In a recent Tax Court Memorandum opinion, the Court was not too pleased with the operations and the administrative proceedings of the IRS involving Notices of Deficiency issued to a taxpayer.1 The taxpayer represented himself and was subjected to a confusing series of communications with the IRS causing the Court to sympathize with the taxpayer in what the taxpayer argued were uncoordinated, parallel audits of his 2014 income tax return. Nevertheless, the Court’s job is to apply the law to the facts, not police the IRS, and thus the Court held in favor of the IRS on all items considered.
The primary issue was the application of Section 7605(b)2 to the somewhat convoluted facts discussed below. §7605(b) protects taxpayers from “unnecessary examination[s] or investigations” and limits the IRS to “only one inspection of a taxpayer’s books of account…for each taxable year unless the taxpayer requests otherwise.” The taxpayer alleged that the IRS had violated §7605(b) when it essentially was conducting dual investigations/audits of the taxpayers 2014 affairs which ultimately resulted in a Notice of Deficiency for the 2014 tax year (the “2014 Notice”) and a Notice of Deficiency being issued for the 2015 tax year (the “2015 Notice”). To rub salt in the taxpayer’s wounds, the Court upheld the accuracy related penalty for the 2015 tax year.
In 2013, Richard Essner, a cancer surgeon, inherited an IRA from his motherwhich she inherited from her late husband. Dr. Essner took distributions of$360,800 and $148,084 in 2014 and 2015, respectively. He previously researched the taximplications of taking such distributions on the IRS website and concluded the distributions were not taxable to him. His basis for this conclusion was not discussed in the opinion. He then hired a return preparer to prepare both his 2014 and 2015 tax return, but did not inform his return preparer of the distributions from the IRA or seek the return preparer’s advice as to the taxability of the distributions. The distributions were not reported on his 2014 and 2015 tax returns. However, the IRA administrator prepared and sent to Dr. Essner and the IRS a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., reporting the 2014 and 2015 distributions.
In March of 2016, the IRS Automated Underreporting (“AUR”) program automatically generated a notice to Dr. Essner for his 2014 tax return based on the discrepancy of the 1099-R received by the IRS and the same income not being reported on Dr. Essner’s return. The AUR notice proposed a change to Dr. Essner’s 2014 income by adding in the 2014 IRA distribution. A second notice was generated and sent to Dr. Essner on May 31, 2016. The next month, Dr. Essner responded via a handwritten note informing the IRS that he did not agree with the proposed changes in the AUR notices. On January 3, 2017, the AUR generated the 2014 Notice. In response, Dr. Essner timely filed his petition to Tax Court.
At the same time the AUR process was underway, Dr. Essner’s 2014 and 2015 tax returns were also the subject of an audit being handled by an Officer Hareshkumar Joshi (“Joshi”) who was not aware of the AUR process simultaneously taking place. Joshi’s examination focused on a variety of issues including travel, meal, and legal expenses but made no mention the IRA distributions or the AUR proceedings.
Since Joshi was unaware of the AUR process, he was also unaware of the Notice of Deficiency issued to Dr. Essner for his 2014 tax year, and Joshi continued his examination after the date of such Notice.
On January 10, 2017, Joshi sent his examination report and proposed adjustments to Dr. Essner. In response, Dr. Essner provided some additional information to Joshi, and Joshi revised his proposed adjustments for petitioner’s tax year 2014. Neither the original nor the revised report included an adjustment relating to petitioner’s IRA distribution in 2014. Dr. Essner responded on March 10th, 2017 with a letter to Joshi which requested a copy of the original report to confirm that the IRA distribution petitioner received in 2014 was not taxable. Dr. Essner ultimately filed his Petition to Tax Court in response to the 2014 Notice on March 27, 2017. Dr. Essner noted in the Petition that there was an ongoing examination of his 2014 tax return being conducted by Joshi.
