When Are Damage Awards Taxable?

Sometimes the Internal Revenue Code has a heart. While the law makes clear that income is taxable from whatever source derived both legal and illegal, Congress in its wisdom created some specific exclusions. It really seems unfair to tax someone who was had physical injuries and receives a legal settlement for them. Those payments are designed to render the injured plaintiff whole again. The thinking may be also that physical injury is preventing them from returning to work. Every year there are numerous tax cases trying to determine whether or not physical injury is involved.  While the code goes easy on physical injury it makes payments for emotional distress taxable. The wisdom here may be a little cloudy but the tax law is not. Of course things can be muddy when one award is made for both physical and emotional injuries or when there is a connection between them. Consider the case of Barbato, TC memo 2016 – 23. In that case a woman suffered actual physical injuries. But the lawsuit that was brought on her behalf claimed that her employer had discriminated against her because she had requested medical accommodation for a prior workplace injury. So the question became was the award for the discrimination sufficiently connected to the physical injury to be excludable? The Tax Court refused to make the connection and held that the payments for the emotional distress were taxable. Litigation lawyers are wise to pay close attention to what they are suing for and alleging in any complaint or petition filed on behalf of their clients as it may dictate the extent that the proceeds will be taxable.

Phony IRS Tax Scam Telephone Calls

         I got home the other night and my old fashion answering machine was blinking. You know it’s the kind you have to push a button to hear the message. Most cold callers when they realize it is an answering machine simply hang up. But this message was a long one and I listened to it several times. It was fun. Maybe we tax lawyers look for a few laughs now and then in odd places. The guy on the line said he was from IRS. He spoke firmly in a non-regional American accent. His message was clear: a warrant had been issued for my arrest for back taxes which were due. He conveniently mentioned no particular years or amounts. The earnestness of his message was impressive. It ended with a phone number and a request that I call immediately to avoid enforcement action, loss of my assets, incarceration and financial penalties. It was perfect. It set the stage for this Bar blurb. I was frankly tempted to call the number and pose as an Assistant US attorney assigned to investigate the caller but realized that may in fact be breaking the law. I considered also playing along with the scam and see how far it would go. I didn’t do that either. I just let it be and relished the fact that someone would call a former IRS agent, IRS tax lawyer, Chairman of the tax committee with 43 years of experience in the tax litigation field and hope to convince me to turn over financial information. How could these phony IRS guys think that anyone would fall victim to their ploy? Well recently IRS Treasury Inspector General for Tax Administration announced that his office had received reports of 896,000 of such contacts since October 2013 and have become aware of over 5000 victims who have collectively paid over $26.5 million as result of the scam. In other words these phone scams work. There are also other varieties of call that claim the taxpayer is entitled to a huge refund and then requests Social Security and other financial information in order to process the gigantic payout. The IRS Commissioner was quoted as saying: “We continue to say, if you are surprised to be hearing from us, then you are not hearing from us.” The IRS has included phone call tax scams on their 2016 dirty dozen list. So let’s be clear about this.  IRS will never call to demand immediate payment or call about taxes owed without first mailing a bill to a taxpayer. They will never demand payment without giving the opportunity to question or appeal the amount they say is owed. In income tax cases an elaborate procedure is provided before IRS can take a valid assessment and bill for taxes owed. Some of these notices must be sent certified mail return receipt requested. IRS would never require use of a specific method of payment such as a prepaid debit card. IRS does not ask for credit or debit card numbers over the phone. And though it sounds silly IRS will not and cannot bring in local police or other law enforcement groups to arrest anyone for not paying taxes. IRS suggests of course not giving out any information and hanging up immediately on the phony call. They would also like taxpayers to report the contact to the Treasury Inspector at 800-366-4484. They also remind taxpayers that that if they do in fact owe taxes they should call IRS at 800-829-1040 or perhaps their favorite tax lawyer. There you go. So any lawyer who receives one of these calls may wish to have some fun with them and let me know how you make out.

IRS Broke?

