TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Monday, January 15, 2018

Lesson From The Tax Court: What Are They Thinking?

Tax Court (2017)I tell my students to be careful with personal pronouns, especially now that the pronoun “they” may properly refer to a singular antecedent. An unclear antecedent can confuse readers.

Today I may have confused you. When you read this post's title, you may have thought “they” refers to “Tax Court.” Maybe you thought this would be a critique of a Tax Court opinion like last week’s post. It’s not. Sorry.

The “they” in the title is deliberately ambiguous, however, because it points to two different antecedents, neither being the Tax Court. First, it points to three taxpayers whose cases were decided last week by the Tax Court. Each case has at least one fact that is so amazing it will leaving you shaking your head (or "SMH" in modern texting parlance) and asking yourself “what were they thinking.”

Second, “they” means Congress. For the past 8 years Congress has adopted a policy of “starving the beast” and forcing the IRS to reduce its workforce. I wrote about that a couple of years ago here. These cases teach us why that Congressional policy is a thoughtless one. 

Each of these three cases shows an educated middle-class taxpayer trying to game the tax system in ways that require significant human resources to combat. In two cases it took human IRS employees to spot the games and defeat them. In the third case, the taxpayer is “winning” his game, at least temporarily, thanks to the Collection Due Process provisions. It will likely take significant additional human effort to collect this taxpayer’s unpaid tax liabilities.

More below the fold.

I’ll take the cases in order they came out last week.

Ankerberg

First up is Curtis Eugene Ankerberg v. Commissioner, T.C. Memo. 2018-1 (Jan. 8, 2018), heard by Judge Cohen. Mr. Ankerberg was a California-licensed CPA. During the years at issue (2012, 2013, 2014) he lived in Medford, Oregon and worked as a return-preparer. He prepared at least 50 returns in each of those years. Oh, actually, his CPA license had expired on June 30, 2009, but as readers well know, there is no federal licensing requirement for return preparers!

Mr. Ankerberg also prepared his own returns for those years. Mr. Ankerberg’s game was to claim personal expenses as business deductions related to his return preparation activity. The Service selected Mr. Ankerberg’s 2012 and 2013 years for examination and then later opened 2014 as a related exam. Due to Mr. Ankerberg’s intransigence, the Revenue Agent eventually had to use the Bank Deposit and Cash Expenditures Method (IRM 4.10.4.6.4). Using that method, the IRS determined (and Mr. Ankerberg agreed to) unreported gross income of over $111k for the three years 2012-2014.  Figuring in the disallowed deductions resulted in understated tax liabilities totaling $60k.  That's $60,000 in taxes that Mr. Ankerberg was trying to evade during just those three years. 

Here’s the SMH fact.  Mr. Ankerberg claimed 50% of his personal residence expenses as home office deductions on Schedule C, but he did not attach the required documentation form, Form 8829 to any of his returns. Why not? Judge Cohen writes that Mr. Ankerberg’s own explanation was that doing so “would be a red flag for audit.” What was he thinking?

If YOU, dear reader, are thinking “fraud," you are not alone. The IRS sought fraud penalties against Mr. Ankerberg and Judge Cohen found that Mr. Ankerberg’s “pattern of unreported income and overstated deductions, failure to keep or produce records, and failure to cooperate with the IRS” justified imposition of the §6663 fraud penalty on the entire $60,000, or about another $45,000. And that’s not counting the accuracy-related penalties under §6662. Gosh, it makes me wonder what kind of "services" he was providing for the taxpayers whose returns he prepared...and may continue to prepare since there is no federal oversight of return preparers.

Here’s the lesson.  Mr. Ankerberg’s game required significant human resources to detect and shut down. It is far more difficult for the IRS to catch taxpayers who try to game the system on the deduction side than the income side because the computers cannot figure that out. The computers are pretty good at catching unreported income because they match third-party information returns against the taxpayer’s return. But the third-party reporting regime cannot help the IRS spot excessive deductions. For that the IRS is stuck with an algorithm called the Discriminant Function (DIF) that assigns a score to each return. Here’s an interesting review of the DIF usage and history. Returns with a certain level DIF score must then be reviewed by IRS employees who select for audit those returns they think are most likely to contain errors. That is a time-consuming and labor-intensive method of selecting returns for audit.  You need a robust and well-trained workforce to do that. 

Notice too that the IRS had to conduct a field audit, requiring the time and efforts of multiple human IRS employees, most notably the Revenue Agent who had to visit Mr. Ankerberg’s home to view the home office. And the Bank Deposit and Cash Expenditures Method can be quite labor-intensive, requiring analysis of actual costs and extensive collection of detailed information.  Again, if you did not catch the point the first time, here it is again: fewer Revenue Officers means fewer audits and that means more folks like Mr. Ankerberg escape detection.

