The Civil Tax Case: Procedure and Strategy
| Publication year | 1983 |
| Pages | 1579 |
1983, October, Pg. 1579. The Civil Tax Case: Procedure and Strategy
Encountering occasional tax cases, the general practitioner confronts an ever-changing maze of technical Internal Revenue Service ("Service") and Tax Court rules and procedures. This article clarifies tax assessment, examination and audit processes, administrative review within the Service, judicial proceedings and tax collection to assist the general practitioner in analyzing and discussing tax cases with clients, tax attorneys and Service representatives.
Forming the bases of a civil tax controversy are the fundamental processes of assessing and collecting internal revenue. The Service collects taxes by either assessment or revenue stamps. The following taxes, collected chiefly by assessment, are within the jurisdiction of the Tax Court and, therefore, can be contested before payment: income taxes, estate taxes, gift taxes, generation-skipping transfer taxes and some excise taxes (e.g., those imposed on public charities, private foundations, and qualified pension plans). Other taxes, also collected by assessment, are not under the jurisdiction of the Tax Court and thus must be paid before their validity can be contested: employment taxes, various sales taxes and other miscellaneous excise taxes.
Income, estate and gift taxes are essentially self-assessed. As required by law, the taxpayer files tax returns upon which he himself computes the tax. By filing the return, the taxpayer agrees to an immediate assessment of the tax on that return. However, the Service must make an official assessment before collecting these taxes. An assessment officer technically assesses taxes on the date he signs a summary record of the taxpayer's name, address and tax liability. The Service then can act immediately to collect any unpaid reported tax.(fn1)
The Service can also assess a deficiency when it determines that the taxpayer's correct tax liability exceeds the tax reported.(fn2) Usually, the Service has three years from the due date of the return or the date the return is filed, whichever is later, to make an assessment. If the taxpayer does not file a return or if he files a false or fraudulent return, the Service can assess the tax at any time.(fn3)
Civil tax disputes involve identifying possible taxpayer violations of statutes or regulations, including criminal violations. Each criminal violation generally carries a related civil penalty for the same conduct. Civil penalties are commonly a percentage of the tax deficiency and include:
1) for fraud, 50 percent of the total amount of the underpayment plus 50 percent of the interest payable on the portion attributed to fraud;
2) for failure to file a return, up to 25 percent of the correct tax liability, and for failure to pay the tax, up to 25 percent.
3) for negligent or intentional disregard of rules and regulations, 5 percent of the underpayment plus 50 percent of the amount of interest due on the underpayment;
4) for substantial understatement of liability, up to 10 percent of the underpayment;
5) for valuation overstatement, up to 30 percent of the underpayment attributed to the valuation overstatement; and
6) other miscellaneous penalties.(fn4)
Four divisions carry out the Service's primary functions of determining, assessing and collecting all internal revenue and other miscellaneous taxes: administration, collection, examination and criminal investigation. Special agents in the criminal investigation division determine whether to initiate criminal proceedings against the taxpayer; should prosecution result, the possible outcome includes imposition of a fine and/or imprisonment. In contrast, the Service's examination branch usually initiates civil proceedings, based upon a determination of the proper tax liability. The collection division ensures that the taxpayer pays the government the amount of tax found to be due. Thus, the taxpayer and the general practitioner in a civil tax controversy will be most involved with the examination and collection divisions.
The Service audits only a small percentage of all returns filed. Careful planning and record-keeping will support the taxpayer's position and minimize the likelihood that the Service will challenge the tax consequences of a transaction in the event of an audit. The selection process starts in the regional Service Center with a preliminary examination of returns for required form and signatures and mathematical errors. If a mathematical error is found, the taxpayer receives either a tax refund for overpayment or a bill for underpayment. A notice for underpayment because of a mathematical error is not grounds for protest or appeal to the Tax Court.(fn5)
After the preliminary examination, the Service Centers further screen and classify returns, relying on a highly random selection, as well as on formulas developed over the years for identifying tax returns with substantial potential for adjustment in favor of the government. Although the Service Centers do not reveal these formulas, the Service actively publicizes audit targets, such as abusive tax shelters, for deterrent effects. Also, newspapers and magazines often publish average deductions for individual taxpayers in various income brackets. Obviously, any gross departure from the norm increases the chance of an audit.
Many other considerations may generate an audit: operating a particular type of business or having a certain professional occupation, reporting large casualty losses or miscellaneous income, using round numbers for all deductions, inadequately explaining deductions, or listing a great number of stock transactions (where more likelihood of error exists). Ultimately, however, a taxpayer can make a common-sense prediction of the likelihood that the Service will audit his return.
The returns of higher income individual taxpayers who have used tax-shelter losses to reduce their gross income are more susceptible to examination under a new program the Service has implemented. Endeavoring to select returns more equitably for examination, the Service now classifies these returns on the basis of "total positive income," rather than "adjusted gross income."(fn6)
The Service Centers correct by correspondence those individual income tax returns with potentially unallowable items and possible mathematical errors. According to workload capacities, the district examination divisions each receive a share of returns requiring further screening from which to select returns most in need of office or field audit. The office audit branch examines questions that can be resolved by correspondence or office interview. If an audit of books and records is necessary, the field audit branch usually conducts the examination.
To calculate the true tax liability, the examining officer must ascertain whether the taxpayer has properly reported all income and whether claimed deductions are allowable. Consequently, by providing sufficient explanatory schedules and statements with the return to show correct tax treatment of potentially disputable items, the taxpayer can avoid later requests for information.
The scope of the audit varies according to the potential problems in the return. An office audit begins with a letter or a telephone call asking the taxpayer to bring to the office his records substantiating specific items on his return. Alternatively, if the issues are simple, the Service may handle the audits of specific items by mail. Revenue agents conduct the more complex field examinations at the taxpayer's office or place of business, usually auditing the entire return.
To avoid repetitive audits of the same issue, an individual can notify the Service that its audit of that issue on his return in either of the two previous years resulted in no change in tax.(fn7) Repetitive audits of individual returns with Schedules C or F, or of business returns normally do not occur because these returns are subject to pre-examination analysis.
Concerned with making the audit of large corporations and conglomerates more current, the Service has substantially changed its corporate audit procedures over the past years. To accelerate the audit, the Service uses a team of two or more revenue agents and specialized agents as needed, under the direction of a case manager in the local district.
Another new audit procedure, affecting partnership taxable years beginning September 3, 1982, is to treat a partnership as an entity for the audit of partnership-related issues and for administrative settlement and judicial review. The new law prohibits the Service from initiating deficiency proceedings against a partner when the Service seeks to assess additional taxes on the basis of incorrect treatment of a partnership item. Rather, the Service must first make an administrative determination at the partnership level of the propriety of the partnership's tax...
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