Following up on my summary of Congressman Dave Camp's discussion draft of the Tax Reform Act of 2014, I had the opportunity to discuss the subject with Colin O'Keefe of LXBN. In the brief interview, I describe some of the proposed tax provisions that will impact individual taxpayers and corporate taxpayers.
On March 3, 2014, the Internal Revenue Service published Announcement 2014-13 (“Announcement”). The Announcement sets forth the disciplinary actions the Office of Professional Responsibility (“OPR”) recently took against practitioners.
The OPR is responsible for interpreting and applying the Treasury Regulations governing practice before the Internal Revenue Service (commonly known as “Circular 230”). It has exclusive responsibility for overseeing practitioner conduct and implementing discipline. For this purpose, practitioners include attorneys, certified public accountants, enrolled agents, enrolled actuaries, appraisers, and all other persons representing taxpayers before the Internal Revenue Service.
In essence, Circular 230 sets forth the “rules of the road” for tax practice before the Service. Circular 230 cases generally revolve around a practitioner’s fitness to practice.
The OPR is comprised of three major divisions:
- Office of the Director;
- Legal Analysis Branch; and
- Operations and Management Branch.
The Director, currently Karen Hawkins, has primary supervisory responsibility for OPR. She reports to the Commissioner and Deputy Commissioner of the Internal Revenue Service. Ms. Hawkins’ authority includes oversight and control of OPR policy decisions.
The Legal Analysis Branch is tasked with the interpretation and application of Circular 230 in the cases involving practitioners. Jack Manhire is currently the Chief of the Legal Analysis Branch.
The Chief of the Operations and Management Branch is currently Robert Johnson. This group manages OPR’s administration, communications, budgetary and personnel functions.
OPR’s authority and case determinations are independent of the Internal Revenue Service enforcement functions. Referrals to OPR, alleging practitioner violations of Circular 230, typically come from two sources:
- Internal sources (e.g., Internal Revenue Service Examination Division); and
- External sources (e.g., taxpayers, boards of accountancy, practitioners, etc.).
Following receipt of a referral, the OPR is tasked with determining, based upon the facts and circumstances, whether a violation of Circular 230 occurred, whether the violation is one which calls into question the practitioner’s fitness to practice, and the appropriate sanction, if any. The life of a referral generally takes the following path:
- The OPR performs a preliminary investigation of the facts and circumstances to determine whether it is likely a violation of Circular 230 occurred.
- If the OPR determines that a violation of Circular 230 likely occurred, it notifies the practitioner and gives the practitioner an opportunity to present evidence to support his or her case.
- After taking into consideration its investigatory findings and information presented by the practitioner, the OPR determines the level of discipline, if any, to apply to the case.
- If the OPR and the practitioner do not agree to an appropriate sanction, OPR prepares a complaint and refers the matter to the General Legal Services Division of the Office of Chief Counsel.
- The Office of Chief Counsel will generally attempt to work with the practitioner, giving him or her another opportunity to resolve the matter. If a resolution is not reached, however, the Office of Chief Counsel files the complaint so that the matter is presented to an administrative law judge (“ALJ”) in accordance with the Administrative Procedures Act.
- The parties can always settle the case during the pendency of the ALJ proceeding.
- If the case is not resolved, a hearing before the ALJ will occur. The ALJ, after hearing the case, issues a decision commonly referred to as the “Initial Decision and Order.”
- Either the OPR or the practitioner may appeal the ALJ decision to the Treasury Appellate Authority. In such event, the Treasury Appellate Authority reviews the case and issues what is commonly referred to as the “Final Agency Decision.” The text of the Final Agency Decision is made available to the public.
- The practitioner may appeal a Final Agency Decision to the U.S. District Court. The proceeding is not, however, a trial de novo. Consequently, the court will only review the findings of fact on the record in the ALJ proceeding and will only set aside the decision if it was arbitrary or capricious, contrary to law, or an abuse of discretion.
- The burden of proof in these cases is on the OPR. It must show the practitioner willfully violated Circular 230 by “clear and convincing evidence.”
