What Are the 10 Most Commonly Litigated Tax Issues?
So, you have been audited either by mail or in person, and the Internal Revenue Service (“IRS”) makes an adjustment to your tax filing for a particular year. You are diligent. You talk to your accountant, and you hire an attorney. You appeal the audit’s finding to IRS Appeals, but they in turn side in favor of the IRS. What next?
You can either file a petition in U.S. Tax Court or pay the proposed adjustment and/or deficiency and then sue for a refund in U.S. District Court. Are there any particular issues that come up more often than not?
As a matter of fact, there are some commonly litigated issues that by examining we can perhaps gain some insight into the inner workings of the IRS. Interestingly, the Internal Revenue Code (“IRC”) section 7803(c)(2)(B)(ii)(XI) requires the National Taxpayer Advocate (“NTA”) to identify in his/her/their Annual Report to Congress the ten tax issues most litigated in federal courts.
The Taxpayer Advocate Service (TAS) is an independent organization within the IRS. In their own words, “We’re here to ensure that every taxpayer is treated fairly and that you know and understand your rights. Our advocates can help if you have tax problems that you can’t resolve on your own.” The NTA is the boss of this organization. It is still a part of the IRS, but it is a little more friendly to taxpayers. Regardless, each year they identify the ten most commonly litigated tax issues. We will examine those now in this blog entry. NOTE: These numbers apply to 2022.
Issue 1: Gross Income (IRC section 61 and Related Code Sections)
This was the number one issue among those litigated in the Tax Court with 17 substantive opinions issued in cases with individuals and ten with business taxpayers where corporate income was at issue. This issue was also the largest category of cases with individual taxpayers (21,215) who petitioned the Tax Court. The second highest total among business taxpayers was sole proprietorship gross income (1,223), and the fourth highest total among business taxpayers was corporate or partnership gross income (297) for taxpayers who petitioned the Tax Court.
Section 61 of the IRC states “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items.” The Code then lists 14 common items such as income derived from business, rent, royalties, etc. Basically, any accession of wealth. If someone or something pays you for some effort on your part, then it is income. However, taxpayers and IRS do not often agree on what constitutes income.
Issue 2: Schedule A Deductions (IRC sections 211-224)
Itemized deductions reported on Schedule A of IRS Form 1040 were frequently the subject of litigation for individual taxpayers and were among the ten most litigated issues for the sixth time since the National Taxpayer Advocate’s 2000 Annual Report to Congress.
This one is not altogether surprising. Taxpayers often claim things as deductions that IRS claims are not. Section 211 states that “certain deductions are allowed”. Sections 212 to 224 then list specific types of deductions (e.g., expenses for the production of income, medical expenses, deductions for taxes and interest, moving expenses, retirement savings, etc.).
Issue 3: Failure-to-File Penalty (IRC section 6651(a)(1)), Failure-to-Pay Penalty (IRC section 6651(a)(2)), and Failure-to-Pay Estimated Tax Penalty (IRC section 6654)
Fourteen opinions were issued by the Tax Court involving individuals and ten opinions involving businesses contesting the imposition of penalties and additions to tax for failure to timely file a tax return, failure to pay an amount shown as tax on a return, or underpayment of estimated taxes.
Tax penalties are just as they sound, a “penalty” failing to do something. For example, IRC section 6651 penalizes taxpayers when they do not file a return for a particular year. Like much of a tax system that relies on the honesty of its taxpayers, this penalty gives taxpayers the incentive to file their tax returns each year. The penalty is larger (up to 75%) when the failure to file was “fraudulent”. This is why it is always good to file your return even if you do not have the money to pay because failure to file penalties can reach the point where they are punitive.
Issue 4: Sole Proprietorships and Schedule C Income and Expenses
This litigation typically focuses on applying well-settled legal principles and statutes and regulations to taxpayers’ particular facts and circumstances. Twenty business cases were issued where this category of issues was litigated in the Tax Court. Taxpayers petitioned the Tax Court in 2,834 instances where sole proprietorships’ trade or business expenses were at issue during the examination in 2022 alone.
This category ranked top among petitioned issues for business taxpayers and ranks high for issues found in opinions issued by the Tax Court. Trade or business deductions have been among the most litigated issues since TAS has tracked such activity.
There is very often a lot of disagreement in this area because the taxpayers in question are not employees of another and no one is withholding their taxes and sending it to the government. Thus, there is a lot of room for disagreement. There is one whole division of IRS called Small Business Self Employed (“SBSE”) that handles these cases. It is the largest division of IRS Chief Counsel handling all cases where the amount in dispute is less than 50 million dollars.
Issue 5: Innocent Spouse Relief (IRC section 6015)
Ten opinions were issued by the Tax Court during the reporting period where taxpayers challenged an IRS determination on innocent spouse relief under IRC section 6015. A taxpayer may seek relief from liability arising from a joint return if the taxpayer can prove the taxpayer’s spouse or former spouse should be held solely liable under IRC section 6015. IRC section 6015 provides three ways for a taxpayer to obtain partial or full relief from a tax liability arising from a return filed jointly with a spouse or ex-spouse. IRC section 6015(b) provides complete relief for deficiencies arising from a jointly filed return. IRC section 6015(c) provides limited relief from a joint liability for spouses who are divorced, separated, widowed, or not living together by allocating the liability between the spouses.
