Myths are not reality, even if they do reflect basic truths. A cherished myth in tax law is that ours is a system of “voluntary self-assessment.” Last week’s opinion in Ramsay v. Commissioner, T.C. Memo. 2017-223 (Nov. 15, 2017), teaches a lesson about that myth.
This myth is not reality. Despite the rhetoric of hobbyists, it is not as though taxpayers have any legal choice in the matter: the law requires them to file returns, report their income and deductions, calculate their taxes, and pay any amounts owed when the return is filed. IRC §§ 6201-6204. Congress weaves together civil and criminal penalties to enforce these duties and leaves the ever unpopular IRS to swing the net. Like Bentham’s Panopticon, the discipline of self-reporting and payment cannot be divorced from the constant coercive threat of discovery and the resulting civil or criminal sanctions.
But there is a basic truth behind the myth. Tax administration rests on taxpayers truthfully disclosing their financial affairs and paying what they owe — through withholding or otherwise — without overt government compulsion. It is “voluntary” in the same sense that stopping one’s car at a red light — at midnight with no traffic and no one looking — is voluntary. It is each citizen’s self-enforcement of the legal duty that keeps both the tax and transportation systems running smoothly. With hundreds of millions of returns filed each year, the system depends on the veracity, not the kindness, of taxpayers.
The myth exists because of IRS decisions just after World War I to start accepting initial returns as presumptively accurate if properly filed. For those interested I explain both the history of tax return processing, and how it started the myth in Theory and Practice in Tax Administration, 29 Va. Tax Rev. 227 (2009).
Mr. Ramsay appears to be the kind of taxpayer who helps the system work. He filed his returns timely. He was careful to be in an overpayment posture at the end of each year. He cautiously directed that part of each year’s overpayment be applied to the following year’s tax liability. He appears to be a model of a taxpayer working within the system.
But when Mr. Ramsay made two mistakes on his 2011 return, he discovered he was unable to fix one of them precisely because ours is not a “self-assessment” system. When a taxpayer attempts to correct a mistake by amending a return, the IRS does not use the same presumption it uses when processing the initial return. Mr. Ramsay learned that lesson the hard way. You can learn it by clicking below the fold.
Mr. Ramsay timely filed his 2011 return. It was the year he retired as a pilot from Delta Air Lines. The return reported an overpayment of more than $10,000, about half of which was an overpayment from the prior year that Mr. Ramsay had directed be applied to his 2011 tax year. Consistent with his historical practice, Mr. Ramsay directed that the entire $10,000 overpayment be held by the IRS to apply to the 2011 tax year.
But Mr. Ramsay’s initial return contained two mistakes. First, Delta had sent him a W-2 for just under $12,000. As part of that amount Delta included just under $900 in imputed income from premiums Delta had paid for a life insurance policy. Mr. Ramsay reported that amount as income on his initial return, but later thought that a mistake.
Second, Mr. Ramsay had taken various distributions from his individual retirement accounts and pensions during 2011 but failed to report those amounts on his return. The taxable distributions totaled about $18,000. Mr. Ramsay was prompted to reconsider this position by a Notice of Deficiency (NOD) he received in 2014, based on the third party information returns reporting the taxable distributions. The IRS proposed to assess an additional $4,000 (but did not propose any penalties).
In response to that NOD Mr. Ramsay filed a timely petition in Tax Court and said he was preparing an amended return. About a year later, in 2015, he ended up filing two separate amended returns, one to correct each mistake. It appears he filed them at the same time, although one had been prepared earlier than the other.
In the first amended return he reported the $18,000 in taxable distributions he had received, but by dividing them into capital gains and ordinary income he reported a total increased liability of only about $3,000, not the $4,000 the IRS NOD had computed. The IRS accepted this amended return and processed it.
In the second amended return Mr. Ramsay sought to decrease the income reported as received from Delta by taking out the $900 in life insurance premiums. The IRS did not accept this amended return.
Mr. Ramsay thought the first amended return just reduced the overpayment he had previously reported and so eliminated the deficiency. By 2015, however, the IRS had already applied his 2011 overpayment to his 2012 tax liability, so there was no longer a 2011 overpayment to be reduced. So a deficiency remained, albeit smaller than the one asserted in the NOD.
If the self-assessment myth were true, then the IRS would have been in error to reject Mr. Ramsay’s second amended return without showing good cause of some kind. As Judge Ashford explained, however, quite the opposite is true: “reporting an item of income on his return constituted an admission that must be overcome by cogent evidence.” So while the myth would support Mr. Ramsay’s argument that the IRS was wrong to reject his second amended return, Judge Ashford exposed the myth by holding that he “has not overcome the effect of the admission on his 2011 original return, which was repeated on his first amended return.”
It’s not that Mr. Ramsay did not try to overcome the initial reporting position. He explained that the IRS had allowed him to omit those premiums from his 2010 income. Judge Ashford cites a line of cases for the proposition that “the acceptance of a position by the IRS for one year...is not controlling in a later year.” While mainly true, there is perhaps a whiff of myth in the broad statement. See, Alamo Nat’l Bank v. Commissioner, 95 F.2d 622, 623 (5th Cir. 1938), cert. denied, 304 U.S. 577 (1938)(suggesting that the IRS has a duty to treat the same taxpayer consistently over time under certain circumstances). But that’s the subject for a different lesson. If you just cannot wait, I urge you to look at Steve Johnson’s really great article: “An IRS Duty of Consistency: The Failure of Common Law Making and a Proposed Legislative Solution,” 77 Tenn. L. Rev. 563, 622 (2010).
So if a return is not a self-assessment, then what is it?? Well...it’s a confession. Or, as Judge Ashford calls it, “an admission.” That’s what the Supreme Court thought as well in the seminal case of Badaracco v. Commissioner, 464 U.S. 386 (1984) cited by Judge Ashford. There, the taxpayers filed fraudulent returns. When they were later the subject of a grand jury investigation, they filed non-fraudulent amended returns, reporting more income and they paid the taxes. The criminal charges for those years were dropped. Six years later, however, the IRS assessed the fraud penalty for those years. The taxpayers admitted that the original returns were false, but argued that their amended returns cured the fraud and started the three year limitation period in 6501(a). The Supremes said that
[nothing] in the wording of § 6501(a)...enables a taxpayer to reinstate the section's general 3-year limitations period by filing an amended return. ...the Internal Revenue Code does not explicitly provide either for a taxpayer's filing, or for the Commissioner's acceptance, of an amended return; instead, an amended return is a creature of administrative origin and grace. Thus, when Congress provided for assessment at any time in the case of a false or fraudulent "return," it plainly included by this language a false or fraudulent original return.
If taxpayers truly “self-assessed” then a corrected return would fix any problems created by the original return, whether those problems were intentional fraud or simply mistakes. The Badaracco case dealt with the former problem. Last week's Ramsay case teaches the same lesson about mistakes. An admission in the return, once accepted by the IRS, is not changeable by the taxpayer alone precisely because it is not the taxpayer’s “assessment” of the situation that controls. It’s the IRS’s “assessment.” Therefore, it is the taxpayer who must convince either the IRS or the Tax Court that the initial confession was wrong and the desired amendment is correct.
That lesson cost Mr. Ramsay time and treasure. You just got it for free.