Today we welcome back Larry Gibbs as guest blogger. A member of Miller & Chevalier and former Commissioner and Acting Chief Counsel, he is one of the nation’s most respected tax practitioners. Earlier this month, Larry received the ABA Tax Section Distinguished Service Award, the Section’s highest award for service to the tax profession. (For a nice summary of his many accomplishments, see Charles Egerton’s article on Larry in the ABA Tax Newsquarterly)
In this post, based on a speech given this week in Wilmington, Larry situates Loving within broader legal and policy issues. He writes from the perspective of someone who has seen our individual income tax system become one in which the filing of individual income tax returns has become largely a mechanism for delivering refunds, increasing the temptation for refund theft and fraud. In addition, he observes how the isolation of tax administration from broader administrative law principles has ended. In this insightful post, Larry discusses Loving in light of these developments, including how the government’s loss will likely have unforeseen consequences. Les
The Internal Revenue Service has been regulating tax return preparation by CPAs, attorneys, and enrolled agents for over 60 years. When I began practicing over 50 years ago, the majority of individual taxpayers prepared their own income tax returns. With few exceptions, CPAs, attorneys, and enrolled agents prepared the rest of the individual income tax returns at that time.
Today the world of tax return preparation is quite different. Paid preparers now prepare the majority of individual returns. Paid preparers fall into two categories, the regulated preparers (who generally are CPAs, enrolled agents, and attorneys) and the commercial preparers who are totally unregulated unless they live in states that provide some regulation. Today unregulated preparers prepare significantly more individual income tax returns than regulated preparers.
A major reason for these changes over the last 50 years has been the change in the role of our Federal tax system. When I began to practice in 1963, the primary role of our tax system was to raise revenue to pay the costs of operating our Federal government. In the 1970s a refundable tax credit called the earned income tax credit was introduced to require the IRS to administer a welfare assistance program previously administered by Health and Human Services. Instead of having the IRS collect taxes and turn a portion of the taxes collected over to HHS to pay welfare assistance benefits, the IRS paid the welfare benefits directly by means of a “refundable credit,” which means the amount of the credit was payable to the taxpayer even if the taxpayer had no tax liability against which to offset the credit.
Over the last 30 years, more and more government assistance or spending programs have been run through our Federal tax system, most recently by the Affordable Care Act, or “Obamacare.” These spending programs usually rely on tax credits – often refundable tax credits – to provide assistance to the beneficiaries of these programs. Many of the beneficiaries of these spending programs are low-income taxpayers who use unregulated commercial preparers to prepare their income tax returns to obtain the benefits of the government assistance programs now being run through the tax system.
A large majority of the low-income taxpayer returns and even many of the returns of more affluent taxpayers are refund returns. Recent IRS statistics indicate that about 75 to 80% of the individual taxpayers file refund returns each year. At the time the IRS pays these refunds, the IRS does not have the capability to determine if the taxpayer to whom the refund is paid is the correct taxpayer, nor if the amount of the refund being paid is the correct amount. Let me explain what I mean. The income information in individual tax returns is not verified by the IRS until the IRS matches W-2 Forms for wage income and 1099 Forms for other income against the individual tax returns that have been filed, and that matching process does not occur until well after the end of the filing season in which the individual tax returns are filed. Therefore, when the IRS pays refunds to taxpayers during and after the filing season, the IRS does not have any way to determine if it is paying the refunds to the right taxpayers, or if the amount of each refund is correct.
Realize, too, that refunds are a reflection of our pay-as-you-go tax system under which our Federal and state governments finance themselves through withholding and estimated tax payments that can be viewed as interest-free loans by taxpayers to their government, particularly if taxpayers overpay their tax liability, which — as I just mentioned — 75 to 80% of the individual taxpayers do. The historical bargain agreed to by the government in exchange for these interest-free loans has been that each taxpayer can obtain repayment of their loans quickly after the close of the year in which these loans are made by simply filing his or her return and requesting a refund for the amount of any overpaid taxes. Realize, too, that today the average size of each individual tax refund is almost $3,000. Now, let’s put all of these pieces together. Today the IRS does not know whether it is paying the right persons in the right amounts when it annually pays out almost 110 million refunds averaging almost $3,000 per refund, and the IRS pays each refund as quickly as possible after each taxpayer files his or her tax return claiming the refund.
Any criminologist will tell you that the foregoing scenario provides an unusually attractive incentive for crooks. The payment of large sums of money quickly and without verification that the payment amounts and payees are correct is an open invitation to theft. And because the Federal government increases the number of refund programs almost every year with new and different types of Federal assistance programs being run through the tax system, the crooks can pick and choose which program to defraud. Ladies and gentlemen, it is for these reasons that identity theft and refund fraud have become the largest and fastest growing problems at the IRS today. Crooks throughout our country are literally leaving the drug trade to steal taxpayer identities and file fraudulent refund returns because there is more money, less chance of being caught, and more lenient penalties even they are caught in filing fraudulent refund tax returns than there is in dealing drugs. And if that is not bad enough, crooks from outside our country are doing the same thing. No one really knows how big the fraudulent refund problem is or may become.
