6694 cannot rely on client data

TRAPS IN RELIANCE ON CLIENT DATA

§1.6694-1 (e) Verification of information furnished by taxpayer

§1.6694-1 (e)(1) In general . For purposes of sections 6694(a) and (b) ‘reasonable cause and good faith under §1.6694-2(e));

The tax return preparer generally may rely in good faith without verification upon information furnished by the taxpayer and upon information and advice furnished by another advisor, another tax return preparer or other party (including another advisor or tax return preparer at the tax return preparer's firm).

The tax return preparer is not required to audit, examine or review books and records, business operations, documents, or other evidence to verify information provided by the taxpayer, advisor, other tax return preparer, or other party.

The tax return preparer, however, may not ignore the implications of information furnished to the tax return preparer or actually known by the tax return preparer. The tax return preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. Additionally, some provisions of the Code or regulations require that specific facts and circumstances exist (for example, that the taxpayer maintain specific documents) before a deduction or credit may be claimed. The tax return preparer must make appropriate inquiries to determine the existence of facts and circumstances required by a Code section or regulation as a condition of the claiming of a deduction or credit.

COMMENT: Vagueness of terms: implications – must make reasonable inquiries –must make appropriate inquiries – facts and circumstances -
Subjective terms: actually known – good faith

The exceptions to the "reliance on client data" are so large that it would be relatively easy for the IRS to impose section 6694(b) penalties on an allegation that the tax return preparer did not make reasonable inquiries.

Also the mandatory "must" word in this regulation leaved no doubt that if there is a statutory notice requirement of a regulation substantiation requirement is not being filed, I see no possibility of escapint the 6694(a) penalty. It is my opinion that the IRS examiner will go for the 6694(b) penalty because failure to follow a regulation is easily within the "reckless" term under 6694(b).

new risk for overseas investments

White House Press Release—Remarks by the President on International Tax Policy Reform, (May. 5, 2009)
2009ARD 087-4
Obama administration: Tax havens: International tax reform
THE WHITE HOUSE
Office of the Press Secretary
For Immediate Release
May 4, 2009
REMARKS BY THE PRESIDENT ON INTERNATIONAL TAX POLICY REFORM
Grand Foyer
11:39 A.M. EDT
THE PRESIDENT: All right. Good morning, everybody. Hope you all had a good weekend.
Let's begin with a simple premise: Nobody likes paying taxes, particularly in times of economic stress. But most Americans meet their responsibilities because they understand that it's an obligation of citizenship, necessary to pay the costs of our common defense and our mutual well-being.
And yet, even as most American citizens and businesses meet these responsibilities, there are others who are shirking theirs. And many are aided and abetted by a broken tax system, written by well-connected lobbyists on behalf of well-heeled interests and individuals. It's a tax code full of corporate loopholes that makes it perfectly legal for companies to avoid paying their fair share. It's a tax code that makes it all too easy for a number—a small number of individuals and companies to abuse overseas tax havens to avoid paying any taxes at all. And it's a tax code that says you should pay lower taxes if you create a job in Bangalore, India, than if you create one in Buffalo, New York.
Now, understand, one of the strengths of our economy is the global reach of our businesses. And I want to see our companies remain the most competitive in the world. But the way to make sure that happens is not to reward our companies for moving jobs off our shores or transferring profits to overseas tax havens. This is something that I talked about again and again during the course of the campaign. The way we make our businesses competitive is not to reward American companies operating overseas with a roughly 2 percent tax rate on foreign profits; a rate that costs—that costs taxpayers tens of billions of dollars a year. The way to make American businesses competitive is not to let some citizens and businesses dodge their responsibilities while ordinary Americans pick up the slack.
Unfortunately, that's exactly what we're doing. These problems have been highlighted by Chairmen Charlie Rangel and Max Baucus, by leaders like Senator Carl Levin and Congressman Lloyd Doggett. And now is the time to finally do something about them. And that's why today, I'm announcing a set of proposals to crack down on illegal overseas tax evasion, close loopholes, and make it more profitable for companies to create jobs here in the United States.
For years, we've talked about ending tax breaks for companies that ship jobs overseas and giving tax breaks to companies that create jobs here in America. That's what our budget will finally do. We will stop letting American companies that create jobs overseas take deductions on their expenses when they do not pay any American taxes on their profits. And we will use the savings to give tax cuts to companies that are investing in research and development here at home so that we can jumpstart job creation, foster innovation, and enhance America's competitiveness.
For years, we've talked about shutting down overseas tax havens that let companies set up operations to avoid paying taxes in America. That's what our budget will finally do. On the campaign, I used to talk about the outrage of a building in the Cayman Islands that had over 12,000 business—businesses claim this building as their headquarters. And I've said before, either this is the largest building in the world or the largest tax scam in the world.
And I think the American people know which it is. It's the kind of tax scam that we need to end. That's why we are closing one of our biggest tax loopholes. It's a loophole that lets subsidiaries of some of our largest companies tell the IRS that they're paying taxes abroad, tell foreign governments that they're paying taxes elsewhere—and avoid paying taxes anywhere. And closing this single loophole will save taxpayers tens of billions of dollars—money that can be spent on reinvesting in America—and it will restore fairness to our tax code by helping ensure that all our citizens and all our companies are paying what they should.
Now, for years, we've talked about stopping Americans from illegally hiding their money overseas, and getting tough with the financial institutions that let them get away with it. The Treasury Department and the IRS, under Secretary Geithner's leadership and Commissioner Shulman's, are already taking far-reaching steps to catch overseas tax cheats—but they need more support.
And that's why I'm asking Congress to pass some commonsense measures. One of these measures would let the IRS know how much income Americans are generating in overseas accounts by requiring overseas banks to provide 1099s for their American clients, just like Americans have to do for their bank accounts here in this country. If financial institutions won't cooperate with us, we will assume that they are sheltering money in tax havens, and act accordingly. And to ensure that the IRS has the tools it needs to enforce our laws, we're seeking to hire nearly 800 more IRS agents to detect and pursue American tax evaders abroad.
So all in all, these and other reforms will save American taxpayers $210 billion over the next 10 years—savings we can use to reduce the deficit, cut taxes for American businesses that are playing by the rules, and provide meaningful relief for hardworking families. That's what we're doing. We're putting a middle class tax cut in the pockets of 95 percent of working families, and we're providing a $2,500 annual tax credit to put the dream of a college degree or advanced training within the reach for more students. We're providing a tax credit worth up to $8,000 for first-time home buyers to help more Americans own a piece of the American Dream and to strengthen the housing market.
So the steps I am announcing today will help us deal with some of the most egregious examples of what's wrong with our tax code and will help us strengthen some of these other efforts. It's a down payment on the larger tax reform we need to make our tax system simpler and fairer and more efficient for individuals and corporations.
Now, it will take time to undo the damage of distorted provisions that were slipped into our tax code by lobbyists and special interests, but with the steps I'm announcing today we are beginning to crack down on Americans who are bending or breaking the rules, and we're helping to ensure that all Americans are contributing their fair share.
In other words, we're beginning to restore fairness and balance to our tax code. That's what I promised I would do during the campaign, that's what I'm committed to doing as President, and that is what I will work with members of my administration and members of Congress to accomplish in the months and years to come.
Thanks very much, guys.


White House Press Release—Leveling The Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas, (May. 5, 2009)
2009ARD 087-1
Obama administration: Tax havens: International tax reform
Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives For Shifting Jobs Overseas
There is no higher economic priority for President Obama than creating new, well-paying jobs in the United States. Yet today, our tax code actually provides a competitive advantage to companies that invest and create jobs overseas compared to those that invest and create those same jobs in the U.S. In addition, our tax system is rife with opportunities to evade and avoid taxes through offshore tax havens:
• ○ In 2004, the most recent year for which data is available, U.S. multinational corporations paid about $16 billion of U.S. tax on approximately $700 billion of foreign active earnings - an effective U.S. tax rate of about 2.3%.
• ○ A January 2009 GAO report found that of the 100 largest U.S. corporations, 83 have subsidiaries in tax havens.
• ○ In the Cayman Islands, one address alone houses 18,857 corporations, very few of which have a physical presence in the islands.
• ○ Nearly one-third of all foreign profits reported by U.S. corporations in 2003 came from just three small, low-tax countries: Bermuda, the Netherlands, and Ireland.
Today, President Obama and Secretary Geithner are unveiling two components of the Administration's plan to reform our international tax laws and improve their enforcement. First, they are calling for reforms to ensure that our tax code does not stack the deck against job creation here on our shores. Second, they seek to reduce the amount of taxes lost to tax havens - either through unintended loopholes that allow companies to legally avoid paying billions in taxes, or through the illegal use of hidden accounts by well-off individuals. Combined with further international tax reforms that will be unveiled in the Administration's full budget later in May, these initiatives would raise $210 billion over the next 10 years. The Obama Administration hopes to build on proposals by Senate Finance Committee Chairman Max Baucus and House Ways and Means Chairman Charles Rangel - as well as other leaders on this issue like Senator Carl Levin and Congressman Lloyd Doggett - to pass bipartisan legislation over the coming months.
1. Replacing Tax Advantages for Creating Jobs Overseas With Incentives to Create Them at Home: The Administration would raise $103.1 billion by removing tax advantages for investing overseas, and would use a portion of those resources to make permanent a tax credit for investment in research and innovation within the United States.
• Reforming Deferral Rules to Curb A Tax Advantage for Investing and Reinvesting Overseas: Currently, businesses that invest overseas can take immediate deductions on their U.S. tax returns for expenses supporting their overseas investments but nevertheless “defer” paying U.S. taxes on the profits they make from those investments. As a result, U.S. taxpayer dollars are used to provide a significant tax advantage to companies who invest overseas relative to those who invest and create jobs at home. The Obama Administration would reform the rules surrounding deferral so that - with the exception of research and experimentation expenses - companies cannot receive deductions on their U.S. tax returns supporting their offshore investments until they pay taxes on their offshore profits. This provision would take effect in 2011, raising $60.1 billion from 2011 to 2019.
• Closing Foreign Tax Credit Loopholes : Current law allows U.S. businesses that pay foreign taxes on overseas profits to claim a credit against their U.S. taxes for the foreign taxes paid. Some U.S. businesses use loopholes to artificially inflate or accelerate these credits. The Administration would close these loopholes, raising $43.0 billion from 2011 to 2019.
• Using Savings from Ending Unfair Overseas Tax Breaks to Permanently Extend the Research and Experimentation Tax Credit for Investment in the United States: The Research and Experimentation Tax Credit - which provides an incentive for businesses to invest in innovation in the United States - is currently set to expire at the end of 2009. To provide businesses with the certainty they need to make long-term investments in research and innovation, the Administration proposes making the R&E tax credit permanent, providing a tax cut of $74.5 billion over 10 years to businesses that invest in the United States.
2. Getting Tough on Overseas Tax Havens: The Administration's proposal would raise a total of $95.2 billion over the next 10 years through efforts to get tough on overseas tax havens by:
• Eliminating Loopholes for “Disappearing” Offshore Subsidiaries : Traditionally, U.S. companies have been required to report certain income shifted from one foreign subsidiary to another as passive income subject to U.S. tax. But over the past decade, so-called “check-the-box” rules have allowed companies to make their foreign subsidiaries “disappear” for tax purposes - permitting them to legally shift income to tax havens and make the taxes they owe the United States disappear as well. The Obama administration proposes to reform these rules to require certain foreign subsidiaries to be considered as separate corporations for U.S. tax purposes. This provision would take effect in 2011, raising $86.5 billion from 2011 to 2019.
• Cracking Down on the Abuse of Tax Havens by Individuals: Currently, wealthy Americans can evade paying taxes by hiding their money in offshore accounts with little fear that either the financial institution or the country that houses their money will report them to the IRS. In addition to initiatives taken within the G-20 to impose sanctions on countries judged by their peers not to be adequately implementing information exchange standards, the Obama Administration proposes a comprehensive package of disclosure and enforcement measures to make it more difficult for financial institutions and wealthy individuals to evade taxes. The Administration conservatively estimates this package would raise $8.7 billion over 10 years by:
o ○ Withholding Taxes From Accounts At Institutions That Don't Share Information With The United States: This proposal requires foreign financial institutions that have dealings with the United States to sign an agreement with the IRS to become a “Qualified Intermediary” and share as much information about their U.S. customers as U.S. financial institutions do, or else face the presumption that they may be facilitating tax evasion and have taxes withheld on payments to their customers. In addition, it would shut down loopholes that allow QIs to claim they are complying with the law even as they help wealthy U.S. citizens avoid paying their fair share of taxes.
o ○ Shifting the Burden of Proof and Increasing Penalties for Well-Off Individuals Who Seek to Abuse Tax Havens: In addition, the Obama Administration proposes tightening the reporting standards for overseas investments, increasing penalties and imposing negative presumptions on individuals who fail to report foreign accounts, and extending the statute of limitations for enforcement.
• Devoting New Resources for IRS Enforcement to Help Close the International Tax Gap: As part of the Obama Administration's budget, the IRS will hire nearly 800 new employees devoted to international enforcement, increasing its ability to crack down on offshore tax avoidance.
Leveling the Playing Field: Removing Tax Incentives For Moving Jobs Overseas and Curbing Tax Havens
Backgrounder
I. Replacing Tax Advantages to Create Jobs Overseas with Incentives to Create Jobs at Home
As the first plank of its international tax reform package, the Obama Administration intends to repeal the ability of American companies to take deductions against their U.S. taxable income for expenses supporting profits in low-tax jurisdictions on which they defer paying taxes on for years and perhaps indefinitely. Combined with closing loopholes in the foreign tax credit program, the revenues saved will be used to make permanent the tax credit for research and experimentation in the United States. This will be accomplished through:
1. Reforming Deferral Rules to Curb A Tax Advantage for Investing and Reinvesting Overseas
Current Law
• Companies Can Defer Paying Taxes on Overseas Profits Until Later, While Taking Tax Deductions on Their Foreign Expenses Now : Currently, a company that invests in America has to pay immediate U.S. taxes on its profits from that investment. But if the company instead invests and creates jobs overseas through a foreign subsidiary, it does not have to pay U.S. taxes on its overseas profits until those profits are brought back to the United States, if they ever are. Yet even though companies do not have to pay U.S. taxes on their overseas profits today, they still get to take deductions today on their U.S. tax returns for all of the expenses that support their overseas investment.
• Deferral Rules Use U.S. Taxpayer Dollars to Create A Tax Advantage for Companies That Invest Abroad: As a result, this preferential treatment uses U.S. taxpayer dollars to provide companies with an incentive to invest overseas, giving them a tax advantage over competitors who make the same investments to create jobs in the United States.
Example Under Current Law:
• Suppose that two U.S. companies decided to borrow to invest in a new factory. Company A invests that money to build its plant in the U.S., while Company B invests overseas in a jurisdiction with a tax rate of only 10 percent.
• Company A will be able to deduct its interest expense, reducing its overall U.S. tax liability by 35 cents for every dollar it pays in interest. But it will also pay a 35 percent tax rate on its corporate profits.
• Company B will also be able to deduct its interest expense from its U.S. tax liabilities at a 35 percent rate. But it will only face a tax of 10 percent on its profits.
• Thus, our current tax code uses U.S. taxpayer dollars to put companies that invest in the United States at a competitive advantage with companies who invest overseas.
The Administration's Proposal
• Level the Playing Field: The Administration's commonsense proposal, similar to an earlier measure proposed by House Ways and Means Chairman Charles Rangel, would level the playing field by requiring a company to defer any deductions - such as for interest expenses associated with untaxed overseas investment - until the company repatriates its earnings back home. In other words, companies would only be able to take a deduction on their U.S. taxes for foreign expenses when they also pay taxes on their foreign profits in the United States. This proposal makes an exception for deductions for research and experimentation because of the positive spillover impacts of those investments on the U.S. economy.
• Raise $60.1 Billion From 2011 to 2019: This proposal goes into effect in 2011, and would raise $60.1 billion between 2011 and 2019.
2. Closing Foreign Tax Credit Loopholes
Current Law
• Companies Can Take Advantage Of Foreign Tax Credit Loopholes: When a U.S. taxpayer has overseas income, taxes paid to the foreign jurisdiction can generally be credited against U.S. tax liabilities. In general, this “foreign tax credit” is available only for taxes paid on income that is taxable in the U.S. The intended result is that U.S. taxpayers with overseas income should pay no more tax on their U.S. taxable income than they would if it was all from U.S. sources. However, current rules and tax planning strategies make it possible to claim foreign tax credits for taxes paid on foreign income that is not subject to current U.S. tax. As a result, companies are able to use such credits to pay less tax on their U.S. taxable income than they would if it was all from U.S. sources - providing them with a competitive advantage over companies that invest in the United States.
The Administration's Proposal
• Reform the Foreign Tax Credit to Remove Unfair Tax Advantages for Overseas Investment: The Administration's proposal would take two steps to rein in foreign tax credit schemes. First, a taxpayer's foreign tax credit would be determined based on the amount of total foreign tax the taxpayer actually pays on its total foreign earnings. Second, a foreign tax credit would no longer be allowed for foreign taxes paid on income not subject to U.S. tax. These reforms would go into effect in 2011, raising $43.0 billion from 2011 to 2019.
3. Making R&E Tax Credit Permanent to Encourage Investment in Innovation in the United States: The resources saved by curbing tax incentives for jobs overseas and limiting losses to tax havens would be used to strengthen incentives to invest in jobs in the United States by making permanent the R&E tax credit.
Current Law
• R&E Credit Is Set to Expire At End of 2009 : Under current law, companies are eligible for a tax credit equal to 20 percent of qualified research expenses above a base amount. But the research and experimentation tax credit has never been made permanent - instead, it has been extended on a temporary basis 13 times since it was first created in 1981 - and is set to expire on December 31, 2009.
How It Works
• Through the research and experimentation tax credit, companies receive a credit valued at 20 percent of qualified research expenses in the United States above a base amount. Taxpayers can also elect to take an alternative simplified research credit that provides an incentive for increasing research expenses above the level of the previous three years. Taxpayers may also take a credit based on spending on basic research and certain energy research.
• Any uncertainty about whether the R&E credit will be extended reduces its effectiveness in stimulating investments in new innovation, as it becomes more difficult for taxpayers to factor the credit into decisions to invest in research projects that will not be initiated or completed prior to the credit's expiration.
The Administration's Proposal
• Create Certainty to Encourage New Investment and Innovation at Home By Making the Research and Experimentation Tax Credit Permanent: To give companies the certainty they need to make long-term research and experimentation investment in the U.S., the Administration's budget includes the full cost of making the R&E credit permanent in future years. By making this tax credit permanent, businesses would be provided with the greater confidence they need to initiate new research projects that will improve productivity, raise standards of living, and increase our competitiveness. And with over 75 percent of credit dollars attributed to wages, the credit would provide an important incentive for businesses to create new jobs.
• Paid For With Provisions That Make the Tax Code More Efficient and Fair: This change would cost $74.5 billion over 10 years, which will be paid for by reforming the treatment of deferred income and the use of the foreign tax credit.
II. Getting Tough on Overseas Tax Havens
Some countries make it easy for U.S. taxpayers to evade or avoid U.S. taxes by withholding information about U.S.-held accounts or giving favorable tax treatment to shell corporations created just to avoid taxes. In certain cases, companies are taking advantage of currently legal loopholes to avoid paying taxes by shifting their profits to tax havens. In other cases, Americans break the law by hiding their income in hidden overseas accounts, and these tax havens refuse to provide the information the IRS needs to enforce U.S. law. Either way, these tax havens make our tax system less fair and harm the U.S. economy. President Obama proposes to address tax havens by:
1. Eliminating Loopholes that Allow “Disappearing” Offshore Subsidiaries: Current law allows U.S. businesses to establish foreign subsidiary corporations, but then to “check a box” to pretend that the subsidiaries do not exist for U.S. tax purposes. This practice allows taxes that would otherwise be paid in the U.S. on passive income to be avoided, at great cost to U.S. taxpayers.
Current Law
• Disappearing Subsidiaries Allow Corporations to Shift Income Tax-Free: Traditionally, if a U.S. company sets up a foreign subsidiary in a tax haven and one in another country, income shifted between the two subsidiaries (for example, through interest on loans) would be considered “passive income” for the U.S. company and subject to U.S. tax. Over the last decade, so-called “check-the box” rules have allowed U.S. firms to make these subsidiaries disappear for U.S. tax purposes. With the separate subsidiaries disregarded, the firm can shift income among them without reporting any passive income or paying any U.S. tax. As a result, U.S. firms that invest overseas are able to shift their income to tax havens. It is clear that this loophole, while legal, has become a reason to shift billions of dollars in investments from the U.S. to other counties.
Example under Current Law
• Suppose that a U.S. company invests $10 million to build a new factory in Germany. At the same time, it sets up three new corporations. The first is a wholly owned Cayman Islands holding company. The second is a corporation in Germany, which is owned by the holding company and owns the factory. The third is a Cayman Islands subsidiary, also owned by the Cayman Islands holding company.
• The Cayman subsidiary makes a loan to the German subsidiary. The interest on the loan is income to the Cayman subsidiary and a deductible expense for the German subsidiary. In this way, income is shifted from higher-tax Germany to the no-tax Cayman Islands.
• Under traditional U.S. tax law, this income shift would count as passive income for the U.S. parent - which would have to pay taxes on it. But “check the box” rules allow the firm to make the two subsidiaries disappear — and the income shift with them. As a result, the firm is able to avoid both U.S. taxes and German taxes on its profits.
The Administration's Proposal
• Require U.S. Businesses That Establish Certain Foreign Corporations To Treat Them As Corporations For U.S. Tax Purposes: The Administration's proposal seeks to abolish a range of tax-avoidance techniques by requiring U.S. businesses that establish certain corporations overseas to report them as corporations on their U.S. tax returns. As a result, U.S. firms that invest overseas would no longer be able to make their subsidiaries — or their income shifts to tax havens — disappear for tax purposes. This would level the playing field between firms that invest overseas and those that invest at home.
• Raise $86.5 Billion from 2011 to 2019: This loophole would be closed beginning in 2011, raising $86.5 billion from 2011 to 2019.
2. Cracking Down on the Abuse of Tax Havens by Individuals: The IRS is already engaged in significant efforts to track down and collect taxes from individuals illegally hiding income overseas. But to fully follow through on this effort, it will need new legal authorities. Current law makes it difficult for the IRS to collect the information it needs to determine that the holder of a foreign bank account is a U.S. citizen evading taxation. The Obama administration proposes changes that will enhance information reporting, increase tax withholding, strengthen penalties, and shift the burden of proof to make it harder for foreign account-holders to evade U.S. taxes, while also providing the enforcement tools necessary to crack down on tax haven abuse.
Current Law
• A Free Ride for Financial Institutions that Flout Reporting Rules: A centerpiece of the current U.S. regime to combat international tax evasion is the Qualified Intermediary (QI) program, under which financial institutions sign an agreement to share information about their U.S. customers with the IRS. Unfortunately, this regime, while effective, has become subject to abuse:
o ○ At Non-Qualifying Institutions, Withholding Requirements Are Easy to Escape: Currently, an investor can escape withholding requirements by simply attesting to being a non-U.S. person. That leaves it to the IRS to show that the investor is actually a U.S. citizen evading the law.
o ○ Loopholes Allow Qualifying Institutions to Still Serve as Conduits for Evasion: Moreover, financial institutions can qualify as QIs even if they are affiliated with non-QIs. As a result, a financial institution need not give up its business as a conduit for tax evasion in order to enjoy the benefits of being a QI. In addition, QIs are not currently required to report the foreign income of their U.S. customers, so U.S. customers may hide behind foreign entities to evade taxes through QIs.
o ○ Legal Presumptions Favor Tax Evaders Who Conceal Transactions: U.S. investors overseas are required to file the Foreign Bank and Financial Account Report, or FBAR, disclosing ownership of financial accounts in a foreign country containing over $10,000. The FBAR is particularly important in the case of investors who employ non-QIs, because their transactions are less likely to be disclosed otherwise. Unfortunately, current rules make it difficult to catch those who are supposed to file the FBAR but do not. And even when the IRS has evidence that a U.S. taxpayer has a foreign account, legal presumptions currently favor the tax evader — without specific evidence that the U.S person has an account that requires an FBAR, the IRS cannot compel an investor to provide the report or impose penalties for the failure to do so. This specific evidence may be almost impossible for the IRS to get.
• The IRS Lacks the Tools It Needs to Enforce International Tax Laws: In addition to the shortcomings of the QI program, current law features inadequate tools to crack down on wealthy taxpayers who evade taxation. Investors who withhold information about overseas investments face penalties limited to 20 percent of the amount of the understatement. The statute of limitations for enforcement is typically only three years - which is often too short a time period for the IRS to get the information it needs to determine whether a taxpayer with an offshore account paid the right amount of tax. And there are no requirements that U.S. individuals or third parties report transfers to and from foreign accounts, limiting the ability of the IRS to determine whether taxpayers are paying what they owe.
Example Under Current Law
• Through a U.S. broker, a U.S. account-holder at a non-qualified intermediary sells $50 million worth of securities.
• If the seller self-certifies that he is not a U.S. citizen and the non-qualified intermediary simply passes that information along to the U.S. broker, the broker may rely on that statement and does not need to withhold money from the transaction.
• As a result, a U.S. taxpayer who provides a false self-certification can easily avoid paying taxes, since the non-QI has not signed an agreement with the IRS, and the IRS may have limited tools to detect any wrongdoing.
Proposal
In addition to initiatives taken within the G-20 to impose sanctions on countries judged by their peers not to be adequately implementing information exchange standards, the Obama administration proposes to make it more difficult to shelter foreign investments from taxation by cracking down on financial institutions that enable and profit from international tax evasion. These measures - expected to raise $8.7 billion over 10 years - would:
• Strengthen the “Qualified Intermediary” System to Crack Down on Tax Evaders: The core of the Obama Administration's proposals is a tough new stance on investors who use financial institutions that do not agree to be Qualifying Intermediaries. Under this proposal, the assumption will be that these institutions are facilitating tax evasion, and the burden of proof will be shifted to the institutions and their account-holders to prove they are not sheltering income from U.S. taxation. As a result, the Administration proposes to:
o Impose Significant Tax Withholding On Transactions Involving Non-Qualifying Intermediaries: The Administration's plan would require U.S. financial institutions to withhold 20 percent to 30 percent of U.S. payments to individuals who use non-QIs. To get a refund for the amount withheld, investors must disclose their identities and demonstrate that they're obeying the law.
o Create A Legal Presumption Against Users Of Non-Qualifying Intermediaries: The Administration's plan would create rebuttable evidentiary presumptions that any foreign bank, brokerage, or other financial account held by a U.S. citizen at a non-QI contains enough funds to require that an FBAR be filed, and that any failure to file an FBAR is willful if an account at a non-QI has a balance of greater than $200,000 at any point during the calendar year. These presumptions will make it easier for the IRS to demand information and pursue cases against international tax evaders. This shifting of legal presumptions is a key component of the anti-tax haven legislation long championed by Senator Carl Levin.
o Limit QI Affiliations With Non-QIs: The Administration's plan would give the Treasury Department authority to issue regulations requiring that a financial institution may be a QI only if all commonly-controlled financial institutions are also QIs. As a result, financial firms couldn't benefit from siphoning business from their legitimate QI operations to illegitimate non-QI affiliates.
• Provide the IRS With The Legal Tools Necessary to Prosecute International Tax Evasion : The Obama administration proposes to improve the ability of the IRS to successfully prosecute international tax evasion through the following steps:
o Increase Penalties for Failing to Report Overseas Investments : The Administration's plan would double certain penalties when a taxpayer fails to make a required disclosure of foreign financial accounts.
o Extend the Statute of Limitations for International Tax Enforcement: The Administration's plan would set the statute of limitations on international tax enforcement at six years after the taxpayer submits required information.
o Tighten Lax Reporting Requirements : The Administration's plan would increase the reporting requirement on international investors and financial institutions, especially QIs. QIs would be required to report information on their U.S. customers to the same extent that U.S. financial intermediaries must. And U.S. customers at QIs would no longer be allowed to hide behind foreign entities. U.S. investors would be required to report transfers of money or property made to or from non-QI foreign financial institutions on their income tax returns. Financial institutions would face enhanced information reporting requirements for transactions that establish a foreign business entity or transfer assets to and from foreign financial accounts on behalf of U.S. individuals.
3. Hire Nearly 800 New IRS Staff to Increase International Enforcement: As part of the President's budget, the IRS would be provided with funds to support the hiring of nearly 800 new employees devoted specifically to international enforcement. The funding would allow the IRS to hire new agents, economists, lawyers and specialists, increasing the IRS' ability to crack down on offshore tax avoidance and evasion, including through transfer pricing and financial products and transactions such as purported securities loans. According to estimates by the IRS, every additional dollar invested in enforcement in recent years has yielded about four dollars in added tax revenues.
White House Press Release—Leveling The Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas, (May. 5, 2009)
2009ARD 087-1
Obama administration: Tax havens: International tax reform
Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives For Shifting Jobs Overseas
There is no higher economic priority for President Obama than creating new, well-paying jobs in the United States. Yet today, our tax code actually provides a competitive advantage to companies that invest and create jobs overseas compared to those that invest and create those same jobs in the U.S. In addition, our tax system is rife with opportunities to evade and avoid taxes through offshore tax havens:
• ○ In 2004, the most recent year for which data is available, U.S. multinational corporations paid about $16 billion of U.S. tax on approximately $700 billion of foreign active earnings - an effective U.S. tax rate of about 2.3%.
• ○ A January 2009 GAO report found that of the 100 largest U.S. corporations, 83 have subsidiaries in tax havens.
• ○ In the Cayman Islands, one address alone houses 18,857 corporations, very few of which have a physical presence in the islands.
• ○ Nearly one-third of all foreign profits reported by U.S. corporations in 2003 came from just three small, low-tax countries: Bermuda, the Netherlands, and Ireland.
Today, President Obama and Secretary Geithner are unveiling two components of the Administration's plan to reform our international tax laws and improve their enforcement. First, they are calling for reforms to ensure that our tax code does not stack the deck against job creation here on our shores. Second, they seek to reduce the amount of taxes lost to tax havens - either through unintended loopholes that allow companies to legally avoid paying billions in taxes, or through the illegal use of hidden accounts by well-off individuals. Combined with further international tax reforms that will be unveiled in the Administration's full budget later in May, these initiatives would raise $210 billion over the next 10 years. The Obama Administration hopes to build on proposals by Senate Finance Committee Chairman Max Baucus and House Ways and Means Chairman Charles Rangel - as well as other leaders on this issue like Senator Carl Levin and Congressman Lloyd Doggett - to pass bipartisan legislation over the coming months.
1. Replacing Tax Advantages for Creating Jobs Overseas With Incentives to Create Them at Home: The Administration would raise $103.1 billion by removing tax advantages for investing overseas, and would use a portion of those resources to make permanent a tax credit for investment in research and innovation within the United States.
• Reforming Deferral Rules to Curb A Tax Advantage for Investing and Reinvesting Overseas: Currently, businesses that invest overseas can take immediate deductions on their U.S. tax returns for expenses supporting their overseas investments but nevertheless “defer” paying U.S. taxes on the profits they make from those investments. As a result, U.S. taxpayer dollars are used to provide a significant tax advantage to companies who invest overseas relative to those who invest and create jobs at home. The Obama Administration would reform the rules surrounding deferral so that - with the exception of research and experimentation expenses - companies cannot receive deductions on their U.S. tax returns supporting their offshore investments until they pay taxes on their offshore profits. This provision would take effect in 2011, raising $60.1 billion from 2011 to 2019.
• Closing Foreign Tax Credit Loopholes : Current law allows U.S. businesses that pay foreign taxes on overseas profits to claim a credit against their U.S. taxes for the foreign taxes paid. Some U.S. businesses use loopholes to artificially inflate or accelerate these credits. The Administration would close these loopholes, raising $43.0 billion from 2011 to 2019.
• Using Savings from Ending Unfair Overseas Tax Breaks to Permanently Extend the Research and Experimentation Tax Credit for Investment in the United States: The Research and Experimentation Tax Credit - which provides an incentive for businesses to invest in innovation in the United States - is currently set to expire at the end of 2009. To provide businesses with the certainty they need to make long-term investments in research and innovation, the Administration proposes making the R&E tax credit permanent, providing a tax cut of $74.5 billion over 10 years to businesses that invest in the United States.
2. Getting Tough on Overseas Tax Havens: The Administration's proposal would raise a total of $95.2 billion over the next 10 years through efforts to get tough on overseas tax havens by:
• Eliminating Loopholes for “Disappearing” Offshore Subsidiaries : Traditionally, U.S. companies have been required to report certain income shifted from one foreign subsidiary to another as passive income subject to U.S. tax. But over the past decade, so-called “check-the-box” rules have allowed companies to make their foreign subsidiaries “disappear” for tax purposes - permitting them to legally shift income to tax havens and make the taxes they owe the United States disappear as well. The Obama administration proposes to reform these rules to require certain foreign subsidiaries to be considered as separate corporations for U.S. tax purposes. This provision would take effect in 2011, raising $86.5 billion from 2011 to 2019.
• Cracking Down on the Abuse of Tax Havens by Individuals: Currently, wealthy Americans can evade paying taxes by hiding their money in offshore accounts with little fear that either the financial institution or the country that houses their money will report them to the IRS. In addition to initiatives taken within the G-20 to impose sanctions on countries judged by their peers not to be adequately implementing information exchange standards, the Obama Administration proposes a comprehensive package of disclosure and enforcement measures to make it more difficult for financial institutions and wealthy individuals to evade taxes. The Administration conservatively estimates this package would raise $8.7 billion over 10 years by:
o ○ Withholding Taxes From Accounts At Institutions That Don't Share Information With The United States: This proposal requires foreign financial institutions that have dealings with the United States to sign an agreement with the IRS to become a “Qualified Intermediary” and share as much information about their U.S. customers as U.S. financial institutions do, or else face the presumption that they may be facilitating tax evasion and have taxes withheld on payments to their customers. In addition, it would shut down loopholes that allow QIs to claim they are complying with the law even as they help wealthy U.S. citizens avoid paying their fair share of taxes.
o ○ Shifting the Burden of Proof and Increasing Penalties for Well-Off Individuals Who Seek to Abuse Tax Havens: In addition, the Obama Administration proposes tightening the reporting standards for overseas investments, increasing penalties and imposing negative presumptions on individuals who fail to report foreign accounts, and extending the statute of limitations for enforcement.
• Devoting New Resources for IRS Enforcement to Help Close the International Tax Gap: As part of the Obama Administration's budget, the IRS will hire nearly 800 new employees devoted to international enforcement, increasing its ability to crack down on offshore tax avoidance.
Leveling the Playing Field: Removing Tax Incentives For Moving Jobs Overseas and Curbing Tax Havens
Backgrounder
I. Replacing Tax Advantages to Create Jobs Overseas with Incentives to Create Jobs at Home
As the first plank of its international tax reform package, the Obama Administration intends to repeal the ability of American companies to take deductions against their U.S. taxable income for expenses supporting profits in low-tax jurisdictions on which they defer paying taxes on for years and perhaps indefinitely. Combined with closing loopholes in the foreign tax credit program, the revenues saved will be used to make permanent the tax credit for research and experimentation in the United States. This will be accomplished through:
1. Reforming Deferral Rules to Curb A Tax Advantage for Investing and Reinvesting Overseas
Current Law
• Companies Can Defer Paying Taxes on Overseas Profits Until Later, While Taking Tax Deductions on Their Foreign Expenses Now : Currently, a company that invests in America has to pay immediate U.S. taxes on its profits from that investment. But if the company instead invests and creates jobs overseas through a foreign subsidiary, it does not have to pay U.S. taxes on its overseas profits until those profits are brought back to the United States, if they ever are. Yet even though companies do not have to pay U.S. taxes on their overseas profits today, they still get to take deductions today on their U.S. tax returns for all of the expenses that support their overseas investment.
• Deferral Rules Use U.S. Taxpayer Dollars to Create A Tax Advantage for Companies That Invest Abroad: As a result, this preferential treatment uses U.S. taxpayer dollars to provide companies with an incentive to invest overseas, giving them a tax advantage over competitors who make the same investments to create jobs in the United States.
Example Under Current Law:
• Suppose that two U.S. companies decided to borrow to invest in a new factory. Company A invests that money to build its plant in the U.S., while Company B invests overseas in a jurisdiction with a tax rate of only 10 percent.
• Company A will be able to deduct its interest expense, reducing its overall U.S. tax liability by 35 cents for every dollar it pays in interest. But it will also pay a 35 percent tax rate on its corporate profits.
• Company B will also be able to deduct its interest expense from its U.S. tax liabilities at a 35 percent rate. But it will only face a tax of 10 percent on its profits.
• Thus, our current tax code uses U.S. taxpayer dollars to put companies that invest in the United States at a competitive advantage with companies who invest overseas.
The Administration's Proposal
• Level the Playing Field: The Administration's commonsense proposal, similar to an earlier measure proposed by House Ways and Means Chairman Charles Rangel, would level the playing field by requiring a company to defer any deductions - such as for interest expenses associated with untaxed overseas investment - until the company repatriates its earnings back home. In other words, companies would only be able to take a deduction on their U.S. taxes for foreign expenses when they also pay taxes on their foreign profits in the United States. This proposal makes an exception for deductions for research and experimentation because of the positive spillover impacts of those investments on the U.S. economy.
• Raise $60.1 Billion From 2011 to 2019: This proposal goes into effect in 2011, and would raise $60.1 billion between 2011 and 2019.
2. Closing Foreign Tax Credit Loopholes
Current Law
• Companies Can Take Advantage Of Foreign Tax Credit Loopholes: When a U.S. taxpayer has overseas income, taxes paid to the foreign jurisdiction can generally be credited against U.S. tax liabilities. In general, this “foreign tax credit” is available only for taxes paid on income that is taxable in the U.S. The intended result is that U.S. taxpayers with overseas income should pay no more tax on their U.S. taxable income than they would if it was all from U.S. sources. However, current rules and tax planning strategies make it possible to claim foreign tax credits for taxes paid on foreign income that is not subject to current U.S. tax. As a result, companies are able to use such credits to pay less tax on their U.S. taxable income than they would if it was all from U.S. sources - providing them with a competitive advantage over companies that invest in the United States.
The Administration's Proposal
• Reform the Foreign Tax Credit to Remove Unfair Tax Advantages for Overseas Investment: The Administration's proposal would take two steps to rein in foreign tax credit schemes. First, a taxpayer's foreign tax credit would be determined based on the amount of total foreign tax the taxpayer actually pays on its total foreign earnings. Second, a foreign tax credit would no longer be allowed for foreign taxes paid on income not subject to U.S. tax. These reforms would go into effect in 2011, raising $43.0 billion from 2011 to 2019.
3. Making R&E Tax Credit Permanent to Encourage Investment in Innovation in the United States: The resources saved by curbing tax incentives for jobs overseas and limiting losses to tax havens would be used to strengthen incentives to invest in jobs in the United States by making permanent the R&E tax credit.
Current Law
• R&E Credit Is Set to Expire At End of 2009 : Under current law, companies are eligible for a tax credit equal to 20 percent of qualified research expenses above a base amount. But the research and experimentation tax credit has never been made permanent - instead, it has been extended on a temporary basis 13 times since it was first created in 1981 - and is set to expire on December 31, 2009.
How It Works
• Through the research and experimentation tax credit, companies receive a credit valued at 20 percent of qualified research expenses in the United States above a base amount. Taxpayers can also elect to take an alternative simplified research credit that provides an incentive for increasing research expenses above the level of the previous three years. Taxpayers may also take a credit based on spending on basic research and certain energy research.
• Any uncertainty about whether the R&E credit will be extended reduces its effectiveness in stimulating investments in new innovation, as it becomes more difficult for taxpayers to factor the credit into decisions to invest in research projects that will not be initiated or completed prior to the credit's expiration.
The Administration's Proposal
• Create Certainty to Encourage New Investment and Innovation at Home By Making the Research and Experimentation Tax Credit Permanent: To give companies the certainty they need to make long-term research and experimentation investment in the U.S., the Administration's budget includes the full cost of making the R&E credit permanent in future years. By making this tax credit permanent, businesses would be provided with the greater confidence they need to initiate new research projects that will improve productivity, raise standards of living, and increase our competitiveness. And with over 75 percent of credit dollars attributed to wages, the credit would provide an important incentive for businesses to create new jobs.
• Paid For With Provisions That Make the Tax Code More Efficient and Fair: This change would cost $74.5 billion over 10 years, which will be paid for by reforming the treatment of deferred income and the use of the foreign tax credit.
II. Getting Tough on Overseas Tax Havens
Some countries make it easy for U.S. taxpayers to evade or avoid U.S. taxes by withholding information about U.S.-held accounts or giving favorable tax treatment to shell corporations created just to avoid taxes. In certain cases, companies are taking advantage of currently legal loopholes to avoid paying taxes by shifting their profits to tax havens. In other cases, Americans break the law by hiding their income in hidden overseas accounts, and these tax havens refuse to provide the information the IRS needs to enforce U.S. law. Either way, these tax havens make our tax system less fair and harm the U.S. economy. President Obama proposes to address tax havens by:
1. Eliminating Loopholes that Allow “Disappearing” Offshore Subsidiaries: Current law allows U.S. businesses to establish foreign subsidiary corporations, but then to “check a box” to pretend that the subsidiaries do not exist for U.S. tax purposes. This practice allows taxes that would otherwise be paid in the U.S. on passive income to be avoided, at great cost to U.S. taxpayers.
Current Law
• Disappearing Subsidiaries Allow Corporations to Shift Income Tax-Free: Traditionally, if a U.S. company sets up a foreign subsidiary in a tax haven and one in another country, income shifted between the two subsidiaries (for example, through interest on loans) would be considered “passive income” for the U.S. company and subject to U.S. tax. Over the last decade, so-called “check-the box” rules have allowed U.S. firms to make these subsidiaries disappear for U.S. tax purposes. With the separate subsidiaries disregarded, the firm can shift income among them without reporting any passive income or paying any U.S. tax. As a result, U.S. firms that invest overseas are able to shift their income to tax havens. It is clear that this loophole, while legal, has become a reason to shift billions of dollars in investments from the U.S. to other counties.
Example under Current Law
• Suppose that a U.S. company invests $10 million to build a new factory in Germany. At the same time, it sets up three new corporations. The first is a wholly owned Cayman Islands holding company. The second is a corporation in Germany, which is owned by the holding company and owns the factory. The third is a Cayman Islands subsidiary, also owned by the Cayman Islands holding company.
• The Cayman subsidiary makes a loan to the German subsidiary. The interest on the loan is income to the Cayman subsidiary and a deductible expense for the German subsidiary. In this way, income is shifted from higher-tax Germany to the no-tax Cayman Islands.
• Under traditional U.S. tax law, this income shift would count as passive income for the U.S. parent - which would have to pay taxes on it. But “check the box” rules allow the firm to make the two subsidiaries disappear — and the income shift with them. As a result, the firm is able to avoid both U.S. taxes and German taxes on its profits.
The Administration's Proposal
• Require U.S. Businesses That Establish Certain Foreign Corporations To Treat Them As Corporations For U.S. Tax Purposes: The Administration's proposal seeks to abolish a range of tax-avoidance techniques by requiring U.S. businesses that establish certain corporations overseas to report them as corporations on their U.S. tax returns. As a result, U.S. firms that invest overseas would no longer be able to make their subsidiaries — or their income shifts to tax havens — disappear for tax purposes. This would level the playing field between firms that invest overseas and those that invest at home.
• Raise $86.5 Billion from 2011 to 2019: This loophole would be closed beginning in 2011, raising $86.5 billion from 2011 to 2019.
2. Cracking Down on the Abuse of Tax Havens by Individuals: The IRS is already engaged in significant efforts to track down and collect taxes from individuals illegally hiding income overseas. But to fully follow through on this effort, it will need new legal authorities. Current law makes it difficult for the IRS to collect the information it needs to determine that the holder of a foreign bank account is a U.S. citizen evading taxation. The Obama administration proposes changes that will enhance information reporting, increase tax withholding, strengthen penalties, and shift the burden of proof to make it harder for foreign account-holders to evade U.S. taxes, while also providing the enforcement tools necessary to crack down on tax haven abuse.
Current Law
• A Free Ride for Financial Institutions that Flout Reporting Rules: A centerpiece of the current U.S. regime to combat international tax evasion is the Qualified Intermediary (QI) program, under which financial institutions sign an agreement to share information about their U.S. customers with the IRS. Unfortunately, this regime, while effective, has become subject to abuse:
o ○ At Non-Qualifying Institutions, Withholding Requirements Are Easy to Escape: Currently, an investor can escape withholding requirements by simply attesting to being a non-U.S. person. That leaves it to the IRS to show that the investor is actually a U.S. citizen evading the law.
o ○ Loopholes Allow Qualifying Institutions to Still Serve as Conduits for Evasion: Moreover, financial institutions can qualify as QIs even if they are affiliated with non-QIs. As a result, a financial institution need not give up its business as a conduit for tax evasion in order to enjoy the benefits of being a QI. In addition, QIs are not currently required to report the foreign income of their U.S. customers, so U.S. customers may hide behind foreign entities to evade taxes through QIs.
o ○ Legal Presumptions Favor Tax Evaders Who Conceal Transactions: U.S. investors overseas are required to file the Foreign Bank and Financial Account Report, or FBAR, disclosing ownership of financial accounts in a foreign country containing over $10,000. The FBAR is particularly important in the case of investors who employ non-QIs, because their transactions are less likely to be disclosed otherwise. Unfortunately, current rules make it difficult to catch those who are supposed to file the FBAR but do not. And even when the IRS has evidence that a U.S. taxpayer has a foreign account, legal presumptions currently favor the tax evader — without specific evidence that the U.S person has an account that requires an FBAR, the IRS cannot compel an investor to provide the report or impose penalties for the failure to do so. This specific evidence may be almost impossible for the IRS to get.
• The IRS Lacks the Tools It Needs to Enforce International Tax Laws: In addition to the shortcomings of the QI program, current law features inadequate tools to crack down on wealthy taxpayers who evade taxation. Investors who withhold information about overseas investments face penalties limited to 20 percent of the amount of the understatement. The statute of limitations for enforcement is typically only three years - which is often too short a time period for the IRS to get the information it needs to determine whether a taxpayer with an offshore account paid the right amount of tax. And there are no requirements that U.S. individuals or third parties report transfers to and from foreign accounts, limiting the ability of the IRS to determine whether taxpayers are paying what they owe.
Example Under Current Law
• Through a U.S. broker, a U.S. account-holder at a non-qualified intermediary sells $50 million worth of securities.
• If the seller self-certifies that he is not a U.S. citizen and the non-qualified intermediary simply passes that information along to the U.S. broker, the broker may rely on that statement and does not need to withhold money from the transaction.
• As a result, a U.S. taxpayer who provides a false self-certification can easily avoid paying taxes, since the non-QI has not signed an agreement with the IRS, and the IRS may have limited tools to detect any wrongdoing.
Proposal
In addition to initiatives taken within the G-20 to impose sanctions on countries judged by their peers not to be adequately implementing information exchange standards, the Obama administration proposes to make it more difficult to shelter foreign investments from taxation by cracking down on financial institutions that enable and profit from international tax evasion. These measures - expected to raise $8.7 billion over 10 years - would:
• Strengthen the “Qualified Intermediary” System to Crack Down on Tax Evaders: The core of the Obama Administration's proposals is a tough new stance on investors who use financial institutions that do not agree to be Qualifying Intermediaries. Under this proposal, the assumption will be that these institutions are facilitating tax evasion, and the burden of proof will be shifted to the institutions and their account-holders to prove they are not sheltering income from U.S. taxation. As a result, the Administration proposes to:
o Impose Significant Tax Withholding On Transactions Involving Non-Qualifying Intermediaries: The Administration's plan would require U.S. financial institutions to withhold 20 percent to 30 percent of U.S. payments to individuals who use non-QIs. To get a refund for the amount withheld, investors must disclose their identities and demonstrate that they're obeying the law.
o Create A Legal Presumption Against Users Of Non-Qualifying Intermediaries: The Administration's plan would create rebuttable evidentiary presumptions that any foreign bank, brokerage, or other financial account held by a U.S. citizen at a non-QI contains enough funds to require that an FBAR be filed, and that any failure to file an FBAR is willful if an account at a non-QI has a balance of greater than $200,000 at any point during the calendar year. These presumptions will make it easier for the IRS to demand information and pursue cases against international tax evaders. This shifting of legal presumptions is a key component of the anti-tax haven legislation long championed by Senator Carl Levin.
o Limit QI Affiliations With Non-QIs: The Administration's plan would give the Treasury Department authority to issue regulations requiring that a financial institution may be a QI only if all commonly-controlled financial institutions are also QIs. As a result, financial firms couldn't benefit from siphoning business from their legitimate QI operations to illegitimate non-QI affiliates.
• Provide the IRS With The Legal Tools Necessary to Prosecute International Tax Evasion : The Obama administration proposes to improve the ability of the IRS to successfully prosecute international tax evasion through the following steps:
o Increase Penalties for Failing to Report Overseas Investments : The Administration's plan would double certain penalties when a taxpayer fails to make a required disclosure of foreign financial accounts.
o Extend the Statute of Limitations for International Tax Enforcement: The Administration's plan would set the statute of limitations on international tax enforcement at six years after the taxpayer submits required information.
o Tighten Lax Reporting Requirements : The Administration's plan would increase the reporting requirement on international investors and financial institutions, especially QIs. QIs would be required to report information on their U.S. customers to the same extent that U.S. financial intermediaries must. And U.S. customers at QIs would no longer be allowed to hide behind foreign entities. U.S. investors would be required to report transfers of money or property made to or from non-QI foreign financial institutions on their income tax returns. Financial institutions would face enhanced information reporting requirements for transactions that establish a foreign business entity or transfer assets to and from foreign financial accounts on behalf of U.S. individuals.
3. Hire Nearly 800 New IRS Staff to Increase International Enforcement: As part of the President's budget, the IRS would be provided with funds to support the hiring of nearly 800 new employees devoted specifically to international enforcement. The funding would allow the IRS to hire new agents, economists, lawyers and specialists, increasing the IRS' ability to crack down on offshore tax avoidance and evasion, including through transfer pricing and financial products and transactions such as purported securities loans. According to estimates by the IRS, every additional dollar invested in enforcement in recent years has yielded about four dollars in added tax revenues.



