Guest blogger Bob Probasco returns with the third and final post on the ban for recklessly or fraudulently claiming refundable credits. Part Three tackles the ban process.
The first two parts of this series (here and here) addressed judicial review of the EITC ban. The National Taxpayer Advocate’s Special Report on the EITC also made several recommendations about improvements during the Exam stage. The report is very persuasive (go read it if you haven’t already). In Part One, I quoted Nina’s preface to the report, which says that she is “hopeful that it will lead to a serious conversation about how to advance the twin goals of increasing the participation rate of eligible taxpayers and reducing overclaims by ineligible taxpayers.” Part Three is my small contribution to the conversation, concerning the ban determination process.
About that “disregard of rules and regulations” standard
The ban provision refers to a final determination that the taxpayer’s claim of credit was due to “reckless or intentional disregard of rules and regulations.” This standard seems to have been imported from section 6662, although there it covers not only reckless or intentional disregard but also negligent disregard. It seems a strange standard in this context, though.
The accuracy-related penalty regulations, § 1.6662-3(b)(1), state that disregard of rules and regulations is not negligent, let alone reckless or intentional, if there is a reasonable basis for the return position. But the definition of reasonable basis, § 1.6662-3(b)(3), cross-references the types of authority, § 1.6662-4(d)(3)(iii), applicable to determining whether there was substantial authority for a return position. And those are legal authorities. Arguably, the “disregard of rules and regulations” standard – for the EITC ban as well as the accuracy-related penalty – carries with it an unexamined implication that the facts are known and indisputable; only the application of the law to those facts is at issue.
Such a standard may make a lot of sense with respect to the accuracy-related penalty, at least for sophisticated taxpayers with good records. Those of us who deal a lot with low-income taxpayers and the EITC, however, know that often the credit is disallowed because the taxpayer’s proof is not considered sufficient. It’s a factual dispute, rather than a dispute as to what the law means.
Osteen v. Commissioner, 62 F.3d 356 (11th Cir. 1995) has some interesting discussion of this distinction in the context of the substantial understatement penalty. The very first sentence of the case mentions “certain tax deductions attributable to their farming and horse breeding operations,” so we know that section 183 is going to be the focus. The taxpayers, both of whom were employed full-time, were breeding and raising Percheron horses with the expressed intent to train them, show them, use them to operate a horse-powered farm, and then sell them. The Tax Court opinion, 66 T.C.M. 1237 (1993), determined that the taxpayers did not have “an actual and honest objective of making a profit,” and the Eleventh Circuit concluded that the court’s determination was not clearly erroneous.
The penalty discussion took much longer than the analysis of the profit objective issue. The Tax Court had rejected the petitioners’ penalty defense, which was based on substantial authority, and that puzzled the Eleventh Circuit:
The application of a substantial authority test is confusing in a case of this kind. If the horse breeding enterprise was carried on for profit, all of the deductions claimed by the Osteens would be allowed. There is no authority to the contrary. If the enterprise was not for profit, none of the deductions would be allowed. There is no authority to the contrary. Nobody argues, however, not even the Government, that because the taxpayers lose on the factual issue, they also must lose on what would seem to be a legal issue.
The court reversed on the penalty issue and said that “substantial authority” for a factual issue is met if a decision in the taxpayers’ favor would not have been clearly erroneous:
If the Tax Court was deciding that there was no substantial authority because of the weakness of the taxpayers’ evidence to establish a profit motive, we reverse because a review of the record reveals there was evidence both ways. In our judgment, under the clearly erroneous standard of review, the Tax Court would be due to be affirmed even if it had decided this case for the taxpayers. With that state of the record, there is substantial authority from a factual standpoint for the taxpayer’s position. Only if there was a record upon which the Government could obtain a reversal under the clearly erroneous standard could it be argued that from an evidentiary standpoint, there was not substantial authority for the taxpayer’s position.
If the Tax Court was deciding there was not substantial legal authority for the deductions, we reverse because of the plethora of cases in which the Tax Court has found a profit motive in the horse breeding activities of taxpayers that were similar to those at hand.
For those interested in the “factual issue versus legal authority” question, there was also an interesting article by Bryan Skarlatos in the June-July 2012 issue of the Journal of Tax Practice & Procedure: “The Problem With the Substantial Authority Standard as Applied to Factual Issues.”
