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Recent Tax Court Case Shows the Need for Senator Warren’s Plan to Overhaul Tax Return Filing

Posted on Apr. 18, 2016

An earlier version of this post appeared on the Forbes PT site on April 15, 2016

Today is the last day for timely filing a tax return without an extension. I (or more precisely my wife Valinda) banged out the return the other day. But before doing it, we scrambled looking for a 1099. Most of our third party information returns come to us at home. This one came to me at the office, and I thought I brought it home and put it in the beat up letter-size folder that says Taxes 2013, 2014 2015. But I did not. So, we searched and eventually found it and off went the return this weekend.

The income tax is complex enough even when you figure out the law and know what facts are relevant. It seems that our system should painlessly allow taxpayers and preparers to access third party tax information in time to ensure that the return at least reflects the information that is reported to the IRS in a before the fact way. Right now, if you leave off something that is reported to the IRS you are likely to get dinged with an AUR type letter, a process that can take months to resolve.

Last week, Senator Warren introduced the the Tax Filing Simplification Act of 2016, legislation that would overhaul the tax return filing process for millions of Americans and require the IRS to do much more in terms of making “third-party provided return information” available to taxpayers in time for filing accurate returns. A link to Senator Warren’s press release from the other day has all sorts of goodies, including the bill’s text, a letter in support from an all star cast of academics (including the brilliant Stanford Law Prof Joe Bankman) and a scathing report critical of the return prep industry.

While there is likely to be a healthy debate on the merits of the legislation calling for the IRS to develop online return prep software that all Americans can access, one part of the legislation seems to me to be a no-brainer is requiring IRS to make third party return information available to taxpayers and preparers. As Americans are scrambling to meet this year’s filing deadline, one painful aspect of prep time is struggling to find or remember the myriad information returns issued by payors and financial institutions. As more Americans work for multiple employers and as so many working Americans change residences it can be a struggle to make sure you have all of what you need when it comes time to file.

What happens if you accidentally fail to include the amounts reflected on information returns? Of course you will have to pay tax and interest, but it is more likely than not you will also get stuck with a 20% civil penalty even if you use a preparer. I have written before about how difficult it is to avoid a 20% civil penalty when you omit income from a W-2 or 1099; see Omitted Income, Accuracy Related Penalties and Reasonable Cause discussing how a couple was able to avoid the penalties even though leaving off $28,000 or so of W-2 wages on a joint return when they thought they gave all information returns to the long-time preparer. That was an unusual case with a longtime preparer and sympathetic facts which suggested that it was reasonable for the taxpayers (and their preparer perhaps) to think that the information was complete even though it was not.

Much more common is last week’s Gilbert v Commissioner, where a taxpayer omitted almost 40% of his wages from one of three entities that issued him W-2’s. Here are the facts as summarized in the summary opinion:

During 2010 petitioner was employed by the City of Chicago Fire Department as a paramedic. Petitioner had also just completed his master’s degree in nursing education and was beginning his teaching career as an adjunct professor at Loyola University in the nursing department. When petitioner was first hired by Loyola University there was some confusion as to where he would be teaching. Within the first month of his employment he was transferred to the Edward Hines, Jr. VA Hospital (Hines VA) to assemble a simulation lab in the nursing department. Although petitioner thought he would be receiving payment for his services directly from Hines VA, Loyola University made initial payments to him. At some point during 2010, however, the Defense Finance and Accounting Service (DFAS) replaced Loyola University as payor for the services petitioner had provided to Hines VA.

Chicago, Loyola, and DFAS all issued Gilbert W-2s reporting wages of $86,298, $6,700, and $59,274. Gilbert, however, testified that he did not receive the W-2 from DFAS and when he went to H&R Block get his return completed Block only included the income from Chicago and Loyola. The return as submitted generated an over $9,000 refund. The opinion notes that he “admitted that he was ‘a bit surprised’ to see the refund, but he did not take any additional steps to ensure the accuracy of the return before signing it.”

What was not surprising is that the Tax Court held that Gilbert was subject to the 20% penalty for a substantial understatement of income tax. Gilbert argued that he should have been excused because it was a simple mistake, one that did not justify a penalty on top of interest. The Tax Court felt otherwise, noting a long line of cases that hold that a nonreceipt of a W-2 is no excuse:

While the Court is persuaded that petitioner’s omission of income was a genuine mistake, he did not act with reasonable cause and in good faith because he never took steps to verify whether the income reported on his Form 1040 and Forms W-2 represented the full amount of income he had actually received in 2010. Even though petitioner did not receive a Form W-2 from DFAS and was under the impression that all of the wages he had received for his teaching services would be reported on the same Form W-2 from Loyola University, he failed to report $59,274 of wage income, representing approximately 40% of his total income; petitioner should have known that at least some of that income was omitted from his income tax return, especially after being surprised to learn that he would be receiving a $9,259 refund.

According to the Court he should have known that he earned more than the roughly $6,000 from teaching on one of the W-2s.

What about the taxpayer using Block to prepare the return? Did that help establish good faith and reasonable cause? No, “because he did not provide the representative with all of the information that was necessary to prepare an accurate income tax return, namely a Form W-2 from DFAS.”

Parting Thoughts

On one hand I have little sympathy for Gilbert and agree with the Tax Court’s decision and analysis. On the other hand it seems odd that Americans and preparers cannot painlessly access all third party information that would allow them to determine if they are including on the tax return itself all information that is provided by third parties. Recent changes that have accelerated the filing date for information returns will help but  Senator Warren’s proposed legislation would bring that reality sooner and substantially reduce compliance costs. As to the overall legislation, if enacted it would disrupt the multi billion dollar return prep and DIY software industries.

At an American Tax Policy Institute/National Tax Association conference in Washington DC next month, I will be moderating a panel on the role of the private sector in tax administration that will include Dave Williams, Chief Tax Officer at Intuit, Bob Weinberger, former executive at Block and now at Aspen Institute, and Kathleen DeLaney Thomas, a law professor at University of North Carolina who has written about technology and tax compliance. It should be a good opportunity to explore those issues, and more. A link to the registration for that is here.

There are multiple interests at play in legislation of this magnitude. It is time to look critically at the process, and a taxpayer-centric perspective is important to guide Congress as to what the future tax days will look like.

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