        The IRS is going bankrupt. Well, almost. The agency requested an increase in budget of $2 billion and got a measly $290 million. A drop in the proverbial bucket. So taxpayers and lawyers alike who deal with these folks can expect more delays and unanswered calls and letters from computers with no knowledge of the issues involved. IRS will also have some of its “we are friendlier” adverts and video productions curtailed as well as awards and bonuses for deserving employees. Not to come to their defense but just to put things in somewhat perspective, the F-35 the newest, sleekest, fastest, radar defying, bomb dropping do all flying war machine has a price tag of about $400 billion and will cost about $1 trillion before the program of about 2500 planes is ever up and running, The pilot’s helmet specially made for the F-35 costs about $250 thousand. Now to Sheridan. That is the New Jersey case that requires judges to forward matters to the IRS when there is a hint of tax goings on. As a practical matter can IRS address all the potential referrals from judges or is there something else going on here? Criminal tax investigations continue to slide as agents retire and IRS is restrained for budget reasons to hire more of them. Only 3,850 such criminal tax investigations were launched in all of 2015. Things have gotten so bad that the criminal division agents want to be moved out of IRS and into the Treasury itself. So how does the administration of the tax law go on with fewer agents to do it? The answer, that may be less than coincidental, is to make we lawyers deputies in the tax compliance business. And frankly that is where Sheridan may come in. No lawyer who is involved in litigation whether it be of the marital variety or an estate dispute or simple business litigation needs to add to his headache the potential for IRS involvement in their clients’ lives. So settlement may look a lot more attractive to the parties when the downside is a long and tortuous journey with IRS. So too may clients be willing to get right with their tax situations with little IRS involvement. Voila the tax administration system is preserved and all within budget.

Tax Debtors to Lose Passports?

  It may be that the Internal Revenue Service feels that taxpayers who have tax liability of $50,000 or more should not be traveling out of the country. There may be a tiny bit of wisdom to that determination. It is a shame that the Constitution may have something to say about this idea. In the highway funding proposal a revenue raiser was included which would allow the State Department to deny or revoke passports if a taxpayer has had a notice of Lien or Levy filed against them. The proposal would exempt taxpayers who have confronted their tax liability and have entered into an installment agreement with the Internal Revenue Service. Anyone who has practiced in this field of IRS dispute work knows this is a disaster about to happen if it should become law. Both Notices of Lien and Notice of Levy are often incorrectly issued by the Internal Revenue Service. A lien is notice to the world that a tax is due and has not been paid. It covers most all of the taxpayer’s assets both real and personal and must be cleared to convey clear title. A Levy is the act of taking property by IRS and is only allowed in most cases with adequate notice to the taxpayer to object and request IRS Appeals Branch review. Having a Lien or Levy removed can present somewhat of a challenge and negotiating an installment agreement with the IRS as to becomes ever more shorthanded can be difficult as well.  It would seem that punishing tax debtors for their tax predicament would be invoking a debtor’s prison of sorts and an unjustified and perhaps unconstitutional extension of IRS power.  

Tax Free Spinoffs and the US Congress

  There is no better music to a tax lawyer’s ears than a business transaction being tax-free. And why not clients love it. A spinoff is a procedure whereby a corporation divides itself into at least two parts and then either sends one part to its old shareholders or creates a relationship of parent and subsidiary. If the rules are followed the new arrangement is tax free to all concerned. The House of Representatives had the nerve to recently consider legislation that would remove the tax free advantages of spinning off corporate real estate into a separate publicly traded real estate investment trust. According to the joint committee on taxation just this move would generate $1.9 billion in additional tax revenue over the next several years. Using spinoffs this way has been a way for companies to unlock cash by separating themselves from their real estate holdings. There have been 15 tax-free real estate spinoffs since 2010 that represented $21.6 billion. In September IRS had announced that it would no longer issue advanced private rulings on this type of tax free spinoff. Tax lawyers in this field are confident that no business would be willing to enter this type of corporate reorganization if the transaction was taxable. Before the ink was applied to the spinoff change however in rode the lobbyists to save the day and their clients at least a billion in potential additional taxes. Now congressmen being bought and paid for by many of the real estate players were quick to stick about 54 words in the 2000 page document to reverse the consequences of the potential taxable change. So the real estate spinoff lives on and another loophole remains in plain sight. Many congressmen in the past have come out and said they just don’t have the time to wade through volumes of tax legislation. Isn't that nice to know.