Tax Day,T.1International Tax Reform Needed to Discourage Offshore Economic Activity, Treasury Official Says, (Oct. 29, 2009)
Stephen Shay, Treasury deputy assistant secretary (International Tax Affairs), said on October 28 that international tax reforms are needed because the current rules provide too much incentive for businesses to engage in economic activity offshore. Shay spoke at the American Institute of Certified Public Accountants (AICPA) Fall Tax Division meeting in Washington, D.C.
The Obama administration’s international reform proposals (TAXDAY, 2009/05/05, W.1) take a balanced approach to address these concerns, Shay said. They include two prongs: an anti-tax evasion component; and structural changes that would affect deferral, the check-the-box rules and the foreign tax credit.
The just-introduced Foreign Account Tax Compliance Bill of 2009 (Sen 1934; TAXDAY, 2009/10/28, C.1) focuses on tax evasion. Although the bill is a product of Capitol Hill, the Treasury provided assistance, and the bill is consistent with a substantial portion of the administration’s budget proposals, according to Shay. The bill, which requires foreign financial institutions to report accounts maintained on behalf of U.S. residents, would be a substantial advance over current law, Shay declared. The proposed law focuses on financial institutions, not on countries.
As an incentive for information reporting, a failure to report would trigger 30-percent withholding. There is high compliance where there is information reporting, Shay noted. He believes it is likely that the bill will pass, although he does not foresee any action on tax reform before 2010.
The bill would also repeal the laws allowing bearer bonds and would require withholding on substitute dividends paid on credit swaps, Shay said. The bill does not contain the administration’s structural proposals, such as those affecting corporate classification.
An audience member suggested that the bill’s requirement for practitioners to report information about their clients raised attorney-client privilege concerns. Shay said that the Treasury was interested in getting comments about this and other proposals. He said there is a high threshold for requiring reporting but that it will affect some organizations.
Shay noted that the offshore bank account disclosure initiative was "very successful." It called attention to a problem and got more cases into the system. He also suggested it could lead to "appropriate prosecutions," although the initiative itself promised protection from criminal prosecution. He noted that disclosures under the initiative involved a wide range of situations, some honorable, others less honorable. The initiative was very healthy for the U.S. tax system and promoted fairness by requiring others to pay their fair share of taxes.

abandonment loss case

Cannot rely on a taxpayer’s statement that there was an abandonment of property. A return preparer will have the duty to make sure that there is substantiation for the abandonment in order to avoid the 6694 penalty. 6694 was not an issue in this case but it could have been if there was a return preparer for the taxpayers in this case.
A married couple was liable for the accuracy-related penalty because the wife, as president and sole shareholder of an S corporation, failed to substantiate that she was entitled to an abandonment loss under section 165(a) that the corporation allocated to her, resulting in the taxpayers' understatement of tax. The S corporation did not maintain any books or records to substantiate the abandonment loss. It was "incredible" that the wife, who was a real estate agent, would not request written documentation with respect to the purchase of the partnership. Accordingly, she acted unreasonably and not with reasonable cause and good faith
C. and Renee M. Milton v. Commissioner., U.S. Tax Court, T.C. Memo. 2009-246, (Oct. 28, 2009), U.S. Tax Court, Dkt. No. 15875-08, TC Memo. 2009-246, October 28, 2009.

MEMORANDUM FINDINGS OF FACT AND OPINION
OPINION
We are asked to decide whether petitioners underreported the distributive share from RMI because RMI was not entitled to deduct an abandonment loss. Respondent argues that petitioner did not establish that an abandonment occurred entitling RMI to a deduction. Respondent also argues that the accuracy-related penalty should be imposed.
I. Abandonment Loss Deduction
We begin with the general rules for deducting abandonment losses. A taxpayer is entitled to deduct uncompensated losses during a given tax year. Sec. 165(a). Deductions are a matter of legislative grace, however, and the taxpayer must show that he or she is entitled to any deduction claimed. 4 Rule 142(a); Deputy v. du Pont, 308 U.S. 488, 493 (1940). This includes the burden of substantiation. Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976). The Court need not accept the taxpayer's self-serving testimony when the taxpayer fails to present corroborative evidence. Beam v. Commissioner, T.C. Memo. 1990-304 (citing Tokarski v. Commissioner, 87 T.C. 74, 77 (1986)), affd. without published opinion 956 F.2d 1166 (9th Cir. 1992).
A taxpayer must prove he or she owned the property abandoned to claim an abandonment loss deduction. JHK Enters., Inc. v. Commissioner, T.C. Memo. 2003-79. Petitioner has not proven that RMI owned the partnership interest it purported to abandon in 2005. There is no evidence that the conversations among petitioner, Mr. Purscelley, and his father resulted in RMI's owning a partnership interest in KM Welding. Petitioner has not provided an asset purchase agreement or any other document to substantiate the transaction. Petitioner even failed to substantiate that the funds were RMI's rather than hers individually. Moreover, the purported partnership interest in KM Welding was not listed as an asset on RMI's beginning-of-the-year balance sheet for 2005. We find that RMI did not own a partnership interest in KM Welding in 2005.
In addition, the taxpayer must also establish to claim an abandonment loss that he or she (1) intended to abandon the property and (2) took affirmative action to abandon the property. Citron v. Commissioner, 97 T.C. 200, 208-209 (1991). The intent to abandon and the affirmative action are to be ascertained from the facts and circumstances surrounding the abandonment. United Cal. Bank v. Commissioner, 41 T.C. 437 (1964), affd. per curiam 340 F.2d 320 (9th Cir. 1965). An abandonment occurs where the taxpayer has relinquished the asset as well as any future claims to the asset. Tsakopoulos v. Commissioner, T.C. Memo. 2002-8, affd. without published opinion 63 Fed. Appx. 400 (9th Cir. 2003). Some express manifestation of abandonment is required when the asset is an intangible property interest, such as a partnership interest. Citron v. Commissioner, supra at 209-210.
Petitioner testified that she intended to abandon her purported partnership interest in KM Welding to avoid damage to her reputation and to her business, RMI. The record does not contain any independent evidence, however, to support her alleged intent. There is no evidence, other than petitioner's self-serving testimony, that petitioner would be held liable for any debts of KM Welding. Moreover, petitioner did not provide any independent evidence of the financial health of KM Welding in 2005, the year RMI “abandoned” the partnership interest. Petitioner also did not provide evidence that KM Welding was not completing projects or timely paying its bills. In fact, KM Welding continued operations after 2005.
Furthermore, petitioner testified she decided, upon her CPA's advice, to abandon the purported partnership interest. Yet petitioner did not provide evidence of the conversations she had with her CPA. Additionally, she admitted at trial that if she received any profits from KM Welding in the future, she would report the income. Petitioner's remarks suggest that she believed there was still a possibility she would receive a return on her investment. Accordingly, we find that petitioner did not truly intend to abandon any interest in KM Welding.
Petitioner did not take any affirmative action in 2005 to abandon the purported partnership interest in KM Welding. Petitioner was unable to provide the date on which she abandoned the interest. Petitioner testified that she did not file any public document indicating that she was no longer associated with KM Welding. Additionally, there is no evidence that petitioner informed her purported partners that she was abandoning the partnership interest. We find that petitioner did not take sufficiently identifiable steps to abandon the interest in KM Welding to thereby be entitled to an abandonment loss deduction.
II. Accuracy-Related Penalty
We turn now to respondent's determination in the deficiency notice that petitioners are liable for the accuracy-related penalty under section 6662(a) and (b)(1). Respondent has the burden of production under section 7491(c) and must come forward with sufficient evidence that it is appropriate to impose the penalty. See Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001).
A taxpayer is liable for an accuracy-related penalty for any portion of an underpayment of income tax attributable to negligence or disregard of rules and regulations, unless he or she establishes that there was reasonable cause for the underpayment and that he or she acted in good faith. Secs. 6662(a) and (b)(1), 6664(c)(1). Negligence is defined as any failure to make a reasonable attempt to comply with the provisions of the Code and includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs.
RMI did not maintain any books or records to substantiate the abandonment loss claimed on RMI's return for 2005. We find it incredible that petitioner, who is in the business of entering into contracts, would not request written documentation of the KM Welding transaction. Furthermore, uncorroborated self-serving testimony was the only evidence petitioner presented regarding the abandonment of the purported partnership interest in KM Welding. We find that petitioners acted negligently in failing to substantiate the abandonment loss, and respondent has met his burden of production.
Notwithstanding that petitioners were negligent, they may avoid the imposition of a penalty if they are able to show that there was a reasonable cause for, and that they acted in good faith with respect to, the underpayment. See sec. 6664(c). The determination of whether the taxpayer acted with reasonable cause and in good faith is made by taking into account all the pertinent facts and circumstances. See sec. 1.6664-4(b)(1), Income Tax Regs.
Petitioner testified that she abandoned the KM Welding partnership interest and claimed a loss deduction for 2005 on the advice of her CPA. We do not even have the name of her CPA, nor do we know what information petitioner provided to the CPA. Petitioner failed to give us adequate evidence that she acted in good-faith reliance. Accordingly, we hold that petitioners are liable for the accuracy-related penalty under section 6662(a) and (b)(1) for 2005.
In reaching our holding, we have considered all arguments made, and, to the extent not mentioned, we conclude that they are moot, irrelevant, or without merit.
To reflect the foregoing and the concessions of the parties,
Decision will be entered under Rule 155.

Footnotes


1
All section references are to the Internal Revenue Code in effect for the year at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.
2
Petitioner conceded Renee Milton, Inc. had $4,488.50 of unreported gross receipts or sales and it is not entitled to a deduction for outside services of $100,000. Respondent conceded that petitioners are entitled to $40,152 of other deductions.
3
Petitioners concede in their brief that the amount claimed should have been $90,000 rather than $100,000.
4
Sec. 7491(a) shifts the burden of proof to the Commissioner in certain circumstances provided the taxpayer complies with substantiation requirements, maintains all required records, and cooperates with the Commissioner's reasonable requests. Petitioners did not seek to shift the burden. In addition, petitioners have failed to substantiate the abandonment loss deduction and maintain the required records, and therefore we decline to shift the burden. See sec. 7491(a)(2)(A) and (B).




Other annotations:

There was no recognizable loss to any partner upon the informal dissolution of a partnership because business operations were not completely terminated. The two withdrawing partners formed a new partnership and retained the clients they had been serving, so that no forfeiture of partnership interests occurred.
E.F. Neubecker, 65 TC 577, Dec. 33,549.
An investor in an oil and gas limited partnership was not entitled to a deduction for theft absent proof that he sustained a loss during the year in question. He was denied an abandonment loss deduction because he did not forfeit his partnership interest.
R. Lapin, 60 TCM 59, Dec. 46,704(M), TC Memo. 1990-343. Aff'd, CA-9 (unpublished opinion 3/12/92).

IRS Small Business/Self-Employed Policies and Procedures for NFTLs first filed after CSEDs, Including Release and Refiling Considerations, SBSE-05-1009-018, (Oct. 20, 2009)

2009ARD 202-3



DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE WASHINGTON. D.C. 20224

SMALL BUSINESS/SELF-EMPLOYED DIVISION

October 14, 2009
Control Number: SB/SE-05-1009-018

Expires: October 9, 2010

Impacted: IRM 5.12.2.20

MEMORANDUM FOR DIRECTORS, COLLECTION AREA OPERATIONS

FROM: Frederick W. Schindler /s/ Laura Hostelley (for) Director, Collection Policy

SUBJECT: Policies and Procedures for NFTLs first filed after CSEDs, Including Release and Refiling Considerations

The purpose of this memorandum is to raise awareness and provide procedures for handling rare instances of Notices of Federal Tax Lien (NFTL) filed, for the first time, on a date later than the original Collection Statute Expiration Date (CSED). These filings occur because the CSED was extended or suspended and a NFTL was not filed prior to that original CSED. The Service used the term “Portland Liens” because the issue was identified in Portland, Oregon. Beginning with this memorandum, these liens are called NFTL After Original CSED (NAOC).

Attachment I: Example A - NAOC with Correct Refile Period Calculated

Example D - NAOC/NFTL in Timeline Format

I. Release of NAOC or NFTL
Expired CSEDs render the liability and underlying statutory lien legally unenforceable. On May 2, 2008 the Automated Lien System (ALS) released liens with expired CSEDs. ALS will continue to release liens when the final CSED expires on a module. Example D, referenced above, shows a release timeline after ALS receives module satisfaction from master file (MF) or determines that a CSED extension, previously received from MF, has expired even though the NAOC (or NFTL) refile period has not expired.

II. Effectiveness of Statutory and Notice of Lien (NAOC or NFTL)
The effectiveness of the notice provided by a NAOC (or NFTL) against third party creditors is distinguishable from the viability of the underlying statutory lien. The viability of the underlying statutory lien is tied to the assessment but circumstances may make its viability distinguishable from the assessment. Placing a date in column “e” of the NFTL causes the lien to self-release saving the Service resources devoted to releasing liens when CSEDs expire. If a CSED has been extended past the date in column “e” but no refile has occurred, the liability remains viable but the statutory lien and NAOC (or NFTL) have been extinguished. When the statutory lien has been extinguished a revocation of release is needed to reestablish it before a new NAOC (or NFTL) can be filed. If the statutory lien remains viable only a new NAOC (or NFTL) need be filed.

The underlying statutory lien is extinguished if :
a. The liability has been fully satisfied by payment

b. The liability becomes legally unenforceable due to no time remaining on the original statute collection period (or longer period if a suspension or extension)

c. A release occurs due to the self-releasing language on Form 668(Y)(c) even though the CSED has been extended or suspended


The NAOC or NFTL is valid if both :
a. The statutory lien is valid, and

b. The NAOC or NFTL refile period has not expired (whichever refile period applies section 6232(g)(3)(A) or section 6323(g)(3)(B) )


The NAOC or NFTL is not valid if either:
a. The statutory lien is not valid, or

b. The refile period has expired whether or not there is a date in column “e”


When a NAOC or NFTL is not valid, the Service must release that NAOC or NFTL within 30 days of the underlying liability becoming unenforceable or satisfied.

Attachment I: Example B - NAOC with Incorrect “Refile By” Date in Column “e”

Example D - NAOC/NFTL in Timeline Format

III. Repair Procedures for NAOC or NFTL with Expired Refile Period
No date in column “e”
If the CSED has not expired

File a new NAOC or NFTL

Attachment I: Example C - NAOC with NA for “Refile By” Date in Column “e”

Date in column “e”

If the CSED has not expired

File a revocation of release

File a new NAOC or NFTL

Attachment I: Example B - NAOC with Incorrect “Refile By” Date in Column “e”

For questions on the validity of NAOC or NFTL contact Advisory or Counsel.

IV. Table 1: Computing “Refile By” Dates for NFTL and NAOC

Refile Period
“Refile By” Date

IRC § 6323(g)(3)
Last Day for Refiling


From
Until
(a/k/a column “e”)


First 10 year period after assessment * **
The first day of a one year period ending with the date calculated to the right
10 years and 30 days after assessment
10 years and 30 days after assessment


Second period for refile
10 years after the date calculated above
10 years after the date calculated above
10 years after date calculated above


Third period for refile
20 years after date calculated in first row
20 years after date calculated in first row
20 years after date calculated in first row


REMINDER: Use the “refile by” date calculated using the table above even if the CSED precedes the “refile by” date.

* NOTE: If the first refile period begins in January, February, or March of a leap year, use IRM Exhibit 5.12.2-2 to obtain the refile period ending date. For questions on these calculations contact Area Counsel to ensure correct refile period calculation.

** NOTE: When encountering old cases, NFTL, NAOC, or judgments involving a tax liability assessed prior to the Revenue Reconciliation Act , effective November 5, 1990, contact Advisory and Counsel for assistance in determining the correct refile period.


If you have any questions, please call me or a member of your staff may contact Christine Kalcevic.

Attachment

cc: Director, Advisory, Insolvency, and Quality www.irs.gov

ATTACHMENT I
Example A NAOC with Correct Refile Period Calculated

1. Assessment date: 07-10-1998

2. Normal CSED: 07-10-2008

3. Prior to 07-10-2008 the Taxpayer submits an offer-in-compromise. The Service accepts the offer for processing by signing the completed Form 656 on 05-10-2008. Beginning on this date, the offer in compromise is pending. The Service accepts the offer in compromise on 11-10-2009.

4. During the time the offer-in-compromise was pending, the running of collection limitation period was suspended. In this case the collection limitation period was suspended for 18 months.

5. New CSED: 01-10-2010

6. NFTL (now known as “NAOC”) filed (for first time): 05-10-2009

7. Refiling Period: 08/10/2017 through 08/09/2018




Assessment
CSED
Original
Refile By
New
CSED
NAOC
Filed
ALS
Release
NAOC
Refile By



A
07-10-1998
07-10-2008
08-09-2008
01-10-2010
05-10-2009
01-10-2010
08-09-2018



Example B NAOC with Incorrect “Refile By” Date in Column “e”
Items 1- 6 are the same as Example A:

Assessment date: 07-10-1998

Normal CSED: 07-10-2008

Prior to 07-10-2008 the Taxpayer submits an offer-in-compromise. The Service accepts the offer for processing by signing the completed Form 656 on 05-10-2008. Beginning on this date, the offer in compromise is pending. The Service accepts the offer in compromise on 11-10-2009.

During the time the offer-in-compromise was pending, the running of collection limitation period was suspended. In this case the collection limitation period was suspended for 18 months.

New CSED: 01-10-2010

NFTL (now known as “NAOC”) filed for first time: 05-10-2009

“Refile by” date entered in column “e” is 08-09-2009 (incorrectly calculated by adding twelve months and thirty days to the original 10-year collection limitation period, thinking that was the end of the refile period)

Statutory lien is extinguished as a consequence of the self-release language contained on the NAOC. The lien is released as of 08-09-2009 even though the collection limitation period remains open until 01-10-2010.

Revocation of release filed (and mailed to taxpayer) 10-01-2009 to reinstate the statutory lien

New NAOC filed 10-02-2009 to reestablish the “notice” of lien against the four classes of creditors enumerated in section 6323(a) . See General Background. Thus, the new NAOC is effective as of 10-02-2009 in competing against these four interests. The effectiveness of the notice does not revert back to 05-10-2009, the date the NAOC was filed.

Correct Refiling Period is 08/10/2017 through 08/09/2018




Assessment
CSED
Original
Refile By
New
CSED
NAOC
Filed
ALS
Release
NAOC Refile By








05-10-2009
* 08-09-2009

B
07-10-1998
07-10-2008
08-09-2008
01-10-2010






* 10-02-2009
01-10-2010
08-09-2018


* Revocation required and filed 10-01-2009


Example C NAOC with NA for “Refile By” Date in Column “e”
1. Original Assessment: 04-23-1992

2. Normal CSED: 04-23-2002

3. 2 bankruptcies and the taxpayer's innocent spouse claim and appeal resulted in an 11-year CSED suspension to: 04-23-2013

4. Lien (NAOC) filed (for first time): 02-15-2004

5. Refile period: 05-24-2011 through 05-23-2012 (using the second ten year period after assessment)

6. NAOC shows “NA” in column “e” and the notice contains the standard self-release language used in NFTLs since 1982

7. NAOC not refiled during refiling period. The lien did not self-release because “NA” or nothing in column “e” makes the self-release language inoperable.

8. On 06-01-2012 a new NAOC filed and this includes 05-23-2022 as the refile by date in column “e”. The new NAOC protects the Service's priority position in relation to other creditors enumerated in section 6323(a) as of 06-01-2012, not 02-15-2004 (NOTE: Revocation of release was not filed because the underlying statutory lien remained viable)




Assessment
CSED
Original
Refile By
New
CSED
NAOC
Filed
ALS
Release
NAOC
Refile By








02-15-2004
*
*

C
04-23-1992
04-23-2002
05-23-2002
04-23-2013






○ 06-01-2012
04-23-2013
05-23-2022


○Second refile period ended 05-23-2012


PDF Version of Example DPDF Version of Example D

FIN 48

IR- 2009-95

Internal Revenue Service: Remarks of IRS Commissioner Shulman: 2009 National Association of Corporate Directors Corporate Governance Conference


PREPARED REMARKS OF COMMISSIONER OF INTERNAL REVENUE DOUGLAS H. SHULMAN
BEFORE THE 2009 NATIONAL ASSOCIATION OF CORPORATE DIRECTORS CORPORATE GOVERNANCE CONFERENCE WASHINGTON, DC OCTOBER 19, 2009
IR-2009-95 , Oct. 19, 2009

WASHINGTON — Thank you for that warm introduction and welcome.

I realize that the IRS Commissioner has not customarily addressed the NACD's corporate governance conference…but what I want to discuss with you this afternoon is the important role that boards of directors can play in overseeing tax risk and tax strategies of corporations. After all, taxes are one of the biggest expenses of a corporation, so how they are managed is very important to most corporations.

Clearly, corporate boards of directors play an incredibly important role in the vibrancy of businesses and our economy. Boards are a source of creative ideas, strategic thinking, and, importantly, governance and oversight. Boards hold management accountable, and in that role, understanding the risk posture of the company is critically important.

So today, I want to share with you some observations of what I have seen since I've taken the helm of the organization responsible for collecting 96% of all federal receipts - around $2.5 trillion.

To begin, I understand that many of you - actually most of you - are not tax experts and you were not installed on the board because of your tax expertise. You bring other critical skills, experiences and expertise to the boardroom.

And I also understand that even with all of your sophistication, expertise and experience in business and financial affairs, it's difficult to understand the tax consequences of a complicated business transaction, such as a tax-free reorganization or a hedging transaction, let alone the corporation's overall tax profile as it relates to federal, state and international taxes. That's why you need to have strong tax departments and outside tax advisors. After all, you have finance experts to help you understand the economic value of hedging transactions, and you need tax experts to help you understand the myriad and complex tax issues facing your company.

Now, my motivation to create this dialogue with you is based in part on personal and professional experience. I moved from the business world where I interacted with boards… to FINRA, the largest independent securities regulator in the U.S. ….to the IRS, where I am focusing on major trends, such as the globalization of tax administration, and innovative ways to strengthen and improve our tax system. In all of these roles, I have seen the importance of board oversight of major areas of risk.

So, I know first hand that in the post-Sarbanes Oxley world, corporations have invested significant time and resources on compliance issues and internal controls. In the tax arena, some have instituted regular meetings between the Audit Committee and the tax director to ensure an open dialogue.

As I mentioned earlier, tax issues should remain on your radar screen - and for good reason. It's one of the biggest expenses on your income statement. In addition, a number of public companies have reported material weaknesses in internal controls related to taxes. Tax strategies can also present a financial and restatement risk, and sometimes when the cases are high profile, a significant risk to corporate reputations. In today's business climate, the general public has little tolerance for overly aggressive tax planning that can be viewed as corporations playing tax games.

So, although the complexity of the tax code may make your eyes glaze over, Board members - like you -are critically important to making sure that the tax system works well and is worthy of the confidence of the American people.

But how can you increase your oversight of tax compliance given the limited amount of time you have available and the competing business issues you face?

Well, you probably know or could figure out, that the IRS conducts risk assessments of its own when determining how to use its time and resources and whom to audit. Similarly, the board of directors can assess its corporation's tax risk profile, internal controls, and relationship with its corporate tax department, to help determine the tax matters of which it should be aware.

Now, we recognize that many businesses are trying to get it right. Positions taken in tax returns may be well-grounded and taken in good faith. Other tax positions taken may be more aggressive and use elaborately structured transactions or arrangements to push tax planning up to the edge, or beyond acceptable bounds.

Enter FIN 48, which establishes the financial statement accounting for uncertain tax positions, including recognizing and measuring their effect on financial statements.

Under FIN 48, companies must identify their material uncertain tax positions. They must quantify the company's maximum exposure and estimated likelihood of winning or losing the issue if challenged by the IRS. And they must record as a liability a specified amount of money relating to these uncertain tax positions. In other words, FIN 48 is a very significant window into tax risk, liability and management in your company.

FIN 48 paints a picture of tax risk by indicating how much money a corporation has to book in tax reserves to reflect the risk should one or more of its tax positions go south.

But let's get behind the reserve numbers for a moment. What are they telling you - the board directors - beyond the dollars in the tax reserve?

They're saying that the audit committee needs to know and influence what tax posture the tax planners are taking. They and you need to know whether that multi-million - or in some cases multi-billon-dollar bet - you and your company are making could be too aggressive and therefore risky.

So where does that bring us? What are the next steps?

Before I get to that, I want to be clear about what I “do” intend and “don't” intend in this dialogue.

We don't intend to second-guess legitimate and thoughtful business decision-making by corporate leaders. And we don't expect that you will always agree with us on identifying and quantifying the risk of various tax positions. But we do want to engage corporate leaders about their roles and responsibilities in conducting appropriate assessment and oversight of tax risk.

I am suggesting that you, the leaders of your organizations, should have a mechanism to oversee tax risk as part of your governance process. For example you might want to:

Set a threshold confidence level for taking a tax position…

Discourage or eliminate opinion shopping by tax departments by having an independent tax firm, which has some direct dialogue with the board of directors, review major tax positions …

Specifically address transfer pricing and the relative profit allocated to low-tax jurisdictions, and make sure they reflect real economic contributions made in those jurisdictions.

And diving down a little deeper, here are some questions you might ask of your tax director and your external auditors relating to FIN 48:

What was the process for identifying uncertain tax positions and how do you know all material issues have been identified?

How did you go about determining the maximum tax exposure relating to each uncertain tax position? What makes you comfortable that it accurately reflects your maximum exposure?

How did you go about quantifying the likelihood of winning or losing uncertain tax positions? Do you plan to litigate the issue if the IRS challenges the position? Does the external auditor or tax advisor agree with the tax director's assessment?

Could the company be subject to potential penalties, such as for underpayment of tax, negligence or worse? If so, are they appropriately recorded, and perhaps more important, what does this say about how aggressive the company's position is regarding those issues?

There are already some IRS programs in place that help provide greater certainty and can give a board more comfort that there won't be second guessing down the road. For example, our compliance assurance program, or CAP where we agree on issues with the taxpayer before a corporate return is filed, envisions full disclosure by the taxpayer in exchange for real time tax certainty. And the Advance Pricing Agreement program, where we agree with a taxpayer on pricing methodology before a return is filed, provides certainty in the complex and uncertain area of transfer pricing.

Now, we're not the only government thinking about the notion that corporate taxpayers that employ sound management and governance practices on tax matters are more likely to be compliant.

One example is Australia. The Australian Tax Office publishes a Governance Guide for Board Members and Directors that suggests useful questions - similar to the ones I just posed - that a corporate director can ask of management.

Some of the Australian Tax Office's questions include: Is there a material difference between the losses reported for accounting purposes and the losses claimed for tax purposes? If so, can the difference be satisfactorily explained? Is the structure and financing for your business or a major transaction complicated, perhaps more complex than necessary to achieve the commercial objectives? These questions give you a flavor of what some other countries are thinking about and doing in the corporate governance area.

On a broader scale, the Organisation for Economic Co-operation and Development has charted a worldwide trend of increased boardroom attention to issues of taxation. A recent guidance document outlines good corporate governance principals in relation to tax, based on advice from governments around the world.

In summary, my main observation to share with you is this: Taxes are an important expense, and like any important expense, management responsible will try to control it. In the case of taxes, controlling it can expose the company to challenge, which can result in reputational damage and perhaps large, unexpected expenses. So you need to understand how management controls this expense and how it decides how aggressive to be. You also need to be certain that reporting is effective.

Tax expense in this sense is no different from other expenses. Manage it too loosely and you give up profit. Manage it too aggressively and there are bad consequences. You, the board, have to oversee how management manages it. That means some level of understanding, a set of policy principles and then a control system of reporting that assures you that the policy is being carried out.

My goal here today was to start a discussion about the board of directors' role in overseeing tax risk. I encourage you to have the dialogue, and offer the IRS as a resource as you continue to evolve your thinking about this topic. At the end of the day, my proposition is that the board needs to have the tools, not to do tax planning, but to oversee tax strategies and risks.

I see my time is up today. I hope it was a good start and that this beneficial dialogue will continue and mature in the weeks and months ahead. Thank you.

AICPA on tax patents

Media Advisory: Consumer and Taxpayer Rights Groups Seek Ban on Tax Patents, (Oct. 21, 2009)
2009ARD 203-8

Tax strategy patents: AICPA advisory: Ban on tax patents


AICPA Media Advisory
Consumer and Taxpayer Rights Groups Seek Ban on Tax Patents
A broad coalition of consumer organizations, taxpayer rights groups and financial planners is calling on Congress to ban people from obtaining patents on strategies for complying with U.S. tax law. With the coalition's support, proponents expect it will be more likely that a ban on tax patents will be included in a larger patent reform bill moving through Congress.

Seventeen organizations signed an Oct. 20 letter to congressional leaders in support of a ban on patents, which unfairly seek to control the ability of all Americans to comply with U.S. tax laws. Among the new supporters of a tax patent ban are the Consumer Federation of American, U.S. PIRG, and the Financial Planning Association. The American Institute of Certified Public Accountants has been at the forefront of a two-year effort to ban tax patents.

In the previous Congress, the House of Representatives passed a patent reform bill that included a ban on tax patents, but a similar provision was not included in the Senate's version of the bill, which never came to a floor vote. Members of the House and Senate Judiciary Committees are now working on a new bill that will be acceptable to both chambers. The Senate is expected to act first on patent reform legislation this Congress and the House may accept the Senate bill without amendments so it is important to include a ban on tax patents in the Senate bill.

Tax patents are a growing problem for taxpayers. The Patent and Trademark Office has issued 82 tax strategy patents and 133 applications are pending. Tax patents may limit taxpayers from using tax laws as they were intended by Congress, may cause taxpayers to pay more taxes than necessary and do not guarantee that the underlying strategy is valid.

October 20, 2009

Cancellation of debt income - a defense

This is a very interesting case for creative tax attornies because it it a roadmap on how to defend against cancellation in indebedness income.


Wm. Jon & Mary Lou McCormick v. Commissioner., U.S. Tax Court, CCH Dec. 57,968(M), T.C. Memo. 2009-239, (Oct. 21, 2009)
U.S. Tax Court, Dkt. No. 14362-08, TC Memo. 2009-239, October 21, 2009.





A married couple was not required to recognize discharge of indebtedness income as a result of settlement of their account with one bank, and the amount of such income was calculated with respect to their settlement of an account with another bank. The taxpayers established by a preponderance of the evidence that bona fide disputes existed regarding both accounts. Furthermore, the IRS failed to produce reasonable and probative information independent of the third-party information returns received from the banks. Consequently, under Code Sec. 61(a)(12), the taxpayers had no cancellation of indebtedness income with respect to one account. With respect to the other account, the cancellation of indebtedness income was the claimed payoff amount less the disputed amount, less the settlement payment made by the taxpayers.—.


MEMORANDUM OPINION
COHEN, Judge: Respondent determined a deficiency of $5,067 in petitioners' Federal income tax for 2005 and an accuracy-related penalty of $1,007 pursuant to section 6662(a).

Unless otherwise indicated, all section references are to the Internal Revenue Code for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

After express concessions and abandoned issues, the issue for decision is whether petitioners must recognize discharge of indebtedness income as a result of settlement of their accounts with CitiFinancial Services and Chase Manhattan Bank.

Background
This case was submitted fully stipulated under Rule 122, and the stipulated facts are incorporated as our findings by this reference. Petitioners resided in Pennsylvania at the time the petition was filed. William Jon McCormick (petitioner) is an attorney.

From at least 2004 petitioners maintained a loan account with CitiFinancial Services (CitiFinancial). Prior to February 1, 2005, petitioners were advised that the “payoff” amount of the loan was $8,042.10. In a fax sent February 1, 2005, to a branch manager, petitioner challenged the payoff amount, claiming that an insurance refund of $492.44 should have been credited to the account. The following day, the manager offered to settle the dispute for a lump-sum payment of $7,500. Petitioner accepted and paid the $7,500. CitiFinancial sent a Form 1099-C, Cancellation of Debt, to the Internal Revenue Service.

Before December 2000, petitioner Mary Lou McCormick, formerly Mary Lou Howard, had a credit card with Chase Manhattan Bank (Chase). The account was placed with collection agencies January 4, 2001, and October 10, 2001. Petitioners disputed the account from at least February 2002. On May 12, 2005, petitioner sent a letter to Chase challenging the alleged account balance of $2,875 and noting that the period of limitations on a suit to collect had expired. Petitioner offered to pay $1,000 as the amount “actually owed”. Chase accepted and mailed petitioner Mary Lou McCormick a 2005 Form 1099-C for $1,875, the difference between the balance on the account and the payment.

Discussion
The issue remaining for decision is whether petitioners had cancellation of indebtedness income from CitiFinancial and Chase.

Section 61(a)(12) includes in the general definition of gross income “income from discharge of indebtedness”. When the amount of a debt is disputed, “a subsequent settlement of the dispute would be treated as the amount of debt cognizable for tax purposes.” Zarin v. Commissioner, 916 F.2d 110, 115 (3d Cir. 1990) (holding that unenforceable debt is also disputed as to amount, and its settlement does not give rise to cancellation of indebtedness income) revg. 92 T.C. 1084 (1989); N. Sobel, Inc. v. Commissioner, 40 B.T.A. 1263, 1265 (1939). There must be evidence of a dispute; a settlement standing alone does not prove that a good-faith dispute existed. See Rood v. Commissioner, T.C. Memo. 1996-248, affd. without published opinion 122 F.3d 1078 (11th Cir. 1997).

In a fax sent to CitiFinancial petitioner argued that the loan payoff amount of $8,042.10 should be reduced by a $492.44 insurance refund. Aside from the insurance refund, petitioners do not argue that the payoff amount was incorrect.

In a letter sent to Chase petitioner argued that the outstanding balance should be $1,000 rather than the $2,875 claimed by the bank. Bank records reflected that the account had been disputed from at least 2002.

The preponderance of the evidence supports a conclusion that a bona fide dispute existed regarding the $492.44 insurance refund on the CitiFinancial debt and the balance of the Chase account over $1,000. See, e.g., Earnshaw v. Commissioner, T.C. Memo. 2002-191, affd. 150 Fed. Appx. 745 (10th Cir. 2005); see also Melvin v. Commissioner, T.C. Memo. 2009-199.

To determine the amount of cancellation of indebtedness income properly attributed to petitioners, we must determine the amount of the CitiFinancial and Chase debt that was definite and liquidated. See Zarin v. Commissioner, supra at 116.

In this case, respondent may not rely on the Forms 1099-C submitted by CitiFinancial and Chase as evidence of the amount of debt that was definite and liquidated. Section 6201(d) provides that in any court proceeding, if a taxpayer asserts a reasonable dispute with respect to any item of income reported on an information return and has fully cooperated, the Commissioner shall have the burden of producing reasonable and probative information concerning the deficiency in addition to the information return. Petitioners have asserted reasonable disputes with respect to the amounts reported by CitiFinancial and Chase. Respondent has failed to produce reasonable and probative information independent of the third-party information returns.

Petitioners did not dispute the CitiFinancial claimed payoff amount of $8,042.10, less the disputed insurance refund of $492.44, a total of $7,549.66. That amount is decreased by the settlement payment of $7,500. We conclude that the amount of petitioners' cancellation of indebtedness income from CitiFinancial is $49.66.

Petitioners had an uncontested and liquidated outstanding balance of $1,000 with Chase. Because they paid $1,000 to settle the account, they have no cancellation of indebtedness income from Chase.

In reaching our decision, we have considered all arguments made by the parties. To the extent not mentioned or addressed, they are irrelevant or without merit.

For the reasons explained above,

Decision will be entered under Rule 155.

6694 and alimony

This is not a 6694 case but the issues can arise if the returns in this case were prepared by a return preparer. Alimony is an issue that can arise in any tax return, and the analysis in this case is a tutorial on that issues.

The negligence issue in this case is one that would have resulted in a 6694(b) penalty.

U.S. Tax Court, Dkt. No. 7422-08, TC Memo. 2009-238, October 20, 2009.


