FTB

Once the assessment is made, the taxing authority then has to try to collect it. The IRS has 10 years. The date that the collection authority ends is called the “CSED” (Collection Statute Expiration Date). The ten-year clock can be tolled by any of several events: bankruptcy, offer in compromise, or collection due process hearing. Installment agreements do not toll the collection period.

For the FTB, the statutory period is 20 years. Installment agreements, bankruptcy, military service, presence in a disaster area, and child support collection actions all toll the statutory period.

While I have counseled taxpayers at the end of the IRS’s 10-year period, I have never counseled anyone at the end of the 20-year period. The main reason is that the statute of limitations is less than 20 years old: prior to July 1, 2006, there was no statute of limitations on collection actions for income tax in California. No one has yet had their California tax liability extinguished by operation of time.

Period before Dischargeability in Bankruptcy – Three-year, Two-year, 240-day Rules

Taxpayers may discharge their liabilities in bankruptcy. However, the law requires the taxing authorities to have a chance to collect those liabilities before the taxpayer can discharge them. Thus, 11 USC Sec. 507(a)(8) and 523(a) work together to create several rules, familiar to most bankruptcy attorneys: in order for a tax liability to be discharged, it must come from a return last due more than three years before the bankruptcy filing (this is October 15 if the taxpayer got an extension), actually filed more than two years before the bankruptcy filing, and the tax on that return must have been assessed more than 240 days prior to the bankruptcy filing (this becomes relevant in an audit situation). These periods may be tolled by bankruptcy, collection due process hearings, and offers in compromise.

Because these rules are set by federal bankruptcy law, not federal and state taxation law, they are identical for the IRS and the FTB. But there is yet a wrinkle between the two: the 240-day rule operates slightly differently for the FTB than for the IRS.

The “assessment date” for the IRS is straightforward: it is the date appearing on the transcript, the date that the tax return was received, the taxpayer agreed to an increased assessment, or the date that a Tax Court decision became final. For the FTB, it is the date that the assessment proposed in the Notice of Proposed Assessment becomes “final.” While the NOPA serves as the assessment date for all kinds of clocks (including the inter-agency agreement determining priority of liens), it does not serve as the starting period for the 240-day rule. Rather, the 240-day clock starts 60 days after the NOPA, thus effectively giving the FTB a 300-day period before dischargeability is allowed.

Guest opinion on cancellation of debt income

Debtor’s often have Notices of Federal Tax Liens outstanding at the time they file bankruptcy. How are these handled?
First, a properly-noticed lien survives bankruptcy. It continues to attach to any property owned at the time of the bankruptcy. It does not attach to any property acquired after the petition date.
1. Lien on real property. If the bankrupt debtor owns a house and the IRS has filed a Notice of Federal Tax Lien against the debtor’s real property (in the county records), the IRS will generally keep that notice in place after bankruptcy. The house may be underwater and the IRS lien thus worthless, but if the house appreciates in value, the IRS is entitled to the new value.
If, however, the debtor acquires a new piece of land after filing bankruptcy and discharging his taxes, the IRS lien won’t attach to the new piece of land.
2. Personal property. If there is a Notice of Federal Tax Lien filed against personal property, it attaches to everything the debtor owns on the day of the bankruptcy petition. Once the debtor discharges the underlying tax, the IRS still has the right to seize all your personal assets (even those exempted) to satisfy its lien, but it just won’t. Imagine: you, as a debtor, file for bankruptcy, go through the entire process, get your debts including your tax debts discharged, and then they send the Asset Recovery Team to your house to seize your car and sofas – for which it could get how much at auction? Also, the lien doesn’t attach to newly-acquired property, so it would need to investigate whether the bracelet it proposes to seize and sell came from Aunt Tammy as a birthday gift after the bankruptcy petition was filed. The IRS long ago figured out that the PR and legal problems here are huge, so they’ll go ahead and release the lien.