This is not directly applicable to the EITC ban but a similar approach seems reasonable. A determination in Exam to disallow the EITC often merely means “the taxpayer didn’t prove that she met the requirements,” rather than “the taxpayer didn’t meet the requirements.” But I suspect that some or many of those who make the ban determination proceed with an assumption, implicit if not explicit, that the former is the equivalent of the latter. If the taxpayer doesn’t meet her burden of proof, that may suffice for denying the credit in the conduct year but may not be enough to impose the ban for future years.
For example, one of the three scenarios in IRM 188.8.131.52.1 (7), used as a starting point to help determine whether the ban is appropriate, addresses situations in which the taxpayer provided insufficient documentation but “indicates they clearly feel they are eligible, and is attempting to prove eligibility and it is clear they do not understand.” In those circumstances, the technician is supposed to “[c]onsider the taxpayer’s lack of understanding” before asserting the ban. There is no reference to the relative strength or weakness of the support offered. That formulation strongly supports an assumption by the technician that (understanding the rules + insufficient documentation), rather than (understanding the rules + not meeting the requirements), is sufficient to assert the ban. If so, that’s a problem.
Recommendations for a revised ban recommendation process
The Office of Chief Counsel issued Significant Service Center Advice in 2002 (SCA 200245051), concluding that neither the taxpayer’s failure to respond to the audit nor a response that fails to provide adequate substantiation is enough by itself to be considered reckless or intentional disregard of rules and regulations. That conclusion is also set forth in IRM 184.108.40.206.1 (1): “A variety of facts must be considered by the CET [correspondence examination technician] in determining whether the 2-Year Ban should be imposed. A taxpayer’s failure to respond adequately or not respond at all does not in itself indicate that the taxpayer recklessly or intentionally disregarded the rules and regulations.”
But, as the Special Report points out, the guidance in IRM 220.127.116.11.1 (7) is erroneous and/or woefully inadequate for the CET’s. And research described in the National Taxpayer Advocate’s 2013 Annual Report to Congress showed an incredibly high error rate in the ban determination. The Special Report recommends that the IRS develop a ban examination process independent from the audit process, modeled on other means-tested programs, to improve accuracy and provide adequate due process protections. The report also mentions several recommendations from earlier annual reports. For example, in the 2014 Annual Report to Congress, the NTA recommended (again) that a single IRS employee be assigned to work any EITC audit in which the taxpayer calls or writes to respond.
The Special Report didn’t, and couldn’t, define the appropriate process in depth. That is something that the IRS, in consultation with TAS, will have to develop, and it may take a significant amount of time. But while we’re waiting for that, here are suggestions for some specific parts of a revised process that would be on my wish list.
First, the ban determination process should incorporate the concept of the strength of evidence for and against eligibility. The ban should be asserted only when the evidence against eligibility is significantly stronger than evidence for eligibility. The inability to provide evidence for eligibility is not equivalent to deemed evidence against eligibility. And some types of evidence against eligibility will be stronger or weaker than other types.
Second, the process for determining eligibility for the credit should expand the types of evidence that can be submitted and considered, which in turn will affect the relative strength of evidence to be considered during the ban determination phase. The standard audit request and the IRM 4.19.14-1 list focus on third-party documents. Third-party documents are strong evidence but they’re not the only evidence; they’re just the only evidence Exam seems to accept. The IRS experimented with allowing third-party affidavits in test cases from 2010-2013. Starting with tax year 2018, taxpayers can submit third-party affidavits (signed by both the taxpayer and the third party) to verify the residency of qualifying children (IRM 18.104.22.168.3). Why not for other aspects of the eligibility determination? Why not talk directly with the taxpayer and assess credibility?
This is a pet peeve of mine. It’s frustrating to receive a notice of deficiency (because the technician did not accept other types of evidence) and then get a full concession by the government in Tax Court (because the IRS attorney understands the validity of testimony as evidence). I like getting the right result but would prefer to avoid the need to go to Tax Court, delaying the resolution. As the Special Report points out, the IRS cannot properly determine whether to assert the ban without talking to the taxpayer. If a technician/examiner is talking to the taxpayer for that, and assessing their understanding of the rules and regulations, why not also accept verbal testimony (or statements by neighbors and relatives) and evaluate credibility, to accurately evaluate the strength of the evidence for eligibility and therefore the propriety of imposing the ban?
The Special Report would, if its recommendations were implemented, transform a critically important benefit to low-income taxpayers. Nina, Les, and the rest of the team did a fantastic job. It will be a long, hard fight to achieve that transformation but it will be worth it.