Alimony Deduction
Petitioner contends that he is entitled to deduct in full the $38,400 he paid to his former wife in 2006 pursuant to the PSA because those payments were alimony, and alimony is a deductible expense. Section 215 permits taxpayers to deduct alimony or separate maintenance payments includable in the gross income of the recipient under section 71. Section 71(b)(1) defines alimony or separate maintenance payment as a payment in cash if: (1) The payment is received by a spouse under a divorce or separation instrument; (2) the divorce or separation instrument does not designate the payment as nondeductible for the paying spouse and not includable in the gross income of the payee spouse; (3) in the case of an individual legally separated from his spouse under a decree of divorce or of separate maintenance, the spouses are not members of the same household when the payment is made; and (4) there is no liability to make any payment for any period after the death of the payee spouse. A divorce or separation instrument is either a decree of divorce or separate maintenance, or a written instrument incident to such a decree; a written separation agreement; or a decree requiring a spouse to make payments for the support or maintenance of the other spouse. Sec. 71(b)(2). Use of the word “alimony” in the decree of divorce or separate maintenance, or in the written separation agreement, will not necessarily result in a payment's being characterized as alimony for Federal income tax purposes. Kean v. Commissioner, supra at 189-190; Okerson v. Commissioner, 123 T.C. 258, 264 (2004).
The first three requirements of the section 71(b)(1) alimony definition are satisfied. First, the PSA payment was made under a divorce or separation instrument because the payment was made pursuant to the PSA, and the PSA was incorporated into the divorce decree. Second, the PSA does not designate the PSA payment as nondeductible for petitioner nor as not includable in the gross income of his former wife. Third, petitioner and petitioner's former wife were not members of the same household during the year in issue.
Ultimately it is not necessary to determine whether the payments are currently allocated. It is necessary to determine only which payments would continue upon petitioner's former wife's death and which would terminate. See sec. 71(b)(1)(D). According to the second sentence of section 9.c. of the PSA, upon the death of petitioner's former wife the payment is allocated $1,700 per month to child support and $1,500 per month to alimony and the alimony portion terminates. Thus, we conclude that the payment of up to $18,000 a year is alimony and anything greater does not satisfy the requirement of section 71(b)(1)(D), and is therefore not deductible.
It appears that the parties to petitioner's divorce created a deliberate ambiguity in order to achieve two purposes, one relating to child support and one relating to tax treatment. It has long been the rule, however, that the labels attached by the parties to a marital settlement agreement or decree are not controlling for Federal tax purposes. See, e.g., Benedict v. Commissioner, 82 T.C. 573, 577 (1984). Even if the language categorizing child support payments as alimony taxable to petitioner's former wife had been unambiguous, the $1,700 per month portion would fail the test for deductibility under section 71(b). As the Court said in Okerson v. Commissioner, supra at 264-265:
Here, the applicable Federal law is set forth in section 71, which, in its present form, provides the exclusive means by which a taxpayer may deduct a payment as alimony for Federal income tax purposes. * * * [ Hoover v. Commissioner, 102 F.3d 842, 844-845 (6th Cir. 1996), affg. T.C. Memo. 1995-183]. Through that section, Congress eliminated any consideration of intent in determining the deductibility of a payment as alimony in favor of a more straightforward, objective test that rests entirely on the fulfillment of explicit requirements set forth in section 71. Id.; see also Rosenthal v. Commissioner, T.C. Memo. 1995-603 (“Whether or not the parties intended for the payments to be deductible to petitioner, we must focus on the legal effect of the agreement in determining whether the payments meet the criteria under section 71.”). As the House Committee on Ways and Means articulated in its report on section 71 in discussing the need for such an objective test:
“The committee believes that a uniform Federal standard should be set forth to determine what constitutes alimony for Federal tax purposes. This will make it easier for the Internal Revenue Service, the parties to a divorce, and the courts to apply the rules to the facts in any particular case and should lead to less litigation. The committee bill attempts to define alimony in a way that would conform to general notions of what type of payments constitute alimony as distinguished from property settlements and to prevent the deduction of large, one-time lump-sum property settlements. [H. Rept. 98-432 (Pt. 2), at 1495-1496 (1984).]” [alteration in original.]
Although the parties to a divorce proceeding may intend that certain payments be considered alimony for Federal income tax purposes, and a court overseeing that proceeding may intend the same, Congress has mandated through section 71(b)(1)(D) that payments qualify as alimony for Federal income tax purposes only when the payor's liability for those payments, or for any payments which may be made in substitute thereof, terminates upon the payee spouse's death. * * *
We need not decide, therefore, whether the terms of the agreement fixed a portion of the payments as child support nondeductible under section 71(a) and (c).
Section 6662 Accuracy-Related Penalty
Petitioner contests the imposition of an accuracy-related penalty for the tax year in issue. Section 6662(a) and (b)(1) and (2) imposes a 20-percent accuracy-related penalty on any underpayment of Federal income tax attributable to a taxpayer's negligence or disregard of rules or regulations, or substantial understatement of income tax. Section 6662(c) defines negligence as including any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code and defines disregard as any careless, reckless, or intentional disregard. Disregard of rules or regulations is careless if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position that is contrary to the rule or regulation. Sec. 1.6662-3(b)(2), Income Tax Regs. Disregard of rules or regulations is reckless if the taxpayer makes little or no effort to determine whether a rule or regulation exists. Id.
Under section 7491(c), the Commissioner bears the burden of production with regard to penalties and must come forward with sufficient evidence indicating that it is appropriate to impose penalties. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). However, once the Commissioner has met the burden of production, the burden of proof remains with the taxpayer, including the burden of proving that the penalties are inappropriate because of reasonable cause or substantial authority. See Rule 142(a); Higbee v. Commissioner, supra at 446-447.
Respondent has satisfied the burden of production by showing that petitioner deducted the entire PSA payment in disregard of the plain language of section 71. See, e.g., Stedman v. Commissioner, T.C. Memo. 2008-239; Tiley v. Commissioner, T.C. Memo. 2003-132.
The accuracy-related penalty under section 6662(a) is not imposed with respect to any portion of the underpayment as to which the taxpayer acted with reasonable cause and in good faith. Sec. 6664(c)(1); Higbee v. Commissioner, supra at 448. The decision as to whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all of the pertinent facts and circumstances. See sec. 1.6664-4(b)(1), Income Tax Regs. “Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances, including the experience, knowledge, and education of the taxpayer.” Id.
Petitioner asserts that he acted with reasonable cause and in good faith. He argues that in deducting the entire PSA payment in 2006 he was just repeating what was ultimately determined by respondent to be permitted in 2005. Furthermore, petitioner points out that although he is an attorney, his practice does not include tax law.
We are not persuaded by petitioner's arguments. What respondent did in 2008 regarding the deduction in 2005 has no bearing on whether petitioner acted with reasonable cause and in good faith in 2006. The statute forbidding a deduction for payments where, as in this case, there is no liability after the death of the payee spouse, is clear. Petitioner's explanations do not demonstrate an honest misunderstanding of fact or law that is reasonable in light of his experience, knowledge, and education.
In reaching our decision, we have considered all arguments made by the parties. To the extent not mentioned or addressed, they are irrelevant or without merit.
For the reasons explained above,
Decision will be entered under Rule 155.
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title Joseph F. Rodkey, Jr., v. Commissioner.
search-title Case: Joseph F. Rodkey, Jr., v. Commissioner., U.S. Tax Court, CCH Dec. 57,967(M), T.C. Memo. 2009-238, (Oct. 20, 2009)
primary-class case-law/case
wk-da number WKUS_TAL_543
CCH Paragraph No. [CCH Dec. 57,967(M)]
language http://psi.oasis-open.org/iso/639/#eng
region United States [http://wk-us.com/meta/regions/#US]
publisher http://wk-us.com/meta/publishers/#CCH
publishing-status new
publishing-dates available-date:
modified-date:
revised-date:
sort-date: 2009-10-20
document-transformation-history SOURCE-CRC: 65475599
G2I-VERSION: Group2Interchange-RELEASE-03-14-0009A
G2I-TRANSFORMATION-DATE: 2009-10-20
I2A-VERSION: I2A-03-15-0005
I2A-TRANSFORMATION-DATE: 2009-10-21
wkcase-law:metadata parties plaintiff:Joseph F. Rodkey, Jr.,
defendant:Commissioner.
case-abbrev-name Joseph F. Rodkey, Jr., v. Commissioner.
case-history [Appealable, barring stipulation to the contrary, to CA-3.—CCH.]
court U.S. Tax Court [http://wk-us.com/meta/courts/#US-FJ-TAX]
document-date , precision: day
2009-10-20
attorneys Joseph F. Rodkey, Jr., pro se; Julia L. Wahl, for respondent.
document-number 7422-08 [docket]
document-number TC Memo. 2009-238 [citation]
document-number CCH Dec. 57,967(M) [primary-citation]
document-number T.C. Memo. 2009-238 [primary-citation]

469 passive loss case

If this tax return were prepared by a return preparer and did not identify the 469 issue, I believe the 6694 penalty would apply. In this instance with discloure, I cannot even argue that the reasonable basis standard had been met.



Francis J. and Andrea P. Bogus v. Commissioner., U.S. Tax Court, T.C. Summary Opinion 2009-160, (Oct. 19, 2009)
Docket No. 14809-07S. Filed October 19, 2009.

Code Sec. 469 passive loss rules precluded a married couple from deducting losses incurred from their dog racing activity. Although the husband was regularly involved in a greyhound racing activity for profit, he failed to prove that he materially participated in the activity. He did not keep a diary, appointment book, calendar or similar record of the time he spent participating in the activity. Instead, he presented only self-serving testimony and exhibits. Furthermore, because he had been engaged in greyhound racing for many years, he had found trustworthy individuals to breed, raise, board, train and race his greyhounds, requiring less material participation by the individual himself.
PURSUANT TO INTERNAL REVENUE CODE SECTION 7463(b), THIS OPINION MAY NOT BE TREATED AS PRECEDENT FOR ANY OTHER CASE.
Francis J. Bogus, pro se. Charles Maurer, Jr., for respondent.
Background
Some of the facts have been stipulated and are so found. The stipulation of facts and the attached exhibits are incorporated herein by this reference. Petitioners resided in Massachusetts when the petition was filed.
During 2003 and 2004 Francis J. Bogus (petitioner) was employed by Verizon as a network technician and typically worked 4 or 5 days per week from 7:30 a.m. to 4:30 p.m. Petitioner worked approximately 40 years for Verizon and was retired at the time of trial.
Petitioner developed an interest in greyhounds approximately 25 years ago. Petitioner was introduced to greyhounds by a friend who also lived in Massachusetts. His friend imported greyhounds from Ireland for resale. Petitioner initially purchased two trained greyhounds from his friend. Petitioner then bred these dogs and contracted with professionals to race them at a dog track in Rhode Island. By 2003 petitioner owned approximately 164 greyhounds, worth an estimated $300,000, all registered with the National Greyhound Association. Petitioner owned greyhound puppies in Oklahoma and Florida and full-grown greyhounds at approximately 10 different racetracks in multiple States.
From birth to 12 months of age the greyhound puppies were in the care of farmers who raised them. Petitioner personally visited a farm in Florida to check on his puppies on only one occasion and then only because he was taking his children to nearby Disney World. Petitioner maintained contact with the farmers by telephone.
From 12 to 16 months of age the greyhounds were in the care of trainers who boarded them and trained them to race. The trainers would call petitioner to report how the dogs were progressing. Petitioner would then determine whether to race a dog and where the dog should be raced.
From 16 months to 5 years of age petitioner's greyhounds raced at one or more tracks. Petitioner contracted with individuals at a number of dog tracks to race his dogs. During the years that a dog was being raced the dog would be cared for by the individual who was racing the dog. Each greyhound would be assigned a grade, depending on how well it raced. The best grade was AA. When one of petitioner's dogs won a race, petitioner would receive money, the amount of which was determined by the grade of the dog and the track where the dog raced. Some race tracks paid better than others. At 5 years of age the greyhounds would be put up for adoption as pets.
Petitioner contracted with professionals to raise, breed, board, train, ship, and race his dogs. In addition to handling contract arrangements, petitioner performed some additional functions. Petitioner went to dog tracks 3 or 4 nights a week for 2 or 3 hours to watch his dogs race live and monitor them for injuries. Most of the time petitioner went to Wonderland Greyhound Park in Revere, Massachusetts, which is about a 5-minute drive from petitioner's residence. From there petitioner could also watch his dogs race at tracks all over the country by simulcast.
Petitioner purportedly spent 1 hour per day on bookkeeping and administration and 2 or 3 hours a week talking to contractors by telephone. Additionally, when one of petitioner's female greyhounds would go into heat, he would be notified by telephone and then would select an appropriate stud from an official breeding publication. Petitioner purportedly spent 3 to 5 hours per month reading professional publications and 5 to 10 minutes per telephone call related to breeding. The record is silent as to how many of these phone calls took place. Petitioner did not keep an appointment book, calendar, or diary that would constitute a narrative summary of his participation in any facet of his activity.
Petitioner did not breed, raise, board, train, ship, or race his dogs personally. Virtually all of the required services were performed by other individuals under contract. Further, petitioner did not own any of the facilities where the services were performed. At trial petitioner presented phone bills showing hundreds of telephone calls to out-of-State locations. Also, petitioner offered into evidence numerous invoices from service providers as well as earnings statements from numerous dog tracks.
Discussion
In general, the Commissioner's determination set forth in a notice of deficiency is presumed correct, and the taxpayer bears the burden of showing that the determination is in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Under section 7491(a) the burden may shift to the Commissioner regarding factual matters if the taxpayer produces credible evidence and meets the other requirements of the section. Petitioner does not argue that he satisfied the elements for a burden shift, but even if he did advance this argument, petitioner did not produce sufficient evidence to support a burden shift. Accordingly, the burden remains on petitioner to disprove respondent's determinations for 2003 and 2004.
The passive loss rules of section 469 place limitations on the deduction of losses relating to passive activities; namely, from activities in which a taxpayer does not materially participate. Sec. 469(a)(1) and (2), (c)(1), (d)(1). As a general rule, a taxpayer will be regarded as not materially participating in an activity if the taxpayer is not involved in the operation of the activity on a basis which is regular, continuous, and substantial. See sec. 469(h)(1); sec. 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988).
The temporary regulations under section 469 contain seven tests, the qualification under any one of which will result in a taxpayer's being treated as materially participating in the activity. Sec. 1.469-5T(a), Temporary Income Tax Regs., supra. Of the seven tests, petitioner presented evidence and made general arguments that are applicable only to the tests found in section 1.469-5T(a)(1) and (7), Temporary Income Tax Regs., supra, which provide that a taxpayer shall be treated as materially participating in an activity if he participates in the activity for more than 500 hours during such year, or if, on the basis of all the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during the taxable year.
A taxpayer may establish the extent of his or her participation in a particular activity by any reasonable means and has the burden of proving material participation in the activity. Rule 142(a); sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988). The method of proof, set out in section 1.469-5T(f)(4), Temporary Income Tax Regs., supra, is quite lenient, letting taxpayers prove their time spent by “any reasonable means.” Reasonable means are not limited to “Contemporaneous daily time reports, logs, or similar documents” but include “the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” Id.; see Mowafi v. Commissioner, T.C. Memo. 2001-111. But despite its apparent leniency, this section of the regulations does not require us to believe a “ballpark guesstimate” of the time spent on different activities. Lee v. Commissioner, T.C. Memo. 2006-193; Bailey v. Commissioner, T.C. Memo. 2001-296; Carlstedt v. Commissioner, T.C. Memo. 1997-331; Speer v. Commissioner, T.C. Memo. 1996-323; Goshorn v. Commissioner, T.C. Memo. 1993-578.
Petitioner alleges that he materially participated in his dog racing activity by: (1) Going to dog tracks and watching his dogs race while monitoring them for injuries for a minimum of 312 and a maximum of 624 hours per year; (2) performing bookkeeping and administrative functions for 365 hours per year; (3) talking to contractors on the telephone for a minimum of 104 and a maximum of 156 hours per year; and (4) spending a minimum of 36 and a maximum of 60 hours per year reading breeding publications such as those published by the Massachusetts Greyhound Association. Therefore, in total, petitioner alleges that he participated in this activity for a minimum of 817 and a maximum of 1,205 hours per year.
Petitioner attempts to come within the provisions of section 1.469-5T(f)(4), Temporary Income Tax Regs., supra, by relying on his own testimony and exhibits such as invoices for services rendered by the National Greyhound Association and other service providers, earnings reports from numerous dog tracks, and telephone bills. Petitioner's vague time estimates and supporting documentation do not constitute a “narrative summary” of petitioner's participation in this activity. Further, petitioner failed to call any witnesses who could corroborate his testimony regarding the number of hours he estimated he spent participating in the activity.
As previously noted, petitioner did not keep a diary, appointment book, calendar, or any other similar type of record of his participation in the activity. We are left with petitioner's self-serving testimony and exhibits that, when viewed in the most favorable light, fail to prove that petitioner materially participated in this activity and, when viewed in the least favorable light, support respondent's position that this is a passive activity. “The Court is not bound to accept the unverified, undocumented testimony of taxpayers, and we decline to do so in the instant case.” Carlstedt v. Commissioner, supra (citing Hradesky v. Commissioner, 65 T.C. 87, 90 (1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976)).
We believe that petitioner was regularly involved in his activity for profit but, unfortunately, was unable to demonstrate and corroborate his material and substantial participation. Petitioner could have maintained a calendar, appointment book, diary, or other record of his participation in the activity to enable him to meet his burden of proof. Lastly, we believe that having been engaged in greyhound dog racing for over 25 years, petitioner has found trustworthy and experienced individuals to breed, raise, board, train, and race his greyhounds. It would follow that this would require less material participation by petitioner than if he were just starting the activity and learning how to operate the business. Therefore, on the basis of the entire record, we hold that petitioner has not met his burden of proving that he has materially and substantially participated in the activity in question, and respondent's determinations are sustained.
To reflect the foregoing,
Decision will be entered for respondent.

Electronically filing Form 8027

Rev. Proc. 2008-34, July 03, 2008.



The IRS issued revised specifications for electronically filing Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips. Form 8027 is used by large food or beverage establishments to report their gross receipts from food or beverage operations and tips reported by employees. The updated specifications are effective for Forms 8027 due on the last day of February 2009 or filed after that date. Rev. Proc. 2006-29, I.R.B. 2006-27, 13, is superseded.



NOTE: Use this revenue procedure to prepare Forms 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, for submission to Internal Revenue Service (IRS) using the FIRE (Filing Information Returns Electronically) System. Please read this publication carefully. Persons required to file may be subject to penalties if they do not follow the instructions in this revenue procedure.

Note: Electronic filing is the ONLY acceptable method for filing Form 8027 with IRS/ECC-MTB.

Significant changes were made to the record layout. Please review this publication carefully before submitting your information.

26 CFR 601.206: Tax forms and instructions.

Rev. Proc. 2008-34

TABLE OF CONTENTS
Part A. General




SEC. 1. PURPOSE





SEC. 2. NATURE OF CHANGES





SEC. 3. WHERE TO FILE AND HOW TO CONTACT THE IRS, ENTERPRISE COMPUTING CENTER — MARTINSBURG





SEC. 4. FILING REQUIREMENTS AND DUE DATES





SEC. 5. FORM 8508, REQUEST FOR WAIVER FROM FILING INFORMATION RETURNS ELECTRONICALLY





SEC. 6. FORM 4419, APPLICATION FOR FILING INFORMATION RETURNS ELECTRONICALLY





SEC. 7. STATE ABBREVIATIONS





SEC. 8. EXTENSION OF TIME





SEC. 9. PENALTIES





SEC. 10. CORRECTED RETURNS, PAPER FORMS, AND COMPUTER-GENERATED FORMS





SEC. 11. VALIDATION OF FORM 8027 AT IRS/ECC-MTB





SEC. 12. DEFINITION OF TERMS





Part B. Electronic Filing Specifications




SEC. 1. GENERAL





SEC. 2. ELECTRONIC FILING APPROVAL PROCEDURE





SEC. 3. TEST FILES





SEC. 4. ELECTRONIC SUBMISSIONS





SEC. 5. PIN REQUIREMENTS





SEC. 6. ELECTRONIC FILING SPECIFICATIONS





SEC. 7. CONNECTING TO THE FIRE SYSTEM





SEC. 8. COMMON PROBLEMS AND QUESTIONS ASSOCIATED WITH ELECTRONIC FILING





Part C. Filing Specifications and Record Layout




SEC. 1. RECORD FORMAT AND LAYOUT



Part A. General
Sec. 1. Purpose
.01 Form 8027 is used by large food or beverage establishments when the employer is required to make annual reports to the IRS on receipts from food or beverage operations and tips reported by employees.

Note: All employees receiving $20.00 or more a month in tips must report 100% of their tips to their employer.

.02 The Internal Revenue Service Enterprise Computing Center — Martinsburg (IRS/ECC-MTB) has the responsibility of processing Forms 8027 submitted electronically. The purpose of this revenue procedure is to provide the specifications for filing Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, electronically. This revenue procedure is updated when legislative changes occur or reporting procedures are modified.

.03 This revenue procedure supersedes the following: Rev. Proc. 2006-29 published in Internal Revenue Bulletin 2006-27, dated July 3, 2006, Specifications for Filing Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, Magnetically or Electronically. This revenue procedure is effective for Forms 8027 due the last day of February 2009 and any returns filed thereafter.

Sec. 2. Nature of Changes
Please read the publication carefully and in its entirety before attempting to prepare your electronic file for submission. Major changes have been emphasized by using italics. The changes are as follows:

.01 IRS/ECC-MTB no longer accepts any form of magnetic media. Electronic filing through the FIRE System is the only method to report Form 8027 to IRS/ECC-MTB.

.02 Title of Publication 1239 was changed to reflect the elimination of magnetic media filing.

.03 Form 4804, Transmittal of Information Returns Reported Magnetically, is obsolete. This form was only required for magnetic media reporting which is no longer a valid method of reporting information returns.

.04 Form 8809, Application for Extension of Time To File Information Returns, is available as a fill-in form on the FIRE System and is highly encouraged in lieu of the paper Form 8809. (See Part B, Sec. 1.)

.05 Additional and clarifying information was added to Part A, Sec. 4 concerning good faith agreements and determination letters.

.06 Several sections have been deleted due to the elimination of magnetic media filing and others combined for greater clarity. Please review the entire Publication for all relevant changes.

.07 Test files can be submitted through the FIRE System. See Part B, Sec. 3 for details.

.08 Special characters of any kind in name and address fields are not acceptable. See note with example in Part C, Sec. 01.

.09 The following changes were made to the record layout:

(a) An additional indicator was added to the Final Return Indicator field, position 371.

(b) An additional indicator was added to the Liable/Not Liable Indicator field, position 374.

(c) The new field, Tax Year, was added to positions 375-378.

(d) The new field, Prior Year Indicator, was added to position 379.

(e) The new field, Test File Indicator, was added to position 380.

(f) The new field, Record Sequence Number, was added to positions 411—418.


Sec. 3. Where to File and How to Contact the IRS, Enterprise Computing Center — Martinsburg
.01 All correspondence concerning Forms 8027 processed at IRS/ECC-MTB should be sent to the following address:

IRS-Enterprise Computing Center — Martinsburg

Information Reporting Program

240 Murall Drive

Kearneysville WV 25430

.02 Requests for paper forms and publications should be requested by calling the “Forms Only Number” toll-free number 1-800-TAX-FORM (1-800-829-3676).

.03 Questions pertaining to electronic filing of Forms W-2 must be directed to the Social Security Administration (SSA). Filers can call 1-800-SSA-6270 to obtain the telephone number of the SSA Employer Services Liaison Officers for their area.

.04 A taxpayer or authorized representative may request a copy of a tax return or a Form W-2 filed with a return by submitting Form 4506, Request for Copy of Tax Return, to IRS. This form may be obtained by calling 1-800-TAX-FORM (1-800-829-3676).

.05 Electronic Products and Services Support, Information Reporting Branch, Customer Service Section (IRB/CSS), located at IRS/ECC-MTB, answers electronic, paper filing, and tax law questions from the payer community relating to the correct preparation and filing of business information returns (Forms 1096, 1098, 1099, 5498, 8027, and W-2G). IRB/CSS also answers questions relating to the electronic filing of Forms 1042-S and to the tax law criteria and paper filing instructions for Forms W-2 and W-3. Inquiries dealing with backup withholding and reasonable cause requirements due to missing and incorrect taxpayer identification numbers are also addressed by IRB/CSS. Assistance is available year-round to payers, transmitters, and employers nationwide, Monday through Friday, 8:30 a.m. to 4:30 p.m. Eastern Time, by calling toll-free 1-866-455-7438 or via e-mail at mccirp@irs.gov. Do not include SSNs or EINs in e-mails or attachments since this is not a secure line. The Telecommunications Device for the Deaf (TDD) toll number is 304-267-3367. Call as soon as questions arise to avoid the busy filing seasons at the end of January and February. Recipients of information returns (payees) should continue to contact 1-800-829-1040 with any questions on how to report the information returns data on their tax returns.

.06 The telephone numbers and web addresses for questions about specifications for electronic submissions are:

Information Reporting Program Customer Service Section

TOLL-FREE 1-866-455-7438 or outside the U.S. 1-304-263-8700

e-mail at mccirp@irs.gov

304-267-3367 — TDD

(Telecommunication Device for the Deaf)

Fax Machine

Toll-free within the U.S. — 877-477-0572

Outside the U.S. — 304-264-5602

Electronic Filing — FIRE System

http://fire.irs.gov

TO OBTAIN FORMS:

1-800-TAX-FORM (1-800-829-3676)

www.irs.gov — IRS website access to forms

Sec. 4. Filing Requirements and Due Dates
.01 Section 6011(e)(2)(A) of the Internal Revenue Code requires that any person, including corporations, partnerships, individuals, estates, and trusts, required to file 250 or more information returns must file such returns electronically.

.02 The filing requirements apply separately to both original and corrected returns.

.03 The above requirements do not apply if you establish undue hardship (see Part A, Sec. 5).

.04 DO NOT SUBMIT THE SAME INFORMATION ON PAPER FORMS THAT YOU SUBMIT ELECTRONICALLY, SINCE THIS WOULD RESULT IN DUPLICATE FILING. This does not mean that corrected documents are not to be filed. If a return has been prepared and submitted improperly, you must file a corrected return as soon as possible. Refer to Part A, Sec. 10 for requirements and instructions for filing corrected returns.

.05 If an allocation of tips is based on a good faith agreement, a copy of this agreement must be submitted within 3 business days after receiving acknowledgement that IRS has accepted the electronically filed Form 8027. Mail or Fax a copy of this agreement using the contact information in Part A, Sec. 3. In your transmittal (e.g., fax transmittal or cover letter), include the words “Form 8027 attachment(s)” and the following information: name of establishment, establishment number, TCC and the tax year of the Form 8027.

.06 Employers can request a lower rate (but not lower than 2%) for tip allocation purposes by submitting an application to the IRS. See Sec. 31.6053—3(h)(4) of Employment Tax Regulations. Detailed instruction for requesting a lower rate can be found in the Instructions for Form 8027. The IRS will issue a determination letter to notify the employer when and for how long a reduced rate is effective. If a lower rate is used on the Form 8027 based on the IRS determination letter, a copy of this letter must be submitted within 3 business days after receiving acknowledgement that IRS has accepted the electronically filed Form 8027. Mail or Fax a copy of this agreement using the contact information in Part A, Sec. 3. In your transmittal (e.g., fax transmittal or cover letter), include the words “Form 8027 attachment(s)” and the following information: name of establishment, establishment number, TCC and the tax year of the Form 8027.

.07 Electronic reporting to IRS for Form 8027 must be on a calendar year basis. The due date for paper reported Forms 8027 is the last day of February. However, Forms 8027 filed electronically are due March 31.

.08 If the due date falls on a Saturday, Sunday, or legal holiday, filing Form 8027 on the next day that is not a Saturday, Sunday, or legal holiday will be considered timely.

Sec. 5. Form 8508, Request for Waiver From Filing Information Returns Electronically
.01 If an employer is required to file electronically but fails to do so and does not have an approved waiver on record, the employer will be subject to a penalty of $50 per return in excess of 250.

.02 If employers are required to file original or corrected returns electronically, but such filing would create a hardship, they may request a waiver from these filing requirements by submitting Form 8508, Request for Waiver From Filing Information Returns Electronically, to IRS/ECC-MTB. Form 8508 can be obtained on the IRS website at www.irs.gov or by calling toll-free 1-800-829-3676.

.03 Even though an employer may submit as many as 249 corrections on paper, IRS encourages electronic filing of corrections. Once the 250 threshold has been met, filers are required to submit any additional returns electronically. However, if a waiver for an original filing is approved, any corrections for the same type of returns will be covered under that waiver.

.04 Generally, only the employer may sign the Form 8508. A transmitter may sign if given power of attorney; however, a letter signed by the employer stating this fact must be attached to the Form 8508.

.05 A transmitter must submit a separate Form 8508 for each employer. Do not submit a list of employers.

.06 All information requested on the Form 8508 must be provided to IRS for the request to be processed.

.07 The waiver, if approved, will provide exemption from electronic filing for the current tax year only. Employers may not apply for a waiver for more than one tax year.

.08 Form 8508 may be photocopied or computer-generated as long as it contains all the information requested on the original form.

.09 Filers are encouraged to submit Form 8508 to IRS/ECC-MTB at least 45 days before the due date of the returns.

.10 All requests for a waiver should be sent using the following address:

IRS-Enterprise Computing Center — Martinsburg

Information Reporting Program

Attn: Extension of Time Coordinator

240 Murall Drive

Kearneysville, WV 25430

.11 File Form 8508 for Forms W-2 with IRS/ECC-MTB, not SSA.

.12 Waivers are evaluated on a case-by-case basis and are approved or denied based on criteria set forth under section 6011(e) of the Internal Revenue Code. The transmitter must allow a minimum of 30 days for IRS/ECC-MTB to respond to a waiver request.

.13 If a waiver request is approved, the transmitter should keep the approval letter on file.

.14 An approved waiver from filing Forms 8027 electronically does not provide exemption from all filing. The employer must timely file Form 8027 on acceptable paper forms with the Cincinnati Service Center. The transmitter should also send a copy of the approved waiver to the Cincinnati Service Center where the paper returns are filed.

Sec. 6. Form 4419, Application for Filing Information Returns Electronically
.01 For the purposes of this revenue procedure, the EMPLOYER is the organization supplying the information and the TRANSMITTER is the organization preparing the electronic file and/or sending the file to IRS/ECC-MTB. The employer and the transmitter may be the same entity. Employers or their transmitters are required to complete Form 4419, Application for Filing Information Returns Electronically.

.02 Form 4419 can be submitted at any time during the year; however, it should be submitted to IRS/ECC-MTB at least 30 days before the due date of the return(s). IRS will act on an application and notify the applicant, in writing, of authorization to file. A five-character alpha/numeric Transmitter Control Code (TCC) will be assigned and included in an acknowledgment letter within 15 to 45 days of receipt of the application. Electronic returns may not be filed with IRS until the application has been approved and a TCC assigned. Include your TCC in any correspondence with IRS/ECC-MTB.

.03 If you file information returns other than Form 8027 electronically, you must obtain a separate TCC for those types of returns. The TCC assigned for Forms 8027 is to be used for the processing of these forms only.

.04 After you have received approval to file electronically, you do not need to reapply each year; however, notify IRS in writing if:

(a) You change your name or the name of your organization, so that your files may be updated to reflect the proper name;

(b) You discontinue filing for two years (your TCC may have been reassigned).

.05 IRS/ECC-MTB encourages filers who plan to submit for multiple employers to submit one application and to use one TCC for all employers.

.06 Approval to file does not imply endorsement by IRS/ECC-MTB of any computer software or of the quality of tax preparation services provided by a service bureau or software vendor.

Sec. 7. State Abbreviations
.01 The following state and U.S. possession abbreviations are to be used when developing the state code portion of address fields.

State
Code
State
Code
State
Code

Alabama
AL
Kentucky
KY
No. Mariana Islands
MP

Alaska
AK
Louisiana
LA
Ohio
OH

American Samoa
AS
Maine
ME
Oklahoma
OK

Arizona
AZ
Marshall Islands
MH
Oregon
OR

Arkansas
AR
Maryland
MD
Pennsylvania
PA

California
CA
Massachusetts
MA
Puerto Rico
PR

Colorado
CO
Michigan
MI
Rhode Island
RI

Connecticut
CT
Minnesota
MN
South Carolina
SC

Delaware
DE
Mississippi
MS
South Dakota
SD

District of Columbia
DC
Missouri
MO
Tennessee
TN

Federated States of Micronesia
FM
Montana
MT
Texas
TX

Florida
FL
Nebraska
NE
Utah
UT

Georgia
GA
Nevada
NV
Vermont
VT

Guam
GU
New Hampshire
NH
Virginia
VA

Hawaii
HI
New Jersey
NJ
(U.S.) Virgin Islands
VI

Idaho
ID
New Mexico
NM
Washington
WA

Illinois
IL
New York
NY
West Virginia
WV

Indiana
IN
North Carolina
NC
Wisconsin
WI

Iowa
IA
North Dakota
ND
Wyoming
WY

Kansas
KS


.02 Filers must adhere to the city, state, and ZIP Code format for U.S. addresses. This also includes American Samoa, Federated States of Micronesia, Guam, Marshall Islands, Commonwealth of the Northern Mariana Islands, Puerto Rico, and the U.S. Virgin Islands.

Note: A Form 8027 is required only for establishments in the 50 states and the District of Columbia.

Sec. 8. Extension of Time
.01 An extension of time to file may be requested for Form 8027.

.02 A paper Form 8809, Application for Extension of Time To File Information Returns, should be submitted to IRS/ECC-MTB. This form may be used to request an extension of time to file information returns submitted on paper or electronically. All requests for an extension of time filed on Form 8809 should be sent using the following address:

IRS-Enterprise Computing Center - Martinsburg

Information Reporting Program

Attn: Extension of Time Coordinator

240 Murall Drive

Kearneysville, WV 25430

Note: Due to the large volume of mail received by IRS/ECC-MTB and the time factor involved in processing Extension of Time (EOT) requests, it is imperative that the attention line be present on all envelopes or packages containing Form 8809.

.03 The fill-in Form 8809 may be completed online via the FIRE System. (See Part B, Sec. 7, for instructions on connecting to the FIRE System.) At the Main Menu, click “Extension of Time Request” and then click “Fill-in Extension Form”. This option is only used to request an automatic 30-day extension. Extension requests completed online via the FIRE System receive an instant response. If you are requesting an additional extension, you must submit a paper Form 8809. Requests for an additional extension of time to file information returns are not automatically granted. Requests for additional time are granted only in cases of extreme hardship or catastrophic event. The IRS will only send a letter of explanation approving or denying your additional extension request. (Refer to .06 of this Section.)

.04 Filers requesting an extension of time for multiple employers may submit one Form 8809 and attach a list of the employer names and their Employer Identification Numbers (EINs). The listing must be attached to ensure the extension is recorded for all employers. Form 8809 may be computer-generated or photocopied. Be sure that all the pertinent information is included.

.05 Requests for extensions of time for multiple employers will be responded to with one approval letter, accompanied by a list of employers covered under that approval.

.06 As soon as it is apparent that an extension of time to file is needed, Form 8809 may be submitted. When granted, the extension will be for 30 days. It will take a minimum of 30 days for IRS/ECC-MTB to respond to an extension request. Under certain circumstances, a request for an extension of time could be denied. When a denial letter is received, any additional or necessary information may be resubmitted within 20 days. When requesting an extension of time, do not hold your files waiting for a response.

.07 While very difficult to obtain, if an additional extension of time is needed, a second Form 8809 must be submitted before the end of the initial extension period. Line 7 on the form should be checked to indicate that an additional extension is being requested. A second 30-day extension will be approved only in cases of extreme hardship or catastrophic events.

.08 Form 8809 must be postmarked no later than the due date of the return for which an extension is requested. If requesting an extension of time to file several types of forms, use one Form 8809, but the Form 8809 must be postmarked no later than the earliest due date. For example, if requesting an extension of time to file both Forms 8027 and 5498, submit Form 8809 postmarked on or before the last day of February.

.09 If an extension request is approved, the approval letter should be kept on file. The approval letter or copy of the approval letter for extension of time should not be sent to IRS/ECC-MTB with the electronic file. When submitting Form 8027 on paper only to the Cincinnati Service Center, attach a copy of the approval letter. If an approval letter has not been received, send a copy of the timely filed Form 8809.

.10 Request an extension for only one tax year.

.11 The extension request must be signed by the employer or a person who is duly authorized to sign a return, statement or other document for the employer.

.12 Failure to properly complete and sign the Form 8809 may cause delays in processing the request or result in a denial. Carefully read and follow the instructions on the back of the Form 8809.

.13 Form 8809 may be obtained by calling 1-800-TAX-FORM (1-800-829-3676) or downloading from www.irs.gov.

Note: An extension of time to file is not an extension to furnish Form W-2 to the employee.

.14 Request an extension of time to furnish the statements to recipients of Forms W-2 by submitting a letter to IRS/ECC-MTB (See Part A, Sec. 3) containing the following information:

(a) Employer name

(b) EIN

(c) Address

(d) Type of return (W-2)

(e) Specify that the extension request is to provide W-2 statements to recipients.

(f) Reason for delay

(g) Signature of employer or person duly authorized.


Requests for an extension of time to furnish the statements for Forms W-2 to recipients are not automatically approved; however, if approved, generally an extension will allow a maximum of 30 additional days from the due date to furnish the statements to the recipients. The request must be postmarked no later than the date on which the statements are due to the recipients.

Sec. 9. Penalties
.01 The Revenue Reconciliation Act of 1989 changed the penalty provisions for any documents, including corrections, which are filed after the original filing date for the return. The penalty for failure to file correct information returns is “time sensitive,” in that prompt correction of failures to file, or prompt correction of errors on returns that were filed, can lead to reduced penalties.

- The penalty generally is $50 for each information return that is not filed, or is not filed correctly, by the prescribed filing date, with a maximum penalty of $250,000 per year ($100,000 for certain small businesses with average annual gross receipts, over the most recent 3-year period, not in excess of $5,000,000). The penalty generally is reduced to:

- $30 for each failure to comply if the failure is corrected more than 30 days after the return was due, but on or before August 1 of the calendar year in which the return was due, with a maximum penalty of $150,000 per year ($50,000 for certain small businesses with average annual gross receipts, over the most recent 3-year period, not in excess of $5,000,000).

- $15 for each failure to comply if the failure is corrected within 30 days after the date the return was due, with a maximum penalty of $75,000 per year ($25,000 for certain small businesses with average annual gross receipts, over the most recent 3-year period, not in excess of $5,000,000).

.02 Penalties can be waived if failures were due to reasonable cause and not to willful neglect. In addition, section 6721(c) of the Code provides a de minimis rule that if:

(a) information returns have been filed but were filed with incomplete or incorrect information, and

(b) the failures are corrected on or before August 1 of the calendar year in which the returns were due, then the penalty for filing incorrect returns (but not the penalty for filing late) will not apply to the greater of 10 returns or one-half of 1 percent of the total number of information returns you are required to file for the calendar year.


.03 Intentional Disregard of Filing Requirements — If any failure to file a correct information return is due to intentional disregard of the filing and correct information requirements, the penalty is at least $100 per information return with no maximum penalty.

Sec. 10. Corrected Returns, Paper Forms, and Computer-Generated Forms
.01 If returns must be corrected, approved electronic filers must provide such corrections electronically for 250 or more forms. If your information is filed electronically, corrected returns are identified by using the “Corrected 8027 Indicator” in field position 370 of the employer record.

.02 A correction file must be identified by entering the correction indicator “G” in position 370.

.03 When replacing a correction file that was bad, you must submit a replacement file. Since you are replacing a correction file you must enter the correction indicator “G” in position 370.

.04 If corrections are not submitted electronically, employers must submit them on official Forms 8027. Substitute forms that have been previously approved by IRS, or computer-generated forms that are exact facsimiles of the official form (except for minor page size or print style deviations), may be submitted without obtaining IRS approval before using the form.

.05 Employers/establishments may send corrected paper Forms 8027 to IRS at the address shown in Part A, Sec. 10.06. Corrected paper returns are identified by marking the “AMENDED” check box on Form 8027.

.06 If you are filing more than one paper Form 8027, you must attach a completed Form 8027-T, Transmittal of Employer's Annual Information Return of Tip Income and Allocated Tips, to the Forms 8027 and send to:

Department of the Treasury

Internal Revenue Service Center

Cincinnati, OH 45999

IRS/ECC-MTB processes Forms 8027 submitted electronically only. Do not send paper Forms 8027 to IRS/ECC-MTB.

.07 If part of a submission is filed electronically and the rest of the submission is filed on paper Forms 8027, send the paper forms to the Cincinnati Service Center. For example, you filed your Forms 8027 electronically with IRS/ECC-MTB, and later you found that some of the forms you filed need correcting. Because of the low volume of corrections, you submit the corrections on paper Forms 8027. You must send these corrected Forms 8027 along with Form 8027-T to the Cincinnati Service Center.

Sec. 11. Validation of Form 8027 at IRS/ECC-MTB
.01 The accuracy of data reported on Form 8027 will be validated at the IRS Service Center. All fields indicated as “Required” in the record layout must contain valid information. If the IRS identifies an error, you will be notified and required to provide correct information.

.02 The address for the establishment must agree with the state and ZIP Code. If there are inconsistencies or if the ZIP code does not agree with the address the record will error out.

.03 All alpha characters must be in upper case.

.04 The following is clarification of monetary amount requirements:

(a) Charged Receipts (positions 260-271) must exceed Charged Tips (positions 248-259).

(b) Total Tips Reported (positions 308-319) must equal the combined amount of the Indirect Tips (positions 284-295) and Direct Tips (positions 296-307).

(c) Gross Receipts (positions 320-331) must exceed all other monetary amounts with the exception of Charged Receipts. It is possible to equal Charged Receipts if all transactions were conducted on charge cards.

(d) The Tip Percentage Rate Times Gross Receipts (332-343) must equal the Gross Receipts times the Tip Rate. Normally, the Tip Rate is 8%. The Tip Rate must be entered as 0800 in positions 344-347 unless you have been granted a lower rate by the IRS.

(e) Generally, you would have allocated tips if the Total Tips Reported (positions 308-319) is less than the Tip Percentage Rate Times Gross Receipts (positions 332-343). The difference must be entered as Allocated Tips (positions 348-359).


Sec. 12. Definition of Terms

ELEMENT
DESCRIPTION


Correction
A correction is an information return submitted by the employer/transmitter to correct an information return that was previously submitted to and successfully processed by IRS, but contained erroneous information.


EIN
A nine-digit Employer Identification Number which has been assigned by IRS to the reporting entity.


Employees hours worked
The average number of employee hours worked per business day during a month is figured by dividing the total hours worked during the month by all your employees who are employed in a food or beverage operation by the average number of days in the month that each food or beverage operation at which these employees worked was open for business.


Employer
The organization supplying their information. Use the same name and EIN you used on your Forms W-2 and Forms 941.


Establishment
A large food or beverage establishment that provides food or beverage for consumption on the premises; where tipping is a customary practice; and where there are normally more than 10 employees who work more than 80 hours on a typical business day during the preceding calendar year.


File
For the purpose of this revenue procedure, a file is the Form 8027 information submitted electronically by an Employer or Transmitter.


More than 10 employees
An employer is considered to have more than 10 employees on a typical business day during the calendar year if half the sum of: the average number of employee hours worked per business day in the calendar month in which the aggregate gross receipts from food and beverage operations were greatest, plus the average number of employee hours worked per business day in the calendar month in which the total aggregate gross receipts from food and beverage operations were the least, equals more than 80 hours.


Replacement
A replacement is an information return file sent by the employer/transmitter at the request of IRS/ECC-MTB because of errors encountered while processing the filer's original file or correction file.


Transmitter
Person or organization preparing electronic file(s). May be employer or agent of employer.


Transmitter Control Code (TCC)
A five-character alpha/numeric code assigned by IRS to the transmitter prior to actual filing electronically. This number is inserted in the record and must be present. An application (Form 4419) must be filed with IRS to receive this number.



Part B. Electronic Filing Specifications
Note: The FIRE System DOES NOT provide fill-in forms, except for Form 8809, Application for Extension of Time To File Information Returns. Filers must program files according to the Record Layout Specifications contained in this publication.

Sec. 1. General
.01 Electronic filing of Forms 8027 information returns, originals and replacements, is a reporting method for filers submitting 250 or more Forms 8027. Payers who are under the filing threshold requirement, are encouraged to file electronically.

.02 All electronic filing of information returns are received at IRS/ECC-MTB via the FIRE (Filing Information Returns Electronically) System. To connect to the FIRE System, point your browser to http://fire.irs.gov. The system is designed to support the electronic filing of information returns only.

.03 The electronic filing of information returns is not affiliated with any other IRS electronic filing programs. Filers must obtain separate approval to participate in each program. Only inquiries concerning electronic filing of information returns should be directed to IRS/ECC-MTB.

.04 Files submitted to IRS/ECC-MTB electronically must be in standard ASCII code. Do not submit paper forms with the same information as electronically submitted files. This would create duplicate reporting resulting in penalty notices.

.05 Form 8809, Application for Extension of Time To File Information Returns, is available as a fill-in form via the FIRE System. If you do not already have a User ID and password refer to Section 7. At the Main Menu, click “Extension of Time Request” and then click “Fill-in Extension Form”. This option is only used to request an automatic 30-day extension and must be completed by the due date of the return for each payer requesting an extension. Print the approval page for your records. Refer to Part A, Sec. 8 for additional details.

Sec. 2. Electronic Filing Approval Procedure
.01 Filers must obtain a Transmitter Control Code (TCC) prior to submitting files electronically. Filers who previously had a TCC for magnetic media filing of Form 8027 may use their assigned TCC for electronic filing. Refer to Part A, Sec. 6, for information on how to obtain a TCC.

.02 Once a TCC is obtained, electronic filers assign their own user ID, password and PIN (Personal Identification Number) and do not need prior or special approval. See Part B, Sec. 5, for more information on the PIN.

.03 If a filer is submitting files for more than one TCC, it is not necessary to create a separate logon and password for each TCC.

.04 For all passwords, it is the user's responsibility to remember the password and not allow the password to be compromised. Passwords are user assigned at first logon and must be 8 alpha/numeric characters containing at least 1 uppercase, 1 lowercase, and 1 numeric. However, filers who forget their password or PIN, can call toll-free 1-866-455-7438 for assistance. Users can change their passwords at any time from the main menu. The FIRE System may require users to change their passwords on a yearly basis.

Sec. 3. Test Files
.01 Filers are not required to submit a test file; however, the submission of a test file is encouraged for all new electronic filers to test hardware and software. If filers wish to submit an electronic test file for Tax Year 2008 (returns to be filed in 2009), it must be submitted to IRS/ECC-MTB no earlier than November 1, 2008, and no later than February 15, 2009.

.02 Filers who encounter problems while transmitting the electronic test file can contact IRS/ECC-MTB toll-free 1-866-455-7438 for assistance.

.03 Within 5 days, the results of the electronic transmission will be e-mailed to you providing you provide an accurate e-mail address on the “Verify Your Filing Information” screen. If you are using e-mail filtering software, configure your software to accept e-mail from fire@irs.gov and irs.e-helpmail@irs.gov. If after receiving the e-mail it indicates that your file is bad, you must log into the FIRE System and go to the CHECK FILE STATUS area of the FIRE System to determine what the errors are in your file. If you do not receive an e-mail in 5 business days, log back into the FIRE System and click on CHECK FILE STATUS to view the results of your file.

Sec. 4. Electronic Submissions
.01 Electronically filed information may be submitted to IRS/ECC-MTB 24 hours a day, 7 days a week. Technical assistance will be available Monday through Friday between 8:30 a.m. and 4:30 p.m. Eastern time by calling toll-free 1-866-455-7438.