- The sanctions against a practitioner in these cases generally include: disbarment or suspension of practice before the Internal Revenue Service; censure (public reprimand); and/or imposition of monetary penalties.
The types of matters referred to the OPR include, without limitation, practitioners involved in promoting abusive tax shelters, preparing and filing frivolous tax returns, willfully attempting to evade any federal tax, diverting taxpayer refunds, repeated patterns of misconduct, and willful violations of Circular 230.
As reflected in the Announcement, during the last half of 2013, three enrolled agents, seven CPAs, three unenrolled preparers, and three attorneys were subjected to OPR discipline. This included 11 suspensions and 5 disbarments.
The Announcement illustrates the high stakes. Practitioners must pay careful attention to Circular 230 and their obligations thereunder.
According to an article published by Kristi Eaton of the Associated Press (“AP”) on February 20, 2014, NBA star Kevin Durant filed a lawsuit against his former accountant, Joel Lynn Elliott, CPA, for alleged mistakes made in the preparation of income tax returns. As a result of the mistakes, Durant alleges he will have to amend certain income tax returns, pay additional taxes, and possibly be subjected to penalties.
The lawsuit, filed in California, where CPA Elliott practices accounting, alleges that the accountant made numerous errors in the preparation of Kevin Durant’s income tax returns, including deducting as business expenses the costs of personal travel and the costs of a personal chef. According to the AP, the complaint provides with respect to the travel expenses: “In preparing a client’s tax returns, a reasonable prudent accountant would have conducted a basic inquiry and sought documentation to confirm that each travel expense for which a deduction was recorded was truly business related.”
As a general proposition, if a tax return preparer gives a client incorrect advice about the deductibility of certain expenses or mistakenly includes non-deductible expenses on the client’s tax return, what are the client’s damages? The taxes, the interest on the underpayment of taxes, the penalties and/or the cost to amend the tax return? If the client ends up engaging a new preparer to amend his or her tax return, and pays the tax, interest on the underpayment of taxes and penalties, it seems logical the preparer could be liable for the cost of amending the returns and the penalties. The client owes the tax; nothing the preparer did likely changes that conclusion. Unless the client would have refrained from incurring the non-deductible expenses in the first place had he or she been given a correct recitation of the tax laws, how can the preparer be liable for the tax? Interest is a bit trickier. Since the client got the use of the money (from the time the taxes were originally due until actually paid), one can argue the preparer is not liable for the interest. Assuming the preparer gave incorrect advice or mistakenly included non-deductible expenses on the client’s tax return, he or she will likely be liable for the cost of amending the tax return and the penalties. Obviously, there may be facts that would cause a court to rule differently.
Mr. Durant is seeking damages from CPA Elliott totaling $600,000. Stay tuned for the outcome of this case!
The moral to this story is simple: While an accountant is not required to audit the client’s business activities, the accountant must act with reasonable diligence. Section 10.22(a)(1) of Circular 230 specifically requires that a practitioner exercise “due diligence” in preparing tax returns. Consequently, tax preparers should:
- Make sure the tax preparation organizer clearly states that: (i) the accountant is not responsible for auditing the client’s business activities; (ii) the client represents the business expense items contained in his or her books and records are ordinary, necessary, and reasonable; and (iii) the client represents that he or she has reasonable documentation to support the amount of the expenses and that the expenses were actually incurred in the normal course of business.
- If the preparer knows or has reason to know an expense item listed as a business expense is in reality a personal expense or was not actually incurred, the preparer should not include the expense on the income tax return. Advise the client that the expense is non-deductible. If the client still wants you to deduct the costs of his or her vacation travel or personal chef, just say no!
- If the preparer suspects a client is classifying personal expenses as business expenses, the preparer should terminate the relationship and memorialize the termination in a disengagement letter. The risks to the preparer are significant. They include, in addition to a lawsuit initiated by the client for allegedly failing to advise him or her that the expenses were not deductible, tax preparer penalties, sanctions and/or disbarment.
