Newsletter -- November 1996 Issue

by Richard A. Levine
Published: November 01, 1996
Source: R & H Newsletter -- Tax Litigation & Procedure


  • Taxpayer Bill of Rights 2 Allows Challenge to Statutory Notice
  • How Do You Fight the IRS if the Government Loses Your Records?
  • New IRS Worker Classification Settlement Program
  • Tax Court Expands and Clarifies Equitable Recoupment Jurisdiction
  • Accountant's Work Product Protected from Disclosure


Taxpayer Bill of Rights 2 Allows Challenge to Statutory Notice

As a general rule the Notice of Deficiency issued by the Service, which allows the taxpayer to petition the Tax Court, is presumptively valid and correct, and the court will not look into whether it is valid. This presumption of validity and correctness puts the taxpayer in the position of having to prove that the adjustments asserted by the Service are incorrect. On rare occasion, the courts have looked behind the Notice of Deficiency to determine whether it was valid, mostly where the Notice of Deficiency alleges omitted income. One such case concerned the IRS's right to impose tax and penalties where the taxpayer's income tax return did not reflect income shown on an information return, Form 1099, which was submitted to the Service by a third-party.

Relying on a Form 1099 from a third-party, the Service asserted that a taxpayer failed to report $24,000 of income. After the taxpayer complained, the Service approached the third-party, who was unable to produce records to justify the figures shown on the Form 1099 he issued. Nevertheless, the Service took the position that it could rely on the Form 1099 even though the person who issued it could not support the figures he showed on the form, and the Service issued a Notice of Deficiency to the taxpayer. In Portillo v. Commissioner, 932 F.2d 1128 (5th Cir. 1991), the court held that the presumption of correctness did not attach to the Notice of Deficiency because the IRS had information before it issued its Notice of Deficiency which cast serious doubt upon the correctness of the Form 1099 and the IRS failed to investigate the matter adequately. Accordingly, the burden of proof was imposed on the IRS.

Computer matching of Forms 1099 with income tax returns has enabled the IRS routinely to assert additional tax liability if a taxpayer fails to report the income. In order to curb potential IRS abuses in the area, Congress, as part of the recently enacted Taxpayer Bill of Rights 2, added IRC Search7RH6201(d), which places on the IRS "the burden of producing reasonable and probative information concerning" a deficiency which is alleged on the basis of an information return submitted to the Service. This burden on the IRS only arises where the taxpayer has notified the IRS of a dispute and fully cooperated with the Service with respect to its investigation of the disputed income item.

The statute does not specify a remedy if the Commissioner does not produce reasonable and probative information. Consistent with Portillo, failure by the Commissioner to produce such information in a Tax Court proceeding should result in the Notice of Deficiency being held to be arbitrary and devoid of a presumption of correctness as to that issue. However, this conclusion is not mandated by the literal words of the statute.

How Do You Fight the IRS if the Government Loses Your Records?

Ordinarily, the burden of proof in a U.S. Tax Court case is on the taxpayer; the taxpayer must prove by a preponderance of the evidence that the IRS determination as set forth in the Notice of Deficiency is erroneous. Since the taxpayer normally has at his or her disposal all the relevant facts and documents relating to a disputed deduction or income item, it is reasonable to impose the burden of proof on the taxpayer. There are a number of exceptions to this rule which are provided for in the Internal Revenue Code and in the Tax Court rules. For example, where the Commissioner asserts fraud for the purpose of exacting a fraud penalty or for keeping the statute of limitations open, the Commissioner has the burden of proving fraud by clear and convincing evidence. Tax Court Rule 142.

What happens, however, when the government seizes and loses all the taxpayer's records needed to meet his burden proof? Both the Tax Court and the Second Circuit Court of Appeals declined to shift the burden of proof to the Commissioner. However, the Second Circuit ruled that where the government itself was responsible for the taxpayer's inability to produce documents necessary to prove some aspect of his entitlement to deductions, two modifications to the normal standards of proof are appropriate: (1) the trier of fact should be permitted to infer that the true facts are as alleged by the taxpayer to be set forth in the documents seized and lost, and (2) where the taxpayer can offer credible evidence that the seized and lost records were properly maintained by the taxpayer prior to their seizure and that they accurately reflected the facts that the taxpayer alleges those documents to reflect, the taxpayer is entitled to a presumption that the records, if available, would correctly reflect those alleged facts. Andrew Crispo Gallery, Inc. v. Commissioner, 16 F.3d 1336 (2d Cir. 1994). The available inference and the presumption, where warranted, would affect only the facts alleged to have been reflected in the documents lost by the government, and the ultimate burden of persuasion as to entitlement to a deduction would remain on the taxpayer.