.02 The FIRE System will be down from the last week of December through the first week of January. This allows IRS/ECC-MTB to update its system to reflect current year changes.

.03 If you are sending files larger than 10,000 records electronically, data compression is encouraged. If you are considering sending files larger than 5 million records, please contact IRS/ECC-MTB for specifics. WinZip and PKZip are the only acceptable compression packages. IRS/ECC-MTB cannot accept self-extracting zip files or compressed files containing multiple files. The time required to transmit information returns electronically will vary depending upon the type of connection to the Internet and if data compression is used. The time required to transmit a file can be reduced by as much as 95 percent by using compression.

.04 Transmitters may create files using self assigned files name(s). Files submitted electronically will be assigned a new unique file name by the FIRE System. The file name assigned by the FIRE System will consist of submission type (ORIG [original], TEST [test], CORR [correction], and REPL [replacement]), the filer's TCC and a four-digit number sequence. The sequence number will be incremented for every file sent. For example, if it is your first original file for the calendar year and your TCC is 44444, the IRS assigned file name would be ORIG.44444.0001. Record the file name. This information will be needed by IRS/ECC-MTB to identify the file, if assistance is required.

.05 If a file was submitted timely and is bad, the filer will have up to 60 days from the date the file was sent to transmit an acceptable file. If an acceptable file is not received within 60 days, then the payer could be subject to late filing penalties.

.06 The following definitions have been provided to help distinguish between a correction and a replacement:

A correction is an information return submitted by the transmitter to correct an information return that was previously submitted to and successfully processed by IRS/ECC-MTB, but contained erroneous information. (See Note.)

Note: Corrections should only be made to forms that have been submitted incorrectly, not the entire file.

A replacement is an information return file sent by the filer because the CHECK FILE STATUS option on the FIRE System indicated the original/correction file was bad. After the necessary changes have been made, the file must be transmitted through the FIRE System. (See Note.)

Note: Filers should never transmit anything to IRS/ECC-MTB as a “Replacement” file unless the CHECK FILE STATUS option on the FIRE System indicates the file is bad.

.07 Prior year data may be submitted, however, each tax year must be submitted in a separate file transmission.

Sec. 5. PIN Requirements
.01 Filers will be prompted to create a PIN consisting of 10 numeric characters when establishing their initial logon name and password.

.02 The PIN is required each time an ORIGINAL, CORRECTION, or REPLACEMENT file is sent electronically and is permission to release the file. It is not needed for a TEST file. An authorized agent may enter their PIN, however, the payer is responsible for the accuracy of the returns. The payer will be liable for penalties for failure to comply with filing requirements. If you forget your PIN, please call toll-free 1-866-455-7438 for assistance.

Sec. 6. Electronic Filing Specifications
.01 The FIRE System is designed exclusively for the filing of Forms 8027, 1098, 1099, 5498, W-2G, and 1042-S.

.02 A transmitter must have a TCC (see Part A, Sec. 6) before a file can be transmitted.

.03 Within 5 days, the results of the electronic transmission will be e-mailed to you providing you provide an accurate e-mail address on the “Verify Your Filing Information” screen. If you are using e-mail filtering software, configure your software to accept e-mail from fire@irs.gov and irs.e-helpmail@irs.gov. If after receiving the e-mail it indicates that your file is bad, you must log into the FIRE System and go to the CHECK FILE STATUS area of the FIRE System to determine what the errors are in your file. If you do not receive an e-mail in 5 business days, log back into the FIRE System and click on CHECK FILE STATUS to view the results of your file.

Sec. 7. Connecting to the FIRE System
.01 Point your browser to http://fire.irs.gov to connect to the FIRE System.

.02 If you are running pop-up blocking software, disable it if you have problems uploading the file.

.03 Before connecting, have your TCC and TIN available.

.04 Your browser must support SSL 128-bit encryption.

First time connection to the FIRE System (If you have logged on previously, skip to Subsequent Connections to the FIRE System.)

Click “Create New Account”.

Fill out the registration form and click “Submit”.

Enter your User ID (most users logon with their first and last name).

Enter and verify your password (the password is user assigned and must be 8 alpha/numerics, containing at least 1 uppercase, 1 lowercase and 1 numeric). FIRE may require you to change the password once a year.

Click “Create”.

If you receive the message “Account Created”, click “OK”.

Enter and verify your 10-digit self-assigned PIN (Personal Identification Number). Click “Submit”.

If you receive the message “Your PIN has been successfully created!”, click “OK”.

Read the bulletin(s) and/or click “Click here to continue”.

Subsequent connections to the FIRE System

Click “Log On”.

Enter your User ID (most users logon with their first and last name).

Enter your password (the password is user assigned and is case sensitive).

Read the bulletins and/or click “Click here to continue”.

Uploading your file to the FIRE System

At Menu Options:

Click “Send Information Returns”

Enter your TCC:

Enter your TIN:

Click “Submit”.

Uploading your file to the FIRE System

The system will then display the company name, address, city, state, ZIP Code, phone number, contact and e-mail address. This information will be used to e-mail the transmitter regarding this transmission. Update as appropriate and/or Click “Accept”.

Note: Please ensure that the e-mail is accurate so that the correct person receives the e-mail and it does not return to us undeliverable. If you are using SPAM filtering software, please configure it to allow an e-mail from fire@irs.gov and irs.e-helpmail@irs.gov.

Click one of the following:

Original File

Correction File

Test File (This option will only be available November through mid-February.)

Replacement File (Click on the file to be replaced.)

Electronic Replacement (file was originally transmitted on this system)

Click the file to be replaced.

Mag Media Replacement (file was originally sent on some type of magnetic media). Enter the alpha character from the letter (L-2494) that was returned. It is located on the top right on the letter under “Refer Reply To:” For example, if the letter indicates TCC 44444A, the alpha code that would be entered is “A”. Click “Submit”.

Enter your 10-digit PIN.

Click “Submit”.

Click “Browse” to locate the file and open it.

Click “Upload”.

When the upload is complete, the screen will display the total bytes received and tell you the name of the file you just uploaded.

If you have more files to upload for that TCC:

Click “File Another?”; otherwise,

Click “Main Menu”.

If you do not receive an e-mail in 5 business days or your e-mail indicates the file is bad, log back into the FIRE System and click on CHECK FILE STATUS to view the results of your file.

Checking your FILE STATUS

At the Main Menu:

Click “Check File Status”.

Enter your TCC:

Enter your TIN:

Click “Search”.

If “Results” indicate:

“Good, Released” — File has been released to our mainline processing.

“Bad” — Correct the errors and timely resubmit the file as a “replacement”.

“Not yet processed” — File has been received, but we do not have results available yet. Please check back in a few days.

Click on the desired file for a detailed report of your transmission.

When you are finished, click on Main Menu.

Click “Log Out”.

Close your Web Browser.

Sec. 8. Common Problems and Questions Associated with Electronic Filing
.01 The following are the major errors associated with electronic filing:

NON-FORMAT ERRORS
1. SPAM filters are not set to receive e-mail from fire@irs.gov and irs.e-helpmail@irs.gov.

If you want to receive e-mails concerning your files, processing results, reminders and notices, set your SPAM filter to receive e-mail from fire@irs.gov and irs.e-helpmail@irs.gov.

2. Incorrect e-mail provided.

When the “Verify Your Filing Information” screen is displayed, make sure your correct e-mail is displayed. If not, please update with the correct e-mail.

3. Transmitter does not check the FIRE System to determine file acceptability.

The results of your file transfer are posted to the FIRE System within 5 business days. If the correct e-mail address was provided on the “Verify Your Filing Information” screen when the file was sent, an e-mail will be sent regarding your FILE STATUS. If the results in the e-mail indicate “Good, Released” and you agree with the “Count of Payees”, then you are finished with this file. If you have any other results, please follow the instructions in the Check File Status option. If the file contains errors, you can get an online listing of the errors. Date received and number of payee records is also displayed.

4. Replacement file is not submitted timely.

If your file is bad, correct the file and timely resubmit as a replacement.

5. Transmitter compresses several files into one.

Only compress one file at a time. For example, if you have 10 uncompressed files to send, compress each file separately and send 10 separate compressed files.

6. Transmitter sends an original file that is good, and then sends a correction file for the entire file even though there are only a few changes.

The correction file, containing the proper coding, should only contain the records requiring correction, not the entire file.

7. File is formatted as EBCDIC.

All files submitted electronically must be in standard ASCII code. All alpha characters must be uppercase.

8. Transmitter has one TCC number, but is filing for multiple companies, which TIN should be used when logging into the system to send the file?

When sending the file electronically, you will need to enter the TIN of the company assigned to the TCC. When you upload the file, it will contain the TINs for the other companies that you are filing for. This is the information that will be passed forward.

9. Transmitter sent the wrong file, what should be done?

Call us as soon as possible toll-free 1-866-455-7438. We may be able to stop the file before it has been processed. Please do not send a replacement for a file that is marked as a good file.

Part C. Filing Specifications and Record Layout
.01 If the file does not meet these specifications, IRS/ECC-MTB will request a replacement file. Filers are encouraged to submit a test prior to submitting the actual file. Contact IRS/ECC-MTB toll-free 1-866-455-7438 for further information.

Note 1: For tax year 2008 filed in calendar year 2009, IRS/ECC-MTB will no longer accept tape cartridges. Electronic filing will be the ONLY acceptable method for filing Form 8027.

Note 2: The only allowable characters in name and address fields are alphas, numeric characters, and blanks. Punctuation such as periods, hyphens, ampersands, slashes and commas are not allowed and will cause your file to be rejected. For example, O'Hurley's Bar & Grill, 210 N. Queen St., Suite #300 must be entered as OHurleys Bar Grill 210 N Queen St Suite 300.

Sec. 1. Record Format and Layout

FORM 8027 RECORD FORMAT


Field Position
Field Title
Length
Description and Remarks


1
Establishment Type
1
Required. This number identifies the kind of establishment. Enter the number which describes the type of establishment, as shown below:
1. for an establishment that serves evening meals only (with or without alcoholic beverages).
2. for an establishment that serves evening meals and other meals (with or without alcoholic beverages).
3. for an establishment that serves only meals other than evening meals (with or without alcoholic beverages).
4. for an establishment that serves food, if at all, only as an incidental part of the business of serving alcoholic beverages.


2-6
Establishment Serial Numbers
5
Required. These five-digit Serial Numbers are for identifying individual establishments of an employer reporting under the same EIN. The employer shall assign each establishment a unique number. Numeric characters only.


7-46
Establishment Name
40
Required. Enter the name of the establishment. Left-justify and fill unused positions with blanks. Allowable characters are alphas, numeric, and blanks.


47-86
Establishment Street Address
40
Required. Enter the mailing address of the establishment. Street address should include number, street, apartment or suite number (use P O Box only if mail is not delivered to street address). Left-justify and blank fill. Allowable characters are alphas, numeric, and blanks.


87-111
Establishment City
25
Required. Enter the city, town, or post office. Left-justify and blank fill. Allowable characters are alphas, numeric, and blanks.


112-113
Establishment State
2
Required. Enter the state code from the state abbreviations table in Part A, Sec. 7.


114-122
Establishment ZIP Code
9
Required. Enter the complete nine-digit ZIP Code of the establishment. If using a five-digit ZIP Code, left-justify the five-digit ZIP Code and fill the remaining four positions with blanks.


Note: Must be nine numeric characters or 5 numeric characters and four blanks. Do not enter the dash.


123-131
Employer Identification Number
9
Required. Enter the nine-digit number assigned to the employer by IRS. Do not enter hyphens, alphas, all 9s or all zeros.


132-171
Employer Name
40
Required. Enter the name of the employer as it appears on your tax forms (e.g., Form 941). Any extraneous information must be deleted. Left-justify and blank fill. Allowable characters are alphas, numeric, and blanks.


172-211
Employer Street Address
40
Required. Enter mailing address of employer. Street address should include number, street, apartment or suite number (use P O Box only if mail is not delivered to street address). Left-justify and blank fill. Allowable characters are alphas, numeric, and blanks.


212-236
Employer City
25
Required. Enter the city, town, or post office. Left-justify and blank fill. Allowable characters are alphas, numeric, and blanks.


237-238
Employer State
2
Required. Enter the state code from the state abbreviations table in Part A, Sec. 7.


239-247
Employer ZIP Code
9
Required. Enter the complete nine-digit ZIP Code of the establishment. If using a five-digit ZIP Code, left-justify the five-digit ZIP Code and fill the remaining four positions with blanks.

Note: Must be nine numeric characters or 5 numeric characters and four blanks. Do not enter the dash.


248-259
Charged Tips
12
Required. Enter the total amount of tips that are shown on charge receipts for the calendar year. Amount must be entered in U.S. dollars and cents. The right-most two positions represent cents. Right-justify and zero fill. If no entry, zero fill. Numeric characters only. Do not enter decimal points, dollars signs, or commas.


260-271
Charged Receipts
12
Required. Enter the total sales for the calendar year other than carry-out sales or sales with an added service charge of 10 percent or more, that are on charge receipts with a charged tip shown. This includes credit card charges, other credit arrangements, and charges to a hotel room unless the employer's normal accounting practice consistently excludes charges to a hotel room. Do not include any state or local taxes in the amount reported. Amount must be entered in U.S. dollars and cents. The right-most two positions represent cents. Right-justify and zero fill. If no entry, zero fill. Numeric characters only. Do not enter decimal points, dollars signs, or commas.


272-283
Service Charge Less Than 10 Percent
12
Required. Enter the total amount of service charges less than 10 percent added to customer's bills and were distributed to your employees for the calendar year. In general, service charges added to the bill are not tips since the customer does not have a choice. These service charges are treated as wages and are included on Form W-2. Amount must be entered in U.S. dollars and cents. The right-most two positions represent cents. Right-justify and zero fill. If no entry, zero fill. Numeric characters only. Do not enter decimal points, dollars signs, or commas.


284-295
Indirect Tips Reported
12
Required. Enter the total amount of tips reported by indirectly tipped employees (e.g., bussers, service bartenders, cooks) for the calendar year. Do not include tips received by employees in December of the prior tax year but not reported until January. Include tips received by employees in December of the tax year being reported, but not reported until January of the subsequent year. Amount must be entered in U.S. dollars and cents. The right-most two positions represent cents. Right-justify and zero fill. If no entry, zero fill. Numeric characters only. Do not enter decimal points, dollars signs, or commas.


296-307
Direct Tips Reported
12
Required. Enter the total amount of tips reported by directly tipped employees (e.g., servers, bartenders) for the calendar year. Do not include tips received by employees in December of the prior tax year but not reported until January. Include tips received by employees in December of the tax year being reported, but not reported until January of the subsequent year. Amount must be entered in U.S. dollars and cents. The right-most two positions represent cents. Right-justify and zero fill. If no entry, zero fill. Numeric characters only. Do not enter decimal points, dollars signs, or commas.


308-319
Total Tips Reported
12
Required. Enter the total amount of tips reported by all employees (both indirectly tipped and directly tipped) for the calendar year. Do not include tips received in December of the prior tax year but not reported until January. Include tips received in December of the tax year being reported, but not reported until January of the subsequent year. Amount must be entered in U.S. dollars and cents. The right-most two positions represent cents. Right-justify and zero fill. If no entry, zero fill. Numeric characters only. Do not enter decimal points, dollars signs, or commas.


320-331
Gross Receipts
12
Required. Enter the total gross receipts from the provision of food and/or beverages for this establishment for the calendar year. Do not include receipts for carry-out sales or sales with an added service charge of 10 percent or more. Do not include in gross receipts charged tips (field positions 248-259) shown on charge receipts unless you have reduced the cash sales amount because you have paid cash to tipped employees for tips they earned that were charged. Do not include state or local taxes in gross receipts. If you do not charge separately for food or beverages along with other services (such as a package deal for food and lodging), make a good faith estimate of the gross receipts attributable to the food or beverages. This estimate must reflect the cost of providing the food or beverages plus a reasonable profit factor. Include the retail value of complimentary food or beverages served to customers if tipping for them is customary and they are provided in connection with an activity engaged in for profit whose receipts would not be included as gross receipts from the provision of food or beverages (e.g., complimentary drinks served to customers at a gambling casino). Amount must be entered in U.S. dollars and cents. The right-most two positions represent cents. Right-justify and zero fill. If no entry, zero fill. Numeric characters only. Do not enter decimal points, dollars signs, or commas.


332-343
Tip Percentage Rate Times Gross Receipts
12
Required. Enter the amount determined by multiplying Gross Receipts for the year (field positions 320-331) by the Tip Percentage Rate (field positions 344-347). For example, if the value of Gross Receipts is “000045678900” and Tip Percentage Rate is “0800”, multiply $456,789.00 by .0800 to get $36,543.12 and enter “000003654312”. If tips are allocated using other than the calendar year, enter zeros; this may occur if you allocated tips based on the time period for which wages were paid or allocated on a quarterly basis. Amount must be entered in U.S. dollars and cents. The right-most two positions represent cents. Right-justify and zero fill. If no entry, zero fill. Numeric characters only. Do not enter decimal points, dollars signs, or commas.


344-347
Tip Percentage Rate
4
Required. Enter 8 percent (0800) unless a lower rate has been granted by the IRS. The determination letter must follow the electronic submission. See Part A, Sec. 4, .06 for details. Numeric characters only. Do not enter decimal points, dollars signs, or commas.


348-359
Allocated Tips
12
Required. If Tip Percentage Rate times Gross Receipts (field positions Tips 332-343) is greater than Total Tips Reported (field positions 308-319), then the difference becomes Allocated Tips. Otherwise, enter all zeros. If tips are allocated using other than the calendar year, enter the amount of allocated tips from your records. Amount must be entered in U.S. dollars and cents. The right-most two positions represent cents. Right-justify and zero fill. If no entry, zero fill. Numeric characters only. Do not enter decimal points, dollars signs, or commas.


360
Allocation Method
1
Required. Enter the allocation method used if Allocated Tips (field positions 348-359) are greater than zero as follows:




0) if allocated tips are equal to zero.




1) for allocation based on hours worked.




2) for allocation based on gross receipts.




3) for allocation based on a good faith agreement. The good faith agreement must follow the electronic submission. See Part A, Sec. 4, .05 for details.

Note: The method of allocation of tips based on the number of hours worked as described in Section 31.6053-3(f)(1)(iv) may be utilized only by an employer that employs less than the equivalent of 25 full-time employees at the establishment during the payroll period. Section 31.6053-3(j)(19) provides that an employer is considered to employ less than the equivalent of 25 full-time employees at an establishment during a payroll period if the average number of employee hours worked per business day during the payroll period is less than 200 hours.


361-364
Number of Directly Tipped Employees
4
Required. Enter the total number (must be greater than zero) of directly tipped employees employed by the establishment for the calendar year. Right-justify and zero fill. Numeric characters only.


365-369
Transmitter Control Code (TCC)
5
Required. Enter the 5-digit Transmitter Control Code assigned by the IRS.


370
Corrected 8027 Indicator
1
Required. Enter blank for original return. Enter “G” for corrected return. A corrected return must be a complete new return replacing the original return.


371
Final Return Indicator
1
Required. Enter the appropriate code: F) if this is the last time you will file Form 8027 N) if this is not the last time you will file Form 8027 Do not enter a blank.


372
Charge Card Indicator
1
Required. Enter the appropriate code:
1) if your establishment accepts credit cards, debit cards or other charges.
2) if your establishment does not accept credit cards, debit cards or other charges.


373
ATIP Indicator
1
Required. Enter “T” if you are participating in the Attributed Tip Income Program; otherwise, enter a blank.


374
Liable/Not Liable Indicator
1
Required. Enter the appropriate code:
N) if you are not liable to file Form 8027
Y) if you are liable to file Form 8027
Do not enter a blank.


375-378
Tax Year
4
Required. Enter the 4-digit tax year.


379
Prior Year Indicator
1
Required. Enter a “P” only if reporting prior year data; otherwise, enter a blank.


380
Test File Indicator
1
Required for test files only. Enter “T” if this is a test file; otherwise, enter a blank.


381-410
Reserved
30
Enter blanks.


411-418
Record Sequence Number
8
Required. Enter the number of the record as it appears within your file. The first record in your file will be “1” and each record, thereafter, must be incremented by one in ascending numerical sequence, i.e., 2, 3, 4, etc. Right-justify numbers with leading zeros in the field. For example the first record in the file would appear as “00000001”, followed by “00000002”, “00000003” and so on until you reach the final record of the file.


419-420
Blank
2
Enter blanks or CR/LF characters.



FORM 8027 RECORD LAYOUT

Establishment Type
Establishment Serial Numbers
Establishment Name
Establishment Street Address


1
2-6
7-46
47-86






Establishment City
Establishment State
Establishment ZIP Code
Employer Identification Number


87-111
112-113
114-122
123-131






Employer Name
Employer Street Address
Employer City
Employer State


132-171
172-211
212-236
237-238






Employer ZIP Code
Charged Tips
Charged Receipts
Service Charge Less Than 10 Percent


239-247
248-259
260-271
272-283






Indirect Tips Reported
Direct Tips Reported
Total Tips Reported
Gross Receipts


284-295
296-307
308-319
320-331






Tip Percentage Rate Times Gross Receipts
Tip Percentage Rate
Allocated Tips
Allocation Method


332-343
344-347
348-359
360






Number of Directly Tipped Employees
Transmitter Control Code (TCC)
Corrected 8027 Indicator
Final Return Indicator


361-364
365-369
370
371



Charge Card Indicator
ATIP Indicator
Liable/Not Liable Indicator
Tax Year
Prior Year Indicator


372
373
374
375-378
379



Test File Indicator
Reserved
Record Sequence Number
Blank or CR/LF


380
381-410
411-418
419-420




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METADATA
title Rev. Proc. 2008-34
search-title Revenue Procedure: Rulings and Other Docs. 2002 - Present, Rev. Proc. 2008-34, (Jul. 3, 2008)
primary-class ruling/revenue-procedure
wk-da number WKUS_TAL_1436
CCH Paragraph No. 2008FED
language http://psi.oasis-open.org/iso/639/#eng
region United States [http://wk-us.com/meta/regions/#US]
publisher http://wk-us.com/meta/publishers/#CCH
publishing-status new
publishing-dates available-date:
modified-date:
revised-date:
sort-date: 2008-07-03

document-transformation-history SOURCE-CRC: 1794348588
G2I-VERSION: Group2Interchange-RELEASE-03-14-0009A
G2I-TRANSFORMATION-DATE: 2009-10-16
I2A-VERSION: I2A-03-15-0005
I2A-TRANSFORMATION-DATE: 2009-10-16

wkrul:metadata document-number Rev. Proc. 2008-34 [primary-citation]
issuing-body Internal Revenue Service [http://wk-us.com/meta/issuing-bodies/#012]
document-date , precision: day
2008-07-03
official-history filed 2008-07-03, precision: day
2008-07-03

This case that was reported out yesterday is interesting because of the discussion of the limitations of the net operating loss. This is an issue any return preparer could encounter and because it does involve negligence, it could result in the 6694(b) penalty. Let me know if anyone disagrees.

U.S. Tax Court, Dkt. No. 6632-08, TC Memo. 2009-235, October 15, 2009.



An individual taxpayer failed to rebut the use of the bank deposit method of determining gross income. The IRS had correctly used bank deposits to determine the taxpayer's gross income for each of the years at issue. Since the apparent source of the income was the individual's wholly-owned S corporation, the income was properly designated as wages, not self-employment income.—CCH.


[ Code Sec. 104]
Compensation for injury or sickness: Damages for personal injury or sickness: Allocation of award or settlement.–

An individual taxpayer failed to show that a lawsuit settlement was properly excluded from his gross income. The settlement was not properly excluded under Code Sec. 104 since the basis of the litigation was the failure by another sibling to properly distribute shares in the family-owned business, not a personal injury. The treatment of the settlement as capital gains was proper.—CCH.


[ Code Secs. 172, 1366 and 6001]
Record requirements: Inadequate records: Missing records: Net operating losses: Computation of NOL: Deduction from gross income: Tax liability of S corporation shareholders: Losses: Limitation on allowable losses.–

An individual taxpayer failed to demonstrate by adequate records that he was entitled to a net operating loss (NOL) deduction as an S corporation shareholder. The individual's failure to keep adequate records for his wholly-owned S corporation prevented him from establishing his basis in the that S corporation stock and his entitlement to a deduction for the carryforward losses generated by the business.—CCH.


[ Code Secs. 6651 and 6654]
Addition for failure to file tax return: Reasonable cause: Failure of individual to pay estimated income tax.–

An individual taxpayer conceded the issue of penalties for failure to file income tax returns; and the penalty for failure to pay estimated taxes for the second year at issue was properly imposed. The individual failed to contest the penalties for failure to file for two years and, even if he had, no reasonable cause was shown for such failure. The penalty for failure to pay estimated taxes for the second year in question was properly imposed even though the taxpayer had no taxes owed in the two prior years.—CCH.


David Wayne Taylor, pro se; Caroline R. Krivacka, for respondent.


MEMORANDUM FINDINGS OF FACT AND OPINION
DAWSON, Judge: This deficiency case arises from a statutory notice of deficiency respondent issued to petitioner on December 13, 2007, for the taxable years 2004 and 2005. Respondent determined the following deficiencies in petitioner's Federal income taxes and additions to tax:


Additions to Tax

Year
Deficiency

Sec. 6651(a)(1)

Sec. 6651(a)(2)

Sec. 6654


2004
$66,857

$14,631.53

$10,404.64

$1,881.67


2005
21,527

4,547.03

2,020.90

804.72



Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

After concessions, 1the issues presented for decision are:

(1) Whether petitioner received, but failed to report, income of $8,539.11 in 2004 and $19,428.25 in 2005, and if so, whether the income constitutes self-employment income;

(2) whether petitioner received, but failed to report, $268,189 in capital gains income in 2004 from a lawsuit settlement;

(3) whether petitioner is entitled to claimed net operating loss deductions in 2004 and 2005;

(4) whether petitioner is liable for the additions to tax pursuant to section 6651(a)(1) and (2) for 2004 and 2005; and

(5) whether petitioner is liable for the estimated tax addition imposed pursuant to section 6654 for 2005.

FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of facts, with the accompanying exhibits, are incorporated by this reference. Petitioner resided in Tennessee when he filed his petition.

Petitioner did not file his Federal income tax returns for 2004 and 2005, and respondent prepared substitutes for returns for both years on December 10, 2007. Petitioner received wages of $17,800 in 2004 and $11,100 in 2005 from Sunwest P.E.O. of Florida VII, Inc. (Sunwest). He received wages of $1,200 from TLR in Bonita, Inc. (TLR), in 2005. Petitioner made no payments on his 2004 and 2005 income tax liabilities other than the tax withheld from wages he received from Sunwest in 2004 and 2005 and from TLR in 2005; this amounted to $1,828 in 2004 and $1,318 in 2005.

Petitioner owned and operated Common Place Management, Inc. (CPM), his wholly owned S corporation, in 2004 and 2005. The corporation did not file any tax returns for the 2004 and 2005 tax years. During 2004 and 2005 petitioner transferred funds from CPM's bank account to his personal accounts.

Petitioner also held an unspecified interest in VIP, Inc. The record does not disclose whether VIP, Inc., is an S corporation or whether it filed tax returns for the years at issue.

A. Reconstruction of Petitioner's Gross Receipts
Petitioner did not keep adequate books and records, and respondent reconstructed petitioner's gross receipts using the bank deposits method.

1. Bank Deposits 2004

Petitioner maintained checking account No. xxxx6225 and savings account No. xxxx3713 at AmSouth Bank in 2004. The AmSouth account No. xxxx6225 was exclusively petitioner's account until September 17, 2004, when his wife was added as a coowner of the account. Petitioner deposited $167,493.79 into the AmSouth account in 2004.

In the notice of deficiency respondent excluded the following deposits to AmSouth account No. xxxx6225 from petitioner's gross receipts in 2004:


Deposit
Amount



Return of capital from VIP, Inc.
$41,500.00



Lawsuit proceeds
68,188.65



Transfers
24,087.76



Returned checks
10,851.30



Petitioner's net wages
14,611.00



Interest
15.99



Total amount excluded in 2004
159,254.70



In the notice of deficiency respondent determined that petitioner deposited gross receipts totaling $8,239.09 into the AmSouth account No. xxxx6225 in 2004.

Petitioner held account No. xxxx9851 at Jax Federal Credit Union in 2004 after he married Elizabeth Taylor. He and his wife deposited $37,490.35 into the Jax account in 2004. In the notice of deficiency respondent excluded from petitioner's gross receipts $8,051.28 attributable to the direct deposit of Mrs. Taylor's wages and 5 cents attributable to interest. In the notice of deficiency respondent determined that petitioner deposited gross receipts of $29,439.02 into the Jax account in 2004.

In the stipulation of facts respondent conceded that an additional $23,139 deposited in the Jax account is not included in petitioner's gross receipts in 2004. In respondent's brief respondent conceded that an additional $6,000 deposited into the Jax account is not included in petitioner's gross receipts in 2004. Thus respondent asserts petitioner deposited $300.02 of gross receipts into the Jax account in 2004.

Respondent asserts petitioner had unreported gross receipts totaling $8,539.11 that were deposited into the AmSouth and Jax accounts in 2004.

2. Bank Deposits 2005

Petitioner held account No. xxxx9851 at Jax Federal Credit Union in 2005. He and his wife deposited $276,248.22 into the Jax account in 2005.

In the notice of deficiency respondent excluded the following deposits from the computation of petitioner's gross receipts in 2005:


Deposit
Amount



Personal injury settlement
$111,355.98



Transfers
68,700.00



Petitioner's wife's wages
22,689.33



Petitioner's wages
10,043.00



Interest/dividends
23.66



Total amount excluded in 2005
212,811.97



In the stipulation of facts respondent conceded that an additional $44,008 deposited into the Jax account in 2005 is attributable to Mrs. Taylor and is not included in computing petitioner's gross receipts. Respondent asserts that petitioner deposited gross receipts totaling $19,428.25 into the Jax account in 2005.

B. Receipt of Lawsuit Settlement Proceeds
In 2004 petitioner received $268,189 pursuant to a settlement agreement with Rose & Ken, Inc., a Florida corporation owned by his brother, Kendall Taylor, and his sister-in-law, Rose Taylor. The settlement proceeds were not paid to petitioner from Rose & Ken, Inc., for personal injury or illness. They resulted from a lawsuit that originated between his brother and his parents. Petitioner and two other siblings subsequently became parties to the litigation.

The litigation began after petitioner's brother purchased the family's marina business from their parents, who believed that the business was being sold to all their children in equal parts.

Petitioner was not responsible for any loans or financing related to the purchase of the family business. His brother Kendall entirely financed the purchase of the family business and never transferred a share of the business to petitioner and his other siblings.

Petitioner's brother filed suit against petitioner's parents relating to the transfer of the real property. The parents counterclaimed against the brother with allegations of fraud, misrepresentation, and breach of the duty of fair dealing. The parents alleged in the counterclaims that the brother improperly failed to transfer portions of the business to petitioner and his siblings as the parents had intended.

The settlement petitioner received was to resolve the counterclaims brought in the lawsuit, and petitioner received the funds as damages for never having received the share of the business his parents intended for him to have.

C. Claimed Net Operating Losses
Petitioner was involved in several businesses and corporations before the years at issue. In his petition he claimed net operating loss deductions for 2004 and 2005 but did not identify the entity purportedly giving rise to the losses or the amounts thereof. However, at trial petitioner stated that the business which incurred the losses was Volusia Fertilizer & Chemical, Inc. (Volusia), a Florida S corporation he had owned in prior years. Petitioner bought Volusia in 1999 for $48,000. Volusia filed Forms 1120S, U.S. Income Tax Return for an S Corporation, for 2001, 2002, and 2003. The returns reported net operating losses (NOLs) of $74,611 for 2001, $45,576 for 2002, and $46,204 for 2003. Petitioner's 2001 return reported an NOL of $61,382 resulting from a “Prior Year NOL” of $69,440 offsetting income of $8,058. Petitioner's 2002 return reported an NOL of $126,135 resulting from current year losses of $56,705 and the “Prior Year NOL” of $69,440 offsetting income of $10. His 2001 and 2002 returns contained a statement waiving the right to carry back the losses. Volusia's 2003 income tax return was examined, and the Internal Revenue Service (IRS) allowed the claimed loss of $46,204 by issuing a no-change letter.

Petitioner did not establish the amount of income in 2002 or 2003 that was offset by the Volusia NOL and did not establish his basis in the stock and debt of Volusia in 2004 or 2005.

OPINION
Generally, the Commissioner's determinations set forth in the notice of deficiency are presumed correct, and the taxpayer bears the burden of showing the determinations are in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Section 7491(a), however, shifts the burden of proof to the Commissioner with respect to a factual issue affecting the tax liability of a taxpayer who meets certain conditions.

Petitioner has neither claimed nor shown that he satisfied the requirements of section 7491(a) to shift the burden of proof to respondent with respect to any factual issue affecting the deficiencies in his taxes. Accordingly, petitioner bears the burden of proof. See Rule 142(a).

Section 7491(c) provides that the Commissioner will bear the burden of production with respect to the liability of any individual for additions to tax. “The Commissioner's burden of production under section 7491(c) is to produce evidence that it is appropriate to impose the relevant penalty, addition to tax, or additional amount”. Swain v. Commissioner, 118 T.C. 358, 363 (2002); see also Higbee v. Commissioner, 116 T.C. 438, 446 (2001). The Commissioner, however, does not have the obligation to introduce evidence regarding reasonable cause. Instead, the taxpayer bears the burden of proof with regard to that issue. Higbee v. Commissioner, supra at 446-447.

A. Bank Deposits
Gross income means all income from whatever source derived, including income derived from business. Sec. 61. Petitioner conducted business through CPM, an S corporation the income of which flowed through to petitioner, its sole shareholder. CPM did not file a Federal income tax return in 2004 or 2005, and petitioner failed to maintain records reflecting his business income in 2004 and 2005.

Respondent reconstructed petitioner's income using the bank deposits method. Absent some explanation, petitioner's bank deposits represent income subject to tax, and the Commissioner's use of the bank deposits method of income reconstruction has long been sanctioned by the courts. See DiLeo v. Commissioner, 96 T.C. 858, 868 (1991), affd. 959 F.2d 16 (2d Cir. 1992). The Commissioner need not show a likely source of the income when using the bank deposits method, but he must take into account any nontaxable items or deductible expenses of which he had knowledge. See Price v. United States, 335 F.2d 671, 677 (5th Cir. 1964).

On the basis of deposits into petitioner's bank accounts, respondent contends that petitioner received, but failed to report, certain gross receipts from self-employment of $8,539.11 in 2004 and $19,428.25 in 2005. In computing petitioner's unreported income using the bank deposits method, respondent excluded (1) petitioner's wage income; (2) $41,500 in return of capital from VIP, Inc.; (3) petitioner's wife's directly deposited wage income; (4) personal injury settlement proceeds; (5) nontaxable transfers; and (6) returned checks. Respondent removed additional deposits attributable to petitioner's wife. Respondent asserts that the remaining deposits are income from petitioner's business activities conducted through CPM and are therefore subject to income tax.

One of the two issues raised in the petition relates to the amount of gross receipts determined by respondent. Specifically, petitioner alleges that some of the funds deposited were the return of capital. Respondent allowed $41,500 as the nontaxable return of capital from petitioner's business entities. Petitioner has not stated how much additional income should be excluded as return of capital. Furthermore, petitioner provided no information or documentation to support allowing a larger amount to be excluded as return of capital.

We hold that petitioner received income of $8,539 in 2004 and $19,428.25 in 2005 from conducting CPM's business. However, income from conducting the business of an S corporation is not subject to self-employment tax. Ding v. Commissioner, 200 F.3d 587, 588 (9th Cir. 1999) (S corporation passthrough items are not included in calculating self-employment tax liability under section 1402(a)), affg. T.C. Memo. 1997-435; Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141, 145 (2001) (“ Section 1366 permits use of S corporation passthrough items only in calculating tax liability under chapter 1, not tax liability under chapters 21 and 23—in which the Federal employment tax provisions for FICA and FUTA are located.”), affd. sub nom. Yeagle Drywall Co. v. Commissioner, 54 Fed. Appx. 100 (3d Cir. 2002). Moreover, an officer who performs substantial services for a corporation and who receives remuneration in any form for those services is considered an employee. Veterinary Surgical Consultants, P.C. v. Commissioner, supra at 144-145. We hold that the deposits of the income from CPM into petitioner's bank accounts are wages paid to him.

B. Lawsuit Settlement Proceeds
Respondent's position regarding this issue is that petitioner received, but failed to report, $268,189 of taxable lawsuit settlement proceeds in 2004.

Proceeds derived from litigation are subject to taxation unless specifically awarded for personal physical injury or physical sickness. Secs. 61(a), 104(a)(2). Petitioner received $268,189 from Rose & Ken, Inc., in 2004. Respondent's revenue agent treated the income as the proceeds from the sale of property in which the petitioner had no basis. The entire amount was included in petitioner's income, but long-term capital gain treatment was allowed in the notice of deficiency.

Petitioner did not raise in his petition any challenge to the inclusion of this income, the taxation of the income at the capital gains rate, or the determination that he had no basis to reduce the amount of gain. However, petitioner argued for the first time at trial that he had a sufficient basis in the proceeds, which were received pursuant to the lawsuit settlement, to result in a large loss rather than a capital gain.

Petitioner asserted that his brother bought the business from his parents on behalf of himself and other siblings and that his brother obtained the financing for the purchase. Petitioner did not personally provide any funds for the purchase of the business.

Petitioner's parents apparently intended for petitioner and his siblings to receive equal shares of their business. The brother and his wife filed suit against petitioner's parents in an attempt to obtain title to realty that may or may not have been included in the original sale of the business by the parents. Petitioner's parents then counterclaimed for the failure to distribute ownership of the business to petitioner and his siblings, who subsequently were added as parties to the suit.

Petitioner submitted two documents at trial to support his contention that he had basis in his interest in the business. The most telling document was an answer filed by his parents in response to the complaint filed by petitioner's brother. The answer includes counterclaims relating to petitioner and the other siblings.

According to the factual allegations set forth in the answer to the complaint and confirmed by petitioner, the cause of action for the lawsuit was the failure to transfer interests in the business to petitioner and his siblings. The net result of the lawsuit was not an award of a portion of the company's ownership. The settlement was a payment of $268,189 in lieu of any interest in the business. Petitioner was awarded the amount to compensate for the fact that his brother failed to transfer to petitioner his share of the business. Petitioner did not sell his share of the business for $268,189 but essentially received damages for never having received his share of the business. Petitioner did not purchase a share of the business, nor did he receive it as a gift from his brother or his parents. He has clearly not established that he had any basis to reduce the amount of gain. The lawsuit settlement proceeds did not constitute the proceeds from the sale of the business interest but rather damages for an interest never received. Accordingly, we conclude that the entire amount is subject to tax, and we sustain respondent's determination that petitioner had long-term capital gain of $268,189 in 2004.

C. Claimed Net Operating Loss Deductions
Deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any claimed deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). As a part of that burden, a taxpayer must substantiate the amounts of his claimed deductions. A taxpayer is required to maintain records sufficient to establish the amount of any deduction claimed. Sec. 6001; sec. 1.6001-1(a), Income Tax Regs.

Respondent contends that petitioner failed to prove he is entitled to his claimed net operating loss deductions for 2004 and 2005 because he has not established his basis in Volusia and therefore the NOLs cannot be carried forward to 2004 and 2005 absent clear information showing that petitioner had a sufficient basis remaining in those years. While petitioner testified that he thought he had bought the Volusia business for about $48,000 and indicated he probably put another $10,000 into the business property, he submitted no documentary evidence to support his testimony.

The term “net operating loss” is defined in section 172(c) to mean the excess of allowable deductions over gross income. Section 172(a) allows a net operating loss deduction for the aggregate of net operating loss carrybacks and carryovers to the taxable year. Section 172(b)(1)(A) generally provides that the period for an NOL carryback is 2 years and that the period for an NOL carryover is 20 years.

A taxpayer may not claim net operating losses from an S corporation in excess of the sum of the shareholder's bases in stock and debt of the S corporation. Sec. 1366(d)(1). Before a shareholder in an S corporation can claim an NOL, the shareholder must determine his adjusted basis in the S corporation. To have a basis in an S corporation, a shareholder must make an actual economic outlay. See Miller v. Commissioner, T.C. Memo. 2006-125 (and cases cited therein).

While petitioner failed to identify in his petition the entity purportedly giving rise to the NOL, he subsequently stated that the business was Volusia, his Florida S corporation in prior years. Volusia filed Forms 1120S for 2001, 2002, and 2003 and reported losses for each year. Volusia's 2003 return was examined, and the IRS sustained the claimed loss in that year.

At no time during the examination or after the filing of the petition did petitioner establish his basis in Volusia. Volusia's tax returns do not support the conclusion that petitioner had a sufficient basis to claim net operating loss deductions in the years at issue. Accordingly, even assuming that Volusia's returns are correct and it incurred losses each year before the years in issue, petitioner cannot carry an NOL forward to 2004 or 2005 absent clear information showing that he had a sufficient basis in the business.

Petitioner claimed the NOL deductions on his 2001 and 2002 income tax returns. A taxpayer claiming an NOL deduction for a taxable year must file with the tax return for that year a concise statement setting forth the amount of the NOL deduction claimed and all material and pertinent facts, including a detailed schedule showing the computation of the NOL deduction. Sec. 1.172-1(c), Income Tax Regs. A taxpayer may elect to relinquish the carryback period with respect to an NOL for any taxable year, thereby using the loss to offset income only in future years. Sec. 172(b)(3). To carry forward or carry back net operating losses, the taxpayer must prove the amount of the net operating loss carryforward or carryback and that his gross income in other years did not offset that loss. Sec. 172(c); Jones v. Commissioner, 25 T.C. 1100, 1104 (1956), revd. and remanded on other grounds 259 F.2d 300 (5th Cir. 1958).

Petitioner did not allege any amount of the NOL deduction to which he believes he was entitled in 2004 and 2005. He did not provide a detailed schedule showing the computation of the NOL during the examination, nor was such a schedule attached to his 2001 or 2002 income tax return. Petitioner asserts that because Volusia's 2003 return reported a loss, and because his own 2001 and 2002 returns claimed an NOL, he should be permitted to carry forward unspecified losses to 2004 and 2005, the years at issue herein. Petitioner's 2001 and 2002 returns did contain a statement waiving the right to carry back the losses.

A tax return is not evidence of the truth of the facts stated in it. Lawinger v. Commissioner, 103 T.C. 428, 438 (1994). Thus the Commissioner's failure to disallow a loss claimed on a return for one year does not estop the Commissioner from disallowing an NOL carryover of that loss to a future year. Rollert Residuary Trust v. Commissioner, 80 T.C. 619, 636 (1983), affd. on another issue 752 F.2d 1128 (6th Cir. 1985). Each taxable year stands alone, and the Commissioner may challenge in a succeeding year what was condoned or agreed to in a former year. Auto. Club of Mich. v. Commissioner, 353 U.S. 180 (1957); Black v. Commissioner, T.C. Memo. 2007-364.

In summary, although respondent acknowledges that the petitioner owned an S corporation that claimed losses, petitioner on this record has not met his burden of proving that he is entitled to claim a specific amount of net operating loss deduction for 2004 or 2005.

D. Section 6651(a)(1) and (2) Additions to Tax
Petitioner did not assign error in his petition with respect to respondent's determinations of the additions to tax imposed for petitioner's failure to file his Federal income tax returns and to pay the taxes due for 2004 and 2005. Apparently, petitioner has conceded them. See Swain v. Commissioner, 118 T.C. at 363-365. In any event, even if we assume that petitioner is considered to have raised the issues in his brief testimony at the trial, respondent has met his burden of production by showing that petitioner was required to file his Federal income tax returns for 2004 and 2005 and pay the taxes due, and he failed to do so. Moreover, with respect to section 6651(a)(2), for each year respondent prepared a substitute for return which meets the requirements of section 6020(b). See Wheeler v. Commissioner, 127 T.C. 200, 208-210 (2006), affd. 521 F.3d 1289 (10th Cir. 2008).

Finally, on this record petitioner has neither alleged nor shown that there was reasonable cause for not filing his income tax returns and paying the taxes due for those years. Accordingly, we hold that petitioner is liable for the additions to tax under section 6651(a)(1) and (2) for 2004 and 2005.

E. Section 6654 Additions to Tax
Section 6654(a) imposes an addition to tax for a taxpayer's failure to make estimated tax payments calculated with reference to four required installment payments of the taxpayer's estimated tax liability. Sec. 6654(c)(1). Each required installment of estimated tax is equal to 25 percent of the required annual payment. Sec. 6654(d)(1)(A). The required annual payment is the lesser of (1) 90 percent of the tax shown on the individual's return for that year (or, if no return is filed, 90 percent of his or her tax for such year), or (2) if the individual filed a return for the immediately preceding taxable year, 100 percent of the tax shown on that return. 2 Sec. 6654(d)(1)(B).