Farr

The second case is Joan Farr f.k.a. Joan Heffington v. Commissioner, T.C. Memo. 2018-2 (Jan. 9, 2018), heard by Judge Chiechi. In 2003 Ms. Farr incorporated the Association for Honest Attorneys (AHA) as a Kansas nonprofit corporation and obtained IRS approval of 501(c)(3) status. Ms. Farr was the CEO of AHA. The AHA "About Us" page (as of today) describes the CEO’s background thusly: “our C.E.O. has 40+ years experience, education and observation of the legal system, holds a B.S. and M.S. Degree in Administration of Justice from Wichita State University, and has helped take ten cases to the United States Supreme Court.”  Like Mr. Ankerberg, Ms. Farr was not some poor schlub who could not understand basic tax rules.

In 2015 the IRS sent AHA notice that the IRS was proposing to revoke AHA’s 501(c)(3) status and that same year sent Ms. Farr a Notice of Deficiency that it was proposing to impose excise taxes on her for “excess benefit transactions.” That’s the technical term for “looting.” Specifically, the IRS thought Ms. Farr had looted AHA in 2010, 2011, and 2012 by using the AHA checking account to pay for personal expenses. The Tax Court agreed.

Here’s the SMH fact.  In 2011, Ms. Farr used the AHA checking account to pay her son’s tuition of $7,750 at St. John’s Military School and to pay $2,200 for the exhumation and DNA testing of a deceased relative. What was she thinking?

She may have been thinking the risk was worth the reward. Certainly the reward is great. If you can sucker people into donating to a putatively non-profit corporation and then use the money for personal expenses, you have just created a stream of tax-free income.  That this is an abuse of the tax laws is not difficult to understand. 

The risk is also great. If you get caught, §4958 imposes two excise taxes: a first tier tax “equal to 25% of the excess benefit” and a second tier tax “equal to 200% of the excess benefit.” The first tier is imposed on all excess benefit transactions, but the second tier is imposed only on those transaction that are not corrected within the same tax period they happen. An “excess benefit transaction” is just what you think: a transaction where the economic benefits exceeds what is given in return. Excess benefit transactions only are taxed at all if they involved a “any person who was, at any time during the 5-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization.” You know, like a CEO.  These are called "disqualified persons."

Here’s the lesson.  The risk materializes only if you get caught. As with Mr. Ankerberg’s game, catching taxpayers at Ms. Farr’s game is a human endeavor, highly dependent on having a stable, well-trained workforce to ensure that exempt organizations get audited. Computers cannot spot looting. The Congressional policy of starving the beast enables taxpayers like Ms. Farr to win their games. Ms. Farr lost, but hers is the exception that likely proves the rule. The IRS exempt organization workforce has been decimated, with the Washington Post reporting this month that staffing has dropped from 889 to 642. Here’s the more polite language the GAO used in GAO-15-164 (December 2014):

IRS budget and staffing levels have declined significantly over recent years. Officials and stakeholders we spoke to noted that IRS resources dedicated to EO oversight have not kept pace with growth in the sector and with the complexity of issues related to tax-exempt organizations. IRS faces difficult decisions about how to allocate resources dedicated to tax-exempt sector oversight and about what specific compliance issues to audit. IRS has already made trade-offs—such as examining fewer organizations and streamlining the application process for organizations seeking tax-exempt status—which may lead to some efficiencies, but will also result in less available information about these organizations.

Lorusso

The last example is Vincent M. Lorusso v. Commissioner, T.C. Memo. 2018-3 (Jan. 11, 2018), heard by Judge Vasquez. Mr. Lorusso appears to be a criminal defense attorney based in Philadelphia. The IRS is trying to collect Mr. Lorusso’s 2007 unpaid tax liability.

Mr. Lorusso’s game is a classic: abuse procedural rules. Specifically, Mr. Lorusso knows how to play the “Collection Delay Process” game, a game that abuses the Collection Due Process (CDP) rules Congress enacted in 1998. The CDP provisions require that the IRS give taxpayers an opportunity to explain why a proposed collection action is improper. In this case, the IRS wanted to levy against Mr. Lorusso’s property. It sent him the requisite notice and Mr. Lorusso timely requested a CDP hearing. After that, nothing. Mr. Lorusso just sat on his hands, making no attempt to explain why collection would be improper and ignoring the IRS Settlement Officer’s requests for information. Basically, Mr. Lorusso defaulted the CDP hearing opportunity. But he did timely petition the Tax Court to review the Notice of Determination (NOD) letter from the Settlement Officer. And then sat on his hands some more. 

[Interesting note: In deficiency cases, the Tax Court does not allow petitions to voluntarily dismiss their petitions in deficiency cases. The Court explained why in Wagner v. Commissioner, 118 T.C. 330 (2002). But in non-deficiency cases the Court uses Federal Rule of Civil Procedure (FRCP) 41 to allow taxpayers to voluntarily dismiss petitions.]

When the IRS moved for Summary Judgment, Mr. Lorusso quick-like-a-bunny moved to voluntarily dismiss his petition. In response the IRS cried foul and asked the Tax Court to impose a §6673penalty on Mr. Lorusso for filing his Tax Court petition primarily for delay purposes. Judge Vasquez declined, basically ruling that since the IRS could now go ahead and resume collection activity, Mr. Lorusso's stunt was "no-harm, no-foul."

