Convincing the IRS to Concede on a Civil Fraud Penalty

Written by: Carolyn Richardson, EA

This case was originally started in November 2011, and involved the 2009 and 2010 tax years. The Member lived in Texas, and the examiner was in Washington, DC. The Revenue Agent (RA) was conducting the audit by correspondence, which was unusual, but he was doing it that way because it had originated from a related corporate examination.

The main issue was a Schedule C loss (self-employment) in both years. The Schedule C showed no gross receipts and the losses were over $130,000 in each year, mostly from a Section 179 deduction. The Schedule D also reflected over $1 million in capital loss carryovers.

A quick review of the two returns revealed that the Member had made a number of unintentional errors on his tax returns for the two years in question. His carryover loss appeared to be a duplication of another figure, and his rental depreciation looked like it had been doubled. His return also showed high medical expenses, which seemed unlikely since his position as a CEO would presumably include medical insurance benefits.

The document request from IRS asked for the original returns from which the capital losses had originated, and the Member explained those had originated in 2003 and 2004. When we received the returns for those years, as well as the intervening tax years between 2005 and 2008, it became increasingly clear that those returns were problematic as well.

I warned the Member about the additional items I had identified on his return as being incorrect, and we went over them in detail. In the course of the conversation he told me that his Schedule C business had been inactive since 2004, and that he had overridden a number of entries in the tax program. I explained that he should expect a large tax bill resulting from the audit and estimated he would owe about $30,000 for each of the two years, before penalties and interest were calculated.

In the meantime, the IRS agent informed me that he was transferring the case to Pittsburgh, as the agents at that location were the ones actually doing the corporate examination. I was contacted by the new Revenue Agent in February 2012, and we briefly discussed the issues the IRS had identified. The RA said he would like to complete the audit as soon as possible, but warned it was not likely to happen that quickly because of his workload and the related corporate audit.

After going back and forth with the Agent regarding document requests and getting those documents from the Member, the RA informed me in September 2012 that he had been promoted to management and the case would be reassigned to a new agent. This meant another delay while the IRS transferred the case to the new agent and she became familiar with the issues.

The Member was becoming increasingly impatient at the pace of the examination and said he wanted us to hurry up and settle the case. I explained to him that we could not settle anything until the IRS decided what adjustments were warranted. In the meantime, the new Revenue Agent expanded the examination to the itemized deductions and a bank deposit analysis. While the Member’s documents for those items were sketchy, it was at least better than his Schedule C documentation, which was nonexistent.

The RA contacted me in June 2013 with the proposed adjustment, disallowing the Schedule C losses in full – as expected – but making no adjustments to the itemized deductions. This had a cascading effect on the rental losses, which were now limited to $0, as well as impacting the Member’s medical deductions. However, she was also proposing to assess the Civil Fraud penalty (which is 75% of the tax) due to the large amount of the disputed deductions. She explained that the IRS felt that the Member’s preparation of his return was so egregious that it rose above mere negligence, and instead was deliberately deceptive.

IRS sent us a three page explanation stating why they felt the civil fraud penalty was appropriate, and gave us time to compose a rebuttal. IRS’s main argument was that a CEO in the Member’s position should have known better than to override the software, and by doing so he had deliberately attempted to deceive the government. The Member was unhappy about the large amount of the adjustment but I was able to point out to him that these were exactly what I had predicted at the beginning of the audit and that this was the amount he rightfully owed. Since he agreed the Schedule C loss was not correct, and the other adjustments were based on the resulting increase to his AGI, I explained that none of this could be negotiated downward any further.

I spent a week composing the rebuttal. I pointed out that the Member had cooperated fully with all requests from the IRS, and that the bank deposit analysis had shown that he and his wife routinely deposited all monies they received, including small gift checks for their children. I also showed that, despite the large refunds he had received every year, he had never reduced his withholding (nearly $50,000 in each year), which was not typical of someone out to defraud the government. Had he prepared the returns correctly, I noted, he still would have received refunds of nearly $10,000 in both years. I agreed that the Member may have seemed negligent in failing to consult with a professional tax advisor, but he was not required to do so, and his misunderstanding of the applicable laws regarding his loss carryovers had tripped up many taxpayers before him.

IRS responded two weeks later stating they would not assess the fraud penalty, but would assess the 20% substantial understatement penalty. They also agreed to abate the interest charges for nearly a year due to the delay incurred by the transferring of the case between agents. While the Member still ended up with a tax bill of nearly $82,000 for the two years, we managed to save him over $45,000 in additional penalties by getting the IRS to concede the fraud penalty.

IRS Compassion for a Happy Ending

Written by: Michael Crowther, EA

When I was assigned an audit for Schedule A charitable contributions and medical expenses, I knew this would be a challenge. The member had claimed over $37,000 of medical expenses on his tax return. When I first spoke to him he explained that a large portion of the medical expenses were related to his 18 year-old daughter, who cannot eat or function without assistance. The member quickly helped me understand that this required dozens and dozens of receipts for necessary expenses to sustain his daughter’s life. I recommended that he send everything he had, including letters from doctors which could document his daughter’s condition, and an explanation of all necessary daily expenses.

A couple weeks went by and all the paperwork flooded in. The documents for the charitable donations were perfect, exactly what we needed to support the position as listed on the tax return. For the medical expenses, I was excited to see that the member had prepared a spreadsheet which listed all the daily medical expenses for his daughter, along with the quantity and the cost per item. I was also glad that we had ample evidence from doctors’ notes and evaluations to prove his daughter’s condition and all the steps necessary to care after her. A sample of the receipts was included, but some of the medical receipts were missing. I expressed my concern that we were missing receipts for some of the expenses. The member understood.

The due date to respond to the notice was already upon us, but I was in a quandary about how to present the medical expenses in less than perfect condition with some of the receipts for expenses missing. I sent the documents to the IRS to prove the charitable contributions and medical expenses, pleading in my letter for a bit of compassion for less than perfect documents.

A couple months later I received a call from the IRS examiner assigned to the case. The examiner quickly advised me that the documents for the charitable contributions were fine, but he questioned me about the medical documents. I explained in detail the specific medical condition faced by the member’s daughter, and then explained the spreadsheet we had provided and how it listed all the daily medical expenses required. I asked the examiner for sympathy and compassion for the member’s situation. I argued that the documents provided from doctors’ letters and evaluations, the spreadsheet of listed daily expenses, along with the sampling of receipts, was enough to establish the amount of necessary medical expenses incurred for the year. The examiner said he would definitely take all this into consideration.

Several weeks later the examination report came. With nervous anticipation, I opened the letter to view the results. The examiner had allowed all expenses as filed and made no changes to the return. What a relief!

I called the member to give him the good news. He was overjoyed to have this burden removed and thanked me for all the help in resolving his case. I was sure to advise the member of the importance of securely saving all receipts for medical expenses in the future so we don’t have to rely on a little compassion from the IRS in the future. Lesson learned.