Petitioner had no Federal income tax liability for 2003. As previously indicated, respondent conceded the estimated tax addition for 2004. Petitioner made no estimated tax payments for 2005 but had $1,318 in taxes withheld from his wages during the year. We hold that, if $1,318 is less than 100 percent of petitioner's tax for 2004 or 90 percent of his tax for 2005 computed under Rule 155, which appears unlikely, then petitioner is liable for the addition to tax pursuant to section 6654 for 2005.

We have considered the arguments raised by both parties, and, to the extent not discussed, we conclude that they are irrelevant or without merit.

To reflect the parties' concessions and our disposition of the disputed issues,

Decision will be entered under Rule 155.


Footnotes

1 Petitioner conceded that he received, but failed to report, (1) wage income of $17,800 in 2004 and $12,300 in 2005 and (2) dividend income of $219 in 2004 and $245 in 2005. In the notice of deficiency respondent determined that petitioner had unreported gross receipts from self-employment of $37,678.11 in 2004 and $63,436.25 in 2005. In the stipulation of facts respondent conceded $23,139 of petitioner's self-employment gross receipts for 2004 and $44,008 of self-employment gross receipts for 2005, reducing the amount of omitted self-employment gross receipts in dispute to $14,539.11 for 2004 and $19,428.25 for 2005. In respondent's brief respondent conceded an additional $6,000 of self-employment gross receipts for 2004, reducing the contested amount for 2004 to $8,539. Respondent also conceded that petitioner is not liable for the addition to tax for failure to pay estimated tax under sec. 6654 for 2004.

2 If an individual's adjusted gross income shown on the previous year's return exceeds $150,000, a higher percentage may apply. See sec. 6654(d)(1)(C).

TIGTA and 6662 penalties

Treasury Inspector General for Tax Administration (TIGTA) Report: Additional Managerial Involvement Is Needed to Promote Consistent Use of Accuracy-Related Penalties (Reference Number : 2009-30-124), (Oct. 15, 2009)
2009ARD 199-6

Treasury Inspector General for Tax Administration (TIGTA) report: Internal Revenue Service: Managerial involvement: Penalties, civil: Accuracy-related penalties


TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION
Additional Managerial Involvement Is Needed to Promote Consistent Use of Accuracy-Related Penalties
September 11, 2009

Reference Number: 2009-30-124

This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.

Redaction Legend :

1 = Tax Return/Return Information

Phone Number | 202-622-6500

Email Address | inquiries@tigta.treas.gov

Web Site | http://www.tigta.gov

DEPARTMENT OF THE TREASURY
WASHINGTON, D.C. 20220

TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION

September 11, 2009

MEMORANDUM FOR COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED DIVISION

FROM: Michael R. Phillips

Deputy Inspector General for Audit

SUBJECT: Final Audit Report - Additional Managerial Involvement Is Needed to Promote Consistent Use of Accuracy-Related Penalties (Audit # 200830053)

This report presents the results of our review to determine whether accuracy-related penalties are assessed during sole proprietor examinations in the Small Business/Self-Employed Division in accordance with Internal Revenue Service (IRS) policies and procedures. This audit is included in our Fiscal Year 2009 Annual Audit Plan coverage under the major management challenge of Tax Compliance Initiatives.

Impact on the Taxpayer
Promoting tax compliance fairly and equitably is of paramount importance to the IRS. Penalties are an important component of tax gap reduction efforts because they promote compliance with the tax laws by imposing an economic cost on taxpayers who choose not to comply voluntarily. Because we found that penalties were not always applied when warranted, the taxpaying public could perceive inequities in the examination process that penalize some but allow others to avoid penalties that otherwise should have been assessed.

Synopsis
Despite having authority under Internal Revenue Code Section 6662 to impose accuracy-related penalties, as well as layers of management controls to guide the penalty-setting process, the IRS is missing opportunities to use penalties to better promote accurate reporting among sole proprietors. We selected a statistically valid sample of 356 sole proprietor examinations that were closed in Fiscal Year 2007 and found that in 84 cases (24 percent), IRS procedures were not followed in recommending accuracy-related penalties for assessment.

Although each case in our population met the minimum threshold (a tax understatement of $5,000 or more) for considering the substantial understatement penalty, examiners were either too lenient and did not recommend penalties that were warranted or had not documented case files indicating that penalties were considered. Moreover, we found no documentation of managerial involvement in 67 of the 105 penalty decisions, despite an Internal Revenue Manual requirement for such involvement in cases where the substantial understatement penalty should be considered.

Besides missing potential opportunities to enhance accurate reporting among sole proprietors, closing the gap between the accuracy-related penalties assessed and those that should be assessed would enhance revenue. To estimate the potential amount of substantial overstatement penalties and interest the 84 sole proprietors were not assessed through April 30, 2009, we followed IRS procedures for computing the substantial understatement penalty on the tax deficiencies, along with the amount of interest owed on each penalty. Overall, we estimate the 84 sole proprietors in our sample cases avoided penalties and interest totaling $354,539. When projected to our population of 4,772 returns, we estimate that over a 5-year period sole proprietors would avoid penalty and interest assessments totaling $24 million (plus or minus $9 million) that otherwise should have been assessed. Our projection is based on a 95 percent confidence level and we assumed that the IRS would not reconsider and subsequently abate any of the assessments.

Recommendations
We recommended that the Director, Examination, Small Business/Self-Employed Division, should require 1) group managers to provide more specific written feedback to examiners on the quality of their penalty determinations and incorporate the feedback into examiner midyear progress reports and annual appraisals when appropriate and 2) Territory managers to use their operational reviews to monitor and assess the written feedback given by group managers on the quality of their examiners' penalty determinations.

Response
IRS management agreed with our recommendations. The Director, Examination Policy, Small Business/Self-Employed Division, will enhance the guidance regarding managerial documentation of examiners' penalty determinations in the document Examination Quality Review System - Multi-Case Review Guidance for Field and Office Examination . The Director, Examination Policy, will also include an article in the managerial guidance document Examination Quality Review System - Performance Perspective that addresses the importance of managerial documentation regarding penalty determinations. Finally, the Director, Examination Policy, will enhance the guidance on group operational reviews in the Examination Quality Review System Field and Office Examination Quality Guide for Operational Reviews to include review of the group manager's oversight of examiners' penalty determinations. However, IRS management commented that our outcome measure calculation may be overstated because it did not consider the effect of subsequent reconsideration and abatements of penalties. Management's complete response to the draft report is included as Appendix VI.

Office of Audit Comment
While we acknowledge that some penalties may be abated in the future, our outcome measure was calculated only for returns that met the requirements for the substantial understatement penalty. Our outcome measure estimates were based on the information available at the time of our review, and the IRS response did not provide an estimate of the amount of substantial understatement penalties that might be abated in future years. Also, publicly released data on abatements, such as the IRS Data Book, does not separately report the amount of substantial understatement penalties abated each year, so we have no reliable basis to calculate an estimate of abated penalties.

Copies of this report are also being sent to the IRS managers affected by the report recommendations. Please contact me at (202) 622-6510 if you have questions or Margaret E. Begg, Assistant Inspector General for Audit (Compliance and Enforcement Operations), at (202) 622-8510.

Table of Contents
Background

Results of Review

Management Controls Are in Place to Guide Examiners Through the Penalty-Setting Process

The Gap Between the Number of Accuracy-Related Penalties Assessed and the Number Warranted Is Considerable

Recommendations 1 and 2 :

Appendices

Appendix I - Detailed Objective, Scope, and Methodology

Appendix II - Major Contributors to This Report

Appendix III - Report Distribution List

Appendix IV - Outcome Measure

Appendix V - Overview of Selected Penalties Applicable to Examinations of Sole Proprietors

Appendix VI - Management's Response to the Draft Report

Abbreviations
FY
Fiscal Year

I.R.C.
Internal Revenue Code

IRM
Internal Revenue Manual

IRS
Internal Revenue Service

SB/SE
Small Business/Self-Employed Division

TIGTA
Treasury Inspector General for Tax Administration


Background
Our tax system is based on the public's willingness to voluntarily prepare an accurate tax return, file it timely, and pay any tax due on time. To encourage voluntary compliance, Congress placed numerous penalty provisions in the tax laws for the Internal Revenue Service (IRS) to administer through its Examination Program and various other compliance programs.

Despite numerous management controls, the gap between the number of accuracy-related penalties assessed and the number that should be assessed is considerable.

Spread across the IRS' four operating divisions, the Examination Program is one of the agency's largest compliance programs. Its examiners are primarily responsible for determining the correct liabilities for taxpayers, including their liabilities for penalties. During an examination of a tax return, such as one filed by a sole proprietor, examiners are required to consider a number of penalties when recommending adjustments to tax liabilities. The numerous penalties generally fall into two broad categories: delinquency and accuracy-related. Delinquency penalties are intended to encourage the timely filing of income tax and information returns, while accuracy-related penalties promote the preparation and submission of complete and correct information on tax returns.

According to our analysis of underlying information from the 2008 IRS Data Book, 1 the IRS assessed individual taxpayers with 2,881,085 delinquency penalties and 343,295 accuracyrelated penalties. Additional information on various penalties within these two broad categories is included in Appendix V.

This review was performed in the IRS Small Business/Self-Employed (SB/SE) Division Headquarters Office in New Carrollton, Maryland, during the period October 2008 through April 2009. Except for auditing IRS databases to validate the accuracy and reliability of the information, 2 this performance audit was conducted in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objective. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objective. Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.

Results of Review
Despite numerous management controls to guide the penalty-setting process, the gap between the number of accuracy-related penalties assessed and the number warranted is considerable. As a result, we are recommending additional managerial involvement in the administration of these penalties.

Management Controls Are in Place to Guide Examiners Through the Penalty-Setting Process
Ultimately, the IRS relies on examiners and their group managers to properly consider and assess penalties during examinations. To assist examiners and group managers in meeting these responsibilities, the IRS has an array of policies, procedures, and techniques (management controls) that are in line with the Government Accountability Office's Standards for Internal Control in the Federal Government.

At the agency level, there is a broad policy statement on penalties that was revised in June 2004 to provide guidance for examiners, as well as other IRS personnel, and included overall goals for implementing the policy. The policy statement underscores the role penalties play in promoting compliance with and fairness of the tax system by imposing an economic cost on those who do not voluntarily comply with tax laws. In implementing the revised policy, the IRS provided an agencywide training session on penalty administration and augmented the training by developing a comprehensive audit technique guide and making it available to examiners throughout the agency. Figure 1 provides an overview of the goals reflected in the IRS' penalty policy.

Figure 1: Goals of the IRS Penalty Policy
Goals
Policy Overview


Enhance and encourage compliance.
Penalties provide an important tool to promote compliance and fairness in the tax system by increasing the costs for those who do not timely and accurately comply with the tax laws.


Curb the use of abusive tax transactions.
Accuracy-related penalties combat the undermining effect abusive transactions have on the tax system.


Promote sound and efficient tax administration.
Penalties may occasionally be waived as part of a strategy to encourage prompt resolution of tax issues.


Promote consistency in applying penalties.
The IRS Office of Penalty Administration reviews and approves changes to its Penalty Handbook, which all agency employees are to use and follow.


Demonstrate fairness of the tax system.
Provide taxpayers with opportunities to provide reasons why penalties should not be assessed by considering evidence in favor of not assessing penalties.


Source: Treasury Inspector General for Tax Administration (TIGTA) analysis of IRS Policy Statement 20-1.


At the division level, Quality Assurance staffs review samples of examinations and assess the degree to which examiners comply with standards, including those related to penalties. The reviews serve as a mechanism for measuring and evaluating the quality of examinations and penalty determinations, communicating areas of concern up the chain of command, identifying potential training needs, and improving work processes. In addition to reviews by Quality Assurance staffs, mid-level managers may evaluate how well examiners are developing penalty issues during their operational reviews. As conducted by Examination function Territory managers, operational reviews are performed on group managers and their respective teams at least annually to ensure work is being done in conformance with procedures.

At the group level, the Internal Revenue Manual (IRM) serves as the official compilation of procedures and detailed instructions that govern examinations and the penalty-setting process. According to the IRM, an examiner's primary responsibility is to determine the correct income tax liability during an examination. However, they are also required to document examination case files with the factors considered in determining a taxpayer's liability for applicable penalties.

To assist examiners in considering the penalties that could apply to a return under examination, the SB/SE Division developed a Penalty Approval Form, shown in Figure 2 below, that is required to be included in the workpapers for every examination.

Figure 2: IRS Penalty Approval Form
Penalty Approval Form


IRC
Penalty
IRM
Assert Penalty
Reference








Yes
No


Penalties Not Requiring Group Managerial Approval






6651(a)(1)
Failure to File
20.1.2.3





6651(a)(2)
Failure to Pay
20.1.2.4





6654
Estimated Tax - Individual
20.1.3.1.1





6655
Estimated Tax - Corporate
20.1.3.5





Penalties Requiring Group Managerial Approval






6651(f)
Fraudulent Failure To File, Civil
20.1.2.7





6662(c)
Negligence
20.1.5.7





6662(d)
Substantial Understatement * Lead Sheet Available
20.1.5.8





6662(b)
Other Accuracy Related
20.1.5.1





6662(h)
Gross Valuation Misstatement
20.1.5.9





6662A
Accuracy Related Penalty on Understatements with Respect to Reportable Transactions (RT)
20.1.5.13





6707A
Failure to Include Reportable Transactions RT Information with Return or Statement
20.1.5.2





6663
Fraud
20.1.5.12






Alternative Penalty Position
20.1.5.12.2

















Consideration of Preparer / Promoter / Material Advisor Penalties
Consider Penalty
Reference









Yes
No


6694(a)
Preparer Penalties - Negligent
20.1.6.3.5





6694(b)
Preparer Penalties - Willful
20.1.6.3.5


6700
Promoting Abusive Tax Shelters
20.1.6.1





6701
Aiding & Abetting understatement of Tax Liability
20.1.6.1





6707
Failure to Furnish Information regarding RT
20.10





6708
Failure to Maintain Lists of Advisees with respect to RT (Formerly Failure to Maintain Lists of Investors in Potentially Abusive Tax Shelters)
20.10









Reason(s) for Non-Assertions of Penalty(s)



No Change or Refund Case



Other: Penalty considerations are to be addressed in all examinations and workpapers should be prepared. When adjustments would appear to warrant a penalty, but it is not asserted, the applicable exceptions to the penalty must be documented in the file. W/P Reference IRM 20.1.5.4.(2)


Group Manager Approval to Assess Penalties Identified Above (Not required on automatic penalties/No Change/Refund cases)


Group Manager Signature: Date:


Source: SB/SE Division Workpaper 300-1.1, dated May 2007.


Besides documenting penalty decisions, the IRM requires group managers to review the examiner's decision not to assert the substantial understatement penalty when the criteria of Internal Revenue Code (I.R.C.) Section 6662(d) is met, including the applicable exception to the penalty. This is an important control component in the penalty-setting process because group managers are responsible for the quality of work performed by the examiners they supervise. To ensure that examiners' work is meeting acceptable quality standards, including penalty considerations, SB/SE Division group managers use a variety of other techniques to ensure quality examinations are performed. These other techniques include observing and discussing examination work with examiners, reviewing in-process and closed examinations, and providing feedback through SB/SE Division's Embedded Quality Review System. 3

The Gap Between the Number of Accuracy-Related Penalties Assessed and the Number Warranted Is Considerable
Despite having authority under I.R.C. Section 6662 to impose accuracy-related penalties, as well as numerous management controls to guide the penalty-setting process, the IRS is missing opportunities to use penalties to better promote accurate reporting among sole proprietors. As shown in Figure 3, we selected a statistically valid sample of 356 sole proprietor returns from a population of 4,772 sole proprietor returns with examinations closed in Fiscal Year (FY) 2007. All returns in our population met the minimum threshold (a tax understatement of $5,000 or more for an individual return) for considering the substantial understatement penalty. We reviewed each selected return using the IRS Integrated Data Retrieval System 4 and eliminated 175 returns that had an accuracy-related penalty assessed by the examiner. We then ordered the administrative case files (examination workpapers) for the 181 returns that did not have an accuracy-related penalty assessed and were able to obtain workpapers for 105 returns. For these 105 returns, we found 84 (24 percent of the 356 returns sampled) in which IRS procedures were not followed in recommending accuracy-related penalties for assessment.

Figure 3: Review of Accuracy-Related Penalties for Sole Proprietor Examinations Closed in FY 2007

Number
Percentage of Sample


Number of sole proprietor returns selected for sample.
356
100 %




Sole proprietor returns with an accuracy-related penalty assessed by examiner.
175
49 %




Sole proprietor returns without an accuracy-related penalty with examination workpapers ordered by the TIGTA.
181
51%




Sole proprietor returns without an accuracy-related penalty with examination workpapers received and reviewed by the TIGTA.
105
29%




Sole proprietor returns without an accuracy-related penalty reviewed by the TIGTA in which IRS procedures were not followed.
84
24%




Sole proprietor returns without an accuracy-related penalty reviewed by the TIGTA in which IRS procedures were followed.
21
6%


Source: TIGTA analysis of 356 sole proprietor examinations closed in FY 2007.


Although each case in our population met the minimum threshold for considering the substantial understatement penalty, examiners were either too lenient and did not recommend penalties that were warranted or had not documented case files indicating that penalties were considered. The majority of cases we reviewed did not entail complicated tax law issues and did not appear to meet any of the IRM exceptions that allow for the abatement of an accuracy-related penalty. Except for a few instances, IRS officials who also reviewed a large group of our case reviews agreed with our conclusions.

We also found no documentation of managerial involvement in 67 of the penalty decisions (19 percent of the 356 returns sampled and 64 percent of the 105 case files reviewed) despite an SB/SE Division requirement of such involvement in cases where adjustments warrant the substantial understatement penalty. For example, we found 30 cases for which well over $10,000 of income tax was not reported and there was no evidence of managerial involvement. The absence of this involvement in these cases is of particular concern because the IRS requires more detailed documentation of managerial involvement in examinations involving unreported income of $10,000 or more. At a minimum, the documentation in these cases should show that the manager and examiner jointly developed an action plan to obtain and document potential fraudulent activities that may be needed in a referral to the IRS Criminal Investigation Division for possible criminal prosecution.

Examiners and group managers need to be held accountable for considering and assessing accuracy-related penalties
We believe there is a combination of factors causing the concerns identified in our case reviews and that there is no easy and quick solution to the problem. Overall, management controls are in place to assist examiners and managers in meeting their responsibilities for considering and assessing penalties when warranted. Also, IRS guidance and directions to examiners and group managers is detailed and adequate. Despite the controls that are in place, some examiners and group managers may be placing too high a value on obtaining agreement to examination results and using penalties as a bargaining chip to obtain agreement. For example, * * * * * This type of action is strictly prohibited by IRS procedures.

As we have reported previously, the performance management process can be an effective tool in helping examiners understand and meet their responsibilities. 5 It also provides opportunities to give meaningful and constructive feedback on performance, pinpoint and address performance gaps, and hold examiners accountable for results. According to the United States Merit Systems Protection Board, continually monitoring and providing feedback to employees is perhaps the most important component of managing performance. In a 2003 report to the President and Congress, the United States Merit Systems Protection Board stated:

This component, more than any other, can give employees a sense of how they are doing and can motivate them to be as effective as possible. Ideally, through these ongoing interactions between employees and supervisors, employees learn how their work fits into the goals of the work unit and how it contributes to the larger mission of the agency.

In response to our 2005 report on penalty determinations in corporate examinations, 6 the SB/SE Division agreed it would issue performance management reminders to Examination function personnel about the need to provide examiners with specific written feedback on the quality of their penalty determinations. Although the Director, Examination, SB/SE Division, issued a memorandum on November 25, 2005, to Examination function area directors, we were unable to determine whether this guidance was communicated to front line Examination function personnel. Moreover, we researched the Embedded Quality Review System to determine if group managers provided performance feedback to 21 examiners involved in 25 of the cases we reviewed and found considerable evidence that suggests the need for group managers to take better advantage of written feedback to hold examiners more accountable for their penalty determinations. Although all 21 examiners failed to follow IRS procedures in considering accuracy-related penalties, 6 (29 percent) of the 21 examiners had not received any narrative feedback on the importance of making quality penalty determinations in workload reviews, midyear progress reports, and annual performance appraisals they received in the Embedded Quality Review System in FY 2008.

Although the performance management process for group managers is somewhat different from the process for examiners, it can be used in much the same way to hold managers accountable for results. One difference is that group managers develop commitments at the beginning of the fiscal year that supplement their critical job responsibilities and can be specifically tailored to meet improvement opportunities. Another important difference is that SB/SE Division Territory managers are responsible for managing and evaluating the performance of group managers. Among the tools used by Territory managers to meet this responsibility are operational reviews, which can be used to better ensure that group managers are providing specific written feedback to examiners on the quality of their penalty determinations.

Promoting tax compliance fairly and equitably is of paramount importance to the IRS. Penalties are an important component of tax gap reduction efforts because they promote compliance with the tax laws by imposing an economic cost on taxpayers who choose not to comply voluntarily. Because we found that penalties were not always applied when warranted, the taxpaying public could perceive inequities in the examination process that penalize some but allow others to avoid penalties that otherwise should have been assessed.

In addition to enhancing accurate reporting among sole proprietors, closing the gap between the number of accuracy-related penalties assessed and the number that should be assessed would enhance revenue. To estimate the potential amount of substantial understatement penalties and interest the 84 sole proprietors were not assessed through April 30, 2009, we followed IRS procedures for computing the substantial understatement penalty on the tax deficiencies, along with the amount of interest owed on each penalty. Overall, we estimate the 84 sole proprietors in our sample cases were not assessed penalties and interest totaling $354,539. When projected to our population of 4,772 cases, we estimate that 1,126 sole proprietors (plus or minus 203 sole proprietors) avoided penalty and interest assessments of $4.8 million per year (plus or minus $1.8 million). Our projection is based on a 95 percent confidence level and assumes that the IRS will not reconsider and abate any of the penalties. 7 When projected over a 5-year period, we estimate with a 95 percent degree of confidence that sole proprietors would avoid penalty and interest assessments totaling $24 million (plus or minus $9 million) that otherwise should have been assessed.

Recommendations
To promote additional managerial involvement in the administration of penalties, we recommend that the Director, Examination, SB/SE Division, require:

Recommendation 1: Group managers to provide more specific written feedback to examiners on the quality of their penalty determinations and incorporate the feedback into examiner midyear progress reports and annual performance appraisals when appropriate.

Management's Response: IRS management agreed with this recommendation. The Director, Examination Policy, SB/SE Division, will enhance the guidance regarding managerial documentation of examiners' penalty determinations included in the document Examination Quality Review System - Multi-Case Review Guidance for Field and Office Examination . The Director, Examination Policy, will also include an article in the managerial guidance document Examination Quality Review System - Performance Perspective that addresses the importance of managerial documentation regarding penalty determinations.

Recommendation 2: Territory managers to use their operational reviews to monitor and assess the written feedback given by group managers on the quality of their examiners' penalty determinations.

Management's Response: IRS management agreed with this recommendation. The Director, Examination Policy, SB/SE Division, will enhance the guidance on group operational reviews in the Examination Quality Review System Field and Office Examination Quality Guide for Operational Reviews to include review of the group manager's oversight of examiners' penalty determinations.

Although agreeing with our recommendations, IRS management commented that our outcome measure calculation may be overstated because it did not consider the effect of subsequent reconsideration and abatements of penalties.

Office of Audit Comment: As noted in Appendix IV, our outcome measure was calculated only for returns that met the requirements for the substantial understatement penalty. While we acknowledge that some of these penalties could be abated in the future, our outcome measure estimates were based on information available at the time of our review, and the IRS response did not provide an estimate of the amount of substantial understatement penalties that might be abated in future years. Also, publicly released data on abatements, such as the IRS Data Book, does not separately report the amount of substantial understatement penalties abated each year, so we have no reliable basis to calculate an estimate of abated penalties.

Appendix I
Detailed Objective, Scope, and Methodology
The overall objective of this review was to determine whether accuracy-related penalties are assessed during sole proprietor examinations in the SB/SE Division in accordance with IRS policies and procedures. To accomplish our objective, we:

I. Selected a statistically valid sample of 356 closed examined sole proprietorship returns using a confidence level of 95 percent, a precision rate of plus or minus 5 percent, and an expected error rate of 50 percent. The returns were selected from the population of 4,772 sole proprietor returns meeting our criteria on the Audit Information Management System 1 Closed Case data file maintained on the TIGTA's Data Center Warehouse. The selection criteria included examinations that were closed as “agreed” between October 1, 2006, and September 30, 2007, had a understatement of tax meeting the minimum threshold of $5,000 for considering the substantial understatement penalty, and involved non-farm businesses with total gross receipts of $100,000 or more with total positive income of less than $200,000. We conducted limited data validation testing by matching the universe of sole proprietor examinations on the Audit Information Management System to the IRS Data Book 2 and selecting a judgmental 3 sample of 20 examinations on the Audit Information Management System and verifying selected taxpayer information to the Integrated Data Retrieval System. 4

II. Conducted research using the Integrated Data Retrieval System on the sample identified in Step I to identify the returns that appeared to meet the criteria for the imposition of accuracy-related penalties (at least $5,000 in additional tax assessed) but do not have a Transaction Code 240 with a Reference Number 680 on the taxpayer's account (indicating the imposition of an accuracy-related penalty). Using the Integrated Data Retrieval System, we determined that the accuracy-related penalty was applied in 175 of the examinations, while the remaining 181 examinations had no accuracy-related penalty applied. We requested the examination workpapers for the 181 returns and any related tax return years and received workpapers for 105 returns.

III. Reviewed the examination workpapers for the 105 closed sole proprietor returns to determine whether examiners followed IRS procedures in recommending accuracy-related penalties for assessment. We estimated the potential revenue that could be generated over a 5-year period if examiners properly considered and assessed penalties by applying the error rates and penalty amounts determined in the cases reviewed against examinations in our population having similar deficiencies and characteristics, but no accuracy-related penalties applied.

IV. Evaluated the adequacy of controls for ensuring accuracy-related penalties are properly considered and applied during sole proprietor examinations by documenting the applicable I.R.C. sections, Treasury Regulations, IRM (policy and procedural) sections, management directives, examiner training materials, and IRS public announcements and notices that provide the authority and reasons for assessing the penalty.

V. Used the results from FYs 2007 and 2008 quality reviews (National Quality Review System 5 and Embedded Quality Review System) 6 to identify weaknesses in the use of accuracy-related penalties and assess the effectiveness of corrective actions taken in response to the weaknesses identified.

VI. Evaluated the extent of training that group managers and examiners received on considering and applying accuracy-related penalties by reviewing the FYs 2007 and 2008 training records of the managers and examiners included in our case reviews.

VII. Assessed how well Territory managers are holding group managers accountable for ensuring the examiners they supervise are properly considering accuracy-related penalties by evaluating FY 2008 operational reviews, midyear appraisals, and annual appraisals they provided to the group managers for cases included in our review.

VIII. Assessed how well group managers are holding examiners accountable for properly considering accuracy-related penalties by evaluating the FY 2008 workload reviews (on-the-job visits, etc.), midyear appraisals, and annual appraisals they provided to the examiners for cases included in our review.

IX. Determined the number of accuracy-related penalties that were assessed in sole proprietor examinations in FYs 2006, 2007, and 2008 by analyzing the IRS Statistics of Income data files that support the number and amount of these penalties in the corresponding IRS Data Books.

X. Assessed the status of ongoing changes to improve the administration of penalties by interviewing SB/SE Division management and program analysts in its Offices of Examination Policy and Penalties and Interest to identify ongoing changes, such as policy and procedural changes, examiner training, stakeholder outreach activities, and IRS public notices and announcements that are aimed at enhancing administration of penalties. We assessed the effectiveness of any ongoing changes identified.


Appendix II
Major Contributors to This Report
Margaret E. Begg, Assistant Inspector General for Audit (Compliance and Enforcement Operations)

Frank Dunleavy, Director

Robert Jenness, Audit Manager

Debra Mason, Lead Auditor

Earl Charles Burney, Senior Auditor

William Tran, Senior Auditor

Ali Vaezazizi, Auditor

Appendix III
Report Distribution List
Commissioner C

Office of the Commissioner - Attn: Chief of Staff C

Deputy Commissioner for Services and Enforcement SE

Deputy Commissioner, Small Business/Self-Employed Division SE:S

Director, Examination, Small Business/Self-Employed Division SE:S:E

Chief Counsel CC

National Taxpayer Advocate TA

Director, Office of Legislative Affairs CL:LA

Director, Office of Program Evaluation and Risk Analysis RAS:O

Office of Internal Control OS:CFO:CPIC:IC

Audit Liaison: Commissioner, Small Business/Self-Employed Division SE:S

Appendix IV
Outcome Measure
This appendix presents detailed information on the measurable impact that our recommended corrective actions will have on tax administration. This benefit will be incorporated into our Semiannual Report to Congress.

Type and Value of Outcome Measure:
Increased Revenue - Potential; $4.8 million per year (plus or minus $1.8 million), or $24 million (plus or minus $9 million), over 5 years. The potential revenue increase is related to 1,126 sole proprietors who were not assessed an accuracy-related penalty that was warranted (see page 5). In making the projection, we assumed that the IRS would not reconsider and subsequently abate any of the assessments.

Methodology Used to Measure the Reported Benefit:
To estimate the potential additional revenue associated with closing the gap between the number of accuracy-related penalties assessed and the number warranted in sole proprietor examinations, we:

1. Analyzed a statistically valid sample of 356 examinations from a population of 4,772 returns with the potential for accuracy-related penalties closed in FY 2007 for which sole proprietors agreed with the IRS that they understated their tax liabilities by more than $5,000 but avoided an accuracy-related penalty.

2. Used the sample occurrence rate (of missed opportunities for applying the accuracy-related penalty) of 23.60 percent (84 divided by 356) from the results of our case review samples to project that as many as 1,126 (23.60 percent multiplied by 4,772) sole proprietors were not assessed an accuracy-related penalty that was warranted, plus or minus 203 sole proprietors.

3. Followed the IRS procedures for computing the substantial understatement penalty related to the deficiencies owed to calculate that accuracy-related penalties of $307,440 were not assessed on the 84 returns.

4. Used IRS computer programs with the applicable Federal interest rate to calculate that $47,099 of interest would have been owed on the penalties for the 84 returns through April 30, 2009.

5. Used variable sampling techniques based on the amount of penalties and interest that should have been assessed for the 84 cases ($354,539) to determine the estimated amount of penalties and interest per case to be $4,221 ($354,539 divided by 84). Applied the per case estimate to the projected number of sole proprietors not assessed the penalty to determine that the amount of missed penalty and interest opportunities for our population was $4.8 million per year ($4,221 multiplied by 1,126), plus or minus $1.8 million.

6. Shared our sampling methodology with an outside statistical expert who confirmed the accuracy of our methodology and projection.


Appendix V
Overview of Selected Penalties Applicable to Examinations of Sole Proprietors
This appendix provides a brief overview of some common penalties examiners should consider and possibly apply during a sole proprietor examination. There are relief standards that can be invoked to avoid the imposition of the penalties below. The I.R.C., for example, generally provides that penalties can be avoided if there was reasonable cause and the sole proprietor acted in good faith.

Selected Penalties Considered During a Sole Proprietor Examination
Delinquency Penalties


Title
I.R.C. Section(s)
Overview


Failure to File
6651(a)(1)
If an examination results in a tax deficiency and the tax return was not filed by the prescribed due date (or extended due date), a failure to file penalty can be applied on the tax deficiency from the tax return due date (or extended due date) until paid or until the maximum penalty is applied.


Failure to File Information Returns
6721, 6722, 6723, 6679, 6038(b), 6038A(d)
Sole proprietors are required to file certain information returns and/or furnish certain statements to payees under various sections of the I.R.C. Information return reporting penalties can involve amounts ranging from $50 up to $250,000.


Accuracy-Related Penalties


Negligence
6662(c)
Negligence includes any failure to make a reasonable attempt to comply with the provisions of the tax law, exercise ordinary and reasonable care in tax return preparation, or keep adequate books and records. The penalty is 20 percent of the portion of the underpayment attributable to negligence.


Substantial Understatement
6662(d)
The substantial understatement penalty may be applied when an understatement exceeds $5,000 or 10 percent of the tax required to be shown for the tax year, whichever is greater. The penalty is equal to 20 percent of the underpayment of tax attributable to the understatement.


Substantial Valuation Misstatement
6662(e)
The substantial valuation misstatement exists if the value or adjusted basis of any property claimed on a return is 150 percent or more of the amount determined to be the correct amount of such value or adjusted basis. The penalty is 20 percent of the underpayment of tax.


Gross Valuation Misstatement
6662(h)
The gross valuation misstatement penalty exists if the value or adjusted basis of any property claimed on a return is 200 percent or more of the corrected amount; or if the price for any property or service (or for the use of property) claimed on a return is 400 percent or more (or 25 percent or less) of the amount determined under I.R.C. Section 482 to be the correct price; or if the net section 482 adjustment exceeds the lesser of $20,000,000 or 20 percent of the taxpayer's gross receipts. The penalty is 40 percent of the underpayment of tax.


Fraud
6663(a)
If any underpayment of tax is due to fraud, a penalty may be imposed equal to 75 percent of the portion of the underpayment due to fraud. Although the I.R.C. does not define the term fraud, most courts define fraud as the “intent to evade tax.”


Source: TIGTA analysis of selected sections of the I.R.C.


Appendix VI
Management's Response to the Draft Report
DEPARTMENT OF THE TREASURY INTERNAL REVENUE SERVICE WASHINGTON, D.C. 20224

COMMISSIONER SMALL BUSINESS/SELF-EMPLOYED DIVISION

August 17, 2009

MEMORANDUM FOR MICHAEL R. PHILLIPS DEPUTY INSPECTOR GENERAL FOR AUDIT

FROM: Christopher Wagner

Commissioner, Small Business/Self-Employed Division

SUBJECT: Draft Audit Report Additional Managerial Involvement is Needed to Promote Consistent Use of Accuracy-Related Penalties (Audit No. 200830053)

We have reviewed your report “Additional Managerial Involvement Is Needed to Promote Consistent Use of Accuracy-Related Penalties.” Penalties provide an important tool in promoting compliance and faimess in the tax system. We agree with the recommendations contained in your report and concur that managerial oversight of examiners' consideration of the application of penalties is important for ensuring compliance and fairness.

We appreciate you acknowledging that the guidance previously provided to group managers was detailed, adequate and meets the standards set forth in the Government Accountability Office's (GAO) Standards for Internal Control in the Federal Government. We agree that an outcome measure should be computed for this audit but we believe your calculation should consider the effect of subsequent reconsideration and abatement of penalties. By not including this factor in the calculation, there is a potential that the outcome measure may be overstated.

Attached is a detailed response outlining our corrective actions. If you have questions, please call me at (202) 622-0600 or Monica Baker, Director, Examination at (202) 283-2659.

Attachment

Attachment
RECOMMENDATION 1 :

To promote additional managerial involvement in the administration of penalties, we recommend that the Director, Examination, SB/SE Division, require Group managers to provide more specific written feedback to examiners on the quality of their penalty determinations and incorporate the feedback into examiner midyear progress reports and annual performance appraisals when appropriate.

CORRECTIVE ACTION :

1. We will enhance the guidance already included in the “Examination Quality Review System (EQRS) - Multi-Case Review Guidance for Field and Office Examination” regarding managerial documentation of examiners' penalty determinations.

2. We will include an article in the managerial guidance document, “EQRS Performance Perspective” that addresses the importance of managerial documentation regarding penalty determinations.


IMPLEMENTATION DATE:

1. March 15, 2010

2. March 15, 2010

RESPONSIBLE OFFICIAL:

Director, Examination Policy SB/SE Division

CORRECTIVE ACTION MONITORING PLAN:

The Director, Examination Policy will monitor the status and will advise the Director, Examination of any delays in completing the corrective action.

RECOMMENDATION 2 :

To promote additional managerial involvement in the administration of penalties, we recommend that the Director, Examination, SB/SE Division, require Territory managers to use their operational reviews to monitor and assess the written feedback given by group managers on the quality of their examiners' penalty determinations.

CORRECTIVE ACTION :

We will enhance the guidance on group operational reviews already included in the “EQRS Field and Office Examination EQ Guide for Operational Reviews” to include review of the group manager's oversight of examiners' penalty determinations.

IMPLEMENTATION DATE:

March 15, 2010

RESPONSIBLE OFFICIAL:

Director, Examination Policy SB/SE Division

CORRECTIVE ACTION MONITORING PLAN:

The Director, Examination Policy will monitor the status and will advise the Director, Examination of any delays in completing the corrective action.


Footnotes

1 The IRS Data Book is published annually by the IRS and contains statistical tables and organizational information on a fiscal year basis.

2 The accuracy of the data was verified to individual recipients during our case review.

3 The Embedded Quality Review System allows field managers to provide timely feedback to individual employees through performance case reviews.

4 IRS computer system capable of retrieving or updating stored information; it works in conjunction with a taxpayer's account records.

5 Performance Management in the Large and Mid-Size Business Division's Industry Case Program Needs Strengthening (Reference Number 2005-30-084, dated May 27, 2005).

6 The Strategy to Reemphasize Penalties in Corporate Examinations Could Be Enhanced (Reference Number 2005-30-123, dated August 23, 2005).

7 The IRS Taxpayer Advocate's 2008 Annual Report to Congress noted that 11 percent of all accuracy-related penalties assessed were abated after several years, comprising 37 percent of the dollars assessed. However, this amount includes both individual and corporate examinations with any amount assessed, while our sample included only sole proprietors with more than $5,000 assessed. Also, our outcome measure only includes the substantial understatement accuracy-related penalty.

1 A computer system used by the SB/SE Division Examination Operations function and others to control returns, input assessments/adjustments to the Master File, and provide management reports.

2 The IRS Data Book provides information on returns filed and taxes collected, enforcement, taxpayer assistance, the IRS budget and workforce, and other selected activities.

3 Judgmental sampling was used because of limited resources and time available to complete the audit in a reasonable time period.

4 IRS computer system capable of retrieving or updating stored information; it works in conjunction with a taxpayer's account records.

5 The National Quality Review System conducts closed case reviews and provides quality measurement results for the SB/SE Division.

6 The Embedded Quality Review System allows field managers to provide timely feedback to individual employees through

TIGTA Report on 6662 penalties

Negligence penalties on clients are likely to result in 6694(b) penalties for return preparers.

Treasury Inspector General for Tax Administration (TIGTA) Report: Additional Managerial Involvement Is Needed to Promote Consistent Use of Accuracy-Related Penalties (Reference Number : 2009-30-124), (Oct. 15, 2009)
2009ARD 199-6

Treasury Inspector General for Tax Administration (TIGTA) report: Internal Revenue Service: Managerial involvement: Penalties, civil: Accuracy-related penalties


TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION \
Additional Managerial Involvement Is Needed to Promote Consistent Use of Accuracy-Related Penalties
September 11, 2009

Reference Number: 2009-30-124

This report has cleared the Treasury Inspector General for Tax Administration disclosure review process and information determined to be restricted from public release has been redacted from this document.

Redaction Legend :

1 = Tax Return/Return Information

Phone Number | 202-622-6500

Email Address | inquiries@tigta.treas.gov

Web Site | http://www.tigta.gov

DEPARTMENT OF THE TREASURY
WASHINGTON, D.C. 20220

TREASURY INSPECTOR GENERAL FOR TAX ADMINISTRATION

September 11, 2009

MEMORANDUM FOR COMMISSIONER, SMALL BUSINESS/SELF-EMPLOYED DIVISION

FROM: Michael R. Phillips

Deputy Inspector General for Audit

SUBJECT: Final Audit Report - Additional Managerial Involvement Is Needed to Promote Consistent Use of Accuracy-Related Penalties (Audit # 200830053)

This report presents the results of our review to determine whether accuracy-related penalties are assessed during sole proprietor examinations in the Small Business/Self-Employed Division in accordance with Internal Revenue Service (IRS) policies and procedures. This audit is included in our Fiscal Year 2009 Annual Audit Plan coverage under the major management challenge of Tax Compliance Initiatives.

Impact on the Taxpayer
Promoting tax compliance fairly and equitably is of paramount importance to the IRS. Penalties are an important component of tax gap reduction efforts because they promote compliance with the tax laws by imposing an economic cost on taxpayers who choose not to comply voluntarily. Because we found that penalties were not always applied when warranted, the taxpaying public could perceive inequities in the examination process that penalize some but allow others to avoid penalties that otherwise should have been assessed.

Synopsis
Despite having authority under Internal Revenue Code Section 6662 to impose accuracy-related penalties, as well as layers of management controls to guide the penalty-setting process, the IRS is missing opportunities to use penalties to better promote accurate reporting among sole proprietors. We selected a statistically valid sample of 356 sole proprietor examinations that were closed in Fiscal Year 2007 and found that in 84 cases (24 percent), IRS procedures were not followed in recommending accuracy-related penalties for assessment.

Although each case in our population met the minimum threshold (a tax understatement of $5,000 or more) for considering the substantial understatement penalty, examiners were either too lenient and did not recommend penalties that were warranted or had not documented case files indicating that penalties were considered. Moreover, we found no documentation of managerial involvement in 67 of the 105 penalty decisions, despite an Internal Revenue Manual requirement for such involvement in cases where the substantial understatement penalty should be considered.

Besides missing potential opportunities to enhance accurate reporting among sole proprietors, closing the gap between the accuracy-related penalties assessed and those that should be assessed would enhance revenue. To estimate the potential amount of substantial overstatement penalties and interest the 84 sole proprietors were not assessed through April 30, 2009, we followed IRS procedures for computing the substantial understatement penalty on the tax deficiencies, along with the amount of interest owed on each penalty. Overall, we estimate the 84 sole proprietors in our sample cases avoided penalties and interest totaling $354,539. When projected to our population of 4,772 returns, we estimate that over a 5-year period sole proprietors would avoid penalty and interest assessments totaling $24 million (plus or minus $9 million) that otherwise should have been assessed. Our projection is based on a 95 percent confidence level and we assumed that the IRS would not reconsider and subsequently abate any of the assessments.

Recommendations
We recommended that the Director, Examination, Small Business/Self-Employed Division, should require 1) group managers to provide more specific written feedback to examiners on the quality of their penalty determinations and incorporate the feedback into examiner midyear progress reports and annual appraisals when appropriate and 2) Territory managers to use their operational reviews to monitor and assess the written feedback given by group managers on the quality of their examiners' penalty determinations.

Response
IRS management agreed with our recommendations. The Director, Examination Policy, Small Business/Self-Employed Division, will enhance the guidance regarding managerial documentation of examiners' penalty determinations in the document Examination Quality Review System - Multi-Case Review Guidance for Field and Office Examination . The Director, Examination Policy, will also include an article in the managerial guidance document Examination Quality Review System - Performance Perspective that addresses the importance of managerial documentation regarding penalty determinations. Finally, the Director, Examination Policy, will enhance the guidance on group operational reviews in the Examination Quality Review System Field and Office Examination Quality Guide for Operational Reviews to include review of the group manager's oversight of examiners' penalty determinations. However, IRS management commented that our outcome measure calculation may be overstated because it did not consider the effect of subsequent reconsideration and abatements of penalties. Management's complete response to the draft report is included as Appendix VI.

Office of Audit Comment
While we acknowledge that some penalties may be abated in the future, our outcome measure was calculated only for returns that met the requirements for the substantial understatement penalty. Our outcome measure estimates were based on the information available at the time of our review, and the IRS response did not provide an estimate of the amount of substantial understatement penalties that might be abated in future years. Also, publicly released data on abatements, such as the IRS Data Book, does not separately report the amount of substantial understatement penalties abated each year, so we have no reliable basis to calculate an estimate of abated penalties.

Copies of this report are also being sent to the IRS managers affected by the report recommendations. Please contact me at (202) 622-6510 if you have questions or Margaret E. Begg, Assistant Inspector General for Audit (Compliance and Enforcement Operations), at (202) 622-8510.

Table of Contents
Background

Results of Review

Management Controls Are in Place to Guide Examiners Through the Penalty-Setting Process

The Gap Between the Number of Accuracy-Related Penalties Assessed and the Number Warranted Is Considerable

Recommendations 1 and 2 :

Appendices

Appendix I - Detailed Objective, Scope, and Methodology

Appendix II - Major Contributors to This Report

Appendix III - Report Distribution List

Appendix IV - Outcome Measure

Appendix V - Overview of Selected Penalties Applicable to Examinations of Sole Proprietors

Appendix VI - Management's Response to the Draft Report

Abbreviations
FY
Fiscal Year

I.R.C.
Internal Revenue Code

IRM
Internal Revenue Manual

IRS
Internal Revenue Service

SB/SE
Small Business/Self-Employed Division

TIGTA
Treasury Inspector General for Tax Administration


Background
Our tax system is based on the public's willingness to voluntarily prepare an accurate tax return, file it timely, and pay any tax due on time. To encourage voluntary compliance, Congress placed numerous penalty provisions in the tax laws for the Internal Revenue Service (IRS) to administer through its Examination Program and various other compliance programs.