To address this mounting refund fraud problem, three years ago, in the summer of 2011, the IRS issued regulations under Circular 230 in order to regulate the previously unregulated commercial tax return preparation industry. Now, let me be absolutely clear here. There are many commercial tax return preparers who are law-abiding, competent tax professionals. Unfortunately, as numerous studies and an increasing number of court decisions indicate, there also are many commercial tax return preparers who are neither competent nor law-abiding. To address this situation, the IRS in 2011 published regulations that imposed four new requirements on each previously unlicensed commercial tax return preparer in order for each commercial preparer to be able to continue to prepare tax returns as a “registered tax return preparer.” To satisfy these four requirements, each commercial preparer was required to: (1) register with the IRS, (2) obtain from the IRS and use a preparer tax information number, or “PTIN,” (3) pass an initial test to verify the preparer’s knowledge of the relevant tax law, and (4) renew the registration each year by satisfying a 15-hour continuing educational requirement to keep up with changes in the tax law. Fees were charged by the IRS in connection with each of the four requirements.
Two years ago, three commercial preparers filed a lawsuit under the Administrative Procedure Act to enjoin the IRS from enforcing these regulations. A little over a year ago, the Federal District Court for the District of Columbia in a decision entitled Loving v. IRS enjoined the IRS from enforcing the 2011 Circular 230 regulations, except for the provision requiring each preparer to obtain a PTIN, which remains in force.
The District Court in the Loving case based its decision primarily on its analysis of the language of an 1884 statute that enables the IRS to regulate the conduct of tax practitioners under Circular 230. The 1884 statute was re-codified in 1982, but the legislative history of the re-codification statute makes it clear that there was no intention in 1982 to change the scope or the effect of the 1884 statute. After reviewing the provisions of the 1884 statute and the language of the 1982 statute, the District Court held that the Congress clearly intended to draw a bright line between the authority of the IRS to regulate, on the one hand, the conduct of tax practitioners who advise and assist taxpayers in preparing their tax returns to be filed with the IRS and, on the other hand, the conduct of tax practitioners who advise and assist taxpayers in dealing with return-related issues after the returns are filed. The court held that, although the IRS has the authority to regulate the conduct of tax practitioners who defend positions taken in tax returns after the returns are filed, the IRS has no authority to regulate the conduct of commercial tax return preparers who prepare the returns taking such positions before the returns are filed.
In so holding, the District Court relied upon provisions of the Administrative Procedure Act to declare unlawful and enjoin the enforcement of the 2011 regulations. To be specific, the District Court found that tax return preparers are not taxpayer “representatives” who “practice before the IRS” within the meaning of the 1884 and the 1982 statutes. In other words, the court found that the 1884 statute and its 1982 re-codification were clear on their face and held, therefore, that the 2011 regulations flunked the first step of the Chevron test to determine the validity of disputed regulations because the 2011 regulations were inconsistent with the 1884 and 1982 statutes.
Three months ago, the Circuit Court of Appeals for the District of Columbia affirmed the District Court decision and generally accepted and followed the District Court’s reasoning. Two weeks ago the Department of Justice announced it would not seek certiorari or otherwise pursue the Loving case. As a result, the 2011 Circular 230 regulations are no longer enforceable, except for the PTIN provisions, and that means the IRS cannot effectively regulate the tax return preparation conduct of commercial tax return preparers.
Last month the Senate Finance Committee held a hearing to discuss possible legislation to enable the IRS to regulate commercial preparers. (For my post on the hearing and assorted links, see here –Les) Although several bills have been introduced, it is unclear if such legislation can be passed by itself or as part of a broader tax reform effort. The reason for this uncertainty is that there has been a libertarian reaction — particularly in the Republican controlled House — against regulating small tax return preparation businesses.
Meanwhile, the Department of Justice continues to prosecute and enjoin fraudulent commercial tax return preparers on a case-by-case basis. Some states are beginning to either take a harder look at initially regulating commercial return preparers or enhancing laws already on their books to do so. But state regulation for the most part has been spotty, lacks uniformity, and often has been ineffective to prevent incompetent or fraudulent practices by some commercial tax return preparers. As a result, consumer protection advocates continue to push for legislation at the Federal and state levels because of the continuing amounts of incompetence and fraud involved in commercial tax return preparation.
The IRS presently is looking at a possible program to enable reputable commercial preparers to voluntarily continue the IRS program envisioned by the 2011 regulations, but because the program would be voluntary, it is unlikely to deter either the less competent or the more aggressive commercial tax return preparers. More significantly, the IRS recently announced that it is considering two other important steps. First, the IRS said it plans to review the possibility of requiring filers of W-2 forms to provide their W-2 information to the IRS more quickly after year-end, perhaps by the end of January. Second, the IRS said it plans to review the possibility of delaying the payment of refunds. The net effect of these two actions, if ultimately taken by the IRS, would be to enable the IRS to better determine the accuracy of the identities of those to whom the IRS is paying refunds and the accuracy of the amounts being refunded in order to enable the IRS to reduce the present level of refund fraud.