New IRS Worker Classification Settlement Program

One of the hottest current audit areas for the IRS is the employee/independent contractor issue. An employer who has misclassified workers as independent contractors faces potential liability for employee income tax withholding, employer and employee FICA taxes, federal unemployment tax (FUTA), as well as interest and penalties thereon.

Over the years, Congress has provided some relief to employers who misclassify workers. For example, under IRC Search7RH3509, the amount of liability for income tax withholding and the employee portion of FICA is greatly reduced if the error was simply misclassification. Further, under IRC Search7RH6205(a)(1), if an employer pays income tax withholding and FICA tax deficiencies after an audit but before the Service Center issues a bill for these items, no interest is due on these amounts. Rev. Rul. 75-464, 1975-2 C.B. 474. In Search7RH530 of the Revenue Act of 1978, Congress created safe harbors for employers to continue to treat certain workers as independent contractors who would, under common law tests, be considered employees. Such safe harbors include (1) that the employer previously underwent an IRS audit where the worker classification issue was not raised or was resolved favorably to the taxpayer, or (2) that a substantial segment of the relevant industry also treats such workers as independent contractors.

Under pressure from Congress, the IRS has now adopted its own program to expedite resolution of worker classification audit disputes. The new "Classification Settlement Program" (CSP) is an optional settlement program which IRS agents can offer to employers under audit.

Under CSP, an IRS agent who concludes that workers were improperly treated as independent contractors both under the common law test and the safe harbors of Search7RH530 of the Revenue Act of 1978 will, if the employer has filed Forms 1099, be able to offer a closing agreement which seeks only one year of tax deficiency if the employer agrees to treat the workers as employees prospectively. This tax deficiency is computed with the reductions of IRC Search7RH3509 relief. An agent who concludes that the employer has an arguable, but still erroneous, position for entitlement to Search7RH530 relief may offer the employer a closing agreement seeking only 25% of one year's tax deficiency (again, taking into account IRC Search7RH3509 relief), if the employer agrees to treat the workers as employees prospectively.

The CSP is a great improvement over the prior system of contesting these disputes before the IRS Appeals level or in the courts. Before adoption of the CSP, if the employer continued to treat the workers as independent contractors while contesting the issue for one or more earlier years at IRS Appeals or in court, the employer exposed itself to even greater liability if it lost the dispute. CSP settlements must be entered into prior to March 5, 1998.

While the CSP, Search7RH530 and IRC Search7RH3509 provide significant relief from possible payroll tax liability, before agreeing to classify workers as employees, consideration must be given to possible liability for state employment taxes, as well as for health benefits and past and future pension plan contributions for such individuals. By agreeing to treat individuals as employees, the taxpayer might be subjecting itself to claims by those individuals that they should be treated as employees from the date they originally began work for the taxpayer.

Tax Court Expands and Clarifies Equitable Recoupment Jurisdiction

The Estate of Gordon Bartels recently found itself in a common situation. There had been a long-standing income tax audit of Gordon Bartels's 1981 and 1982 tax years, and that audit eventually found its way into the U.S. Tax Court. In the meantime, Mr. Bartels died, an estate tax return was filed, and the executor failed to list as a claim against the gross estate the potential pre-death income tax deficiencies.

When the IRS and the Estate finally agreed to the amount of the income tax deficiencies, it was more than three years after the estate tax return had been filed. Accordingly, it was too late for the Estate to file a timely refund claim for all of the overpaid estate taxes which would result from deducting the agreed upon income tax deficiencies from the gross estate.

There has long been a doctrine accepted in most U.S. courts, which allows a taxpayer to offset a potential tax deficiency with a time-barred refund of some other tax, so long as the refund arises from the same transaction. The doctrine, known as "equitable recoupment", has long been accepted by the IRS. See Rev. Rul. 71-56, 1971-1 C.B. 404. For years, however, the IRS and the Tax Court believed that the Tax Court lacked the power to grant equitable recoupment. The argument went like this: The Tax Court is not a court of equity. It is a creature of statute. One provision of the statute, IRC Search7RH6214(b), denies the Tax Court jurisdiction in an income or gift tax case to determine whether or not the tax for any other year or calendar quarter has been overpaid or underpaid. Thus, the Court lacked jurisdiction to apply one tax overpayment not before it to the deficiency that was before it.