Despite numerous management controls, the gap between the number of accuracy-related penalties assessed and the number that should be assessed is considerable.

Spread across the IRS' four operating divisions, the Examination Program is one of the agency's largest compliance programs. Its examiners are primarily responsible for determining the correct liabilities for taxpayers, including their liabilities for penalties. During an examination of a tax return, such as one filed by a sole proprietor, examiners are required to consider a number of penalties when recommending adjustments to tax liabilities. The numerous penalties generally fall into two broad categories: delinquency and accuracy-related. Delinquency penalties are intended to encourage the timely filing of income tax and information returns, while accuracy-related penalties promote the preparation and submission of complete and correct information on tax returns.

According to our analysis of underlying information from the 2008 IRS Data Book, 1 the IRS assessed individual taxpayers with 2,881,085 delinquency penalties and 343,295 accuracyrelated penalties. Additional information on various penalties within these two broad categories is included in Appendix V.

This review was performed in the IRS Small Business/Self-Employed (SB/SE) Division Headquarters Office in New Carrollton, Maryland, during the period October 2008 through April 2009. Except for auditing IRS databases to validate the accuracy and reliability of the information, 2 this performance audit was conducted in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objective. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objective. Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.

Results of Review
Despite numerous management controls to guide the penalty-setting process, the gap between the number of accuracy-related penalties assessed and the number warranted is considerable. As a result, we are recommending additional managerial involvement in the administration of these penalties.

Management Controls Are in Place to Guide Examiners Through the Penalty-Setting Process
Ultimately, the IRS relies on examiners and their group managers to properly consider and assess penalties during examinations. To assist examiners and group managers in meeting these responsibilities, the IRS has an array of policies, procedures, and techniques (management controls) that are in line with the Government Accountability Office's Standards for Internal Control in the Federal Government.

At the agency level, there is a broad policy statement on penalties that was revised in June 2004 to provide guidance for examiners, as well as other IRS personnel, and included overall goals for implementing the policy. The policy statement underscores the role penalties play in promoting compliance with and fairness of the tax system by imposing an economic cost on those who do not voluntarily comply with tax laws. In implementing the revised policy, the IRS provided an agencywide training session on penalty administration and augmented the training by developing a comprehensive audit technique guide and making it available to examiners throughout the agency. Figure 1 provides an overview of the goals reflected in the IRS' penalty policy.

Figure 1: Goals of the IRS Penalty Policy
Goals
Policy Overview


Enhance and encourage compliance.
Penalties provide an important tool to promote compliance and fairness in the tax system by increasing the costs for those who do not timely and accurately comply with the tax laws.


Curb the use of abusive tax transactions.
Accuracy-related penalties combat the undermining effect abusive transactions have on the tax system.


Promote sound and efficient tax administration.
Penalties may occasionally be waived as part of a strategy to encourage prompt resolution of tax issues.


Promote consistency in applying penalties.
The IRS Office of Penalty Administration reviews and approves changes to its Penalty Handbook, which all agency employees are to use and follow.


Demonstrate fairness of the tax system.
Provide taxpayers with opportunities to provide reasons why penalties should not be assessed by considering evidence in favor of not assessing penalties.


Source: Treasury Inspector General for Tax Administration (TIGTA) analysis of IRS Policy Statement 20-1.


At the division level, Quality Assurance staffs review samples of examinations and assess the degree to which examiners comply with standards, including those related to penalties. The reviews serve as a mechanism for measuring and evaluating the quality of examinations and penalty determinations, communicating areas of concern up the chain of command, identifying potential training needs, and improving work processes. In addition to reviews by Quality Assurance staffs, mid-level managers may evaluate how well examiners are developing penalty issues during their operational reviews. As conducted by Examination function Territory managers, operational reviews are performed on group managers and their respective teams at least annually to ensure work is being done in conformance with procedures.

At the group level, the Internal Revenue Manual (IRM) serves as the official compilation of procedures and detailed instructions that govern examinations and the penalty-setting process. According to the IRM, an examiner's primary responsibility is to determine the correct income tax liability during an examination. However, they are also required to document examination case files with the factors considered in determining a taxpayer's liability for applicable penalties.

To assist examiners in considering the penalties that could apply to a return under examination, the SB/SE Division developed a Penalty Approval Form, shown in Figure 2 below, that is required to be included in the workpapers for every examination.

Figure 2: IRS Penalty Approval Form
Penalty Approval Form


IRC
Penalty
IRM
Assert Penalty
Reference








Yes
No


Penalties Not Requiring Group Managerial Approval






6651(a)(1)
Failure to File
20.1.2.3





6651(a)(2)
Failure to Pay
20.1.2.4





6654
Estimated Tax - Individual
20.1.3.1.1





6655
Estimated Tax - Corporate
20.1.3.5





Penalties Requiring Group Managerial Approval






6651(f)
Fraudulent Failure To File, Civil
20.1.2.7





6662(c)
Negligence
20.1.5.7





6662(d)
Substantial Understatement * Lead Sheet Available
20.1.5.8





6662(b)
Other Accuracy Related
20.1.5.1





6662(h)
Gross Valuation Misstatement
20.1.5.9





6662A
Accuracy Related Penalty on Understatements with Respect to Reportable Transactions (RT)
20.1.5.13





6707A
Failure to Include Reportable Transactions RT Information with Return or Statement
20.1.5.2





6663
Fraud
20.1.5.12






Alternative Penalty Position
20.1.5.12.2

















Consideration of Preparer / Promoter / Material Advisor Penalties
Consider Penalty
Reference









Yes
No


6694(a)
Preparer Penalties - Negligent
20.1.6.3.5





6694(b)
Preparer Penalties - Willful
20.1.6.3.5


6700
Promoting Abusive Tax Shelters
20.1.6.1





6701
Aiding & Abetting understatement of Tax Liability
20.1.6.1





6707
Failure to Furnish Information regarding RT
20.10





6708
Failure to Maintain Lists of Advisees with respect to RT (Formerly Failure to Maintain Lists of Investors in Potentially Abusive Tax Shelters)
20.10









Reason(s) for Non-Assertions of Penalty(s)



No Change or Refund Case



Other: Penalty considerations are to be addressed in all examinations and workpapers should be prepared. When adjustments would appear to warrant a penalty, but it is not asserted, the applicable exceptions to the penalty must be documented in the file. W/P Reference IRM 20.1.5.4.(2)


Group Manager Approval to Assess Penalties Identified Above (Not required on automatic penalties/No Change/Refund cases)


Group Manager Signature: Date:


Source: SB/SE Division Workpaper 300-1.1, dated May 2007.


Besides documenting penalty decisions, the IRM requires group managers to review the examiner's decision not to assert the substantial understatement penalty when the criteria of Internal Revenue Code (I.R.C.) Section 6662(d) is met, including the applicable exception to the penalty. This is an important control component in the penalty-setting process because group managers are responsible for the quality of work performed by the examiners they supervise. To ensure that examiners' work is meeting acceptable quality standards, including penalty considerations, SB/SE Division group managers use a variety of other techniques to ensure quality examinations are performed. These other techniques include observing and discussing examination work with examiners, reviewing in-process and closed examinations, and providing feedback through SB/SE Division's Embedded Quality Review System. 3

The Gap Between the Number of Accuracy-Related Penalties Assessed and the Number Warranted Is Considerable
Despite having authority under I.R.C. Section 6662 to impose accuracy-related penalties, as well as numerous management controls to guide the penalty-setting process, the IRS is missing opportunities to use penalties to better promote accurate reporting among sole proprietors. As shown in Figure 3, we selected a statistically valid sample of 356 sole proprietor returns from a population of 4,772 sole proprietor returns with examinations closed in Fiscal Year (FY) 2007. All returns in our population met the minimum threshold (a tax understatement of $5,000 or more for an individual return) for considering the substantial understatement penalty. We reviewed each selected return using the IRS Integrated Data Retrieval System 4 and eliminated 175 returns that had an accuracy-related penalty assessed by the examiner. We then ordered the administrative case files (examination workpapers) for the 181 returns that did not have an accuracy-related penalty assessed and were able to obtain workpapers for 105 returns. For these 105 returns, we found 84 (24 percent of the 356 returns sampled) in which IRS procedures were not followed in recommending accuracy-related penalties for assessment.

Figure 3: Review of Accuracy-Related Penalties for Sole Proprietor Examinations Closed in FY 2007

Number
Percentage of Sample


Number of sole proprietor returns selected for sample.
356
100 %




Sole proprietor returns with an accuracy-related penalty assessed by examiner.
175
49 %




Sole proprietor returns without an accuracy-related penalty with examination workpapers ordered by the TIGTA.
181
51%




Sole proprietor returns without an accuracy-related penalty with examination workpapers received and reviewed by the TIGTA.
105
29%




Sole proprietor returns without an accuracy-related penalty reviewed by the TIGTA in which IRS procedures were not followed.
84
24%




Sole proprietor returns without an accuracy-related penalty reviewed by the TIGTA in which IRS procedures were followed.
21
6%


Source: TIGTA analysis of 356 sole proprietor examinations closed in FY 2007.


Although each case in our population met the minimum threshold for considering the substantial understatement penalty, examiners were either too lenient and did not recommend penalties that were warranted or had not documented case files indicating that penalties were considered. The majority of cases we reviewed did not entail complicated tax law issues and did not appear to meet any of the IRM exceptions that allow for the abatement of an accuracy-related penalty. Except for a few instances, IRS officials who also reviewed a large group of our case reviews agreed with our conclusions.

We also found no documentation of managerial involvement in 67 of the penalty decisions (19 percent of the 356 returns sampled and 64 percent of the 105 case files reviewed) despite an SB/SE Division requirement of such involvement in cases where adjustments warrant the substantial understatement penalty. For example, we found 30 cases for which well over $10,000 of income tax was not reported and there was no evidence of managerial involvement. The absence of this involvement in these cases is of particular concern because the IRS requires more detailed documentation of managerial involvement in examinations involving unreported income of $10,000 or more. At a minimum, the documentation in these cases should show that the manager and examiner jointly developed an action plan to obtain and document potential fraudulent activities that may be needed in a referral to the IRS Criminal Investigation Division for possible criminal prosecution.

Examiners and group managers need to be held accountable for considering and assessing accuracy-related penalties
We believe there is a combination of factors causing the concerns identified in our case reviews and that there is no easy and quick solution to the problem. Overall, management controls are in place to assist examiners and managers in meeting their responsibilities for considering and assessing penalties when warranted. Also, IRS guidance and directions to examiners and group managers is detailed and adequate. Despite the controls that are in place, some examiners and group managers may be placing too high a value on obtaining agreement to examination results and using penalties as a bargaining chip to obtain agreement. For example, * * * * * This type of action is strictly prohibited by IRS procedures.

As we have reported previously, the performance management process can be an effective tool in helping examiners understand and meet their responsibilities. 5 It also provides opportunities to give meaningful and constructive feedback on performance, pinpoint and address performance gaps, and hold examiners accountable for results. According to the United States Merit Systems Protection Board, continually monitoring and providing feedback to employees is perhaps the most important component of managing performance. In a 2003 report to the President and Congress, the United States Merit Systems Protection Board stated:

This component, more than any other, can give employees a sense of how they are doing and can motivate them to be as effective as possible. Ideally, through these ongoing interactions between employees and supervisors, employees learn how their work fits into the goals of the work unit and how it contributes to the larger mission of the agency.

In response to our 2005 report on penalty determinations in corporate examinations, 6 the SB/SE Division agreed it would issue performance management reminders to Examination function personnel about the need to provide examiners with specific written feedback on the quality of their penalty determinations. Although the Director, Examination, SB/SE Division, issued a memorandum on November 25, 2005, to Examination function area directors, we were unable to determine whether this guidance was communicated to front line Examination function personnel. Moreover, we researched the Embedded Quality Review System to determine if group managers provided performance feedback to 21 examiners involved in 25 of the cases we reviewed and found considerable evidence that suggests the need for group managers to take better advantage of written feedback to hold examiners more accountable for their penalty determinations. Although all 21 examiners failed to follow IRS procedures in considering accuracy-related penalties, 6 (29 percent) of the 21 examiners had not received any narrative feedback on the importance of making quality penalty determinations in workload reviews, midyear progress reports, and annual performance appraisals they received in the Embedded Quality Review System in FY 2008.

Although the performance management process for group managers is somewhat different from the process for examiners, it can be used in much the same way to hold managers accountable for results. One difference is that group managers develop commitments at the beginning of the fiscal year that supplement their critical job responsibilities and can be specifically tailored to meet improvement opportunities. Another important difference is that SB/SE Division Territory managers are responsible for managing and evaluating the performance of group managers. Among the tools used by Territory managers to meet this responsibility are operational reviews, which can be used to better ensure that group managers are providing specific written feedback to examiners on the quality of their penalty determinations.

Promoting tax compliance fairly and equitably is of paramount importance to the IRS. Penalties are an important component of tax gap reduction efforts because they promote compliance with the tax laws by imposing an economic cost on taxpayers who choose not to comply voluntarily. Because we found that penalties were not always applied when warranted, the taxpaying public could perceive inequities in the examination process that penalize some but allow others to avoid penalties that otherwise should have been assessed.

In addition to enhancing accurate reporting among sole proprietors, closing the gap between the number of accuracy-related penalties assessed and the number that should be assessed would enhance revenue. To estimate the potential amount of substantial understatement penalties and interest the 84 sole proprietors were not assessed through April 30, 2009, we followed IRS procedures for computing the substantial understatement penalty on the tax deficiencies, along with the amount of interest owed on each penalty. Overall, we estimate the 84 sole proprietors in our sample cases were not assessed penalties and interest totaling $354,539. When projected to our population of 4,772 cases, we estimate that 1,126 sole proprietors (plus or minus 203 sole proprietors) avoided penalty and interest assessments of $4.8 million per year (plus or minus $1.8 million). Our projection is based on a 95 percent confidence level and assumes that the IRS will not reconsider and abate any of the penalties. 7 When projected over a 5-year period, we estimate with a 95 percent degree of confidence that sole proprietors would avoid penalty and interest assessments totaling $24 million (plus or minus $9 million) that otherwise should have been assessed.

Recommendations
To promote additional managerial involvement in the administration of penalties, we recommend that the Director, Examination, SB/SE Division, require:

Recommendation 1: Group managers to provide more specific written feedback to examiners on the quality of their penalty determinations and incorporate the feedback into examiner midyear progress reports and annual performance appraisals when appropriate.

Management's Response: IRS management agreed with this recommendation. The Director, Examination Policy, SB/SE Division, will enhance the guidance regarding managerial documentation of examiners' penalty determinations included in the document Examination Quality Review System - Multi-Case Review Guidance for Field and Office Examination . The Director, Examination Policy, will also include an article in the managerial guidance document Examination Quality Review System - Performance Perspective that addresses the importance of managerial documentation regarding penalty determinations.

Recommendation 2: Territory managers to use their operational reviews to monitor and assess the written feedback given by group managers on the quality of their examiners' penalty determinations.

Management's Response: IRS management agreed with this recommendation. The Director, Examination Policy, SB/SE Division, will enhance the guidance on group operational reviews in the Examination Quality Review System Field and Office Examination Quality Guide for Operational Reviews to include review of the group manager's oversight of examiners' penalty determinations.

Although agreeing with our recommendations, IRS management commented that our outcome measure calculation may be overstated because it did not consider the effect of subsequent reconsideration and abatements of penalties.

Office of Audit Comment: As noted in Appendix IV, our outcome measure was calculated only for returns that met the requirements for the substantial understatement penalty. While we acknowledge that some of these penalties could be abated in the future, our outcome measure estimates were based on information available at the time of our review, and the IRS response did not provide an estimate of the amount of substantial understatement penalties that might be abated in future years. Also, publicly released data on abatements, such as the IRS Data Book, does not separately report the amount of substantial understatement penalties abated each year, so we have no reliable basis to calculate an estimate of abated penalties.

Appendix I
Detailed Objective, Scope, and Methodology
The overall objective of this review was to determine whether accuracy-related penalties are assessed during sole proprietor examinations in the SB/SE Division in accordance with IRS policies and procedures. To accomplish our objective, we:

I. Selected a statistically valid sample of 356 closed examined sole proprietorship returns using a confidence level of 95 percent, a precision rate of plus or minus 5 percent, and an expected error rate of 50 percent. The returns were selected from the population of 4,772 sole proprietor returns meeting our criteria on the Audit Information Management System 1 Closed Case data file maintained on the TIGTA's Data Center Warehouse. The selection criteria included examinations that were closed as “agreed” between October 1, 2006, and September 30, 2007, had a understatement of tax meeting the minimum threshold of $5,000 for considering the substantial understatement penalty, and involved non-farm businesses with total gross receipts of $100,000 or more with total positive income of less than $200,000. We conducted limited data validation testing by matching the universe of sole proprietor examinations on the Audit Information Management System to the IRS Data Book 2 and selecting a judgmental 3 sample of 20 examinations on the Audit Information Management System and verifying selected taxpayer information to the Integrated Data Retrieval System. 4

II. Conducted research using the Integrated Data Retrieval System on the sample identified in Step I to identify the returns that appeared to meet the criteria for the imposition of accuracy-related penalties (at least $5,000 in additional tax assessed) but do not have a Transaction Code 240 with a Reference Number 680 on the taxpayer's account (indicating the imposition of an accuracy-related penalty). Using the Integrated Data Retrieval System, we determined that the accuracy-related penalty was applied in 175 of the examinations, while the remaining 181 examinations had no accuracy-related penalty applied. We requested the examination workpapers for the 181 returns and any related tax return years and received workpapers for 105 returns.

III. Reviewed the examination workpapers for the 105 closed sole proprietor returns to determine whether examiners followed IRS procedures in recommending accuracy-related penalties for assessment. We estimated the potential revenue that could be generated over a 5-year period if examiners properly considered and assessed penalties by applying the error rates and penalty amounts determined in the cases reviewed against examinations in our population having similar deficiencies and characteristics, but no accuracy-related penalties applied.

IV. Evaluated the adequacy of controls for ensuring accuracy-related penalties are properly considered and applied during sole proprietor examinations by documenting the applicable I.R.C. sections, Treasury Regulations, IRM (policy and procedural) sections, management directives, examiner training materials, and IRS public announcements and notices that provide the authority and reasons for assessing the penalty.

V. Used the results from FYs 2007 and 2008 quality reviews (National Quality Review System 5 and Embedded Quality Review System) 6 to identify weaknesses in the use of accuracy-related penalties and assess the effectiveness of corrective actions taken in response to the weaknesses identified.

VI. Evaluated the extent of training that group managers and examiners received on considering and applying accuracy-related penalties by reviewing the FYs 2007 and 2008 training records of the managers and examiners included in our case reviews.

VII. Assessed how well Territory managers are holding group managers accountable for ensuring the examiners they supervise are properly considering accuracy-related penalties by evaluating FY 2008 operational reviews, midyear appraisals, and annual appraisals they provided to the group managers for cases included in our review.

VIII. Assessed how well group managers are holding examiners accountable for properly considering accuracy-related penalties by evaluating the FY 2008 workload reviews (on-the-job visits, etc.), midyear appraisals, and annual appraisals they provided to the examiners for cases included in our review.

IX. Determined the number of accuracy-related penalties that were assessed in sole proprietor examinations in FYs 2006, 2007, and 2008 by analyzing the IRS Statistics of Income data files that support the number and amount of these penalties in the corresponding IRS Data Books.

X. Assessed the status of ongoing changes to improve the administration of penalties by interviewing SB/SE Division management and program analysts in its Offices of Examination Policy and Penalties and Interest to identify ongoing changes, such as policy and procedural changes, examiner training, stakeholder outreach activities, and IRS public notices and announcements that are aimed at enhancing administration of penalties. We assessed the effectiveness of any ongoing changes identified.


Appendix II
Major Contributors to This Report
Margaret E. Begg, Assistant Inspector General for Audit (Compliance and Enforcement Operations)

Frank Dunleavy, Director

Robert Jenness, Audit Manager

Debra Mason, Lead Auditor

Earl Charles Burney, Senior Auditor

William Tran, Senior Auditor

Ali Vaezazizi, Auditor

Appendix III
Report Distribution List
Commissioner C

Office of the Commissioner - Attn: Chief of Staff C

Deputy Commissioner for Services and Enforcement SE

Deputy Commissioner, Small Business/Self-Employed Division SE:S

Director, Examination, Small Business/Self-Employed Division SE:S:E

Chief Counsel CC

National Taxpayer Advocate TA

Director, Office of Legislative Affairs CL:LA

Director, Office of Program Evaluation and Risk Analysis RAS:O

Office of Internal Control OS:CFO:CPIC:IC

Audit Liaison: Commissioner, Small Business/Self-Employed Division SE:S

Appendix IV
Outcome Measure
This appendix presents detailed information on the measurable impact that our recommended corrective actions will have on tax administration. This benefit will be incorporated into our Semiannual Report to Congress.

Type and Value of Outcome Measure:
Increased Revenue - Potential; $4.8 million per year (plus or minus $1.8 million), or $24 million (plus or minus $9 million), over 5 years. The potential revenue increase is related to 1,126 sole proprietors who were not assessed an accuracy-related penalty that was warranted (see page 5). In making the projection, we assumed that the IRS would not reconsider and subsequently abate any of the assessments.

Methodology Used to Measure the Reported Benefit:
To estimate the potential additional revenue associated with closing the gap between the number of accuracy-related penalties assessed and the number warranted in sole proprietor examinations, we:

1. Analyzed a statistically valid sample of 356 examinations from a population of 4,772 returns with the potential for accuracy-related penalties closed in FY 2007 for which sole proprietors agreed with the IRS that they understated their tax liabilities by more than $5,000 but avoided an accuracy-related penalty.

2. Used the sample occurrence rate (of missed opportunities for applying the accuracy-related penalty) of 23.60 percent (84 divided by 356) from the results of our case review samples to project that as many as 1,126 (23.60 percent multiplied by 4,772) sole proprietors were not assessed an accuracy-related penalty that was warranted, plus or minus 203 sole proprietors.

3. Followed the IRS procedures for computing the substantial understatement penalty related to the deficiencies owed to calculate that accuracy-related penalties of $307,440 were not assessed on the 84 returns.

4. Used IRS computer programs with the applicable Federal interest rate to calculate that $47,099 of interest would have been owed on the penalties for the 84 returns through April 30, 2009.

5. Used variable sampling techniques based on the amount of penalties and interest that should have been assessed for the 84 cases ($354,539) to determine the estimated amount of penalties and interest per case to be $4,221 ($354,539 divided by 84). Applied the per case estimate to the projected number of sole proprietors not assessed the penalty to determine that the amount of missed penalty and interest opportunities for our population was $4.8 million per year ($4,221 multiplied by 1,126), plus or minus $1.8 million.

6. Shared our sampling methodology with an outside statistical expert who confirmed the accuracy of our methodology and projection.


Appendix V
Overview of Selected Penalties Applicable to Examinations of Sole Proprietors
This appendix provides a brief overview of some common penalties examiners should consider and possibly apply during a sole proprietor examination. There are relief standards that can be invoked to avoid the imposition of the penalties below. The I.R.C., for example, generally provides that penalties can be avoided if there was reasonable cause and the sole proprietor acted in good faith.

Selected Penalties Considered During a Sole Proprietor Examination
Delinquency Penalties


Title
I.R.C. Section(s)
Overview


Failure to File
6651(a)(1)
If an examination results in a tax deficiency and the tax return was not filed by the prescribed due date (or extended due date), a failure to file penalty can be applied on the tax deficiency from the tax return due date (or extended due date) until paid or until the maximum penalty is applied.


Failure to File Information Returns
6721, 6722, 6723, 6679, 6038(b), 6038A(d)
Sole proprietors are required to file certain information returns and/or furnish certain statements to payees under various sections of the I.R.C. Information return reporting penalties can involve amounts ranging from $50 up to $250,000.


Accuracy-Related Penalties


Negligence
6662(c)
Negligence includes any failure to make a reasonable attempt to comply with the provisions of the tax law, exercise ordinary and reasonable care in tax return preparation, or keep adequate books and records. The penalty is 20 percent of the portion of the underpayment attributable to negligence.


Substantial Understatement
6662(d)
The substantial understatement penalty may be applied when an understatement exceeds $5,000 or 10 percent of the tax required to be shown for the tax year, whichever is greater. The penalty is equal to 20 percent of the underpayment of tax attributable to the understatement.


Substantial Valuation Misstatement
6662(e)
The substantial valuation misstatement exists if the value or adjusted basis of any property claimed on a return is 150 percent or more of the amount determined to be the correct amount of such value or adjusted basis. The penalty is 20 percent of the underpayment of tax.


Gross Valuation Misstatement
6662(h)
The gross valuation misstatement penalty exists if the value or adjusted basis of any property claimed on a return is 200 percent or more of the corrected amount; or if the price for any property or service (or for the use of property) claimed on a return is 400 percent or more (or 25 percent or less) of the amount determined under I.R.C. Section 482 to be the correct price; or if the net section 482 adjustment exceeds the lesser of $20,000,000 or 20 percent of the taxpayer's gross receipts. The penalty is 40 percent of the underpayment of tax.


Fraud
6663(a)
If any underpayment of tax is due to fraud, a penalty may be imposed equal to 75 percent of the portion of the underpayment due to fraud. Although the I.R.C. does not define the term fraud, most courts define fraud as the “intent to evade tax.”


Source: TIGTA analysis of selected sections of the I.R.C.


Appendix VI
Management's Response to the Draft Report
DEPARTMENT OF THE TREASURY INTERNAL REVENUE SERVICE WASHINGTON, D.C. 20224

COMMISSIONER SMALL BUSINESS/SELF-EMPLOYED DIVISION

August 17, 2009

MEMORANDUM FOR MICHAEL R. PHILLIPS DEPUTY INSPECTOR GENERAL FOR AUDIT

FROM: Christopher Wagner

Commissioner, Small Business/Self-Employed Division

SUBJECT: Draft Audit Report Additional Managerial Involvement is Needed to Promote Consistent Use of Accuracy-Related Penalties (Audit No. 200830053)

We have reviewed your report “Additional Managerial Involvement Is Needed to Promote Consistent Use of Accuracy-Related Penalties.” Penalties provide an important tool in promoting compliance and faimess in the tax system. We agree with the recommendations contained in your report and concur that managerial oversight of examiners' consideration of the application of penalties is important for ensuring compliance and fairness.

We appreciate you acknowledging that the guidance previously provided to group managers was detailed, adequate and meets the standards set forth in the Government Accountability Office's (GAO) Standards for Internal Control in the Federal Government. We agree that an outcome measure should be computed for this audit but we believe your calculation should consider the effect of subsequent reconsideration and abatement of penalties. By not including this factor in the calculation, there is a potential that the outcome measure may be overstated.

Attached is a detailed response outlining our corrective actions. If you have questions, please call me at (202) 622-0600 or Monica Baker, Director, Examination at (202) 283-2659.

Attachment

Attachment
RECOMMENDATION 1 :

To promote additional managerial involvement in the administration of penalties, we recommend that the Director, Examination, SB/SE Division, require Group managers to provide more specific written feedback to examiners on the quality of their penalty determinations and incorporate the feedback into examiner midyear progress reports and annual performance appraisals when appropriate.

CORRECTIVE ACTION :

1. We will enhance the guidance already included in the “Examination Quality Review System (EQRS) - Multi-Case Review Guidance for Field and Office Examination” regarding managerial documentation of examiners' penalty determinations.

2. We will include an article in the managerial guidance document, “EQRS Performance Perspective” that addresses the importance of managerial documentation regarding penalty determinations.


IMPLEMENTATION DATE:

1. March 15, 2010

2. March 15, 2010

RESPONSIBLE OFFICIAL:

Director, Examination Policy SB/SE Division

CORRECTIVE ACTION MONITORING PLAN:

The Director, Examination Policy will monitor the status and will advise the Director, Examination of any delays in completing the corrective action.

RECOMMENDATION 2 :

To promote additional managerial involvement in the administration of penalties, we recommend that the Director, Examination, SB/SE Division, require Territory managers to use their operational reviews to monitor and assess the written feedback given by group managers on the quality of their examiners' penalty determinations.

CORRECTIVE ACTION :

We will enhance the guidance on group operational reviews already included in the “EQRS Field and Office Examination EQ Guide for Operational Reviews” to include review of the group manager's oversight of examiners' penalty determinations.

IMPLEMENTATION DATE:

March 15, 2010

RESPONSIBLE OFFICIAL:

Director, Examination Policy SB/SE Division

CORRECTIVE ACTION MONITORING PLAN:

The Director, Examination Policy will monitor the status and will advise the Director, Examination of any delays in completing the corrective action.


Footnotes

1 The IRS Data Book is published annually by the IRS and contains statistical tables and organizational information on a fiscal year basis.

2 The accuracy of the data was verified to individual recipients during our case review.

3 The Embedded Quality Review System allows field managers to provide timely feedback to individual employees through performance case reviews.

4 IRS computer system capable of retrieving or updating stored information; it works in conjunction with a taxpayer's account records.

5 Performance Management in the Large and Mid-Size Business Division's Industry Case Program Needs Strengthening (Reference Number 2005-30-084, dated May 27, 2005).

6 The Strategy to Reemphasize Penalties in Corporate Examinations Could Be Enhanced (Reference Number 2005-30-123, dated August 23, 2005).

7 The IRS Taxpayer Advocate's 2008 Annual Report to Congress noted that 11 percent of all accuracy-related penalties assessed were abated after several years, comprising 37 percent of the dollars assessed. However, this amount includes both individual and corporate examinations with any amount assessed, while our sample included only sole proprietors with more than $5,000 assessed. Also, our outcome measure only includes the substantial understatement accuracy-related penalty.

1 A computer system used by the SB/SE Division Examination Operations function and others to control returns, input assessments/adjustments to the Master File, and provide management reports.

2 The IRS Data Book provides information on returns filed and taxes collected, enforcement, taxpayer assistance, the IRS budget and workforce, and other selected activities.

3 Judgmental sampling was used because of limited resources and time available to complete the audit in a reasonable time period.

4 IRS computer system capable of retrieving or updating stored information; it works in conjunction with a taxpayer's account records.

5 The National Quality Review System conducts closed case reviews and provides quality measurement results for the SB/SE Division.

6 The Embedded Quality Review System allows field managers to provide timely feedback to individual employees through performance case reviews.



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www.irsforum.org as 6694 clearinghouse

The IRS Forum is a nonprofit 501(c)(3) organization

It has a "forum" or "thread" for 6694 tax issues.

If you have an experience with the IRS on any kind of a 6694 issue, or if your client had that experience with the IRS or if there was a prior IRS experience with a 6694 issue, you can use the 6694 forum or thread to upload that experience.

You can also use the IRS Forum 6694 upload for any comment you wish to make about 6694 - the statute, regs, etc.

In short the IRS Forum at www.irsforum.org can be used as a clearinghouse for any IRS matter dealing with 6694 including any opinion or experience you have dealing with that subject.

You do not have to disclose your identity for an upload.

I have discussed the IRS Forum with staff on the Committee on Ways & means and the Oversight Subcommittee and they approve and encourage uploads to the IRS Forum as a vehicle to provide "IRS transparency." In short, going forward, uploads to the IRS Forum have the attention of staff of the Committee on Ways & Means and the Oversight Subcommittee.

If you wish a "forum" to discuss any other tax issue at the IRS Forum, contact me at ab@irstaxattorney.com

Great defense to 6663 penalty - bogus return

CCA 200923028, January 05, 2009

Symbol: CC:PA:01-POSTN-144754-08

DATE: January 05, 2009

TO: Jeffrey L. Heinkel, Associate Area Counsel (Area 7) (Small Business/Self-Employed)

FROM: Charles A. Hall, Senior Technician Reviewer, Branch 1 (Procedure & Administration)

SUBJECT: Imposition of penalties with respect to a bogus return

This Chief Counsel Advice responds to your October 17, 2008 request for assistance. This advice may not be used or cited as precedent.

ISSUES

1. Whether the Service can impose the fraud penalty under section 6663 against a wife (W) who filed a bogus return in her husband's (H) name.

2. Whether the Service can impose the section 6701 penalty for aiding in the understatement of tax against W for filing a bogus return in H's name.

3. Whether any other penalties can be imposed against W.

CONCLUSIONS

1. The Service cannot impose the section 6663 penalty against W because the bogus return is invalid.

2. The Service cannot impose the section 6701 penalty against W because the bogus return is invalid.

3. No penalties under our jurisdiction apply to the facts of this case.

FACTS

H and W were married during Y1. In Y2, separate federal income tax returns were filed electronically in H and W's names for taxable year Y1. Each return claimed head of household status and the earned income credit (EIC). H's return listed W as a third party designee. The Service processed both returns and issued refunds to both taxpayers, based upon the EIC. Each refund was deposited in the bank account identified on the respective return.

H and W separated sometime during Y2. In Y3, H informed the Service that W had filed H's Y1 return without his knowledge. H was incarcerated during Y1 and at the time the returns for Y1 were filed in Y2 and claims that he did not earn any income in Y1. Therefore, H was not required to file a return for Y1 and did not intend to file one for Y1 in Y2. H subsequently submitted a paper return to the Service for Y1. The Service then began an investigation. Upon examination, both of the returns filed for Y1 in Y2 identified the same bank account as the account into which to deposit the refunds. The bank account is in H's name but W had access to the account. H claims he did not receive any refund and that W kept both refunds. In addition, the personal identification number (PIN) on H's Y1 return is the same one that had been used previously by W not H. Both Y1 returns used PIN 1. W's Y0 return used PIN 1. H's Y0 and Y3 returns used PIN 2. No return was filed in H's name for Y2. No other returns for H (besides Y1) used PIN 1. W has signed an affidavit under oath stating that she “filed taxes in the name of [H]… without his knowledge for the Y1 tax year.”

LAW AND ANALYSIS

H's Y1 return is invalid

A valid return is a document that: (1) purports to be a return, (2) is executed under penalties of perjury, (3) reports sufficient data to calculate the tax liability, and (4) most importantly, constitutes an honest and reasonable attempt to satisfy the requirements of the law. See Beard v. Commissioner, 82 T.C. 766 (1984) [CCH Dec. 41,237], aff'd 793 F.2d 139. (6 th Cir. 1986).

The signature requirement derives from section 6065, which provides that generally, any return, declaration, statement, or other document required to be made under any provision of the internal revenue laws or regulations shall contain or be verified by a written declaration that it is made under penalties of perjury. The purpose of this requirement is to authenticate the signed document, and to verify its truthfulness. Thus, if a return is not properly signed by the taxpayer, the return is invalid. Such a return remains invalid even if the Service processes the return. See Ulicher v. Commissioner, T.C. Memo. 2002-55 [CCH Dec. 54,665(M)].

The signature requirements for electronically filed returns are the same as those for paper returns. I.R.M. §§ 3.42.5.16.8.1 and 3.42.5.16.1.1. Taxpayers may create their own Personal Identification Number (PIN) and file a completely paperless return through their tax preparation software or their tax professional. I.R.M. §§ 3.42.5.16.1.1 and 3.42.1.3.1(1) c. The mere existence of an electronic signature does not cause it to be valid if there are indications of invalidity. See I.R.M. § 3.42.5.16.1.1.

In the instant case, there are indications of an invalid signature. The same PIN was used for both spouse's Y1 returns. H has never used that PIN but W has. Furthermore, W admitted filing the return without H's knowledge. None of the exceptions that would allow someone to sign on behalf of another apply here. Therefore, the Y1 return was not verified and signed by the H and cannot be a valid return for H for Y1. If the paper return that H subsequently submitted to the Service for Y1 is a valid return, then the Service should process that return, if it has not already done so, and adjust H's accounts accordingly.

The refund issued with respect to H's invalid electronic return for Y1 is an erroneous refund. See I.R.C. §§ 7405 and 6532(b). The Manual/Erroneous Refunds division in Fresno Submission Processing, Accounting Operations Service can pursue the refund administratively from W, as she is the person that received the refund. If administrative procedures are not effective, the Service can request that the Department of Justice file an erroneous refund suit against W.

Section 6663 penalty does not apply
If any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud. I.R.C. § 6663(a). The Commissioner has the burden of proving that some portion of an underpayment is due to fraud by clear and convincing evidence. I.R.C. § 7454(a); Tax Court Rule 142(b). Fraud is shown by proof that the taxpayer intended to conceal, mislead or otherwise prevent the collection of his or her taxes, and that there is an underpayment of taxes. Stoltzfus v. United States, 398 F.2d 1002, 1004 (3rd Cir. 1968) [ 68-2 USTC ¶9499]; Rowlee v. Commissioner, 80 T.C. 1111, 1123 (1983) [CCH Dec. 40,228].

Section 6664 contains definitions and special rules that apply to the fraud penalty under section 6663 and the accuracy-related penalties under sections 6662 and 6662A. Under section 6664(b), those penalties shall not apply where no return is filed. When a return is determined to be invalid, it is a nullity and, thus, it is as if no return has been filed. Accordingly, the section 6663 penalty cannot apply here against either H or W. See Turner v. Commissioner, T.C. Memo. 2004-251 [CCH Dec. 55,794(M)] (holding that, pursuant to section 6664(b), the section 6662 penalty could not apply because the return was invalid).

Section 6701 penalty does not apply

Section 6701 provides for a penalty for aiding and abetting the understatement of tax liability. No return needs to be filed for the penalty to be imposed. See Kuchan v. United States, 679 F.Supp. 764, 768-69 (N.D. IL 1988) [ 88-1 USTC ¶9377]. It does not appear based on the facts presented that W aided, assisted, or advised H with respect to the bogus return, as H did not request W's assistance with filing a return and in fact had no knowledge that a return was being prepared on his behalf and did not intend to file the bogus return. The legislative history to section 6701, enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982, notes that this penalty was intended as the civil corollary to the criminal penalty for aiding and abetting, which is section 7206(2). S. Rep. No. 97-494(I), at 275 (1982); H.R. Rep. No. 97-760, at 576 (1982) (Conf. Rep.). The legislative history notes that the purpose of the penalty is to “protect taxpayers from advisors who seek to profit by leading innocent taxpayers into fraudulent conduct.” S. Rep. No. 97-494(I), at 275 (1982). W's conduct, while fraudulent, is not the type of conduct Congress intended to penalize under section 6701.

No other penalties seem to apply

This office handles a variety of penalties. Penalties are determined based on the specific facts and circumstances of each case, so it can be difficult to generalize about them. We do not address here all of the penalties within our jurisdiction, as many plainly would not apply. Therefore, only certain penalties are discussed below. For more information on penalties, refer to IRM 20.1.

Section 6702 provides a penalty for frivolous returns. 1 The penalty is imposed on any individual who files a tax return that, in relevant part, either “does not contain information on which the substantial correctness of the self-assessment may be judged” or “contains information that on its face indicates that the self-assessment is substantially incorrect.” I.R.C. § 6702(a)(1). Due to the nature of the false information reported on the bogus return, it was not evident from looking at the return that the information was not correct and that the self-assessment was in error. Therefore, the frivolous return penalty does not apply.

A new penalty was enacted as section 6676 (“Erroneous Claim for Refund or Credit”) on May 25, 2007, as part of the Small Business and Work Opportunity Tax Act of 2007. Section 6676 provides for a penalty in the case of a claim made for refund or credit of income tax where the amount of such claim is “excessive” unless it is shown that a reasonable basis exists for the claim. I.R.C. § 6676(a). The penalty applies to claims filed after May 25, 2007. The penalty is equal to 20% of the excessive amount claimed, which is defined as the difference between the amount sought in the claim and the amount of the claim actually allowed. I.R.C. § 6676(a), (b). The penalty does not apply to a claim for a refund or credit relating to the earned income credit. I.R.C. § 6676(a). The penalty does not apply to this case, as the bogus return was filed before May 25, 2007. Furthermore, as the false refund related to the earned income credit, it would not apply to a similar case in which the return was filed after the effective date of the statute. We note, however, that such a penalty could apply to other bogus return cases in which an excessive refund is claimed.

As H did not hire W to prepare a return for him, none of preparer penalties (e.g. sections 6694 and 6695) apply to this case. See I.R.C. 7701(a)(36). Criminal penalties may apply to W but such penalties are outside our jurisdiction. For example, W may have filed a false or fraudulent return in violation of section 7206(1).

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

*****

This writing may contain privileged information. Any unauthorized disclosure of this writing may undermine our ability to protect the privileged information. If disclosure is determined to be necessary, please contact this office for our views.

If you have any further questions, please call (202) 622-4910.


Footnotes

1 The penalty was amended in 2006 but the penalty, as amended, does not apply to this case.

6694 penalty case -

The 6694(b) penalty in 1995 was $1,000 - there were 35 penalties. If those penalties were assessed to day, the penalty would be $175,000 The IRS does target tax return perparers as they did to Anthony Michael.

Anthony G. Michael v. Commissioner., U.S. Tax Court, CCH Dec. 57,959, 133 T.C. No. 10, (Oct. 8, 2009)
U.S. Tax Court, Dkt. No. 21341-07L, 133 TC —, No. 10, October 8, 2009.