This is not a surprising issue either. Given the rate at which marriages and relationships fail in the United States one would expect the couples to argue over taxes the same as they argue over everything else.
Issue 6: Adjusted Gross Income (“AGI”) Exclusions and Deductions
Seven opinions involving individual taxpayers where the taxpayer claimed a portion of his/her/their income could be excluded from the calculation of AGI and not subject to federal income tax. For example, these cases sometimes involve a claimed net operating loss. In other cases, taxpayers argued that income was excludable under IRC sections 121 and 132(a)(1). Some taxpayers in this category also claimed deductions for casualty losses.
Similar to other deduction cases, it is not uncommon for IRS and taxpayers to disagree over deductions and exclusions. Exclusion being something that is “excluded” or not included in income all together (e.g., your parents give you a graduation present of 10,000). Deduction is something that is used to reduce your tax burden by various percentages depending on what deduction is being considered.
Issue 7: Whistleblower Award Determinations (IRC section 7623(b)(1))
Whistleblower award determinations under IRC section 7623(b)(1) made the list for the second consecutive year. Seven opinions were issued by the Tax Court where individuals challenged an IRS determination on issuing whistleblower awards during the reporting period. The IRS Whistleblower Office pays monetary awards to eligible individuals if the IRS uses information from the whistleblower to take judicial or administrative action – an audit or investigation resulting in the collection of proceeds. Final determinations of the IRS Whistleblower Office regarding awards under IRC section 7623(b) may, within 30 days of such determination, be appealed to the Tax Court. In 2021, the Whistleblower Office made 179 awards to whistleblowers totaling over $36 million, which included 20 post-petition whistleblower awards awarded under IRC section 7623(b).
This is sort of an odd inclusion. As you can see, only 179 awards were made in 2021 so the actual volume of whistleblowers is quite small. The tricky part is reporting this correctly. Given the high number of cases versus the low number of whistleblowers it is a good practice to see the advice of a good accountant or tax attorney when reporting this on your income tax return.
Issue 8: Charitable Contribution Deductions (IRC § 170)
Five opinions were issued by the Tax Court in individual cases and eight in business cases during the reporting period on the deductibility of charitable contributions under IRC § 170. Most of these cases arose due to the increased IRS focus on curtailing abuse in the syndicated conservation easement arena, including by designating syndicated conservation easements as a listed transaction and aggressively auditing taxpayers. In 2022, business taxpayers petitioned the Tax Court in 41 cases where charitable contributions were an issue and 438 total for individual taxpayer case.
Charitable deductions are not surprising either given the inclusion of conservation easements on the IRS’s listed transactions. Put simply, the abuse comes when taxpayers overvalue land used for a conservation easement and take a deduction way out of proportion with reality.
Issue 9: Passive Activities (Schedule E) Income and Expenses
Five cases where passive activity income and expenses reported on Schedule E were at issue before the Tax Court. Schedule E (Form 1040) is used to report income or loss from rental real estate, royalties, partnerships, S corporations, estates, trusts, and residual interests in Real Estate Mortgage Investment Conduits. Taxpayers must keep records to support items reported on Schedule E, and unsubstantiated deductions are likely the reason underlying the initial issuance of the statutory notices of deficiency.
Issue 10: Fraud Penalty (IRC section 6663)
Last but not least are cases related to the Fraud Penalty. Four opinions with individual taxpayers and five with business taxpayers were issued by the Tax Court where the civil fraud penalty under IRC section 6663 was at issue. IRC section 6663(a) provides that “[i]f any part of any underpayment of tax required to be shown on a return is due to fraud, there shall be added to the tax an amount equal to 75 percent of the portion of the underpayment which is attributable to fraud.”
The IRS has the burden of proving by clear and convincing evidence that (1) an underpayment of tax exists and (2) the underpayment was due to fraud. If the IRS establishes that any portion of the underpayment is attributable to fraud, the entire underpayment shall be treated as attributable to fraud and subject to a 75 percent penalty unless the taxpayer establishes by a preponderance of the evidence that some part of the underpayment is not attributable to fraud.
This is not surprising given the difficulty of proving fraud and the size of the penalty. “Clear and convincing” is a pretty high standard and some commentators have likened it 75% assurance that what happened was as the IRS claims. Thus, these are not easy cases for the IRS to win.
Rest assured whatever tax issue you have, the Tax Court has likely seen it in the past. Taxpayers and the IRS often disagree over the same issues time and time again. Yet the issues listed above are so fundamental and basic to the tax code that they are not that surprising.
Whatever your issue it is imperative that you are diligent in pursuing it, and hiring a qualified tax attorney is often a good start.