In addition to the 2014 proceedings, Dr. Essner received the 2015 Notice on October 23, 2017. The 2015 Notice alleged a deficiency of $101,750 and also hit Dr. Essner with an accuracy-related penalty under §6662(a) of $20,350. The Court notes that, based on the record, it is unclear exactly when Joshi began examining the 2015 tax return, but such facts were immaterial to the case at hand. In response to the 2015 Notice, Dr. Essner timely filed a Petition to Tax Court for his 2015 tax year, and the 2014 and 2015 cases were consolidated.
With respect to the taxability of the distributions, Dr. Essner did not deny receipt of the funds but instead alleged that a portion of the distributions was attributable to his father’s initial investment and was thus not taxable. Dr. Essner requested the records from the IRA account holder but the records were not able to be located.
At issue in Tax Court were the following:
- Were the full distributions taxable or was Dr. Essner allowed to offset distributions in part with his father’s initial investment in the IRA, an amount that could not be substantiated?
- Did the IRS violate §7605(b) due to the dual 2014 proceedings by the IRS through the AUR process and Joshi?
- Did the accuracy-related penalty under §6662(a) apply to the 2015 tax year?
Were the distributions fully taxable?
The IRS quickly disposed of this issue due to Dr. Essner having no records to substantiate his father’s original investment in the account. The Court noted that IRS determinations in a Notice of Deficiency are presumed correct, and the taxpayer generally bears the burden of proving that those determinations are incorrect.3 Since Dr. Essner resided in California and his case was appealable to the Ninth Circuit, the IRS determination “that a taxpayer underreported income is presumed correct only if it is supported by a minimal factual foundation.4 If the IRS is able to provide such support, then the burden shifts to the taxpayer.5 Lacking any substantiation whatsoever, Dr. Essner’s argument was dead on arrival in his attempt to offset some of the distributions with his father’s original investment. The Court noted its sympathy for the position Dr. Essner because he was not able to locate such records after diligent inquiries, but nevertheless ruled against him. The Court also noted in a footnote that, while in general, distributions from a regular IRA are fully taxable, it was possible that Dr. Essner’s argument had merit when construed broadly.6
Did the IRS violate Section 7605(b)?
The real issue to be determined in Dr. Essner’s case was whether §7605(b) was violated. As noted earlier, §7605(b) protects taxpayers from “unnecessary examination[s] or investigations” and limits the IRS to “only one inspection of a taxpayer’s books of account…for each taxable year unless the taxpayer requests otherwise.” Generally, the Court does not look past the Notice of Deficiency to determine what took place during the course of an IRS examination.7 However, the application of §7605(b) presents a narrow exception to that rule and allowed the Court to examine such facts for the 2014 tax year but not the 2015 tax year.8
Because Dr. Essner was the subject of both the AUR process and Joshi’s audit for 2014, he alleged that he had been the subject of an unnecessary examination and that his books and records had been inspected twice in violation of §7605(b). In response, the IRS alleged that while Joshi’s examination did inspect Dr. Essner’s books and records, the AUR program merely pulled information from Dr. Essner’s already filed 2014 tax return without any review of or reference to Dr. Essner’s books and records. Accordingly, no violation of §7605(b) had occurred.
Prior to beginning its analysis of the issue, the Court took some time to scold the IRS for its actions in dealing with Dr. Essner and clearly felt some empathy for him. The Court notes how confusing all of Dr. Essner’s communications with the IRS must have been when various offices of the IRS were contacting him “without coordination, without clarity as to what the other parts were doing, and without providing petitioner a clear explanation as to why the IRS was speaking out of many mouths.” The Court lamented how Dr. Essner was wrongly subjected to “such a byzantine examination.” With that said, the Court also noted its place of not being “empowered to police what ought to have occurred in an examination…[but being] limited to considering whether Section 7605(b), as written, was violated.”9As a side note, the IRS received some similar scolding in a recent United States District Court case out of Wisconsin which my colleague Josh Sage recently discussed.10
The Court began its analysis with an outline of how §7605(b) is to be applied, noting that there are two limitations found in the statute, that while they may often overlap, are separate and distinct. First, the IRS is prohibited from conducting “unnecessary examinations”. Second, the IRS is prohibited from an unauthorized second inspection of a taxpayer’s books.11 The Supreme Court has also weighed in on the issue stating that §7605(b) imposes “no severe restriction” on the IRS’s power to investigate taxpayers and the provision is to be read narrowly.12 In previous opinions, the Court has stated that “mere communication with the taxpayer does not fall within the scope of” section 7605(b).13 §7605(b) does not prohibit the IRS from consulting other third-party records related to the taxpayer’s tax return14 and does not limit the IRS’s ability to review already filed tax returns in the possession of the IRS.15
Since the AUR program was merely a matching of third-party provided records from the 1099-Rs received by the IRS, the AUR process was not deemed to be an examination of Dr. Essner’s records. Accordingly, the Court found that the only examination of Dr. Essner’s records was that of the examination conducted by Joshi. Further, since the 2014 distribution from the IRA was not reported, and there were other adjustments made to Dr. Essner’s 2014 tax return, the 2014 examination could not be held to have been “unnecessary”. While the Court did not dismiss Dr. Essner’s frustration, the Court ultimately concluded that “a failure to communicate and coordinate within the IRS standing alone” does not violate §7605(b) and thus ruled in the IRS’ favor.
