We welcome back frequent guest blogger Carl Smith who writes about a case caught in the fall out of Rand in which the IRS sought to assert a penalty under 6676 after losing in Rand the effort to assert penalties on overpayments of refundable credits under 6662. We are not normally this close to the news but the Court’s order was issued yesterday. On Tuesday, the Tax Court issued another interesting order in the Rand lineage in the case of Galloway v. Commissioner. Judge Halpern suggests that the PATH legislative fix to the Rand problem may not have quite done the trick. These are interesting cases to follow while we wait for the IRS to abate the hundreds of thousands of wrongful assessments still on its books for Rand type cases assessed during 2009-2011. Keith
Readers of PT probably never heard of the 20% excessive refund claim penalty of section 6676 before the Tax Court issued its opinion in Rand v. Commissioner in November 2013. Keith’s post from January 6, 2016 contains links to five prior posts on Rand. This is still another post on the fallout from Rand.
Post-Rand, in PMTA 2014-15 (Aug. 6, 2014), the IRS held that where it determined a section 6676 penalty on the disallowance of a refundable tax credit, the section 6676 penalty should be included in the notice of deficiency disallowing the credit, since the penalty was related to the disallowed credit. The PMTA acknowledged that where the section 6676 penalty was not imposed on a tax amount subject to the deficiency procedures, the penalty should be asserted directly by assessment without a deficiency notice. Section 6671(a). But, the PMTA noted that the Tax Court often has jurisdiction over penalties that are computed based on a deficiency. In a post I did on February 19, 2015, I criticized the IRS’ reasoning that the 6676 penalty could ever be subject to the deficiency procedures and predicted that the Tax Court would reject any attempt to assert that it ever had deficiency jurisdiction over a section 6676 penalty. In a post on November 3, 2015, Professor Del Wright agreed with me that the IRS’ reasoning was the result of bad logic and noted that Saltzman and Book similarly rejects the idea that section 6676 penalties can be assessed under the deficiency procedures.
Apparently, one attorney in the IRS did not get the memo. In a motion filed on July 10, 2015, in the Tax Court in Kahanyshyn v. Commissioner, Docket No. 29697-14, the attorney argued, contrary to PMTA 2014-15, that the court lacked jurisdiction to consider a section 6676 penalty relating to a disallowed refundable First Time Homebuyer Credit (FTHBC) involved in the deficiency jurisdiction case. In an order in the case issued on September 4, 2015, Special Trial Judge Armen granted the IRS’s motion and dismissed for lack of jurisdiction the taxpayer’s attempt to litigate the section 6676 penalty. In an order issued on February 10, 2016, Judge Gustafson gave more factual background on the case and the penalty before disallowing the FTHBC and granting the IRS summary judgment, since there were no other contested issues in the case.
Although the jurisdictional ruling was only in an unpublished order, I have no reason to think that the Tax Court will ever rule any differently in any future case attempting to assert that it has jurisdiction under its deficiency procedures to consider the validity of a section 6676 penalty.
Prior to Rand, the IRS did not assert the 20% section 6676 excessive refund claim penalty when it disallowed a refundable tax credit, but rather, based on the appropriate conduct, the IRS included in the notice of deficiency disallowing the refundable credit a 20% section 6662 (accuracy-related) or 75% 6663 (fraud) penalty. The section 6676 penalty cannot be imposed when the same disallowance is subject to a penalty under section 6662 or 6663. Section 6676(d).
Rand disabused the IRS of the idea that it could collect section 6662 or section 6663 penalties on the entire amounts of refundable tax credit disallowances. Rand held that, while entire disallowed refundable tax credits can form part of the “deficiency”, as defined in section 6211, disallowed refundable tax credits can only be subject to those penalties to the extent that the credits were used to reduce the tax down to $0, but not below $0. That is because there is a provision at section 6211(b)(4) that adds the amount of disallowed refundable tax credits that exceed the tax shown on the return into the deficiency computation as a negative amount of tax. At the time Rand was decided, though, there was no provision similar to section 6211(b)(4) in the definition of “underpayment” in section 6664(a) on which the sections 6662 and 6663 penalties are imposed. But Rand also pointed out to the IRS that (except in the case of EITCs), the IRS still could get 20% section 6676 penalties on the portions of the disallowed credits that were not included in the “underpayment” calculation. So, except as to EITC disallowances, the IRS was not really any worse off as regards penalties with respect to non-fraudulent, but incorrect, claims of refundable credits.