Here’s the SMH fact.  This was Mr. Lorusso’s fourth trip to Tax Court playing the Collection Delay Process game. And he’s getting better at it. Judge Vasquez noted that since 2015, Mr. Lorusso “has initiated four distinct cases with similar factual backgrounds. Two of these cases were decided in favor of respondent on his motions for summary judgment. The other two cases include the instant case and another pending case not presently before us; in both of these cases, respondent filed motions for summary judgment and petitioner filed motions to dismiss.”

Here’s the lesson.  To give proper CDP rights takes a huge expenditure of human resources.  The legislative history shows that concern is partly what led Congress to give taxpayers such a very short window to invoke CDP rights.  As a consequence, CDP is a nasty piece of legislation, denying anything like “due process” to the vast majority of taxpayers who actually need help, but permitting game-players like Mr. Lorusso to avoid paying what they owe by soaking up IRS employee time and effort.  But don't take my word for it....well...actually, yes, please DO take my word for it.  After reading almost 1,000 CDP cases in 2008, I wrote an article about CDP.  Here's the summary: 

This article documents and explains CDP's failure to provide a meaningful external check on tax collection abuses. In fact, CDP most likely hurts those who most need its promised protection from arbitrary agency action: the working poor who risk seeing their Earned Income Tax Credit subsidies snatched away by the over-reaching tax collector. *** Some commentators contend there can be no proper "rule of law" without adversarial process. This study of CDP proves the opposite claim: adversarial process, used in the wrong place and the wrong time, becomes a rule of deception rather than a rule of law. CDP is a failure on many levels, but an instructive one for it tells much about the problem of using adversarial process in the administrative state.

Conclusion

Two of these three taxpayers did not get away with their games. But for every taxpayer who gets a Tax Court “game over” decision, there is probably about a million others---yes, you read that right---who are winning similar games. I say a million because that’s just basic math. The 2016 IRS Data Book, Table 2 says the IRS received over 150 million returns from individuals in FY2016. Table 9a says the IRS received over 17 million returns like Mr. Ankerberg’s—returns that reported business income on Schedule C (which gives them the opportunity to play the fake deduction game). Let’s assume only 10% of those taxpayers falsify their deductions, like Mr. Ankerberg did. That’s still 1.7 million game-players. Then you add in the Ms. Farr’s and Mr. Lorusso’s and, yeah, I there are likely at least a million taxpayers getting away with improper deductions, looting tax-exempt organizations, and playing the Collection Delay Process games.   Sure, you have poor taxpayers playing games too, with EITC and other credits, but how many of them cost the Treasury $60,000 in lost revenue in a three year period like Mr. Ankerberg did?  

And yet Congress micromanages the IRS into disproportionately auditing the ETIC returns.  And Congress continues to refuse to pay for hiring and training a stable IRS workforce. 

What are they thinking?

https://taxprof.typepad.com/taxprof_blog/2018/01/i-tell-my-students-to-be-careful-with-personal-pronouns-especially-now-that-the-pronoun-they-may-properly-refer-to-a-s.html

Bryan Camp, New Cases, Tax, Tax Practice And Procedure | Permalink

Comments

Gary Bedker (1968) noted that the lowest-cost way to deter crime is to have giant penalties with low probability of detection. The first two cases here sound like crimes to me. Why doesn't the IRS add criminal charges? Is it that much more work beyond the civil investigation and charges? Note, too, that it could be done on the cheap, though the staff woudl complain because they don't like losing. Filing and then using minimal resources has a significant chance of winning, unlike not filing at all. In fact, couldn't the IRS/Justice get volunteer lawyers with zero experience to prosecute slam-dunk cases like these? If they win, great; if they lose, no harm done, and the bad guy at least had to pay legal fees and maybe stay in jail until trial.

Posted by: Eric Rasmusen | Jan 15, 2018 7:19:42 AM

The reason Congress doesn't want to give the IRS more money for enforcement is it does not want to hurt it contributors. These people don't care that it costing America millions if not billions of dollars. Too bad there aren't criminal laws to be enforced against a Congress who will not act.

Posted by: Sid | Jan 15, 2018 10:07:50 PM

@Eric, The IRS cannot file criminal charges. When a Revenue Agent (RA) is conducting an audit, the RA must refer the matter to the IRS Office of Criminal Investigation (CI) when the RA has a "firm indication of fraud." At that point, a Special Agent (SA) in CI takes over the case and the RA must stop work on the civil audit. The SA investigates and makes a decision about whether the criminal case is worth pursuing.

If the SA concludes that a criminal case is worth pursuing, the IRS cannot just file criminal charges. That’s the DOJ’s role. The SA must make a referral to DOJ. DOJ might or might not accept the referral. Much depends on the facts of the case and the factors that you refer to. But, as you intuit, it is neither easy nor cheap to bring criminal charges.

If the SA concludes the criminal case is not worth the effort, he or she sends the case back to the RA who completes the civil audit. I suspect that is what happened in Mr. Ankenberg's case.

Posted by: Bryan Camp | Jan 18, 2018 4:10:08 PM