When the Sheridan Hits the Fan

           Why do litigation lawyers wake up in the middle of the night? Let’s not exclude mediators and arbitrators perhaps as well. It’s the ghost of Sheridan rapping at their chamber door. And who could get a decent night’s sleep when the parties to the upcoming courtroom battle are waging war over their marital or business issues and making veiled threats about the other’s tax deeds. We all know now that there is a third hostile party in court these days. It’s IRS. The courts and judges know that too. They did not get that seat on the bench being babes in the woods. How does this arise? Easy. One party alleges tax shenanigans: “You think he was cheating on me? Take a look at his tax returns.” The business partner who knows where the bodies are buried: “She’s deducted all her personal expenses through the company” Then to quote that great investigator: “The Game is Afoot”. Judges are required to seek IRS involvement. Now I confess my state court trial experience is limited at best as an expert witness in IRS tax matters. But after consulting with my brethren at the bar I can assure the reader that I know of what I speak. This is a problem. And it gets worst as we lawyers as officers of the court must deal with these issues ethically. Don’t ask, Don’t tell may not be the answer. Charlie Abut in July, 2008 did an article for the New Jersey Law Journal which I recommend as must reading. In essence Charlie agrees that looking the other way is not the answer. There is way too much at stake for all concerned. He suggests consulting the New Jersey rules of professional conduct and considering the risk /reward ratio. For lawyers who practice before the Internal Revenue Service knowledge about a client’s nonfiling or incorrect filing requires some action. Circular 230 is the conduct Bible. It requires that we tell a client of the error and advise them they must correct it. Those conduct rules do not require us to turn the matter over to the Internal Revenue Service. If clients have invested in their tax attorney hopefully they will be willing to take advice. For clients who refuse to take any action the only alternative may be to withdraw from the matter. In marital disputes where joint tax returns have been filed or are intending to be filed resting the client’s future on being able to claim innocent spouse status is shaky at best. Such status is far from automatic and actual knowledge and benefit could make such relief impossible. What then is the best answer in handling a potential Sheridan problem? Where tax problems raise their head a diligent lawyer should confront the issue. The purpose is to both insulate the lawyer from ethical issues and to assist the client to be in a better position as litigation goes forward. In difficult cases resort may be had to the IRS voluntary disclosure policy. Fixing the tax problem could be the most important service the lawyer will render no matter how the litigation turns out. There is certainly no easy solution and each case will stand on its own facts.

Sections of Circular 230: Practice Rules before the IRS

31 U.S.C. §330. Practice before the Department (a) Subject to section 500 of title 5, the Secretary of the Treasury may — (1) regulate the practice of representatives of persons before the Department of the Treasury; and (2) before admitting a representative to practice, require that the representative demonstrate — (A) good character; (B) good reputation; (C) necessary qualifications to enable the representative to provide to persons valuable service; and (D) competency to advise and assist persons in presenting their cases. (b) After notice and opportunity for a proceeding, the Secretary may suspend or disbar from practice before the Department, or censure, a representative who — (1) is incompetent; (2) is disreputable; (3) violates regulations prescribed under this section; or (4) with intent to defraud, willfully and knowingly misleads or threatens the person being represented or a prospective person to be represented. The Secretary may impose a monetary penalty on any representative described in the preceding sentence

§ 10.1 Offices. (a) Establishment of office(s). The Commissioner shall establish the Office of Professional Responsibility and any other office(s) within the Internal Revenue Service necessary to administer and enforce this part. The Commissioner shall appoint the Director of the Office of Professional Responsibility and any other Internal Revenue official(s) to manage and direct any office(s) established to administer or enforce this part. Offices established under this part include, but are not limited to: (1) The Office of Professional Responsibility, which shall generally have responsibility for matters related to practitioner conduct and shall have exclusive responsibility for discipline, including disciplinary proceedings and sanctions;

(4) Practice before the Internal Revenue Service comprehends all matters connected with a presentation to the Internal Revenue Service or any of its officers or employees relating to a taxpayer’s rights, privileges, or liabilities under laws or regulations administered by the Internal Revenue Service. Such presentations include, but are not limited to, preparing documents; filing documents; corresponding and communicating with the Internal Revenue Service; rendering written advice with respect to any entity, transaction, plan or arrangement, or other plan or arrangement having a potential for tax avoidance or evasion; and representing a client at conferences, hearings, and meetings.