R assessed return preparer penalties of $35,000 under sec. 6694(b), I.R.C., against P in June 1995 for taxable years 1989, 1990, and 1991. P paid $5,250, the equivalent of 15 percent of the assessed sec. 6694, I.R.C., penalties, and R credited $1,000 toward 1989, $4,250 toward 1990, and nothing toward 1991. P filed a refund claim with the IRS, which was denied, and then commenced a suit for refund.
In August 1997 the parties to the refund suit reached a settlement agreement in which P agreed to pay $15,500 in satisfaction of his liabilities, minus the $5,250 payments already made plus interest under the settlement. P's agreed liability for 1989 was $250. P did not pay the amount due under the settlement agreement. In April 2005 R issued a notice of intent to levy based on the assessment. P requested and received a CDP hearing in which the settlement officer determined that P was entitled to a reduction in accordance with the settlement agreement.
On Aug. 22, 2007, R issued a notice of determination upholding the levy for taxable years 1989, 1990, and 1991.
R has filed a motion for summary judgment. P alternatively argues: (1) This Court lacks jurisdiction to sustain the levy; (2) R failed to make a valid assessment; (3) R failed to issue a notice and demand for payment for the settlement amount; and (4) a genuine issue of material fact exists.
Held: R's determination to sustain the levy for 1989 was an abuse of discretion because the facts show that petitioner has overpaid his tax liability for that year according to the terms of the settlement agreement.
Held, further, R did not abuse his discretion with respect to the levy for the taxable years 1990 and 1991 and is entitled to summary judgment for the taxable years 1990 and 1991 as a matter of law because a levy is a permissible means for R to collect the amount in the settlement agreement.
OPINION
GOEKE, Judge: This matter is before the Court on respondent's motion for summary judgment pursuant to Rule 121. 1 The issue we must decide is whether respondent abused his discretion in sustaining a levy to collect tax preparer penalties under section 6694 for 1989, 1990, and 1991. Petitioner opposes respondent's motion for summary judgment and argues that the Court should grant summary judgment in his favor. For the reasons set forth below, we shall grant summary judgment in petitioner's favor for the taxable year 1989 and grant respondent's motion for summary judgment for the taxable years 1990 and 1991.
Background
At the time the petition was filed, petitioner resided in Michigan.
In June 1995 respondent assessed tax preparer penalties under section 6694(b) against petitioner of $1,000 per return for recklessly or intentionally disregarding rules and regulations with respect to 35 returns as follows:
Penalty
Year Returns at Issue Sec. 6694

1989 1 $1,000
1990 25 25,000
1991 9 9,000
Total 35 35,000
Respondent assessed the penalties with statutory interest and issued to petitioner statutory notices of assessment and demand for payment. See sec. 6303(a). Petitioner paid $5,250 or 15 percent of the assessed section 6694 penalties, which he was required to pay to file a refund claim. See sec. 6694(c)(1). The Internal Revenue Service (IRS) credited $1,000 toward 1989 and $4,250 toward 1990. The IRS did not credit any portion of petitioner's payment toward 1991. The IRS's crediting of petitioner's $5,250 payment did not reflect his intended allocation to the years at issue as reflected on Form 6118, Claim of Income Tax Return Preparers. Petitioner filed a refund claim for each year at issue, which respondent denied.
Petitioner commenced a refund suit in the District Court for the Eastern District of Michigan alleging that he was not liable for the section 6694(b) penalty for any of the years at issue. The United States filed a counterclaim to collect the unpaid balance of the section 6694(b) penalty assessments. In August 1997 the parties reached a settlement in which petitioner agreed to pay the section 6694(b) penalty for a portion of the 35 returns and to pay a section 6694(a) penalty of $250 per return for the remainder of the 35 returns for an understatement of tax liability due to a position that does not have a realistic possibility of being sustained on the merits. In total, petitioner agreed to pay $15,500 in section 6694 penalties minus any payments already made plus interest (the settlement agreement) allocated as follows:
Penalties
Year No. Returns Subject to Sec. 6694(a)
No. Returns Subject to Sec. 6694(b)
Sec. 6694(a)
Sec. 6694(b)

1989 1 0 $250 -0-
1990 19 6 4,750 $6,000
1991 6 3 1,500 3,000
The parties read the terms of the settlement into the court record at the final pretrial conference. The District Court dismissed the complaint with prejudice. The District Court's dismissal order stated that “either party may reopen the matter within sixty (60) days of the date of this order to enforce the settlement agreement.” Petitioner did not pay the amount due under the settlement agreement, and the Government did not seek to reopen the case within the 60-day enforcement period.
On April 13, 2005, respondent issued a notice of intent to levy for the years at issue to petitioner for amounts based on the original assessments. The levy notice did not reflect the terms of the settlement agreement. On May 5, 2005, respondent received petitioner's request for a collection due process hearing (CDP hearing). At the CDP hearing petitioner argued that the assessments are invalid because the District Court dismissed the Government's counterclaim in the refund suit with prejudice, the parties did not enter a decision document in the refund suit, and respondent failed to issue to petitioner a notice and demand for payment that was based on the terms of the settlement agreement. Petitioner did not propose any collection alternatives during the CDP hearing.
Following the CDP hearing, the settlement officer determined that petitioner is entitled to a reduction in the amounts assessed against him in accordance with the terms of the settlement agreement. The settlement officer incorrectly allocated the $15,500 settlement agreement to the years at issue as follows:
Year Returns Penalty
1989 4 $1,000
1990 28 11,500
1991 3 3,000
Total 35 15,500
The settlement officer requested an adjustment to the assessments against petitioner for 1990 and 1991 to reflect the settlement agreement. The record establishes that petitioner's payment credited to 1989 exceeds his agreed-upon 1989 penalty. On August 22, 2007, respondent issued a notice of determination for the taxable years 1989, 1990, and 1991 that granted relief from the levy in part and sustained the levy in part.
Discussion
Summary judgment is intended to expedite litigation and avoid unnecessary and expensive trials. Fla. Peach Corp. v. Commissioner, 90 T.C. 678, 681 (1988). The Court may grant summary judgment where there is no genuine issue of material fact and a decision may be rendered as a matter of law. Rule 121(a) and (b); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), affd. 17 F.3d 965 (7th Cir. 1994). The moving party bears the burden of proving that there is no genuine issue of material fact and the Court will view any factual inferences in a light most favorable to the nonmoving party. Dahlstrom v. Commissioner, 85 T.C. 812, 821 (1985). Under Rule 121(d), where the moving party properly makes and supports a motion for summary judgment “an adverse party may not rest upon the mere allegations or denials of such party's pleading” but must set forth specific facts, by affidavits or otherwise “showing that there is a genuine issue for trial.”
Respondent has conceded that petitioner is not liable for the amount of the original assessments in excess of the amount in the settlement agreement. Petitioner challenges respondent's authority to collect the settlement amount by levy. Petitioner is not entitled to challenge the merits of his liability for the section 6694 penalties because he had an opportunity to dispute his liability in the refund suit. See sec. 6330(c)(2)(B); Farley v. Commissioner, T.C. Memo. 2004-168. Where the underlying tax liability is not properly at issue, the Court reviews the administrative determination regarding the collection action for abuse of discretion. Sego v. Commissioner, 114 T.C. 604, 610 (2000); Goza v. Commissioner, 114 T.C. 176, 182 (2000). The abuse of discretion standard requires the Court to decide whether the Appeals officer's determination was arbitrary, capricious, or without sound basis in fact or law. Mailman v. Commissioner, 91 T.C. 1079, 1084 (1988).
Upon issuance of a notice of levy, a taxpayer is entitled to an administrative hearing before an impartial officer or employee of the Appeals Office. Sec. 6330(b). At the hearing a taxpayer may raise any relevant issue regarding the collection action, including possible collection alternatives. Sec. 6330(c)(2)(A). Following a CDP hearing, the Appeals officer must determine whether to proceed with the collection action, after verification that the requirements of applicable law and administrative procedure have been met, considering any relevant issues the taxpayer raised and whether the collection action balances the need for the efficient collection of taxes with the legitimate concern of the taxpayer that any collection action be no more intrusive than necessary. Sec. 6330(c)(3). The settlement officer assigned to petitioner's case determined that all requirements of applicable law and administrative procedure were met, including that respondent made the assessments pursuant to section 6201 and mailed a notice and demand for payment to petitioner at his last known address within 60 days of the assessments pursuant to section 6303.
Petitioner argues that respondent abused his discretion in sustaining the levy for the years at issue. Petitioner argues: (1) The Court lacks jurisdiction to sustain the levy; (2) respondent failed to make a valid assessment against petitioner; (3) respondent failed to issue a notice and demand for payment for the settlement amount; and (4) a genuine issue of material fact exists because respondent failed to provide the settlement agreement in support of his summary judgment motion.
I. Jurisdiction Argument
Petitioner argues that the Court lacks jurisdiction to sustain respondent's levy action because the District Court dismissed the Government's counterclaim for collection with prejudice and this Court lacks jurisdiction to enforce the terms of the settlement agreement, citing Kokkonen v. Guardian Life Ins. Co. of Am., 511 U.S. 375 (1994). In Kokkonen, the Supreme Court held that when a Federal District Court dismisses a case with prejudice upon the basis of a settlement agreement in a nontax case, the parties must bring an action for enforcement of the settlement in State court rather than resorting to the District Court for enforcement where the District Court did not retain jurisdiction to enforce the settlement. Id. at 382. The District Court in petitioner's refund action limited the parties' right to seek enforcement through the District Court to 60 days.
Section 6330(d) grants this Court exclusive jurisdiction to review appeals from all section 6330 determinations made after October 16, 2006, irrespective of the type of tax making up the underlying tax liability. Sec. 6330(d)(1); Pension Protection Act of 2006, Pub. L. 109-280, sec. 855, 120 Stat. 1019; see Ginsberg v. Commissioner, 130 T.C. 88, 92 (2008). In a levy action under section 6330, the Court's jurisdiction depends on the issuance of a notice of determination and the taxpayer's timely filing of a petition. See Sarrell v. Commissioner, 117 T.C. 122, 125 (2001); Moorhous v. Commissioner, 116 T.C. 263, 269 (2001). The Government's counterclaim in the refund suit does not preclude the Court's having jurisdiction to review section 6330 determinations. The statutory collection remedies available to the Commissioner are separate from the Government's right to counterclaim for unpaid taxes in a refund action. Except as may be required by the application of estoppel principles, the District Court's dismissal of the refund action with prejudice on the basis of the settlement agreement does not render the administrative statutory collection remedies unavailable. See secs. 6321, 6331. Nor does the District Court's retention of jurisdiction for the 60-day enforcement period eliminate respondent's right to statutorily created collection remedies such as a levy. Sec. 6331(a). Accordingly, we hold that the Court has jurisdiction to review respondent's determination to sustain the levy and to determine whether respondent may collect the unpaid section 6694 penalties by levy.
II. Validity of Assessment Argument
Respondent's levy notice was based on the original assessments. Petitioner argues that the levy is not based on a valid assessment. According to petitioner, the settlement agreement invalidated the original assessments, and respondent did not make a new assessment to reflect the terms of the settlement agreement. Petitioner does not argue that the levy notice was otherwise invalid.
Deficiency procedures do not apply to section 6694 penalties. Sec. 6696(b). The assessments at issue were valid when made. Petitioner does not argue that the original assessments were arbitrary or without sound basis in fact.
Petitioner's argument is unconvincing. An assessment is not invalid because the liability is afterwards reduced by settlement. Section 6404(a)(1) authorizes the Secretary to abate the unpaid portion of the assessment of any tax to the extent the assessment may be excessive.
The reference in section 6404(a) to abating a portion of an assessment implies that abatement is not an all-or-nothing proposition. If a penalty under section 6694(a) or (b) concerning a return or claim for refund has been assessed against a preparer, and if it is established at any time in a final administrative determination or a final judicial decision that only a portion of the assessment is valid, then the excess assessment must be abated. If an amount of the abated assessed penalty was paid, that amount must be refunded, as if the payment were an overpayment of tax, without consideration of any period of limitations. Sec. 1.6694-1(d), Income Tax Regs.
Section 301.6325-1(a), Proced. & Admin. Regs., provides that a lien shall be released when the entire liability has been satisfied and the lien has become legally unenforceable. Section 6325 does not apply because petitioner's liability has not been fully satisfied.
An incorrect assessment is not void. When a court is faced with an incorrect but otherwise valid assessment, the proper course is not to void the assessment but to determine what, if anything, the taxpayer owes the Government. See Helvering v. Taylor, 293 U.S. 507 (1935). As long as the assessment had any foundation, the assessment would not be void. See Burns v. United States, 974 F.2d 1064, 1066 (9th Cir. 1992); United States v. Schroeder, 900 F.2d 1144, 1148-1149 (7th Cir. 1990).
Respondent was not required to issue a second or supplemental assessment based on the terms of the settlement agreement. See sec. 6204 (granting the Commissioner authority to issue supplemental assessments); sec. 6404 (granting the Commissioner authority to abate an assessment); sec. 1.6694-1(d), Income Tax Regs. (requiring abatement of the assessment of a section 6694 penalty where it is established that there was no understatement of tax liability). The statutory requirement that the Commissioner abate the excessive amount of the assessment clearly implies that the valid portion of the assessment will stand. Accordingly, we hold that the assessments are valid and provide a basis for the levy action.
III. Notice and Demand Argument
Petitioner argues that the IRS failed to provide notice and demand for payment of petitioner's agreed-upon tax liability pursuant to the settlement agreement. Section 6331 authorizes the IRS to collect unpaid assessments by levy where the taxpayer fails to pay any tax liability within 10 days after notice and demand for payment. The failure to provide the statutory notice and demand may bar administrative collection actions such as a levy. United States v. Berman, 825 F.2d 1053, 1060 (6th Cir. 1987); see also United States v. Chila, 871 F.2d 1015, 1019 (11th Cir. 1989). Section 6303 requires the Secretary to give notice and to demand payment within 60 days of assessment by leaving the notice and demand at the taxpayer's dwelling or usual place of business or mailing it to the taxpayer's last known address. See sec. 1.6694-4(a)(2), Income Tax Regs. (requiring notice and demand upon the assessment of section 6694 penalties); sec. 1.6696-1(a)(1), Income Tax Regs. Failure to provide notice and demand within the 60-day period does not invalidate an otherwise valid assessment. Sec. 301.6303-1(a), Income Tax Regs.
Respondent issued to petitioner the notice and demand for payment based on the original assessment as required by section 6303(a) on June 9, 1995. There is no requirement for respondent to issue a second notice and demand for payment based on the terms of the settlement agreement. See sec. 7122 (relating to compromises of tax liability). Petitioner was not prejudiced by not receiving a second notice and demand for payment because he had an opportunity to contest the assessments on the merits. Petitioner entered into the settlement agreement with full knowledge that his liability was reduced to $15,500. Because respondent satisfied the assessment and notice and demand requirements, we reject petitioner's argument that section 6331 forbids respondent to collect the unpaid section 6694 penalties by levy.
IV. Failure To Provide Settlement Agreement Argument
Petitioner argues that the Court should deny respondent's summary judgment motion because respondent failed to provide a transcript of the settlement agreement, creating a genuine issue of material fact for trial. In support of the motion for summary judgment, respondent presented the District Court's transcript of the pretrial conference where the parties entered the terms of the settlement on the record. We find this evidence sufficient to establish the terms of the settlement agreement. Petitioner has not set forth specific facts with respect to the terms of the settlement agreement that show a genuine issue of material fact exists for trial. Bare allegations will not avoid summary judgment. Rauenhorst v. Commissioner, 119 T.C. 157, 176 (2002). In addition, petitioner's allegations that respondent failed to provide his entire administrative file in response to his request under the Freedom of Information Act does not necessitate a denial of respondent's summary judgment motion since petitioner has not set forth specific facts that create a genuine issue of material fact for trial. 2
We hold that respondent's determination to sustain the levy for 1989 was an abuse of discretion because the facts show that on the basis of the terms of the settlement agreement, petitioner has overpaid his tax liability for that year. Accordingly, we shall deny respondent's motion for summary judgment for the taxable year 1989 and grant summary judgment in petitioner's favor for the taxable year 1989.
We find that respondent did not abuse his discretion with respect to the levy for the taxable years 1990 and 1991. We hold that there is no dispute of material fact with respect to the taxable years 1990 and 1991, and respondent is entitled to summary judgment for the taxable years 1990 and 1991 as a matter of law. 3
To reflect the foregoing,
An appropriate order and decision will be entered.

Footnotes


1
Unless otherwise indicated, all Rule references are to the Tax Court Rules of Practice and Procedure, and all section references are to the Internal Revenue Code.
2
The petition raised the statute of limitations as a defense. However, petitioner did not raise the statute of limitations in his response to respondent's summary judgment motion. The Commissioner may collect an unpaid tax liability by levy within 10 years after the assessment. Sec. 6502(a)(1). A CDP request suspends the running of the period of limitations for collection while the hearing and any appeals thereof are pending. Sec. 6330(e)(1); see also sec. 6694(c)(3). Respondent assessed the sec. 6694 penalties on June 9, 1995. Respondent received petitioner's request for a CDP hearing on May 5, 2005, suspending the 10-year limitations period as of that date. Accordingly, the statute of limitations does not bar respondent from collecting petitioner's tax liability. Petitioner's filing of the refund action in District Court would also suspend the running of the period of limitations. See sec. 6694(c)(1), (3).

3
In petitioner's response to respondent's motion for summary judgment, petitioner contends that the Court should grant costs and attorney's fees to petitioner. We shall deny this request.

A tax return preparer's claim for a refund of a penalty assessed against him was dismissed for lack of jurisdiction because he did not file his action within 30 days of the expiration of 6 months after filing the claim with the IRS.
J.J. O'Keefe, DC, 81-1 ustc ¶9289.
Similarly.
R.C. Mayo, DC, 82-2 ustc ¶9488.
A tax return preparer whose refund claim did not comply with IRS requirements could not maintain an action to recover Code Sec. 6694 penalties assessed against him.
F.F. Finocchiaro, CtCls, 82-1 ustc ¶9310.
A tax return preparer's claim for a refund of penalties assessed against him was dismissed for lack of jurisdiction because he did not pay 15 percent of the penalties assessed against him within 30 days of the assessment. Instead, he first sought to challenge the assessment by written protests, which were later denied by the IRS. He then waited over 14 months after the last assessments were made to pay the required 15 percent.
S.W. Kline, DC Ohio, 84-1 ustc ¶9401.
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IRS statement on classification issues

As an aside, there are over 9,000 persons who follow this blog and there has been over 25GIG data downloaded from this web page.

The classification issue, noted below, is something I regularly see in examination.
On this and other issues, I prepare technical support on the factual and legal issues on this and other matters.



2009 IRS Summertime Tax Tip 2009-20,2009ARD 165-1, (Aug. 27, 2009)
2009ARD 165-1




Employee vs. Independent Contractor - Ten Tips for Business Owners

IRS Summertime Tax Tip 2009-20

If you are a small business owner, whether you hire people as independent contractors or as employees will impact how much taxes you pay and the amount of taxes you withhold from their paychecks. Additionally, it will affect how much additional cost your business must bear, what documents and information they must provide to you, and what tax documents you must give to them.

Here are the top ten things every business owner should know about hiring people as independent contractors versus hiring them as employees.

1. Three characteristics are used by the IRS to determine the relationship between businesses and workers: Behavioral Control, Financial Control, and the Type of Relationship.

2. Behavioral Control covers facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.

3. Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker's job.

4. The Type of Relationship factor relates to how the workers and the business owner perceive their relationship.

5. If you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees.

6. If you can direct or control only the result of the work done — and not the means and methods of accomplishing the result — then your workers are probably independent contractors.

7. Employers who misclassify workers as independent contractors can end up with substantial tax bills. Additionally, they can face penalties for failing to pay employment taxes and for failing to file required tax forms.

8. Workers can avoid higher tax bills and lost benefits if they know their proper status.

9. Both employers and workers can ask the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing a Form SS-8 - Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding - with the IRS.

10. You can learn more about the critical determination of a worker's status as an Independent Contractor or Employee at IRS.gov by selecting the Small Business link. Additional resources include IRS Publication 15-A, Employer's Supplemental Tax Guide, Publication 1779, Independent Contractor or Employee, and Publication 1976, Do You Qualify for Relief under Section 530? These publications and Form SS-8 are available on the IRS Web site or by calling the IRS at 800-829-3676 (800-TAX-FORM).

Passive activity win

Taxpayer operated a charter fishing business could deduct the losses generated from the business because the business did not constitute a passive activity under Code Sec. 469(c). The couple materially participated in the business because they participated in the business activity for more than 100 hours during the year at issue and their participation was not less than the participation of any other individual during that year.

Failure to support a passive activity loss will result in a 6694 penalty

Sean Kieran Hegarty and Kerry Ann Hegarty v. Commissioner., U.S. Tax Court, T.C. Summary Opinion 2009-153, (Oct. 6, 2009)
Docket No. 3730-07S. Filed October 6, 2009.


Discussion
Respondent relies upon section 469 to support the disallowance of the loss from Blue Marlin. That section generally disallows for the taxable year any passive activity loss. Sec. 469(a)(1). The term “passive activity loss” is defined as the excess of the aggregate losses from all passive activities for the taxable year over the aggregate income from all passive activities for that year. Sec. 469(d)(1). A passive activity is any activity which involves the conduct of any trade or business and in which the taxpayer does not materially participate. Sec. 469(c)(1). For this purpose, a “trade or business” is generally defined as any activity in connection with a trade or business or any activity for the production of income under section 212. Sec. 469(c)(6).
A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is regular, continuous, and substantial. Sec. 469(h)(1). The participation of the taxpayer's spouse is taken into account in the determination of the extent to which a taxpayer materially participates in an activity. Sec. 469(h)(5).
The applicable regulations provide that if: (1) The individual participates in the activity for more than 500 hours during such year; or (2) the individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year; or (3) the individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year; or (4) the activity is a significant participation activity for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours; or (5) the individual materially participated in the activity for any 5 taxable years (whether or not consecutive) during the 10 taxable years that immediately precede the taxable year; or (6) the activity is a personal service activity, and the individual materially participated in the activity for any 3 taxable years (whether or not consecutive) preceding the taxable year; or (7) based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year, then the individual will be treated as materially participating in an activity for purposes of section 469. Sec. 1.469-5T(a)(1) through (7), Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988).
According to respondent, because the business was conducted through a limited liability company, petitioners are treated as limited partners in considering whether they materially participated in the business. That being so, and relying upon section 469(h)(2) and section 1.469-5T(e)(1) and (2), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25, 1988), 4 respondent argues that they did not materially participate in the business because they have not established that their participation in the business during 2003 exceeded 500 hours.
We would be reluctant to find that they did, but for reasons discussed in Garnett v. Commissioner, 132 T.C. ___, ___ (2009) (slip op. at 22), such a finding is not necessary. In Garnett we found the Commissioner's reliance upon section 469(h)(2) to be misplaced and held that the material participation of a taxpayer who participated in a business conducted through a limited liability company is determined with reference to any of the seven tests listed in section 1.469-5T(a)(1) through (7), Temporary Income Tax Regs., supra.
As noted, a taxpayer is treated as having materially participated in the activity if the taxpayer participates in the activity for more than 100 hours during the taxable year and the taxpayer's participation in the activity for the taxable year is not less than the participation of any other individual. Sec. 1.469-5T(a)(3), Temporary Income Tax Regs., supra. We are satisfied that petitioners participated in the business for more than 100 hours during 2003. We are further satisfied that their participation was not less than the participation of any other individual during that year. See sec. 1.469-5T(a)(2), Temporary Income Tax Regs., supra. It follows that petitioners materially participated in the business during 2003, and the deduction attributable to that business is not subject to limitation under section 469.
Respondent's disallowance of the deduction of the loss attributable to Blue Marlin is rejected.
To reflect the foregoing,
Decision will be entered under Rule 155.

Footnotes


1
Unless otherwise indicated, section references are to the Internal Revenue Code of 1986, as amended, in effect for the year in issue. Rule references are to the Tax Court Rules of Practice and Procedure.
2
Respondent agrees that the charter fishing activity constituted a trade or business within the meaning of sec. 162(a) during the year in issue.

3
Petitioners retrofitted the vessel with the necessary equipment to convert it into a fishing boat fit for charter.
4
Sec. 469(h)(2) states, “Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.” As relevant here, sec. 1.469-5T(e)(1) and (2), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25, 1988), provides that as limited partner a taxpayer shall be treated as having materially participated in an activity only if the taxpayer participated in the activity for more than 500 hours during the taxable year.

Defining a trade or business

The red flag for a return prepar in this case is that the attorney had no income.
These issues will always be 6694 issues.

U.S. Tax Court, Dkt. No. 23122-07, TC Memo. 2009-228, October 5, 2009.

An individual taxpayer was not entitled to deduct business expenses since her activity as a contract attorney did not amount to a trade or business. The activity lasted only for the first two months of the year in question, after which the taxpayer returned to work as a securities regulator for a state department. In addition, her activity was not regular and continuous because, during the two-month period, she did not negotiate for or perform any legal services as a contract attorney and her only activity was attendance at an American Bar Association meeting. Moreover, the taxpayer's activity was not a continuation of a trade or business carried on in a previous period since, even though she worked as a contract attorney years ago, there was a substantial lack of continuity between her prior work and her efforts in the year at issue.


MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: Respondent determined a $1,882 deficiency in petitioner's 2003 Federal income tax. After concessions, 1 the issue for decision is whether petitioner is entitled to deduct certain business expenses under section 162(a). 2We hold that she is not.

FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts and the attached exhibits are incorporated herein by this reference. Petitioner resided in California at the time she filed her petition.

Petitioner was admitted to practice law in California in 1974 and in Colorado in 1986. Before 1988 petitioner worked as a contract attorney performing various legal services, e.g., researching legal issues, attending hearings, etc., on behalf of other attorneys. She represented her own clients on occasion, but this was rare. In some cases petitioner became an employee of the attorney or law firm she worked for. From 1988 until her employment was terminated in 2000 she worked as a securities regulator for the California Department of Corporations (the department). Petitioner worked as a contract attorney again in 2000 but not at all during 2001 and 2002.

In 2003 petitioner decided once again to try to work as a contract attorney. She attended the ABA 2003 Midyear Meeting in Seattle, Washington, on February 8-11. While there she attended a women's caucus luncheon, a solo and small firm lawyers breakfast caucus, and seminars on securities law. Petitioner networked with colleagues and informed them she was available as a contract attorney to perform various legal services on their behalf.

Petitioner also purchased various supplies, including a computer, printer, paper products, etc., as well as telephone, fax, and Internet services between January and March 2003. Petitioner attempted to be reinstated as a securities regulator by the department and eventually filed suit against the department in 2003. She used some of the supplies she had purchased to assist in her reinstatement efforts. Before petitioner secured any clients or earned any income as a contract attorney in 2003, she was reinstated by the department and returned to work on or around March 25.

On October 15, 2006, petitioner filed Form 1040, U.S. Individual Income Tax Return, for 2003 (2003 return). She included with her 2003 return Schedule A, Itemized Deductions. On Schedule A petitioner claimed $19,192.52 in deductions for other expenses, which the IRS did not question. Petitioner attached to Schedule A a listing of these expenses summarized as follows:

Business travel to professional conventions
$3,303.84


Professional fees, dues, education costs, etc.
3,384.13


Mail and photocopy costs
835.73


Computer, Internet, and supplies
2,146.84


Business telephone and fax
725.00


Litigation expenses and attorney's fees
7,496.98


Business use of car
1,300.00



Total
19,192.52



Petitioner did not include Schedule C, Profit or Loss From Business, or Form 6251, Alternative Minimum Tax—Individuals, with her 2003 return.

Respondent determined a $1,882 deficiency in petitioner's 2003 Federal income tax arising from petitioner's failure to report alternative minimum tax (AMT) liability. Petitioner timely filed a petition with this Court. She concedes the AMT adjustment but asserts that $1,761 of her expenses reported on Schedule A should be recast as Schedule C business expense deductions. 3

OPINION
Petitioner has neither claimed nor shown that she satisfied the requirements of section 7491(a) to shift the burden of proof to respondent with regard to any factual issue. Accordingly, the burden of proof is on petitioner to show that respondent's determination set forth in the notice of deficiency is incorrect.See Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Deductions are a matter of legislative grace; petitioner has the burden of showing that she is entitled to any deduction claimed. See Rule 142(a); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

Petitioner argues that during 2003 she carried on a trade or business, i.e., she worked as a contract attorney providing legal services to other attorneys, and that she paid certain expenses in connection with this alleged trade or business. Respondent argues petitioner was not engaged in a trade or business because she admittedly had no clients and reported no income related to the activity during 2003.

Section 162(a) allows a deduction for ordinary and necessary expenses paid during the taxable year in carrying on any trade or business. In order for the expenses to be deductible under section 162, the expenses must relate to a trade or business functioning at the time the expenses were incurred. Hardy v. Commissioner, 93 T.C. 684, 687 (1989), affd. in part and remanded in part on another issue per order (10th Cir., Oct. 29, 1990); sec. 1.162-1(a), Income Tax Regs. Whether a taxpayer's activities constitute the carrying on of a trade or business requires an examination of the facts and circumstances of each case. Commissioner v. Groetzinger, 480 U.S. 23, 36 (1987); Higgins v. Commissioner, 312 U.S. 212 (1941); O'Donnell v. Commissioner, 62 T.C. 781, 786 (1974), affd. without published opinion 519 F.2d 1406 (7th Cir. 1975).

The U.S. Court of Appeals for the Ninth Circuit, the court to which this case would be appealable, has held that to constitute a trade or business, “[the taxpayer's primary purpose for engaging in the activity must be for income or profit.]” Smith v. Commissioner, 182 F.3d 927 (9th Cir. 1999) (quoting Commissioner v. Groetzinger, supra at 35), affg. without published opinion T.C. Memo. 1997-503; Warden v. Commissioner, 111 F.3d 139 (9th Cir. 1997), affg. without published opinion T.C. Memo. 1995-176; Barter v. Commissioner, 980 F.2d 736 (9th Cir. 1992), affg. without published opinion T.C. Memo. 1991-124. An income-producing activity also must be regular and continuous to be a trade or business. Finnegan v. Commissioner, T.C. Memo. 1997-486 (adopting the reasoning of the Tax Court), affd. without published opinion 168 F.3d 498 (9th Cir. 1999). Thus, for a taxpayer to be engaged in a trade or business, the taxpayer's involvement in the activity must be regular and continuous and the taxpayer's primary purpose for engaging in the activity must be for income or profit. Commissioner v. Groetzinger, supra at 35.

Petitioner argues that her activity was a continuation of a trade or business carried on previously; i.e., in the 1980s and in 2000. However, even if her activities in the past amounted to a trade or business, which we do not decide, there was a substantial lack of continuity between her prior work and her efforts in 2003. Petitioner did not work as a contract attorney between 1988 and 2000 while she worked for the department. She also did not work as a contract attorney in 2001 or 2002, and her activity in 2003 was sporadic. Accordingly, under the facts of this case petitioner's activity in 2003 was not a continuation of a trade or business carried on in any previous period.

Petitioner did not decide to work as a contract attorney until mid-January of 2003, and she returned to work with the department on or around March 25 of that year. Therefore, the alleged trade or business existed only from mid-January to late March, or just over 2 months. This is not a substantial time period. 4

Even though petitioner expended some time and effort in an attempt to find work as a contract attorney during this period, her involvement was not regular and continuous. Her only activity was her attendance at the ABA meeting for 4 days in February, at which petitioner marketed herself to other attorneys. She did not negotiate for or perform any legal services as a contract attorney for any party during this period. Finally, she abandoned her efforts upon returning to the department in late March. Accordingly, her activity was neither regular nor continuous.

We conclude that petitioner's activity as a contract attorney in 2003 was not regular and continuous. Having so decided, we need not decide whether petitioner's primary purpose for engaging in the activity was to earn a profit. See Finnegan v. Commissioner, supra (holding real estate activity was not a trade or business because time and effort devoted to it was not regular and continuous and declining to decide whether there was a profit motive). Therefore, we hold that petitioner's activity in 2003 did not amount to a trade or business.

Conclusion
After reviewing all of the facts and circumstances, we conclude that petitioner failed to prove the existence of a trade or business as a contract attorney in 2003. Accordingly, she is not entitled to deduct business expenses under section 162(a).

In reaching all of our holdings herein, we have considered all arguments made by the parties, and to the extent not mentioned above, we find them to be irrelevant or without merit.

To reflect the foregoing,

Decision will be entered for respondent..


Footnotes

1 Petitioner concedes respondent's adjustment to alternative minimum tax liability and that her expense for airfare to an American Bar Association (ABA) meeting cannot be deducted because the ABA reimbursed her.

2 Unless otherwise indicated, all section references are to the Internal RevenueCode in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

3 The $1,761 of expenses petitioner claims she paid in connection with the alleged trade or business consist of the following: $211.81 to Costco for office supplies and miscellaneous items; $129.45 to Office Depot; $493.14 to the Seattle Hilton hotel; $35 to the Commission on Women in the Profession; $195 to the Clerk of the Supreme Court; $18.15 to Federal Express for the ABA; $73.94 to Pacific Bell; $140 to the Los Angeles County Bar Association for dues; $315 to the State Bar of California; $115 to the ABA; and $34.35 to Staples for paper and other supplies.

4 We do not decide whether a trade or business could be found in a 2-month period under a different set of facts and circumstances.

required gambling records

An individual did not maintain adequate records under Code Sec. 6001 to shift the burden of proof regarding her gambling winnings to the IRS under Code Sec. 7491 nor did she keep a notebook tracking her gambling as recommended by the IRS. Thus, the IRS findings regarding her winnings and losses was upheld.
Because the IRS increased the taxpayer’s gross income from gambling, she was required, but failed, to include a greater percentage of her Social Security benefit in income. Nonetheless, the taxpayer avoided the accuracy-related penalty because she acted with good faith and reasonable cause in relying on a competent tax professional to prepare her returns.

I believe the return preparer in this case would be subject to the 6694(b) penalty because he should have inquired about the required support for gambling income and expenses.

Ann M. Laplante v. Commissioner., U.S. Tax Court, CCH Dec. 57,954(M), T.C. Memo. 2009-226, (Oct. 1, 2009), U.S. Tax Court, Dkt. No. 17591-07
.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOLDBERG, Special Trial Judge: Respondent determined a deficiency of $1,808 in petitioner's Federal income tax for 2004 and an accuracy-related penalty of $362 under section 6662(a) for negligence.
The deficiency arises from petitioner's reporting of her 2004 recreational gambling activities. Petitioner reported $4,000 in income from gambling winnings on her 2004 Form 1040, U.S. Individual Income Tax Return, and she deducted $4,000 in gambling losses on her 2004 Schedule A, Itemized Deductions, under “Other Miscellaneous Deductions”. After examination, respondent determined that petitioner should have reported $30,170 in gross income from gambling winnings, causing an automatic computational increase in the amount of petitioner's Social Security benefits includable in income, and petitioner should have deducted $30,170 in gambling losses for 2004.
As a result, the issues for decision are: (1) Whether petitioner's gambling winnings for 2004 were $30,170 as respondent determined; and (2) whether petitioner is liable for the section 6662(a) accuracy-related penalty for negligence for 2004.
Unless otherwise indicated, all section references are to the Internal Revenue Code (Code), and all Rule references are to the Tax Court Rules of Practice and Procedure. All amounts are rounded to the nearest dollar.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts and the attached exhibits are incorporated herein by this reference. Petitioner resided in Massachusetts at the time she filed her petition.
Petitioner is a widow and is retired. She worked for 48 years from 1950 to 1998 for John C. Tombarello & Sons, a scrap iron and metal facility in Lawrence, Massachusetts, retiring when the owners sold the business. Before the sale, the business employed 35 to 40 people. Petitioner's original duties included bookkeeping, but as the business grew she became the office manager and had a bookkeeper reporting to her.
When petitioner gambles, she enjoys playing the slot machines. She began slot machine gambling in earnest in 1988 on a trip to Las Vegas. While she was still employed, petitioner would vacation a couple of times a year in Las Vegas and would also travel to Atlantic City to gamble. After Foxwoods Resort Casino opened in Ledyard, Connecticut, in 1992 and after petitioner retired from her job, she eventually became a regular Foxwoods patron.
Petitioner participated in Foxwoods' loyalty program, which provided her with a Wampum Club card. Petitioner would insert the Wampum Club card into a slot machine, and the casino would track her play. She would receive Wampum points on the basis of the time she spent at the machines, not on the basis of the amount of money she spent or lost. Foxwoods has restaurants, hotel rooms, stores, and boutiques. Petitioner would use the Wampum points to purchase clothing and jewelry. Foxwoods would also provide petitioner at no charge complimentary (commonly called comp) meals, rooms, and occasional limousine rides from her home to and from the casino.
During 2004 petitioner traveled with a group of friends to Foxwoods on 25 to 30 separate occasions. Petitioner's normal practice was to spend at least 8 hours at the casino and then return home. Sometimes she would stay longer and return home after spending 2 or more full days at the casino. Typically, petitioner would start at 25 cents per wager, progress to 50 cents, then $1, and finally $5 per wager.
Whenever she won $1,200 or more from one pull (or push of a button), the casino would promptly provide her with a Form W-2G, Certain Gambling Winnings, reflecting her winnings from that one pull or push. During 2004 petitioner received 26 Forms W-2G, which reported winnings totaling $56,200. Petitioner received a Form W-2G on 22 separate days in 2004. On 4 days petitioner won two prizes of $1,200 or more, causing the casino to issue two Forms W-2G for those 4 days. A review of the dates from petitioner's summary of the Forms W-2G indicates that petitioner gambled at Foxwoods on many different days of the week, receiving at least one Form W-2G on 5 Sundays, 11 Mondays, 1 Tuesday, 2 Wednesdays, and 3 Saturdays.
Petitioner engaged an attorney to prepare her 2004 Federal income tax return, the same attorney she had used to prepare her prior years' returns. Attached to the return was a two-page document entitled “MEMORANDUM Re: W-2G” addressing petitioner's 2004 gambling activity. The first page detailed by date and amount the winnings on each of the 26 Forms W-2G totaling $56,200. The second page was a legal memorandum providing the attorney's rationale for petitioner's including only $4,000 of the gambling winnings in her 2004 income. Petitioner did not discuss or report in income any of her gambling winnings below $1,200; neither did she include in income the fair market value of meals, rooms, limousine rides, clothing, jewelry, and the other comps she received from Foxwoods.
Petitioner reported adjusted gross income totaling $36,111 for 2004. In addition to the $4,000 in gambling winnings, petitioner's other items of income for 2004 were: Interest of $2,262; dividends of $755; refunds of State and local income taxes of $158; capital gain distributions of $78; IRA distributions of $7,197; pension and annuities of $11,367; net income from rental real estate of $1,663; and Social Security benefits of $22,758, of which $8,631 was includable in income. Petitioner also claimed itemized deductions of $12,638 on Schedule A, of which pertinent here was a deduction of $4,000 for gambling losses.
Respondent examined petitioner's 2004 Federal income tax return, determining that the correct amount of her gambling winnings and losses for 2004 was $30,170. The $30,170 consists of the total of 11 of 26 Form W-2G amounts, but the record is silent as to why respondent chose to exclude some of the Forms W-2G and how respondent determined which ones to exclude.
Because of the adjusted gross income thresholds in section 86, Social Security and Tier 1 Railroad Retirement Benefits, the additional $26,170 in wagering income caused a computational increase to the portion of petitioner's $22,758 in Social Security benefits includable in income from $8,631 (38 percent) to $19,345 (85 percent). As a result, respondent issued a notice of deficiency determining a deficiency of $1,808 in Federal income tax for 2004 and an accuracy-related penalty of $362 for negligence. Petitioner timely petitioned the Court seeking a redetermination of the deficiency and the accuracy-related penalty.
At trial the Court received into evidence two documents purporting to support petitioner's claim of receiving only $4,000 in gambling winnings and $4,000 in gambling losses. One document was an undated and untitled two-page worksheet with 33 specific dates in 2004 reflecting a dollar amount in at least one of four columns showing: (1) Checks she cashed at the casino totaling $14,600; (2) markers totaling $42,000, which represent cash advances the casino provided to petitioner during her play in exchange for petitioner's authorization for the casino to withdraw reimbursement within 2 weeks from her checking account; (3) money market checks totaling $61,100, which petitioner cashed before her trips to the casino to have about $2,000 to $3,000 in cash on hand when she began each visit; and (4) deposits she returned to the checking account totaling $28,600.
With respect to the deposit column, the worksheet contains a notation immediately to the right of three of the seven deposits. Next to the August 31 deposit of $2,000 is the notation “winnings”, and next to the November 17 and December 11 deposits of $10,000 and $4,000, respectively, are notations indicating the deposits were transfers of funds from her money market account. The other four deposits totaling $14,600 have no notation next to them. An IRS date stamp on petitioner's 2004 Federal income tax return shows that respondent received petitioner's return on October 15, 2005. The record does not clarify whether petitioner prepared the worksheet around the end of 2004, near her tax return filing date of October 15, 2005, or in preparation for trial.
The second document is a letter dated February 22, 2005, from Foxwoods Resort Casino to petitioner printed on plain paper, not on Foxwoods' letterhead. The letter states that petitioner's win or loss total from table games was zero and that she lost a total of $35,480 at slot machines during 2004. The letter explained that “the total slot machine activity is the total coin deposited in the machines, less the total coin paid out, and less jackpots paid by hand with currency.” The letter advised that the “information is derived from the use of your Wampum Club Card as recorded in Foxwoods Resort Casino's player rating system, which is maintained for marketing purposes only.”
OPINION
I. Reporting of Gambling Winnings and Losses
Gambling winnings are includable in gross income. Sec. 61(a); Merkin v. Commissioner, T.C. Memo. 2008-146. The Code treats gambling losses in one of two ways. Taxpayers engaged in the trade or business of gambling may deduct their gambling losses against their gambling winnings above the line as a trade or business expense in arriving at adjusted gross income. Sec. 62(a)(1); Merkin v. Commissioner, supra. In contrast, taxpayers who are not in the trade or business of gambling are typically called recreational or casual gamblers and may deduct their gambling losses less favorably below the line as an itemized deduction in arriving at taxable income. Sec. 63(a); Merkin v. Commissioner, supra. Irrespective whether the taxpayer is a professional or a casual gambler, “Losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.” Sec. 165(d); Merkin v. Commissioner, supra; sec. 1.165-10, Income Tax Regs.
Petitioner was a recreational gambler in 2004. See generally Merkin v. Commissioner, supra. Petitioner argues for a different methodology for reporting her gambling winnings and losses. Petitioner contends the summation of her individual gambling wins does not accurately reflect true winnings because she promptly plowed the individual winnings back into the casino's slot machines. In petitioner's view, a gambling session is not complete until the gambler finishes gambling for the day or weekend or weeklong visit to the casino and leaves the casino at the conclusion of the visit with either a net win or loss.
Petitioner emphasizes that the tracking of individual wins and losses is unrealistic when placing many bets at slot machines during a long session of plays. As a result, according to petitioner a gambler should net the winnings and losses from each visit to the casino. On those visits where the gambler leaves with more money than the gambler brought to the casino (here and for the rest of this opinion the term “brought” encompasses a broad definition to include cash in the gambler's pocket when the gambler arrived at the casino plus cash the gambler added at the casino from markers, ATM draws, credit card advances, and cashing checks), the gambler should recognize the net winnings for the visit in a single amount. The gambler should then total the net winning visits in a year to determine an aggregate amount to include in income as gambling winnings for that year.
Similarly, in those instances where the gambler leaves the casino with less money than brought, the gambler should recognize a net loss for the visit. The gambler should then aggregate the net amounts from losing visits for the year and may deduct the total losses as an itemized deduction up to the total winnings from the successful gambling sessions for the year.
Applying her theory to her own situation, petitioner determined her $4,000 in gambling winnings and losses for 2004 in the following manner. Petitioner claims that on only one occasion in her 25 to 30 visits did she leave the casino with more money than she brought. On that one occasion, she won a single jackpot of $8,000 on Monday, August 30, 2004, of which Foxwoods held back 25 percent or $2,000 for petitioner's Federal income tax withholding. Petitioner claims she gambled and lost $4,000 of the winnings, and left the casino with the remaining $2,000. Consequently, according to petitioner her one net win of $2,000 plus the $2,000 in withholding represents her sole gambling winnings for the year totaling $4,000.
With respect to gambling losses for 2004, petitioner contends that she broke even or lost money on every one of her other 24 to 29 visits to the casino during the year. Petitioner claims her losses totaled much more than $4,000, but pursuant to the gambling loss limitation of section 165(d) she limited her gambling losses to the amount of her gambling winnings, $4,000, and deducted the $4,000 gambling loss as an itemized deduction for 2004.
In general, casual gamblers such as petitioner should report the gross amount of their gambling winnings as income and should deduct separately as an itemized deduction the gross amount of their gambling losses up to the amount of gambling winnings. See Merkin v. Commissioner, supra (taxpayers not in the trade or business of gambling may report gambling losses only as an itemized deduction); Hardwick v. Commissioner, T.C. Memo. 2007-359 (same); Lutz v. Commissioner, T.C. Memo. 2002-89 (“It is well settled that taxpayers [who are recreational gamblers] have a duty to report as gross income gambling winnings” and “gambling losses must be claimed as itemized deductions”).
Respondent nonetheless agrees with petitioner's theory of recognizing slot machine play on the basis of net wins or losses per visit to the casino. Specifically, respondent states the following:
[T]he better view is that a casual gambler playing a slot machine, such as the petitioner, recognizes a wagering gain or loss at the time she redeems her tokens. The fluctuating wins and losses left in play are not accessions to wealth until the taxpayer redeems her tokens and can definitively calculate the amount above or below basis (the wager) realized. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955).
Respondent's agreement, however, does not mean petitioner wins the day. Respondent argues instead that petitioner's contentions fail because petitioner did not maintain adequate records to substantiate her claims of net gambling winnings and losses.
We do not have to decide and we explicitly do not decide the propriety of petitioner's theory of income recognition from recreational slot machine play because, as discussed below, we agree with respondent that with respect to 2004, petitioners did not maintain adequate records to substantiate her claims of net gambling winnings and losses. Thus, in its essence this case is solely one of substantiation. See Gagliardi v. Commissioner, T.C. Memo. 2008-10 (concluding that that gambling case was solely “a substantiation case”, with the sole issue being whether the taxpayer had substantiated the gambling losses which the Commissioner had disallowed).
II. Substantiation of Gambling Winnings
Petitioner's situation is different from the usual gambling case where the taxpayer tries to prove gambling losses greater than the amount the Commissioner allowed. See, e.g., Briseno v. Commissioner, T.C. Memo. 2009-67; Gagliardi v. Commissioner, supra; Hardwick v. Commissioner, supra. Petitioner is already at the maximum of losses that section 165(d) allows (gambling losses may not exceed reported gambling winnings). Instead, to refute respondent's determination, petitioner must establish that she had less than the $30,170 in gambling winnings that respondent determined.
In general, the Court presumes the Commissioner's determination of a deficiency in a notice of deficiency is correct, and the burden is on the taxpayer to prove otherwise. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933). Under certain circumstances the taxpayer may shift the burden to the Commissioner regarding factual matters affecting tax if the taxpayer produces credible evidence and meets the other requirements of the section including maintaining records required by the Code. Sec. 7491(a). Petitioner does not argue that she satisfied the elements for a burden shift, but even if she did advance this argument, petitioner did not produce sufficient substantiation to support her claims as section 6001 requires. See Higbee v. Commissioner, 116 T.C. 438, 443 (2001). Accordingly, the burden of proof remains on petitioner to prove the $30,170 in gambling winnings that respondent determined for 2004 was in error. With respect to the accuracy-related penalty, the burden of production is on respondent. See sec. 7491(c).
Deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to deductions claimed on a return. Rule 142(a)(1); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Implicit in this burden is the requirement that taxpayers must prove the amount of gambling winnings as well as losses. Schooler v. Commissioner, 68 T.C. 867, 869 (1977); Donovan v. Commissioner, T.C. Memo. 1965-247, affd. per curiam 359 F.2d 64 (1st Cir. 1966).
Section 6001 and the regulations thereunder require taxpayers to keep permanent records sufficient to substantiate the amounts of income, deductions, and credits shown on their income tax returns. Sec. 1.6001-1(a), Income Tax Regs. The obligation to maintain sufficient supporting records for wagering transactions is no more onerous than the recordkeeping requirements for taxpayers engaged in daily activities such as business travel and entertainment. Schooler v. Commissioner, supra at 870-871; see also Rodriguez v. Commissioner, T.C. Memo. 2001-36.
Petitioner's evidence consists of the following three items: (1) The undated four-column worksheet that petitioner prepared; (2) the February 22, 2005, letter from Foxwoods; and (3) petitioner's oral testimony that on only one occasion did she leave the casino with more money that she wagered. We review in turn each of these three pieces of evidence.
Petitioner relies on the four-column worksheet with the written notation “winnings” next to one deposit of $2,000 as the documentary evidence that only one of her visits to Foxwoods in 2004 resulted in a net win, and the amount of that win was $4,000 (including the $2,000 in Federal tax withholding). However, shortcomings exist with respect to this evidence. No valid reason exists for taxpayers engaged in wagering transactions not to maintain a contemporaneous gambling diary or gambling log. Schooler v. Commissioner, supra at 870-871. Petitioner acknowledged that she did not prepare the worksheet contemporaneously, stating that she tried to “keep up with it [her recordkeeping] daily, but if not, it would have to be yearly. It would be a lot easier to go through it yearly.” Petitioner was not specific as to whether she prepared the worksheet around the end of the 2004 calendar year, 10 months later when she filed her 2004 return, or 3 years later in preparation for trial.
Additionally, the worksheet was untitled, had no explanation of its purpose, and did not explain many items on the document. For instance, the worksheet showed $14,600 of deposits with no explanation, which may have been additional gambling winnings. Similarly, petitioner did not reconcile the worksheet to the winnings Foxwoods reported on the Forms W-2G.
Moreover, petitioner did not provide copies of bank statements, canceled checks, or other corroborating evidence to establish the accuracy of individual line items on the worksheet or to establish the completeness of the worksheet by reconciling the worksheet to figures supplied by the bank. Without support, the worksheet is unreliable to corroborate petitioner's claims.
The February 22, 2005, letter from Foxwoods also has shortcomings. The letter reports that petitioner lost a total of $35,480 at the slots during 2004. However, the letter provides no detail by which we could determine which of petitioner's 25 to 30 visits to the casino for the year were a net win or a net loss. Since the net win or loss per visit is the mainstay of petitioner's argument, and since Foxwoods' letter stated the casino was tracking petitioner's results, we find it curious that petitioner did not ask Foxwoods to provide, or that petitioner did not supply to the Court, a more detailed statement from Foxwoods showing the results for each visit. In summary, the letter is helpful in confirming the overall picture that petitioner lost money for 2004, a point not in dispute, but the letter does not shed light on the decisive matter regarding which of petitioner's visits were net wins or losses and in what amounts.
With respect to petitioner's testimony, petitioner claims that she walked away a winner from Foxwoods on only 1 of her 25 to 30 visits to the casino during 2004. Given the nature of gambling, where the house usually wins; Foxwoods' letter stating petitioner's overall losses for 2004; and petitioner's credible testimony, we find it likely that she lost money on most of her visits to the casino during 2004. However, a general tenor is not the same as accepting petitioner's unsupported assertion of precisely $4,000 in income from just one win. See Crepeau v. Commissioner, 438 F.2d 1228 (1st Cir. 1971) (uncontradicted oral testimony is not adequate to overcome insufficiently supported taxpayer statements), affg. T.C. Memo. 1969-236; Niedringhaus v. Commissioner, 99 T.C. 202, 212 (1992) (we need not accept a taxpayer's testimony in the absence of corroborating evidence).
We also note that petitioner did not call as a witness any friend with whom she traveled to Foxwoods to corroborate her testimony. The failure to call witnesses leads to an inference that if called they would testify adversely. Interstate Circuit, Inc. v. United States, 306 U.S. 208, 226 (1939); Bresler v. Commissioner, 65 T.C. 182, 188 (1975); Blum v. Commissioner, 59 T.C. 436, 440-441 (1972); Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th Cir. 1947).
Moreover, respondent has already reduced the gambling winnings that Foxwoods reported for 2004 on the Forms W2-G, from $56,200 to $30,170. Petitioner has simply not provided sufficient corroborating evidence to make an estimate beyond the reduction respondent has already determined. See Hardwick v. Commissioner, T.C. Memo. 2007-359 (the Court should not make an estimate in a gambling case where the taxpayer's substantiation has too many omissions and discrepancies, especially where the taxpayer could have simply provided evidence from use of a casino Players' Club card to document slot machine play during each gambling trip). Further, respondent made the reduction even though petitioner almost certainly had many winnings below the Form W2-G threshold amount of $1,200 and despite petitioner's receiving comps from Foxwoods for some meals, hotel stays, limousine rides, and shopping. See Libutti v. Commissioner, T.C. Memo. 1996-108 (comps are “increases to * * * wealth” and therefore fall within the plain meaning of section 165(d) as gains from wagering transactions).
In summary, we find that petitioner has not met her burden of proving that respondent's determination is incorrect. Because petitioner has not provided a reasonable basis to estimate which of her visits to the casino resulted in a net win or a net loss, or the dollar amount of each outcome, to reduce income more than respondent has already done would be unguided largesse. Therefore, we sustain respondent's determination.
III. Accuracy-Related Penalty
Respondent also determined that petitioner is liable for a 20-percent accuracy-related penalty under section 6662(a) and (b)(1) for 2004 for an underpayment of income tax that results either from negligence or disregard of rules and regulations. The term “negligence” includes any failure to make a reasonable attempt to comply with the provisions of the Code, and the term “disregard” includes any careless, reckless, or intentional disregard. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs. Negligence is also “‘a lack of due care or the failure to do what a reasonable and ordinarily prudent person would do under the circumstances.’” Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quoting Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), affg. in part and remanding in part 43 T.C. 168 (1964) and T.C. Memo. 1964-299), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991).
As noted, the Commissioner bears the burden of production with respect to penalties. Sec. 7491(c). To meet this burden, the Commissioner must produce evidence to show that it is appropriate to impose the relevant penalty. Swain v. Commissioner, 118 T.C. 358, 363 (2002); Higbee v. Commissioner, 116 T.C. at 446. Respondent has met his burden by establishing that petitioner did not keep adequate records as required by section 6001 to substantiate the amount of gambling income she reported on her 2004 Federal income tax return.
Nonetheless, a taxpayer may overcome the accuracy-related penalty if the taxpayer can show that the underpayment of income tax was due to “reasonable cause * * * and that the taxpayer acted in good faith”. Sec. 6664(c)(1). The taxpayer bears the burden of proving reasonable cause. Higbee v. Commissioner, supra at 446-447. The Court decides reasonable cause and good-faith effort on a case-by-case basis, taking into account all pertinent facts and circumstances, including the extent of the taxpayer's efforts to assess his or her proper tax liability; the taxpayer's education, knowledge, and experience; and the taxpayers' reasonable reliance on a tax professional. Higbee v. Commissioner, supra at 448; Sec. 1.6664-4(b)(1), Income Tax Regs. The extent of the taxpayer's efforts to assess the proper tax liability is generally the most important factor. Sec. 1.6664-4(b)(1), Income Tax Regs.
Good faith reliance on professional advice concerning tax laws may provide a basis for a reasonable cause defense. United States v. Boyle, 469 U.S. 241, 250-251 (1985); see also sec. 1.6664-4(b)(1), Income Tax Regs. Reliance on professional advice is not an absolute defense to the section 6662(a) penalty. Freytag v. Commissioner, supra at 888. Reasonable cause exists where a taxpayer relies in good faith on the advice of a qualified tax adviser where the following three elements are present: “(1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment.” Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affd. 299 F.3d 221 (3d Cir. 2002).
Petitioner made a good-faith effort to determine the proper tax by engaging an attorney to prepare her return, the same attorney who had prepared her prior returns which respondent never challenged. Petitioner's attorney was certainly competent: respondent agreed with the attorney's theory of the case that taxpayers should recognize results from slot machine play on the basis of net wins or losses per visit to the casino.
Petitioner's overall story is also credible, albeit unsupported. That she probably did lose money on most of her visits to the casino is reflected in the fact that respondent reduced the amount of petitioner's winnings for 2004 from $56,200 to $30,170, and reflected in a reduction from 26 to 11 in the number of Forms W-2G that respondent required petitioner to recognize for 2004.
Petitioner disclosed all of her $56,200 of Form W-2G winnings to her attorney. Petitioner relied in good faith on the attorney's judgment, disclosing to respondent on her 2004 Federal income tax return the Forms W-2G that led to the $56,200 total and attaching a memorandum describing the attorney's theory of netting wins and losses per visit to the casino. “To require the taxpayer to challenge the attorney, to seek a ‘second opinion,’ or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place.” United States v. Boyle, supra at 251.
In summary, we conclude that petitioner has done what a reasonable person would do under the circumstances to determine the proper tax. Therefore, on the basis of the record before us, for all of the above reasons, we find that petitioner had reasonable cause and acted in good faith. We do not sustain respondent's determination of an accuracy-related penalty for 2004.
To reflect our disposition of the issues,
Decision will be entered for respondent as to the deficiency and for petitioner as to the accuracy-related penalty.