Due to the possible publicity, CPA Elliott may be facing more than Kevin Durant’s lawsuit. While it is not a sure thing, he could be subjected to an investigation by his local board of accountancy and/or the Office of Professional Responsibility. This case should serve as a reminder—tax preparers cannot put their heads in the sand! While preparers are not required to audit their clients, they must act prudently and with reasonable care in the preparation of tax returns.
The Estate of Michael Jackson is battling it out with the IRS in a dispute over the value of the late pop star’s estate. To borrow the titles from two of Michael Jackson’s hit songs, the Service is alleging the estate is “Bad” in that it substantially understated the value of the decedent’s assets, while the estate is telling the Service that it is wrong and it should simply “Beat It.”
What is the battle about? The answer is simple: Lots of money! The Service asserts the understatement results in the estate owing taxes of over $500 million more than actually reported on the estate’s tax return, plus almost $200 million in penalties. If the Service is correct, the State of California will likely have its hand out, asking the estate for a significant amount of additional taxes, plus penalties.
According to the petition filed by the estate in the United States Tax Court, representatives of the estate placed a date of death value on the decedent’s property at a little over $7 million. The IRS, on the other hand, asserts the value was closer to $1.125 billion dollars. If the Service is correct, the estate was undervalued by more than 160 times.
Estates are not often subjected to a substantial valuation understatement penalty. The reason is obvious. The Code is very generous in this regard. The understatement of value must be significant for a penalty to apply. First, a penalty cannot be triggered unless the underpayment of tax exceeds $5,000. Next, there must be a “substantial understatement of value” for a penalty to apply. IRC § 6662(g)(1) provides a substantial estate tax valuation understatement occurs if the value of property on the return is 65% or less of the correct value. Pursuant to IRC § 6662(a), the resulting penalty is 20% of the tax underpayment. If, however, the value of the property on the return is 40% or less of the correct value, the penalty is increased to 40% of the tax underpayment. IRC § 6662(h)(2)(C).
So, the threshold for a penalty of this nature is high. The resulting tax must exceed $5,000 and the understatement of value itself must be more than 35%. In cases where the understatement of value is more than 60%, the penalty doubles. Consequently, in this case, if the Service’s values are correct, the 40% penalty is applicable.
The bulk of the Service’s fight with Michael Jackson’s estate appears to center around the value of Michael Jackson’s image, the estate’s intellectual property rights to certain songs, including some of the Beatles song catalog which Michael Jackson acquired prior to his death, and an interest in a trust. The estate valued the image at a little over two thousand dollars, while the Service’s experts put the value at over $434 million. The estate valued the estate’s interest in the musical collection at zero. The IRS, on the other hand, valued this asset at around $469 million. Last, the estate valued its interest in the trust at around $2 million, but the Service asserts its actual value is closer to $61 million.
Other items in dispute include: (a) stocks and bonds which the Service values at $64.4 million more than the estate reported on the return; (b) Jackson 5 master recordings which the Service values at over $34 million more than the estate reported on the return; and (c) three Rolls Royces and a Bentley which the Service values at about $160,000 more than the estate reported on the return.
This will be an interesting case for at least two reasons: (1) the valuation issues, including valuation of a person’s likeness, are interesting and will result in a battle of the experts; and (2) application of the 40% valuation understatement penalty is not terribly common.
Stay tuned! The decision of the U.S. Tax Court will likely be an interesting read.
Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "Evaluating the Built-in Gains Tax for C to S Conversions After TCJA," New York University Summer Institute in Taxation – Advanced Conference on Subchapter SNew York, NY, 7.26.18
- "S Corporation Distributions – The Ins and Outs," New York University 77th Institute on Federal TaxationNew York, NY, 10.21.18-10.26.18
- Portland, OR, 11.5.18
- "The Tax Cuts and Jobs Act – What It May Mean to Your Clients," Estate Planning Council of Portland Mini-SeminarPortland, OR, 11.7.18
- "S Corporation Distributions – The Ins and Outs," New York University 77th Institute on Federal TaxationSan Diego, CA, 11.11.18-11.16.18