In 1993, in Estate of Mueller v. Commissioner, 101 T.C. 551, the Tax Court reversed its long-standing position and held in an estate tax deficiency case, where an asset's value was being increased, that the Court could grant equitable recoupment for the time-barred overpayment of income tax of a testamentary trust which sold the asset and computed its gain using the same value for the asset as was used in the estate tax return. The Court distinguished IRC Search7RH6214(b) as not applying to estate tax deficiency proceedings.

The Tax Court recently held it has equitable recoupment power in the reverse situation: where there is an income tax deficiency and a time-barred estate tax overpayment. In Estate of Bartels v. Commissioner, 106 T.C. No. 24 (June 11, 1996), the Court allowed the Estate to reduce the income tax deficiency by the amount of the estate tax overpayment. Again, it held IRC Search7RH6214(b) to be inapplicable.

Even more recently, the Tax Court clarified the scope of its equitable recoupment jurisdiction. After the Tax Court issued its 1993 Mueller opinion, the parties were directed to recompute the estate tax deficiency as it was impacted by other issues in the case. The recomputation showed an overpayment of estate tax, not a deficiency, before the time-barred income tax overpayment was considered. In Estate of Mueller v. Commissioner, 107 T.C. No. 13 (November 5, 1996), the Tax Court held that since there was now no estate tax deficiency, no recoupment of the income tax overpayment was possible. The Court noted that recoupment may only be used to defend against a timely claim; it may not be used affirmatively to revive a time-barred claim. If the income tax overpayment were added to the estate tax overpayment, in effect, the taxpayer would have revived the time-barred income tax claim.

Accountant's Work Product Protected from Disclosure

For the Work Product Doctrine to apply in tax cases the taxpayer must have truly and reasonably anticipated litigation with the Internal Revenue Service. Also, to be afforded protection, the materials must have been prepared with an expectation that they would be kept confidential, and not for the purpose of providing them to the IRS. Ordinarily, absent special circumstances, litigation with the Internal Revenue Service is not reasonably anticipated at the time of filing a Federal income tax return. The Work Product Doctrine does not apply to protect the pro forma tax preparation work papers of an accountant, unless they were not prepared in the ordinary course of business, but rather with an eye towards a concrete expectation of resolving a matter through litigation.

It is not necessary that a Notice of Deficiency first be issued or that a suit for refund have been commenced before litigation can be reasonably anticipated. In an income tax case involving the valuation of a charitable gift of a sculpture, the taxpayers received notice from the IRS Art Advisory Panel indicating that it had determined that the fair market value of the sculpture was substantially less than the amount of the charitable contribution deduction the taxpayers claimed on their Federal income tax return. The taxpayers' accountant informed them that he believed that they would have to litigate to challenge the IRS's position as to the fair market value of the sculpture. The Tax Court held that it was reasonable to anticipate litigation with the IRS after receipt of the Panel's notice, and therefore, materials prepared by the accountant after that date enjoyed work product protection. Bernardo v. Commissioner, 104 T.C. 677 (1995). Other courts have suggested that the Work Product Doctrine would be available to shield material from disclosure which had been prepared even before any hint of a communication from the IRS as to the existence of any potential dispute.

What makes Bernardo noteworthy is that the Tax Court formally recognized that Work Product protection, which traditionally had been within the sole domain of either attorneys or accountants who aided attorneys, may also be claimed independently by an accountant working directly for the taxpayer. The accountant in Bernardo was never engaged by the taxpayers' attorney, and the materials protected from disclosure were not prepared at the behest of taxpayers' counsel. Nevertheless, once the court was comfortable that there was sufficient proof of the potential for litigation, the accountant's work product was afforded the same safeguards from disclosure as those traditionally accorded to attorneys.

While Bernardo demonstrates that it is not necessary in all cases that an attorney be involved for the protection of the Work Product Doctrine to apply, the involvement of an attorney who would be available to litigate the matter with the IRS adds credibility to the claim that the taxpayer reasonably anticipated litigation with the IRS. In Bernardo, the taxpayers' accountant had prepared the income tax returns and represented the taxpayers both at the Examination Division and at the Appeals Division. The taxpayers' attorney, who did not appear before the IRS, was advising the taxpayers and the accountant during the IRS audit and was, presumably, prepared to litigate the matter in due course.