Late last month in Baker v Commissioner, the Tax Court decided a case with facts that are familiar to clinic and legal services attorneys who work tax cases. Frank Baker had two relatively low paying jobs that paid a total of about $17,000, and lived with his fiancée and her two biological children. The fiancée had no earned income, and Frank supported the household. He went to a paid preparer for assistance in preparing his tax year 2011 federal income tax return. The preparer advised him to claim his fiance’s kids as dependents and qualifying children for the earned income tax credit. On examination, IRS disallowed the earned income credit because the kids were not related to Frank, and thus not his qualifying children. For good measure, the IRS also imposed the accuracy related penalty and, to top it all off, proposed the two year ban on the credit under IRC 32(k). Thus the net result of this taxpayer’s challenge to meet the basic living needs of his family was an improperly prepared return for which he paid both a filing fee and the lost refund, a proposed penalty, and a ban on claiming the credit in the next two years. I digress for a moment to observe that the EITC ban would further complicate this family’s tax life: if Frank and his fiancée marry and she becomes employed, would she be subject to the ban on the couple’s MFJ return? And if she didn’t work within the two-year ban period, would Frank be disallowed from claiming the children he clearly would otherwise be able to claim as his qualifying children because he is their stepfather?
The IRS has to play the cards Congress deals. As the Internal Revenue Code is one of the main delivery vehicles for benefits, the IRS is now in the ironic position of becoming a lifeline for many working families who depend on the earned income tax credit. For some families, this credit represents one-half to one-third of their annual income. Congress likes refundable credits rather than direct spending programs for many reasons. One is the relatively low direct administrative costs associated with IRS administered programs. Self-declaring eligibility rather than meeting a caseworker keeps direct administrative costs way down, and lessens the stigma of getting aid. I wonder, however, if the total cost of the earned income credit – preparer, audit, tax court, and collection – may end up equaling the costs of the food stamp program where agency employees meet with individuals to review their documents and determine eligibility. The credit has spawned a thriving ancillary multi-billion dollar industry, that of commercial tax return preparation and software development. In so doing, has Congress shifted the responsibility of government to the private sector?
The downside of this post-review tax audit process has been the relatively high error rates compared with other programs administered outside the IRS. Significantly the dollars associated with errors from small business taxpayer underreporting dwarf the costs from refundable credit errors, yet we do not see the same level of scrutiny and animus directed at this segment of taxpayers.
The role paid preparers play in the tax administration process is drawing the attention of the Tax Court, which has started looking at the relationship between preparers and taxpayers. Last year, in a post called Life on the Edge: The Earned Income Credit, Civil Penalties and the Role of Return Preparers, guest blogger Susan Morgenstern and I wrote about Edge v Commissioner and how the Tax Court declined to impose an accuracy-related penalty when the taxpayer used a paid preparer and improperly wound up claiming his fiancé’s kids:
IRS properly disallowed the EIC as a result of the child’s lack of relationship with Edge. The Tax Court upheld that part of IRS’s decision. Significantly, the Court addressed whether Mr. Edge should be subject to a 20 per cent accuracy-related penalty on top of the disallowed EIC. The issue of whether penalties should apply when a taxpayer makes a mistake on his tax return after receiving erroneous advice from a tax advisor is one that comes up with frequency in tax cases, though has not been an issue in many reported EIC cases.
Citing to the regs under Section 6664, and some recent cases addressing how the Tax Court considers whether reliance on a tax professional is reasonable cause for the error, Edge lays out the standard, and concludes that the penalties are not appropriate:
The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account the pertinent facts and circumstances, including the taxpayer’s reliance on professional advice.
It is clear from the record that petitioner, a cook, is not a tax expert or experienced in tax matters. Moreover, we find that petitioner relied reasonably and in good faith on his commercial preparer, with whom he had an established relationship of several years’ standing without incident and with whom he met to fully disclose the information necessary to determine his proper tax liability for 2011.(citations omitted)
That theme is continuing in Baker, where Judge Guy linked the role of the preparer to the improperly prepared return, and the consequence to that taxpayer of an improperly prepared return. Judge Guy in Baker concluded that the 2-year ban was not justified, as “he [the taxpayer] testified credibly that he relied upon and followed the advice of his paid tax return preparer. On this record, we conclude that petitioner did not act recklessly or with intentional disregard of rules and regulations.” For similar reasons, a good faith reasonable cause defense based on reliance on his preparer, the Court declined to impose accuracy-related penalties:
It is clear from the record that petitioner is not a tax expert or experienced in tax matters. We are satisfied that petitioner met with his return preparer and fully disclosed the facts necessary to compute his correct tax liability. After considering the totality of the facts and circumstances, we conclude that petitioner acted in good faith and comes within the reasonable cause exception of section 6664(c)(1).
This decision draws attention to the IRS’s utter failure to establish a process for determining whether the taxpayer acted with “reckless or intentional disregard for the rules and regulations,” or even a notion of what that might mean. Unanswered in this case, too, is the question of what constitutes a “final determination” and when is the proper time for when a taxpayer can challenge the imposition of the ban. I do not believe the Tax Court has adequately explained how it can have jurisdiction over the merits of the ban relating to future years when there is no proposed deficiency for those future years. The Tax Court has previously side-stepped this issue, as I discussed in my prior post on 32(k). And it is likely that the 32(k) issues will continue to vex the Court until the IRS establishes the process, separate from the exam process, by which it makes the state of mind determination so central to 32(k)’s required findings.
The introduction of a voluntary certification regime creates some interesting implications for taxpayers using commercial preparers. Will the absence of certification be held against a taxpayer seeking to avoid penalties and the EITC ban? Or will the presence of certain types of preparers suggest a presumption against the imposition of that punitive scheme? With the Rand decision upending accuracy-related penalties added to the mix, we have a very uncertain area of the law, and one that is ripe for legislative and administrative attention.