Subpart B — Duties and Restrictions Relating to Practice Before the Internal Revenue Service § 10.20 Information to be furnished. (a) To the Internal Revenue Service. (1) A practitioner must, on a proper and lawful request by a duly authorized officer or employee of the Internal Revenue Service, promptly submit records or information in any matter before the Internal Revenue Service unless the practitioner believes in good faith and on reasonable grounds that the records or information are privileged.

§ 10.21 Knowledge of client’s omission. A practitioner who, having been retained by a client with respect to a matter administered by the Internal Revenue Service, knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return, document, affidavit, or other paper which the client submitted or executed under the revenue laws of the United States, must advise the client promptly of the fact of such noncompliance, error, or omission. The practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission.

§ 10.23 Prompt disposition of pending matters. A practitioner may not unreasonably delay the prompt disposition of any matter before the Internal Revenue Service.

§ 10.27 Fees. (a) In general. A practitioner may not charge an unconscionable fee in connection with any matter before the Internal Revenue Service. (b) Contingent fees — (1) Except as provided in paragraphs (b)(2), (3), and (4) of this section, a practitioner may not charge a contingent fee for services rendered in connection with any matter before the Internal Revenue Service. (2) A practitioner may charge a contingent fee for services rendered in connection with the Service’s examination of, or challenge to — (i) An original tax return; or (ii) An amended return or claim for refund or credit where the amended return or claim for refund or credit was filed within 120 days of the taxpayer receiving a written notice of the examination of, or a written challenge to the original tax return. (3) A practitioner may charge a contingent fee for services rendered in connection with a claim for credit or refund filed solely in connection with the determination of statutory interest or penalties assessed by the Internal Revenue Service. (4) A practitioner may charge a contingent fee for services rendered in connection with any judicial proceeding arising under the Internal Revenue Code.

§ 10.29 Conflicting interests. (a) Except as provided by paragraph (b) of this section, a practitioner shall not represent a client before the Internal Revenue Service if the representation involves a conflict of interest. A conflict of interest exists if — (1) The representation of one client will be directly adverse to another client; or (2) There is a significant risk that the representation of one or more clients will be materially limited by the practitioner’s responsibilities to another client, a former client or a third person, or by a personal interest of the practitioner. (b) Notwithstanding the existence of a conflict of interest under paragraph (a) of this section, the practitioner may represent a client if — (1) The practitioner reasonably believes that the practitioner will be able to provide competent and diligent representation to each affected client; (2) The representation is not prohibited by law; and (3) Each affected client waives the conflict

§ 10.31 Negotiation of taxpayer checks. (a) A practitioner may not endorse or otherwise negotiate any check (including directing or accepting payment by any means, electronic or otherwise, into an account owned or controlled by the practitioner or any firm or other entity with whom the practitioner is associated) issued to a client by the government in respect of a Federal tax liability.

§ 10.35 Competence. (a) A practitioner must possess the necessary competence to engage in practice before the Internal Revenue Service. Competent practice requires the appropriate level of knowledge, skill, thoroughness, and preparation necessary for the matter for which the practitioner is engaged. A practitioner may become competent for the matter for which the practitioner has been engaged through various methods, such as consulting an expert or study.

The practitioner must— (i) Base the written advice on reasonable factual and legal assumptions (including assumptions as to future events); (ii) Reasonably consider all relevant facts and circumstances that the practitioner knows or reasonably should know; (iii) Use reasonable efforts to identify and ascertain the facts relevant to written advice on each Federal tax matter; (iv) Not rely upon representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) of the taxpayer or any other person if reliance on them would be unreasonable;

§ 10.51 Incompetence and disreputable conduct. (a) Incompetence and disreputable conduct. Incompetence and disreputable conduct for which a practitioner may be sanctioned under §10.50 includes, but is not limited to —

