Top 10 Most Litigated Tax Issues

Kelly Phillips Erb for Forbes writes: What happens when a taxpayer disagrees with the Internal Revenue Service? Some people think that the matter ends there: the IRS always wins, right? Not necessarily.

There are a few ways to appeal an action with IRS but in a weird twist, most of those appeals actions are actually taken up with IRS. In other words, if you disagree with IRS, you ask the IRS to change their minds (you can imagine how often that happens).

Except for one. A big one. You can take your tax matter to court. Specifically, you head over to United States Tax Court. The Tax Court is a real federal court and not, as some people think, actually affiliated with the IRS. The IRS is a party to an action in Tax Court just as the taxpayer would be. Generally, a case ends up in front of the Tax Court after a taxpayer is assessed a deficiency and decides to challenge the amount in court rather than pay. There are other reasons why a matter might end up in Tax Court, including interest abatements, worker classification disagreements, and a request for relief from joint and several liability on a joint return. If a specific federal tax related questions doesn’t fall under the jurisdiction of the U.S Tax Court, the matter may decided in other courts, such as Bankruptcy Court and the U.S. Court of Federal Claims.

Procedurally, to get your matter before the Tax Court, you file a petition. The petition has to be timely filed – there are no excuses or extensions (not even the government shutdown). Once the is filed, it’s put on the calendar for trial. If the matter makes it to trial (in many instances, the matter gets settled before a court date), it goes before a judge (there are no jury trials in Tax Court) where it proceeds just like any other court with both sides presenting their arguments. Taxpayers can be represented by an attorney (in order for an attorney to appear in Tax Court, he or she must be admitted to the bar of the Tax Court) or they can opt represent themselves, a move called pro se. Of the cases reviewed this year, just under half (about 45%) were filed as pro se matters.

The Tax Court receives tens of thousands of filings each year (averaging about 30,000) but most of those are settled and do not actually go to trial. For those that do make it to trial, a number involve the same kinds of issues. As part of the report that National Taxpayer Advocate (NTA), Nina E. Olson, presented to Congress, the NTA took a detailed look at the most litigated issues at court. Here’s what Olson’s office found to be the top litigated issues from June 1, 2012, to May 31, 2013:

1. Accuracy-Related Penalties. The IRS may impose a penalty for an underpayment of tax, if the underpayment meets certain criteria. Examples of accuracy-related penalty cases filed this year included a taxpayer’s failure to keep records substantiating income and failure to report the proceeds from the sale of a house. Taxpayers were fully successful about 15% of the time and split the decision with IRS about 10% of the time. In one case, Bartlett v. Comm’r, T.C. Memo. 2012-254, taxpayer lost his argument for an abatement based on a reliance on TurboTax (I guess he forgot that the so-called “TurboTax defense” didn’t work for Geithner) while in another case, Neff v. Comm’r, T.C. Memo. 2012-244, the Court agreed that taxpayer relied on the advice of a competent tax professional.
2. Trade or Business Expenses. No surprise here. The deductibility of trade or business expenses has long been an issue for taxpayers and this year was no exception. A recurring theme? Failure to keep good records. Time after time, taxpayers could not produce receipts to justify deductions and expenses. Another handful of cases were lost because taxpayers failed to separate personal use from business use of assets, including vehicles, and still others claimed business losses for what was properly a hobby (everything from cat shows to drag races was litigated). And predictably, taxpayers and IRS bickered over home office expense deductions (fortunately, you can opt into a more simple calculation this year). The IRS was the overwhelming victor in most of these cases: taxpayers only fully prevailed in 2% of cases.
3. Gross Income. As with trade or business expenses, the matter of reporting of income was again at the top of the list. The NTA analyzed such 117 cases, most of which involved taxpayers failing to report items of income. Recurring themes included cancellation of debt income, unreported settlement proceeds and of court, failure to report wages. Taxpayers won fully or in part about 15% of the time.
4. Summons Enforcements. Under the Tax Code, the IRS is allowed to examine any books, records, or other documentation related to a civil or criminal tax liability. One of the ways to get this data is to serve a summons directly on the subject of the investigation or on a third party (like a bank or employer) who may possess relevant information. If a person who is summoned refuses to produce the information, the IRS may seek to enforce it. In that way, these kinds of cases are different from others on the list since it may be the case that it is the government bringing the action rather than the taxpayer – statistically, that happened 68% of the time last year. The IRS won most of these cases by far (95% of the time).
5. Appeals From Collection Due Process Hearings. Collection Due Process (CDP) hearings are relatively new, just created in 1998. CDP hearings offer taxpayers the chance to request an independent review of their tax dispute by the IRS Office of Appeals in matters involving a lien or levy. Taxpayers who don’t agree with the results of a timely requested CDP hearing have the right to petition the Tax Court for a review. The lack of agreement usually resulted in an “abuse of discretion” charge against the IRS; all in all, taxpayers were successful in whole or in part about 10% of the time.
6. Failure to File and Failure To Pay Penalties. If you fail to file on time, or if you fail to pay on time, you may be subject to a penalty. There are instances where the penalty may not be imposed – and that’s what the majority of these cases focused on. The IRS was successful in just over 82% of cases. Taxpayers were able to prove reasonable cause for all or some of the failures to file or pay in some cases by arguing health problems (Wright v. Comm’r, T.C. Memo. 2013-129) and damaged records due to Hurricane Katrina (Johnson v. Comm’r, T.C. Memo. 2012-231).
7. Charitable Deductions. If you itemize on your federal income tax return, you may take a deduction for donations made to a qualifying charitable organization. Taxpayers disagreed with IRS’ denial of deduction in a number of instances including whether the organization was a qualifying charitable organization, whether the amount of the donation represented fair market value and whether the donation was properly substantiated. Taxpayers were successful in whole or in part about 20% of the time.
8. Frivolous Issues Penalty. The IRS takes a hard stance against taxpayers who raise frivolous arguments (such as “there is no constitutional basis for the income tax”) or those who take unnecessary steps to delay collections enforcement. The court did not entertain arguments that tax was not required and in one case, failed to agree with a taxpayer who claimed a form W-2 was “hearsay” (Davenport v. Comm’r, T.C. Memo. 2013-41). Despite some clear losers, taxpayers were successful nearly 45% of the time though many were warned about the potential risks of continuing such behavior. Of the cases that IRS won, most penalties hovered around the low four figures (near $2,000) with some climbing as high as $25,000.
9. Civil Actions to Enforce Federal Tax Liens. When a taxpayer refuses or neglects to pay tax, the IRS may file a federal tax lien against the taxpayer’s property. This is a pretty broad right and the IRS liberally enforces it. The IRS was successful in court in more than 90% of these cases.
10. Relief from Joint and Several Liability (Innocent Spouse). Married couples who file jointly agree that they are jointly and severally liable for the tax due. That means that the IRS may try to collect any or all of the amount due from either taxpayers. The Tax Code provides relief from this liability in some circumstances. One of the most interesting things about these cases is that while the action is filed against the IRS, a third party (the former spouse, called an intervenor) has the right to step in and force a matter to court even when the IRS may be inclined to settle. That likely skews the numbers since it may boost the number of cases headed to court which would have otherwise been resolved prior. Of the seven cases where an intervenor was involved, taxpayers were completely successful in two instances and partially successful in two more. Overall, taxpayers in these matters were successful about 33% of the time.