At this point, however, it is unclear whether the IRS can obtain enough information soon enough from an accelerated W-2 information program and delay the payment of refunds long enough for the combination of these two potential changes to make a significant dent in the identity theft and refund fraud that presently is taking place. In this regard, the tax filing season often is surprisingly sensitive to certain kinds of changes. Past studies of proposed changes to the April 15 filing season deadline and IRS filing season schedules and programs have concluded that some of the previously proposed changes would have such undesirable fiscal impacts that the changes were considered untenable. Time will tell if the two new studies will be able to avoid these prior problems and at the same time be helpful in reducing the present level of refund fraud.
The potential ramifications of the Loving decision are far reaching. As a result of Loving, tax practitioners are beginning to contest the authority of the IRS — or more specifically, the authority of the Office of Professional Responsibility within the IRS — to regulate the behavior of tax practitioners in a variety of ways. Previously, if a CPA, enrolled agent, or attorney was found to have violated the provisions of Circular 230, the IRS often sanctioned the offender by precluding him or her from preparing any tax returns during any period of suspension from practicing before the IRS. Today I am told some practitioners are relying on the rationale of the Loving decision to question the authority of the IRS to enforce such a sanction. In other words, in some future cases, the Office of Professional Responsibility may be able to suspend an attorney, CPA, and enrolled agent from practicing because of incompetence or even fraud in previously preparing clients’ tax returns. However, in light of the Loving rationale, OPR may be unable to prevent the offender from continuing to prepare returns by working for another licensed preparer during the period of suspension, a result that seems counter-intuitive on its face.
With the increasing trend toward specialization, some CPAs, attorneys, and enrolled agents apparently are abandoning the traditional forms of licensed tax practice to form companies that provide more specialized tax advisory and related services, such as valuation studies, research and development tax credit assistance, inventory and tax accounting methods advice, transfer pricing studies, depreciation and amortization studies, and other specialty tax-related services to clients prior to the time the clients file their tax returns. Some of these new businesses are taking the position, based on the rationale of the Loving decision, that the IRS has no authority to regulate them or their services under Circular 230 since they perform their services prior to the time any tax return is prepared and filed and they do not represent taxpayers before IRS
Even more broadly, as a result of the Loving decision’s reliance on the Administrative Procedure Act, tax practitioners are beginning to explore the potential use of the provisions of the APA to contest the authority of the IRS to take certain actions. In the past, the IRS and many tax practitioners devoted little time and attention to the potential application of the APA to tax cases, but that is changing. The 2011 Supreme Court decision in the Mayo case makes it clear that the APA applies to IRS actions. In response, taxpayers and their advisors are using the APA to attack the validity of regulations and other forms of IRS guidance. In addition, a tax article published last fall suggests that taxpayers and their advisors should consider bypassing Appeals to file a Tax Court petition in order to use the APA to contest the sufficiency of any unclear or otherwise abbreviated IRS deficiency notice issued after an IRS audit. If successful, this approach would rely on a procedural due process notice requirement of the APA, as developed by the APA caselaw, to overturn IRS examination determinations by requesting that the Tax Court dismiss, with prejudice, any IRS statutory notice that failed to give a taxpayer adequate notice of the grounds upon which the IRS was relying in issuing its final notice of tax deficiency to the taxpayer. No one is suggesting the APA is, or should be, a panacea to resolve all tax issues, but the APA rules are sometimes different from some of the traditional tax rules. The application of the APA to tax cases is a developing area, and some are suggesting that tax practitioners should consider its potential benefit for their clients’ cases.
Let me conclude with the following thoughts. Tax return preparation is an increasingly important part of our tax system. In the first half of my career, tax return preparation was relatively straightforward because it was performed for the most part by licensed professionals whose behavior was regulated by the IRS under Circular 230. The more recent trend of the last 25 years toward using refundable tax credits to administer increasing numbers of government assistance programs through the tax law has relied on tax return preparation to enable taxpayers to file refund returns to receive the program benefits. The existing refund policies of the IRS require payment of the refunds before the identity of the payee and the correct amount of the refund can be verified, a situation that has proven irresistible to the fraudsters.
The IRS effort to regulate the tax return preparation behavior of commercial preparers in order to address the increasing incidents of incompetence and fraud in tax return preparation has been overturned by the Loving decision. As I have described, the rationale of the Loving decision has far reaching implications for tax practitioners and the IRS. Some of the changes now being considered by the IRS to accelerate the filing of W-2 Forms and to delay the payment of refunds, in order to reduce the levels of refund fraud, are much more fundamental changes with perhaps even greater ramifications. These changes are still developing and I suggest that all of us, as tax practitioners, should monitor these ongoing changes closely in the future.