New Rev Proc on 1.274-5(g) travel expenses

Rev. Proc. 2009-47,Internal Revenue Service, (Oct. 1, 2009)
2009FED ¶46,501


Deductions: Business expenses: Per diem rates


Part III
Administrative, Procedural, and Miscellaneous
26 CFR 601.105: Examination of returns and claims for refund, credit, or abatement; determination of correct tax liability.

(Also Part I, §§ 62 , 162, 267, 274; 1.62-2, 1.162-17, 1.267(a)-1, 1.274-5.)

Rev. Proc. 2009-47

SECTION 1. PURPOSE

This revenue procedure updates Rev. Proc. 2008-59 , 2008-41 I.R.B. 857, and provides rules under which the amount of ordinary and necessary business expenses of an employee for lodging, meal, and incidental expenses, or for meal and incidental expenses, incurred while traveling away from home are deemed substantiated under § 1.274-5 of the Income Tax Regulations when a payor (the employer, its agent, or a third party) provides a per diem allowance under a reimbursement or other expense allowance arrangement to pay for the expenses. In addition, this revenue procedure provides an optional method for employees and self-employed individuals who are not reimbursed to use in computing the amounts paid or incurred for business meal and incidental expenses, or for incidental expenses only if no meal expenses are paid or incurred, while traveling away from home. Use of a method described in this revenue procedure is not mandatory, and a taxpayer may use actual allowable expenses if the taxpayer maintains adequate records or other sufficient evidence for proper substantiation. This revenue procedure does not provide rules under which the amount of an employee's lodging expenses are deemed substantiated to a payor when a payor provides an allowance to pay for lodging expenses but not meal and incidental expenses.

SECTION 2. BACKGROUND AND CHANGES
.01 Section 162(a) of the Internal Revenue Code allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Under that provision, an employee or self-employed individual may deduct expenses paid or incurred while traveling away from home in pursuit of a trade or business. However, under § 262 , no portion of travel expenses attributable to personal, living, or family expenses is deductible.

.02 Section 274(n) generally limits the amount allowable as a deduction under § 162 for any expense for food, beverages, or entertainment to 50 percent of the amount of the expense that otherwise would be allowable as a deduction. In the case of any expenses for food or beverages consumed while away from home (within the meaning of § 162(a)(2) ) by an individual during, or incident to, the period of duty subject to the hours of service limitations of the Department of Transportation, § 274(n)(3) provides that, for taxable years beginning in 2009 or thereafter, the deductible percentage for these expenses is 80 percent.

.03 Section 274(d) provides, in part, that no deduction is allowed under § 162 for any travel expense (including meals and lodging while away from home) unless a taxpayer complies with certain substantiation requirements. Section 274(d) further provides that regulations may prescribe that some or all of the substantiation requirements do not apply to an expense that does not exceed an amount prescribed by the regulations.

.04 Section 1.274-5(g) , in part, grants the Commissioner the authority to prescribe rules relating to reimbursement arrangements or per diem allowances for ordinary and necessary expenses paid or incurred while traveling away from home. Under this grant of authority, the Commissioner may prescribe rules under which these arrangements or allowances, if in accordance with reasonable business practice, are regarded (1) as equivalent to substantiation, by adequate records or other sufficient evidence, of the amount of travel expenses for purposes of § 1.274-5(c) , and (2) as satisfying the requirements of an adequate accounting to the employer of the amount of travel expenses for purposes of § 1.274-5(f) .

.05 For purposes of determining adjusted gross income, § 62(a)(2)(A) allows an employee a deduction for expenses allowed by Part VI ( § 161 and following), subchapter B, chapter 1 of the Code, the employee pays or incurs in performing services as an employee under a reimbursement or other expense allowance arrangement with a payor.

.06 Section 62(c) provides that an arrangement is not treated as a reimbursement or other expense allowance arrangement for purposes of § 62(a)(2)(A) if it—

(1) Does not require the employee to substantiate the expenses covered by the arrangement to the payor, or

(2) Provides the employee with the right to retain any amount in excess of the substantiated expenses covered under the arrangement. Section 62(c) further provides that these substantiation requirements do not apply to any expense to the extent that, under the grant of regulatory authority in § 274(d) , the Commissioner provides that substantiation is not required for the expense.

.07 Under § 1.62-2(c) , a reimbursement or other expense allowance arrangement satisfies the requirements of § 62(c) if it meets the requirements of business connection, substantiation, and returning amounts in excess of expenses as specified in the regulations. If an arrangement meets these requirements, all amounts paid under the arrangement are treated as paid under an accountable plan and are excluded from income and wages. If an arrangement does not meet these requirements, all amounts paid under the arrangement are treated as paid under a nonaccountable plan and are included in an employee's gross income, must be reported as wages or compensation on the employee's Form W-2, and are subject to the withholding and payment of employment taxes. Section 1.62-2(e)(2) specifically provides that substantiation of certain business expenses in accordance with rules prescribed under the authority of § 1.274-5(g) is treated as substantiation of the amount of the expenses for purposes of § 1.62-2 . Under § 1.62-2(f)(2) , the Commissioner may prescribe rules under which an arrangement providing per diem allowances is treated as satisfying the requirement of returning amounts in excess of expenses, even though the arrangement does not require the employee to return the portion of the allowance that relates to days of travel substantiated and that exceeds the amount of the employee's expenses deemed substantiated under rules prescribed under § 274(d) , provided the allowance is reasonably calculated not to exceed the amount of the employee's expenses or anticipated expenses and the employee is required to return within a reasonable period of time any portion of the allowance that relates to days of travel not substantiated.

.08 Section 1.62-2(h)(2)(i)(B) provides that, if a payor pays a per diem allowance that meets the requirements of § 1.62-2(c)(1) , the portion, if any, of the allowance that relates to days of travel substantiated in accordance with § 1.62-2(e) , that exceeds the amount of an employee's expenses deemed substantiated for the travel under rules prescribed under § 274(d) and § 1.274-5(g) , and that the employee is not required to return, is subject to withholding and payment of employment taxes. See §§ 31.3121(a)-3 , 31.3231(e)-1(a)(5), 31.3306(b)-2, and 31.3401(a)-4 of the Employment Tax Regulations. Because the employee is not required to return this excess portion, the reasonable period of time provisions of § 1.62-2(g) (relating to the return of excess amounts) do not apply to this portion.

.09 Under § 1.62-2(h)(2)(i)(B)(4) , the Commissioner has the discretion to prescribe special rules regarding the timing of withholding and payment of employment taxes on per diem allowances.

.10 Section 1.274-5(j)(1) grants the Commissioner the authority to establish a method under which a taxpayer may elect to treat a specific amount as paid or incurred for meals while traveling away from home in lieu of substantiating the actual cost of meals.

.11 Section 1.274-5(j)(3) grants the Commissioner the authority to establish a method under which a taxpayer may elect to treat a specific amount as paid or incurred for incidental expenses while traveling away from home in lieu of substantiating the actual cost of incidental expenses.

.12 This revenue procedure includes modifications to Rev. Proc. 2008-59 as follows:

(1) Sections 3 .02(1)(a), 4.04(6), and 5.06 provide transition rules for the last 3 months of calendar year 2009.

(2) Section 5.02 contains revisions to the per diem rates for high-cost localities and for other localities for purposes of section 5 .

(3) Section 5.03 contains the list of high-cost localities, and section 5.04 describes changes to the list of high-cost localities for purposes of section 5 .

(4) The reference in section 6.04 to section 4.04 is deleted. Section 6.04 references taxpayers that use section 4.02 or 4.03 to determine the amount of travel expenses deemed substantiated. Taxpayers described in section 4.04 use section 4.02 or 4.03. Therefore, the reference to section 4.04 in section 6.04 is unnecessary and potentially confusing.

SECTION 3. DEFINITIONS
.01 Per diem allowance . The term “per diem allowance” means a payment under a reimbursement or other expense allowance arrangement that is B

(1) Paid for ordinary and necessary business expenses incurred, or that the payor reasonably anticipates will be incurred, by an employee for lodging, meal, and incidental expenses, or for meal and incidental expenses, for travel away from home performing services as an employee of the employer,

(2) Reasonably calculated not to exceed the amount of the expenses or the anticipated expenses, and

(3) Paid at or below the applicable federal per diem rate, a flat rate or stated schedule, or in accordance with any other Service-specified rate or schedule.

.02 Federal per diem rate and federal M&IE rate .

(1) In general . The federal per diem rate is equal to the sum of the applicable federal lodging expense rate and the applicable federal meal and incidental expense (M&IE) rate for the day and locality of travel.

(a) CONUS rates . The rates for localities in the continental United States (“CONUS”) are set forth in Appendix A to 41 C.F.R. ch. 301. However, in applying section 4.01 , 4.02, or 4.03 of this revenue procedure, taxpayers may continue to use the CONUS rates in effect for the first 9 months of 2009 for expenses of all CONUS travel away from home that are paid or incurred during calendar year 2009 in lieu of the updated GSA rates. A taxpayer must consistently use either these rates or the updated rates for the period October 1, 2009, through December 31, 2009.

(b) OCONUS rates . The rates for localities outside the continental United States (“OCONUS”) are established by the Secretary of Defense (rates for non-foreign localities, including Alaska, Hawaii, Puerto Rico, the Northern Mariana Islands, and the possessions of the United States) and by the Secretary of State (rates for foreign localities), and are published in the Per Diem Supplement to the Standardized Regulations (Government Civilians, Foreign Areas) (updated on a monthly basis).

(c) Internet access to the rates . The CONUS and OCONUS rates may be found on the Internet at www.gsa.gov.

(2) Locality of travel . The term “locality of travel” means the locality where an employee traveling away from home performing services as an employee of an employer stops for sleep or rest.

(3) Incidental expenses . The term “incidental expenses” has the same meaning as in the Federal Travel Regulations, 41 C.F.R. 300-3.1 (2009). The Federal Travel Regulations currently include as incidental expenses fees and tips given to porters, baggage carriers, bellhops, hotel maids, stewards or stewardesses and others on ships, and hotel servants in foreign countries; transportation between places of lodging or business and places where meals are taken, if suitable meals can be obtained at the temporary duty site; and the mailing cost associated with filing travel vouchers and payment of employer-sponsored charge card billings.

.03 Flat rate or stated schedule .

(1) In general . Except as provided in section 3.03(2) of this revenue procedure, an allowance is paid at a flat rate or stated schedule if it is provided on a uniform and objective basis for the expenses described in section 3.01 of this revenue procedure. The allowance may be paid for the number of days away from home performing services as an employee or on any other basis that is consistently applied and in accordance with reasonable business practice. Thus, for example, an hourly payment to cover meal and incidental expenses paid to a pilot or flight attendant who is traveling away from home performing services as an employee is an allowance paid at a flat rate or stated schedule. Likewise, a payment based on the number of miles traveled (such as cents per mile) to cover meal and incidental expenses paid to an over-the-road truck driver who is traveling away from home performing services as an employee is an allowance paid at a flat rate or stated schedule.

(2) Limitation . An allowance that is computed on a basis similar to that used in computing an employee's wages or other compensation (such as the number of hours worked, miles traveled, or pieces produced) does not meet the business connection requirement of § 1.62-2(d) , is not a per diem allowance, and is not paid at a flat rate or stated schedule, unless, as of December 12, 1989, (a) the allowance was identified by the payor either by making a separate payment or by specifically identifying the amount of the allowance, or (b) an allowance computed on that basis was commonly used in the industry in which the employee performed services. See § 1.62-2(d)(3)(ii) .

SECTION 4. PER DIEM SUBSTANTIATION METHOD
.01 Per diem allowance . If a payor pays a per diem allowance in lieu of reimbursing actual lodging, meal, and incidental expenses incurred or to be incurred by an employee for travel away from home, the amount of the expenses that is deemed substantiated for each calendar day is equal to the lesser of the per diem allowance for that day or the amount computed at the federal per diem rate (see section 3.02 of this revenue procedure) for the locality of travel for that day (or partial day, see section 6.04 of this revenue procedure).

.02 Meal and incidental expenses only per diem allowance . If a payor pays a per diem allowance only for meal and incidental expenses in lieu of reimbursing actual meal and incidental expenses incurred or to be incurred by an employee for travel away from home, the amount of the expenses that is deemed substantiated for each calendar day is equal to the lesser of the per diem allowance for that day or the amount computed at the federal M&IE rate for the locality of travel for that day (or partial day). A per diem allowance is treated as paid only for meal and incidental expenses if (1) the payor pays the employee for actual expenses for lodging based on receipts submitted to the payor, (2) the payor provides the lodging in kind, (3) the payor pays the actual expenses for lodging directly to the provider of the lodging, (4) the payor does not have a reasonable belief that lodging expenses were or will be incurred by the employee, or (5) the allowance is computed on a basis similar to that used in computing an employee's wages or other compensation (such as the number of hours worked, miles traveled, or pieces produced).

.03 Optional method for meal and incidental expenses only deduction . In lieu of using actual expenses in computing the amount allowable as a deduction for ordinary and necessary meal and incidental expenses paid or incurred for travel away from home, employees and self-employed individuals who pay or incur meal expenses may use an amount computed at the federal M&IE rate for the locality of travel for each calendar day (or partial day) the employee or self-employed individual is away from home. This amount is deemed substantiated for purposes of paragraphs (b)(2) and (c) of § 1.274-5 , provided the employee or self-employed individual substantiates the elements of time, place, and business purpose of the travel for that day (or partial day) in accordance with those regulations. See section 6.05(1) of this revenue procedure for rules related to the application of the limitation under § 274(n) to amounts determined under this section 4.03 . See section 4.05 of this revenue procedure for a method for substantiating incidental expenses that may be used by employees or self-employed individuals who do not pay or incur meal expenses.

.04 Special rules for transportation industry .

(1) In general . This section 4.04 applies to (a) a payor that pays a per diem allowance only for meal and incidental expenses for travel away from home to an employee in the transportation industry and computes the amount under section 4.02 of this revenue procedure, or (b) an employee or self-employed individual in the transportation industry who computes the amount allowable as a deduction for meal and incidental expenses for travel away from home under section 4.03 of this revenue procedure.

(2) Transportation industry defined . For purposes of this section 4.04 , an employee or self-employed individual is in the transportation industry only if the employee's or self-employed individual's work (a) is of the type that directly involves moving people or goods by airplane, barge, bus, ship, train, or truck, and (b) regularly requires travel away from home which, during any single trip away from home, usually involves travel to localities with differing federal M&IE rates. For purposes of the preceding sentence, a payor must determine that an employee or a group of employees is in the transportation industry by using a method that is consistently applied and in accordance with reasonable business practice.

(3) Rates . A taxpayer described in section 4.04(1) of this revenue procedure may treat $59 as the federal M&IE rate for any CONUS locality of travel, and $65 as the federal M&IE rate for any OCONUS locality of travel. A payor that uses either (or both) of these special rates for an employee must use the special rate(s) for all amounts deemed substantiated under section 4.02 of this revenue procedure paid to that employee for travel away from home within CONUS and/or OCONUS, as the case may be, during the calendar year. Similarly, an employee or self-employed individual that uses either (or both) of these special rates must use the special rate(s) for all amounts deemed substantiated under section 4.03 of this revenue procedure for travel away from home within CONUS and/or OCONUS, as the case may be, during the calendar year. See section 4.04(6) of this revenue procedure for transition rules.

(4) Periodic rule . A payor described in section 4.04(1) of this revenue procedure may compute the amount of the employee's expenses that is deemed substantiated under section 4.02 of this revenue procedure periodically (not less frequently than monthly), rather than daily, by comparing the total per diem allowance paid for the period to the sum of the amounts computed either at the federal M&IE rate(s) for the localities of travel, or at the special rate described in section 4.04(3) , for the days (or partial days) the employee is away from home during the period.

(5) Examples .

(a) Example 1 . Taxpayer, an employee in the transportation industry, travels away from home on business within CONUS on 16 days (including partial days) during a calendar month. A payor pays Taxpayer a per diem allowance only for meal and incidental expenses that the payor computes using section 4.04(3) of this revenue procedure and the method of proration described in section 6.04(2) of this revenue procedure. The amount deemed substantiated under section 4.02 of this revenue procedure is equal to the lesser of the total per diem allowance paid for the month or $944 (16 days at $59 per day).

(b) Example 2 . Taxpayer, a truck driver employee in the transportation industry, is paid a “cents-per-mile” allowance that qualifies as an allowance paid under a flat rate or stated schedule as defined in section 3.03 of this revenue procedure. Taxpayer travels away from home on business for 10 days. Based on the number of miles driven by Taxpayer, Taxpayer's employer pays an allowance of $500 for the 10 days of business travel. Taxpayer actually drives for 8 days, and does not drive for the other 2 days Taxpayer is away from home. Taxpayer is paid under the periodic rule used for transportation industry employers and employees in accordance with section 4.04(4) of this revenue procedure. The amount deemed substantiated is the full $500 because that amount does not exceed $590 (ten days away from home at $59 per day).

(6) Transition rules . Under the calendar-year convention provided in section 4.04(3) , a taxpayer who used the federal M&IE rates during the first 9 months of calendar year 2009 to substantiate the amount of an individual's travel expenses under sections 4 .02 or 4.03 of Rev. Proc. 2008-59 may not use, for that individual, the special transportation industry rates provided in this section 4.04 until January 1, 2010. Similarly, a taxpayer who used the special transportation industry rates during the first 9 months of calendar year 2009 to substantiate the amount of an individual's travel expenses may not use, for that individual, the federal M&IE rates until January 1, 2010.

.05 Optional method for incidental expenses only deduction . In lieu of using actual expenses in computing the amount allowable as a deduction for ordinary and necessary incidental expenses paid or incurred for travel away from home, employees and self-employed individuals who pay or incur incidental expenses but do not pay or incur meal expenses for a calendar day (or partial day) of travel away from home may use, for each calendar day (or partial day) the employee or self-employed individual is away from home, an amount computed at the rate of $5 per day for any CONUS or OCONUS locality of travel. This amount is deemed substantiated for purposes of paragraphs (b)(2) and (c) of § 1.274-5 , provided the employee or self-employed individual substantiates the elements of time, place, and business purpose of the travel for that day (or partial day) in accordance with those regulations. See section 4.03 of this revenue procedure for a method that may be used by employees or self-employed individuals who pay or incur meal expenses. The method authorized by this section 4.05 may not be used by payors that use section 4.01 , 4.02, or 5.01 of this revenue procedure, or by employees or self-employed individuals who use the method described in section 4.03 of this revenue procedure. See section 6.05(5) of this revenue procedure for rules related to the application of the limitation under § 274(n) to amounts determined under this section 4.05 .

SECTION 5. HIGH-LOW SUBSTANTIATION METHOD
.01 In general . If a payor pays a per diem allowance in lieu of reimbursing actual lodging, meal, and incidental expenses incurred or to be incurred by an employee for travel away from home and the payor uses the high-low substantiation method described in this section 5 for travel within CONUS, the amount of the expenses that is deemed substantiated for each calendar day is equal to the lesser of the per diem allowance for that day or the amount computed at the rate provided in section 5.02 of this revenue procedure for the locality of travel for that day (or partial day, see section 6.04 of this revenue procedure). Except as provided in section 5.06 of this revenue procedure, this high-low substantiation method may be used in lieu of the per diem substantiation method provided in section 4.01 of this revenue procedure, but may not be used in lieu of the meal and incidental expenses only per diem substantiation method provided in section 4.02 of this revenue procedure.

.02 Specific high-low rates . Except as provided in section 5.06 of this revenue procedure, the per diem rate set forth in this section 5.02 is $258 for travel to any “high-cost locality” specified in section 5.03 of this revenue procedure, or $163 for travel to any other locality within CONUS. The high or low rate, as appropriate, applies as if it were the federal per diem rate for the locality of travel. For purposes of applying the high-low substantiation method and the § 274(n) limitation on meal expenses (see section 6.05(3) of this revenue procedure), the amount of the high and low rates that is treated as paid for meals is $65 for a high-cost locality and $52 for any other locality within CONUS.

.03 High-cost localities . The following localities have a federal per diem rate of $211 or more, and are high-cost localities for all of the calendar year or the portion of the calendar year specified in parentheses under the key city name:

Key city
County or other defined location

Arizona


Phoenix/Scottsdale
Maricopa



(January 1-May 31)


Sedona
City limits of Sedona



(March 1-April 30)




California


Monterey
Monterey


Napa
Napa



(October 1-November 30 and April 1-September 30)


San Diego
San Diego


San Francisco
San Francisco


Santa Barbara
Santa Barbara


Santa Monica
City limits of Santa Monica


South Lake Tahoe
El Dorado



(December 1-March 31)




Colorado


Aspen
Pitkin



(December 1-April 30)


Denver/Aurora
Denver, Adams, Arapahoe, and Jefferson


Steamboat Springs
Routt



(December 1-March 31)


Telluride
San Miguel



(December 1-March 31 and June 1-September 30)


Vail
Eagle



(December 1-March 31)




District of Columbia



Washington D.C. (also the cities of Alexandria, Falls Church, and Fairfax, and the counties of Arlington and Fairfax, in Virginia; and the counties of Montgomery and Prince George's in Maryland) (See also Maryland and Virginia)




Florida


Fort Lauderdale
Broward



(October 1-April 30)


Fort Walton Beach/De Funiak Springs
Okaloosa and Walton



(June 1-July 31)


Key West
Monroe


Miami
Miami-Dade



(January 1-March 31)


Naples
Collier



(January 1-April 30)




Illinois


Chicago
Cook and Lake




Maine


Bar Harbor
Hancock



(July 1-August 31)




Maryland


Baltimore City
Baltimore City



(October 1-November 30 and March 1-September 30)


Cambridge/St. Michaels
Dorchester and Talbot



(June 1-August 31)


Ocean City
Worcester



(June 1-August 31)


Washington, DC Metro Area
Montgomery and Prince George's




Massachusetts


Boston/Cambridge
Suffolk, City of Cambridge


Martha's Vineyard
Dukes



(June 1-August 31)


Nantucket
Nantucket



(June 1-September 30)




New Hampshire


Conway
Carroll



(July 1-August 31)




New York


Floral Park/Garden City/Great Neck
Nassau


Glens Falls
Warren



(July 1-August 31)


Lake Placid
Essex



(July 1-August 31)


Manhattan (includes the boroughs of Manhattan, Brooklyn, the Bronx, Queens and Staten Island)
Bronx, Kings, New York, Queens, Richmond


Saratoga Springs/Schenectady
Saratoga and Schenectady



(July 1-August 31)


Tarrytown/White Plains/New Rochelle
Westchester




Pennsylvania


Hershey
City of Hershey



(June 1-August 31)


Philadelphia
Philadelphia




Rhode Island


Jamestown/Middletown/Newport
Newport



(October 1-October 31 and May 1-September 30)




Utah


Park City
Summit



(January 1-March 31)




Virginia


Washington, DC Metro Area
Cities of Alexandria, Fairfax, and Falls Church; counties of Arlington and Fairfax




Washington


Seattle
King




Wyoming
Teton and Sublette


Jackson/Pinedale



(July 1-August 31)


.04 Changes in high-cost localities . The list of high-cost localities in section 5.03 of this revenue procedure differs from the list of high-cost localities in section 5.03 of Rev. Proc. 2008-59 (changes listed by key cities).

(1) The following localities have been added to the list of high-cost localities: Monterey, California; Denver/Aurora, Colorado; Bar Harbor, Maine; Conway, New Hampshire; Glens Falls, New York; Lake Placid, New York; and Hershey, Pennsylvania.

(2) The portion of the year for which the following are high-cost localities has been changed: Phoenix/Scottsdale, Arizona; Napa, California; San Diego, California; Telluride, Colorado; Vail, Colorado; Miami, Florida; Naples, Florida; Baltimore City, Maryland; Cambridge/St. Michaels, Maryland; Ocean City, Maryland; and Jamestown/Middletown/Newport, Rhode Island.

(3) The following localities have been removed from the list of high-cost localities: Crested Butte/Gunnison, Colorado; Silverthorne/Breckenridge, Colorado; and Palm Beach, Florida.

(4) The following localities have been redefined: Floral Park/Garden City/Great Neck, New York no longer includes Glen Gove and Roslyn; Tarrytown/White Plains/New Rochelle, New York no longer includes Yonkers .

.05 Specific limitation .

(1) Except as provided in section 5.05(2) of this revenue procedure, a payor that uses the high-low substantiation method for an employee must use that method for all amounts paid to that employee for travel away from home within CONUS during the calendar year. See section 5.06 of this revenue procedure for transition rules.

(2) For an employee described in section 5.05(1) of this revenue procedure, the payor may reimburse actual expenses or use the meal and incidental expenses only per diem substantiation method described in section 4.02 of this revenue procedure for any travel away from home, and may use the per diem substantiation method described in section 4.01 of this revenue procedure for any OCONUS travel away from home.

.06 Transition rules . A payor who used the substantiation method of section 4.01 of Rev. Proc. 2008-59 for an employee during the first 9 months of calendar year 2009 may not use the high-low substantiation method in section 5 of this revenue procedure for that employee until January 1, 2010. A payor who used the high-low substantiation method of section 5 of Rev. Proc. 2008-59 for an employee during the first 9 months of calendar year 2009 must continue to use the high-low substantiation method for the remainder of calendar year 2009 for that employee. A payor described in the previous sentence may use the rates and high-cost localities published in section 5 of Rev. Proc. 2008-59 , in lieu of the updated rates and high-cost localities provided in section 5 of this revenue procedure, for travel on or after October 1, 2009, and before January 1, 2010, if those rates and localities are used consistently during this period for all employees reimbursed under this method.

SECTION 6. LIMITATIONS AND SPECIAL RULES
.01 In general . The federal per diem rate and the federal M&IE rate described in section 3.02 of this revenue procedure for the locality of travel apply in the same manner as they apply under the Federal Travel Regulations, 41 C.F.R. Part 301-11 (2009), except as provided in sections 6 .02 through 6.04 of this revenue procedure.

.02 Federal per diem rate . A receipt for lodging expenses is not required in determining the amount of expenses deemed substantiated under section 4.01 or 5.01 of this revenue procedure. See section 7.01 of this revenue procedure for the requirement that the employee substantiate the time, place, and business purpose of the expense.

.03 Federal per diem or M&IE rate . A payor is not required to reduce the federal per diem rate or the federal M&IE rate for the locality of travel for meals provided in kind, provided the payor has a reasonable belief that the employee incurred or will incur meal and incidental expenses during each day of travel.

.04 Proration of the federal per diem or M&IE rate . Under the Federal Travel Regulations, in determining the federal per diem rate or the federal M&IE rate for the locality of travel, the full applicable federal M&IE rate is available for a full day of travel from 12:01 a.m. to 12:00 midnight. The method described in section 6.04(1) of this revenue procedure must be used for purposes of determining the amount deemed substantiated under section 4.03 or 4.05 of this revenue procedure for partial days of travel away from home. For purposes of determining the amount deemed substantiated under section 4.01 , 4.02, or 5 of this revenue procedure for partial days of travel away from home, either of the following methods may be used to prorate the federal M&IE rate to determine the federal per diem rate or the federal M&IE rate for the partial days of travel:

(1) The rate may be prorated using the method prescribed by the Federal Travel Regulations. Currently the Federal Travel Regulations allow three-fourths of the applicable federal M&IE rate for each partial day during which an employee or self-employed individual is traveling away from home performing services as an employee or self-employed individual. The same ratio may be applied to prorate the allowance for incidental expenses described in section 4.05 of this revenue procedure; or

(2) The rate may be prorated using any method that is consistently applied and in accordance with reasonable business practice. For example, if an employee travels away from home from 9 a.m. one day to 5 p.m. the next day, a method of proration that results in an amount equal to two times the federal M&IE rate is treated as being in accordance with reasonable business practice (even though the Federal Travel Regulations would allow only one and a half times the federal M&IE rate).

.05 Application of the appropriate § 274(n) limitation on meal expenses . Except as provided in section 6.05(5) , all or part of the amount of an expense deemed substantiated under this revenue procedure is subject to the appropriate limitation under § 274(n) (see section 2.02 of this revenue procedure) on the deductibility of food and beverage expenses.

(1) If an amount for meal and incidental expenses is computed under section 4.03 of this revenue procedure, a taxpayer must treat that amount as an expense for food and beverages.

(2) If a per diem allowance is paid only for meal and incidental expenses, a payor must treat an amount equal to the lesser of the allowance or the federal M&IE rate for the locality of travel for each day (or partial day, see section 6.04 of this revenue procedure) as an expense for food and beverages.

(3) If a per diem allowance is paid for lodging, meal, and incidental expenses for each calendar day (or partial day) an employee is away from home at a rate equal to or in excess of the federal per diem rate for the locality of travel, a payor must treat an amount equal to the federal M&IE rate for the locality of travel for each calendar day (or partial day) as an expense for food or beverages.

(4) If a per diem allowance is paid for lodging, meal, and incidental expenses for each calendar day (or partial day) an employee is away from home at a rate less than the federal per diem rate for the locality of travel, a payor must:

(a) Treat an amount equal to the federal M&IE rate for the locality of travel for each calendar day (or partial day) or, if less, the amount of the allowance, as an expense for food or beverages; or

(b) Treat an amount equal to 40 percent of the allowance as an expense for food or beverages.

(5) If an amount for incidental expenses is computed under section 4.05 of this revenue procedure, none of the amount is subject to limitation under § 274(n) .

.06 No double reimbursement or deduction . If a payor pays a per diem allowance in lieu of reimbursing actual lodging, meal, and incidental expenses, or meal and incidental expenses, in accordance with section 4 or 5 of this revenue procedure, and the amount is treated as paid under an accountable plan, any additional payment for those expenses is treated as paid under a nonaccountable plan, is included in an employee's gross income, is reported as wages or other compensation on the employee's Form W-2, and is subject to withholding and payment of employment taxes. Similarly, if an employee or self-employed individual computes the amount allowable as a deduction for meal and incidental expenses for travel away from home in accordance with section 4.03 or 4.04 of this revenue procedure, no other deduction is allowed to the employee or self-employed individual for those expenses. For example, assume an employee receives a per diem allowance from a payor for lodging, meal, and incidental expenses, or for meal and incidental expenses, incurred while traveling away from home and the amount is treated as paid under an accountable plan. During that trip, the employee pays for dinner for the employee and two business associates. The payor reimburses as a business entertainment meal expense the meal expense for the employee and the two business associates. Because the payor also pays a per diem allowance to cover the cost of the employee's meals, the amount paid for the employee's portion of the business entertainment meal expense is treated as paid under a nonaccountable plan, is reported as wages or other compensation on the employee's Form W-2, and is subject to withholding and payment of employment taxes.

.07 Related parties . Sections 4 .01 and 5 of this revenue procedure do not apply if a payor and an employee are related within the meaning of § 267(b) , but for this purpose the percentage of ownership interest referred to in § 267(b)(2) is 10 percent.

SECTION 7. APPLICATION
.01 An employee satisfies the adequate accounting and substantiation requirements of § 1.274-5(c) and (f)(4) and § 1.274-5T(c) if—

(1) The employee uses this revenue procedure to substantiate to a payor the amount of the employee's travel expenses, and

(2) Within a reasonable period of time, the employee also substantiates to the payor the elements of time, place, and business purpose of the travel in accordance with § 1.274-5T(b)(2) and (c) and § 1.274-5(c) (other than § 1.274-5(c)(2)(iii)(A)) .

.02 An arrangement providing per diem allowances is treated as satisfying the requirement of § 1.62-2(f)(2) of returning amounts in excess of expenses if an employee is required to return within a reasonable period of time (as defined in § 1.62-2(g)) any portion of the allowance that relates to days of travel not substantiated, even though the arrangement does not require the employee to return the portion of the allowance that relates to days of travel substantiated and that exceeds the amount of the employee's expenses deemed substantiated. For example, assume a payor provides an employee an advance per diem allowance for meal and incidental expenses of $250, based on an anticipated 5 days of business travel at $50 per day to a locality for which the federal M&IE rate is $46, and the employee substantiates 3 full days of business travel. The requirement to return excess amounts is treated as satisfied if the employee is required to return within a reasonable period of time (as defined in § 1.62-2(g)) the portion of the allowance that is attributable to the 2 unsubstantiated days of travel ($100), even though the employee is not required to return the portion of the allowance ($12) that exceeds the amount of the employee's expenses deemed substantiated under section 4.02 of this revenue procedure ($138) for the 3 substantiated days of travel. However, the $12 excess portion of the allowance is treated as paid under a nonaccountable plan as discussed in section 7.04 of this revenue procedure.

.03 An employee is not required to include in gross income the portion of a per diem allowance received from a payor that is less than or equal to the amount deemed substantiated under the rules provided in section 4 or 5 of this revenue procedure if the employee substantiates the business travel expenses covered by the per diem allowance in accordance with section 7.01 of this revenue procedure. See § 1.274-5T(f)(2)(i) . If the remaining requirements for an accountable plan provided in § 1.62-2 are satisfied, that portion of the allowance is treated as paid under an accountable plan, is not reported as wages or other compensation on the employee's Form W-2, and is exempt from the withholding and payment of employment taxes. See § 1.62-2(c)(2) and (c)(4).

.04 An employee is required to include in gross income only the portion of the per diem allowance received from a payor that exceeds the amount deemed substantiated under the rules provided in section 4 or 5 of this revenue procedure if the employee substantiates the business travel expenses covered by the per diem allowance in accordance with section 7.01 of this revenue procedure. See § 1.274-5T(f)(2)(ii) . In addition, the excess portion of the allowance is treated as paid under a nonaccountable plan, is reported as wages or other compensation on the employee's Form W-2, and is subject to withholding and payment of employment taxes. See § 1.62-2(c)(3)(ii) , (c)(5), and (h)(2)(i)(B).

.05 If the amount of the expenses that is deemed substantiated under the rules provided in section 4.01 , 4.02, or 5 of this revenue procedure is less than the amount of an employee's business expenses for travel away from home, an employee may claim an itemized deduction for the amount by which the business travel expenses exceed the amount that is deemed substantiated, provided the employee substantiates all the business travel expenses (not just the excess over the federal per diem rate), includes on Form 2106, “Employee Business Expenses,” the deemed substantiated portion of the per diem allowance received from the payor, and includes in gross income the portion (if any) of the per diem allowance received from the payor that exceeds the amount deemed substantiated. See § 1.274-5T(f)(2)(iii) . However, for purposes of claiming this itemized deduction for meal and incidental expenses, substantiation of the amount of the expenses is not required if the employee is claiming a deduction that is equal to or less than the amount computed under section 4.03 of this revenue procedure minus the amount deemed substantiated under sections 4 .02 and 7.01 of this revenue procedure. The itemized deduction is subject to the appropriate limitation (see section 2.02 of this revenue procedure) on meal and entertainment expenses in § 274(n) and the 2-percent floor on miscellaneous itemized deductions in § 67 .

.06 An employee who pays or incurs meal expenses and does not receive a per diem allowance for meal and incidental expenses may deduct an amount computed under section 4.03 of this revenue procedure only as an itemized deduction. This itemized deduction is subject to the appropriate limitation on meal and entertainment expenses in § 274(n) and the 2-percent floor on miscellaneous itemized deductions in § 67 . See section 7.07 of this revenue procedure for the treatment of an employee who does not pay or incur amounts for meal expenses and does not receive a per diem allowance for incidental expenses.

.07 An employee who does not pay or incur amounts for meal expenses and does not receive a per diem allowance for incidental expenses may deduct an amount computed under section 4.05 of this revenue procedure only as an