Apparently, the IRS auditor of Mr. Kahanyshyn’s 2010 return and the auditor’s boss read Rand and took it to heart.
Mr. Kahanyshyn filed a 2010 income tax return reporting a lot of gross income, but also taking a large schedule C loss and various itemized deductions, such that he reported taxable income of $0 and income tax of $0. In the payments section of his return, he listed a withholding tax credit of $10,013, and a FTHBC of $8,000. He sought a refund of $18,013.
From the orders, I can tell that the return was filed 5 or more months late, though I do not know the exact date it was filed. On January 9, 2012, the IRS processed the return and issued a refund check in the amount only of the income tax withheld, not the FTHBC. It appears that the IRS either froze the refund of the FTHBC or, more likely, performed some math error adjustment. The orders don’t mention a notice of deficiency ever being issued seeking to adjust the $8,000 FTHBC.
On April 2014, an IRS auditor sent an IDR to the taxpayer informing him that the IRS was examining his return to determine the applicability of the section 6676 penalty. The IDR sought information regarding Mr. Kahanyshyn’s qualification for the FTHBC, including that the home he purchased was his principal residence and that he had a reasonable basis for claiming the FTHBC.
In an undated letter, Mr. Kahanyshyn responded to the IDR and provided a narrative of why he was entitled to the FTHC and a copy of the residential sale and purchase contract for the property.
On May 21, 2014, the IRS mailed Mr. Kahanyshyn a Letter 950 and an examination report showing a proposed section 6676 penalty and notified him that he could request a conference with the IRS Office of Appeals if he disagreed with the proposed changes.
On May 30, 2014, Mr. Kahanyshyn responded to the examination report and stated that he did not agree with the findings, was submitting a written protest, and requested a telephone conference.
On July 7, 2014, the IRS issued to Mr. Kahanyshyn a Notice of Penalty Charge under Section 6676, for $1,600 (i.e., 20 percent of the $8,000 claimed refund) and attached to it a Form 886-A, “Explanation of Items”. The Form 886-A explained that the facts indicated that he did not use the property and occupy it as his principal residence and that a related income tax examination showed that his adjusted gross income, as corrected by disallowances of the Schedule C loss and all itemized deductions and inclusion of unreported income, now exceeded the level at which the FTHBC could be claimed.
Apparently, at this time, the IRS assessed the section 6676 penalty and somehow permanently disallowed the FTHBC without sending a notice of deficiency. Math error authority?
This is the first case I have ever seen where the IRS actually assessed a section 6676 penalty on a disallowed refundable tax credit disallowance, following the guidance of the Tax Court on this subject in Rand. In pre-Rand cases, the IRS simply included 20% section 6662 penalties on disallowed refundable credits in the notices of deficiency disallowing such credits and did not assert section 6676 penalties. See, e.g., Rand (EITC and ACTC) and Morales v. Commissioner, T.C. Memo. 2012-341, affd. 2015 U.S. App. LEXIS 21713 (9th Cir. 2015) (FTHBC).
On October 7, 2014, the IRS issued a notice of deficiency to the taxpayer for 2009 and 2010 income taxes. With respect to 2010, the notice sought a deficiency of $39,600. That deficiency was all attributable to unreported income, the disallowed Schedule C loss, and the disallowance of itemized deductions. The deficiency amount was calculated without the $8,000 of disallowed FTHBC, since apparently the FTHBC disallowance had been previously assessed. The notice sought a fraud penalty under section 6663 equal to 75% of the proposed deficiency and a late-filing penalty under section 6651(a)(1) equal to 25% of the excess of the deficiency over the amount of taxes that had been withheld.
Tax Court Proceedings
The taxpayer attached the notice of deficiency to a timely pro se Tax Court petition. However, the only issue that the taxpayer sought to litigate was his entitlement to the FTHBC in 2010 and the section 6676 penalty imposed thereon.
In a motion filed on July 10, 2015, the IRS attorney argued, contrary to PMTA 2014-15, that the court lacked jurisdiction to consider the section 6676 penalty, though, under section 6211, the court could consider the FTHBC itself in computing the total amount of deficiency in the case. I assume that, if the court agreed with the taxpayer that he was entitled to the FTHBC, it would reduce the proposed deficiency by $8,000 – thereby undoing the FTHBC’ previous disallowance.
