When the IRS examines a tax return and proposes adjustments, it will send a Notice of Deficiency to the taxpayer setting forth the adjustments. A taxpayer who disagrees with the Notice of Deficiency may file a petition with the U.S. Tax Court disputing the IRS proposed adjustments without first paying the resulting tax, penalties and interest. Although this seems like a simple and economical means for disputing IRS examination adjustments, as former football coach and current ESPN commentator Lee Corso says, “Not so fast my friend!!”
In Wegbreit v. Commissioner, T.C. Memo. 2019-82, here, the taxpayers sold an interest in a business then took numerous steps to hide the income from the sale including filing tax returns that substantially underreported their income. According to the court, during the IRS examination of the tax returns, the taxpayers provided evasive and misleading responses, conspired to produce fake and backdated documents and failed to cooperate with the IRS examiner, all of which could be used to support a 75% civil fraud penalty. However, the IRS sent a Notice of Deficiency to the taxpayers which increased the taxable income but included only a 20% negligence penalty. The taxpayers timely filed a petition with the U.S. Tax Court and after conducting some discovery, the IRS amended its answer to include a 75% civil fraud penalty. The taxpayers objected to the IRS amended answer, but the Tax Court allowed the IRS to amend its answer and ultimately held that a 75% fraud penalty was applicable.
The lesson to learn from this case and others like it is, that an IRS Notice of Deficiency does not foreclose the IRS from raising new issues in a Tax Court case. Filing a petition in the Tax Court allows the IRS an opportunity to propose new substantive issues involving tax or penalties. If the IRS does so, it will bear the burden of proof on those issues. (See the previous blogs on burden of proof in tax cases, here and here). However, most issues in Tax Court do not turn on which party has the burden of proof. Furthermore, the IRS has the burden of proving civil fraud whether it is initially proposed in the Notice of Deficiency or raised in a subsequent answer. By failing to recognize this potential issue, the taxpayers in Wegbreit more than tripled the penalty they owed the IRS.
As an alternative to a Tax Court petition, a taxpayer can file a refund suit against the IRS in U.S. District Court or the Court of Federal Claims. Before a taxpayer can file a refund suit, he must pay all tax, penalties and interest and file a claim for refund. If the IRS denies the claim for refund the taxpayer can then file a refund action in District Court or the Court of Federal Claims. However, unless the statute of limitations has passed, the government can reopen the original return to create a counterclaim for additional offsetting adjustments, and also to counterclaim for additional taxes. If the statute of limitations is closed, the government can only reopen the original return to create a counterclaim for additional offsetting adjustments. Therefore, monitoring the statute of limitations for filing a claim for refund in that situation is extremely important.
An example will be helpful:
Assume that a taxpayer timely files his Form 1040 on April 15, 2016. The IRS examines the taxpayer’s tax return and proposes adjustments to the return, some of which the taxpayer does not agree, but the IRS fails to discover a very a significant issue on the return. The IRS issues a Notice of Deficiency, the taxpayer does not file a Tax Court petition because the IRS missed a significant issue. The IRS assesses the additional tax, penalty and interest on May 15, 2018 which the taxpayer pays June 15, 2018. The three year statute of limitations on assessment will run on April 15, 2019. The refund statute of limitations, which is two years from the date of payment will run on June 15, 2020. As such, there is a clear 14 month period in which a refund claim is timely, but during which it is impossible for the IRS to assert an additional deficiency. If the IRS denies the refund claim the taxpayer can file a refund action in court and the government would be allowed to reopen the original return to create a counterclaim for additional offsetting taxes, but would not be allowed to bring suit for a net deficiency--in other words the taxpayer can pursue its refund with no fear of a net amount due.
The final lesson to be learned from Wegbreit is “Pigs get fat, hogs get slaughtered”. Based on the facts, the taxpayers were lucky the Notice of Deficiency did not include a 75% civil fraud penalty. They should have taken that as a win and gone home.
For any questions on this or any other tax-related matters, please feel free to contact Joel Crouch at (214) 749-2456 or firstname.lastname@example.org.