(1) Conviction of any criminal offense under the Federal tax laws. (2) Conviction of any criminal offense involving dishonesty or breach of trust. (3) Conviction of any felony under Federal or State law for which the conduct involved renders the practitioner unfit to practice before the Internal Revenue Service. (4) Giving false or misleading information, or participating in any way in the giving of false or misleading information to the Department of the Treasury or any officer or employee thereof, or to any tribunal authorized to pass upon Federal tax matters, in connection with any matter pending or likely to be pending before them, knowing the information to be false or misleading. Facts or other matters contained in testimony, Federal tax returns, financial statements, applications for enrollment, affidavits, declarations, and any other document or statement, written or oral, are included in the term “information.” (5) Solicitation of employment as prohibited under §10.30, the use of false or misleading representations with intent to deceive a client or prospective client in order to procure employment, or intimating that the practitioner is able improperly to obtain special consideration or action from the Internal Revenue Service or any officer or employee thereof. (6) Willfully failing to make a Federal tax return in violation of the Federal tax laws, or willfully evading, attempting to evade, or participating in any way in evading or attempting to evade any assessment or payment of any Federal tax. (7) Willfully assisting, counseling, encouraging a client or prospective client in violating, or suggesting to a client or prospective client to violate, any Federal tax law, or knowingly counseling or suggesting to a client or prospective client an illegal plan to evade Federal taxes or payment thereof. (8) Misappropriation of, or failure properly or promptly to remit, funds received from a client for the purpose of payment of taxes or other obligations due the United States. (9) Directly or indirectly attempting to influence, or offering or agreeing to attempt to influence, the official action of any officer or employee of the Internal Revenue Service by the use of threats, false accusations, duress or coercion, by the offer of any special inducement or promise of an advantage or by the bestowing of any gift, favor or thing of value. (10) Disbarment or suspension from practice as an attorney, certified public accountant, public accountant, or actuary by any duly constituted authority of any State, territory, or possession of the United States, including a Commonwealth, or the District of Columbia, any Federal court of record or any Federal agency, body or board. (11) Knowingly aiding and abetting another person to practice before the Internal Revenue Service during a period of suspension, disbarment or ineligibility of such other person. (12) Contemptuous conduct in connection with practice before the Internal Revenue Service, including the use of abusive language, making false accusations or statements, knowing them to be false, or circulating or publishing malicious or libelous matter. (13) Giving a false opinion, knowingly, recklessly, or through gross incompetence, including an opinion which is intentionally or recklessly misleading, or engaging in a pattern of providing incompetent opinions on questions arising under the Federal tax laws. False opinions described in this paragraph (a)(l3) include those which reflect or result from a knowing misstatement of fact or law, from an assertion of a position known to be unwarranted under existing law, from counseling or assisting in conduct known to be illegal or fraudulent, from concealing matters required by law to be revealed, or from consciously disregarding information indicating that material facts expressed in the opinion or offering material are false or misleading. For purposes of this paragraph (a)(13), reckless conduct is a highly unreasonable omission or misrepresentation involving an extreme departure from the standards of ordinary care that a practitioner should observe under the circumstances. A pattern of conduct is a factor that will be taken into account in determining whether a practitioner acted knowingly, recklessly, or through gross incompetence. Gross incompetence includes conduct that reflects gross indifference, preparation which is grossly inadequate under the circumstances, and a consistent failure to perform obligations to the client. (14) Willfully failing to sign a tax return prepared by the practitioner when the practitioner’s signature is required by Federal tax laws unless the failure is due to reasonable cause and not due to willful neglect. (15) Willfully disclosing or otherwise using a tax return or tax return information in a manner not authorized by the Internal Revenue Code, contrary to the order of a court of competent jurisdiction, or contrary to the order of an administrative law judge in a proceeding instituted under §10.60. (16) Willfully failing to file on magnetic or other electronic media a tax return prepared by the practitioner when the practitioner is required to do so by the Federal tax laws unless the failure is due to reasonable cause and not due to willful neglect. (17) Willfully preparing all or substantially all of, or signing, a tax return or claim for refund when the practitioner does not possess a current or otherwise valid preparer tax identification number or other prescribed identifying number. (18) Willfully representing a taxpayer before an officer or employee of the Internal Revenue Service unless the practitioner is authorized to do so pursuant to this part.