In an order dated September 4, 2015, Judge Armen granted the motion to dismiss the section 6676 penalty issue from the case. The Judge wrote, simply:
Section 6676, which is entitled “Erroneous Claim for Refund or Credit”, provides a penalty if a claim for refund or credit with respect to income tax is made for an excessive amount. The section 6676 penalty is an assessable penalty under subchapter B of chapter 68 that is not subject to the deficiency procedures. Sec. 6671(a); see Smith v. Commissioner, 133 T.C. 424 (2009). Therefore, we are obliged to dismiss so much of this case that purports to relate to that penalty.
In Smith v. Commissioner, the Tax Court had held that, other than in the course of a Collection Due Process case in the Tax Court, the court had no jurisdiction to consider section 6707A penalties for failing to report engaging in listed transactions.
In Judge Armen’s order, he does not even discuss the IRS’ argument in PMTA 2014-15 that the Tax Court’s deficiency jurisdiction over disallowed refundable tax credits should give the court associated deficiency jurisdiction over related section 6676 penalties.
In my view, the IRS argument in the PMTA makes no sense, since it is only section 6665 that allows certain penalties to be assessed under deficiency procedures. While section 6665 covers penalties under sections 6662, 6663, and 6651, as well as assessable penalties at section 6672 et. seq., section 6665 applies only “[e]xcept as otherwise provided in this title”. Section 6671(a) provides for the assessment of assessable penalties (including section 6676 penalties) simply on notice and demand, without any deficiency procedures. Thus, section 6671(a) obviously overrides section 6665’s allowing certain penalties to be assessed though deficiency procedures.
Since the Tax Court’s website does not allow me to review the IRS motion, I can’t even tell whether the IRS attorney in the case discussed section 6665, section 6671, or PMTA 2014-15.
In his order yesterday granting the IRS summary judgment in the case, Judge Gustafson ruled that, since the taxpayer is not contesting the income adjustments in the case that increased adjusted gross income to above the FTHBC phase-out amount, the taxpayer is not entitled to the FTHBC. Thus, the judge upheld the notice of deficiency in full.
As you know from Keith’s post of January 6, 2016, section 209 of the PATH Act recently repealed Rand by amending section 6664(a)’s definition of “underpayment” to include rules similar to the refundable credit rules for computing a deficiency at section 6211(b)(4). That repeal is retroactive to cases open in the Tax Court on the date of the PATH Act’s enactment on December 18, 2015 – which would include the Kahanyshyn case. As Keith pointed out, Chief Counsel has instructed IRS attorneys to apply the amendment retroactively in pending cases. In the Kahanyshyn case, after December 18, 2015, the IRS attorney could have sought to amend the answer to include a section 6663 fraud penalty on the disallowed FTHBC, and the Court would have had to rule that (as always) it had jurisdiction over fraud penalties and that fraud penalties now extend to disallowed refundable tax credits that (as in this case) were not used to reduce tax down to $0. In that instance, the taxpayer could have raised the previously-assessed section 6676 penalty as mitigating the amount of the fraud penalty – by equitable recoupment of any amount he had previously paid toward the section 6676 penalty. The section 6676 penalty literally now should not also apply to the taxpayer, since the IRS could assert a section 6662 or 6663 penalty on the same disallowance. However, the IRS attorney did not at this late date assert the fraud penalty – perhaps not wanting to shoulder the burden of proving fraud with respect to the FTHBC penalty at the forthcoming trial. (The case was still pre-trial, so there was not much reason to think the court wouldn’t allow belatedly raising the fraud penalty and simply converting the motion to one for only partial summary judgment.)
We are also now never likely to see the IRS include section 6676 penalties in notices of deficiency. Now that Rand has been overruled, the IRS will instead assert either the section 6662 or 6663 penalty in notices of deficiency disallowing refundable tax credits. The IRS will now never have to propose section 6676 penalties in that instance at all. So, I don’t expect this jurisdictional issue regarding section 6676 penalties ever again to be litigated in Tax Court deficiency cases. Indeed, I think section 6676 is now a dead letter in the Code, since it only applies to erroneous claims for income tax refunds that are not subject to section 6662 or 6663 penalties, and I can’t think of any instances where an income tax disallowance couldn’t now be subject to section 6662 or 6663 penalties.