Was the accuracy-related penalty under §6662(a) applicable to 2015?
The accuracy-related penalty under §6662(a) was only assessed for the 2015 tax year. Having held that the 2015 distribution from the IRS was fully taxable, that the resulting deficiency was greater than 10% of the income tax required to be shown on the return for the taxable year, and that the IRS met its burden of proof with regard to the §6662(a) penalty, the analysis then turned to whether Dr. Essner had acted in good faith and had reasonable cause for his failure to report the 2015 distribution.16 While Dr. Essner did research the taxability of the 2015 distribution himself, he did not inform his return preparer of the distribution or ask advice of his return preparer with regard to the taxability of the distribution. Due to the size of the distribution and the petitioner’s background, the Court determined such action was not reasonable and upheld the §6662(a) penalty against Dr. Essner.
Many of us know how difficult and frustrating it can sometimes be when dealing with a large federal agency such as the IRS. Dr. Essner found that out firsthand when the IRS’ left hand did not know what the IRS’ right hand was doing. Certainly, this can be cause for concern and frustration, but unless the IRS makes a procedural mishap (which happens occasionally), this doesn’t let the taxpayer off the hook. Here, it is clear the Court was frustrated by the IRS’s inefficiencies in the handling of Dr. Essner’s matters, and the Court no doubt empathized with Dr. Essner, but in the end, the Court had to rule in favor of the IRS since no procedural violations took place.
There is also something to be said about Dr. Essner’s failure to engage a tax professional about the taxability of the distributions. Had Dr. Essner engaged a competent tax professional from the outset and/or fully disclosed the distributions, much of this likely could be avoided (although his 2014 return was still audited and some non-IRA related adjustments would have been made). At the very least, he would have avoided the §6662(a) penalty and saved himself $20,350 on that front.
- Richard Essner v. Comm’r, TC Memo 2020-23.
- All references to a Section or a § are to a Section of the Internal Revenue Code unless otherwise noted.
- Welch v. Helvering, 290 U.S. 111 (1933).
- Palmer v. U.S., 116 F.3d 1309 (9th Cir. 1997).
- Dr. Essner may have been entitled to exclude some portion of these distributions from income if he could have proven a specific amount of “[n]ondeductible contributions to [the account] minus any prior withdrawals or distributions of nondeductible contributions”. Hoang v. Comm’r, T.C. Memo. 2006-47.
- Greenberg’s Express, Inc. v. Comm’r, 62 TC 324 (1974).
- See Footnote 4 Essner, TC Memo 2020-23.
- Greenberg’s Express, Inc. v. Comm’r, 62 T.C. 324 (1974).
- Digby v. Comm’r, 103 T.C. 441 (1994).
- U.S. v. Powell, 379 U.S. 48 (1964).
- Seidel v. Comm’r, T.C. Memo. 2005-67.
- Hubner v. Tucker, 245 F.2d 35 (9th Cir. 1957).
- Estate of Sower v. Comm’r, 149 T.C. 279 (2017).
- See §6664(c).