False withholding claims support different penalties based on refund payment

Plain-English summary

Taxpayers filed original and amended returns claiming false original-issue-discount income and matching withholding credits. Chief Counsel advised that the original returns would likely qualify as valid returns even though they took a frivolous position, with the fraudulent-failure-to-file penalty available as an alternative if a court found them invalid. A false withholding claim can create an underpayment subject to the section 6663 fraud penalty when the IRS pays the claimed refund. When a refund is frozen or an amended-return refund claim is rejected, no underpayment arises, so Chief Counsel recommended the section 6676 erroneous-refund-claim penalty instead.

Ruling snapshot

• Question: Which penalties apply to false withholding claims on original and amended returns when some refunds were paid and others were frozen?
• Outcome: Advice to use the fraud penalty for an underpayment tied to a paid refund and the erroneous-claim penalty for unpaid claims.
• Key authorities: IRC §§ 6651(f), 6663, 6664, 6676, 6702; Treas. Reg. § 1.6664-2.

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201640016
           Release Date: 9/30/2016
           CC:PA:02:SMcLemore
           POSTS-109898-15

 UILC:     6664.01-00, 6663.00-00, 6676.00-00

  date:    June 07, 2016

     to:   Kimberly A. Daigle
           Senior Attorney, (Ft. Lauderdale)
           (Small Business/Self-Employed)

  from:    Ashton P. Trice
           Branch Chief
           (Procedure & Administration)


subject:   Assertion of additional penalties with respect to Forms 1040 and 1040X that claim
           refunds based on overstated withholding

           This Chief Counsel Advice responds to your request for assistance concerning the
           liability for penalties of --------------------------------. This advice may not be used or cited
           as precedent.

           ISSUES

              1. Are the original returns at issue, which falsely claim Form 1099-OID income and
                 tax withholding, valid returns?

              2. If the original returns are valid, is there an underpayment such that the section
                 6663 fraud penalty could apply?

              3. Did the amended returns -------------------filed for tax years ------ and ------ result in
                 underpayments such that the section 6663 fraud penalty could apply, even
                 though the Service did not pay her the refunds that she claimed?

           CONCLUSIONS

              1. It is likely that a court will consider the returns in question to be valid, even if they
                 contain a frivolous position. As an alternative position, any notice of deficiency
POSTS-109898-15                                          2

         should treat the returns as invalid and determine a fraudulent failure to file
         penalty under section 6651(f).

    2. To the extent it is valid, ----------------------------return will give rise to an
       underpayment potentially subject to the fraud penalty under section 6663. --------
       --------------------and ------ returns and -----------------------------return, which claimed
       refunds that the Service did not pay, will not give rise to underpayments and the
       section 6663 fraud payment is inapplicable. We recommend assertion of the
       section 6676 penalty on erroneous claims for refund or credit.

    3. The amended returns -------------------filed for tax years ------ and ------ did not
       result in an underpayment. The section 6663 fraud penalty is inapplicable, but
       the Service could assess the section 6676 penalty on erroneous claims for
       refund or credit.

FACTS

---------------------------------participated in an Original Issue Discount (OID) scheme with
respect to the ----------------and -------taxable years. Both taxpayers utilized -----------------
-------, promoter of Form 1099-OID schemes, to prepare their ----------------and --------
income tax returns. The position the ----------- took with respect to tax years ----------------
has been identified as frivolous for the purposes of the section 6702 frivolous filing
penalty. See Notice 2010-33, 2010-17 I.R.B. 609. The ---------- filed separate returns
for tax years --------------.

------------------

On or about ---------------------, ------------------filed a purported income tax return for tax
year ------. On it, he claimed Form 1099-OID income of -------------and an identical
amount of tax withheld. No Form 1099-OID was attached. The purported return was
processed by the Service and a refund of -------------was issued to the taxpayer. On or
about ---------------------------, a $5,000 section 6702 frivolous filing penalty was assessed
with respect to --------------------purported ------ return. Subsequent to the filing of the
purported--------tax return, ------------------filed purported returns for the -----------------------
tax years.

On or about ---------------------, ------------------filed a purported income tax return for tax
year ------. On it, he claimed Form 1009-OID income of -------------and an identical
amount of income tax withheld. He attached to his--------return Forms 1099-OID
designating income and nearly matching withholding amounts from ---------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
----------------------------------------------------------. All of these entitles verified that there are
no Forms 1099-OID associated with these accounts. The purported--------return was
not processed and no refund was issued. On ---------------------------, a $5,000 frivolous
POSTS-109898-15                                          3

filing penalty under section 6702 was assessed with respect to the purported ------
return.

On or about -----------------------, ------------------filed a purported tax return for tax year -----
------. On it, he claimed Form 1099-OID income of -----------and an identical amount of
income tax withheld. He attached to his return Forms 1099-OID designating income
and nearly matching withholding amounts from ------------------------------------------- ----------
---------------------------------------------------------------------------------------------------------------------
------. Both of these entities have verified that there are no Forms 1099 associated with
these accounts. The purported ------ return was processed but the requested refund
was frozen. On -----------------------, a $5,000 section 6702 frivolous filing penalty was
assessed with respect to the purported ------ return.

------------------was not employed during the tax years at issue. He refused to cooperate
with the Internal Revenue Service Criminal Investigation unit and the revenue agent in
this case. The taxpayer ignored attempts to contact him via telephone and letter and
refused to answer his door when special agents attempted to contact him at his
residence. ------------------responded to an IRS Letter 3176C, informing him that his
filings were frivolous, by submitting a document entitled “Memorandum of Law in
Support of 1099OID – Original Issue Discount.”

On ---------------------------, ------------------was indicted on charges under 18 U.S.C. § 287,
Filing False Claims with a Governmental Agency/ Filing A False Income Tax Return and
Title 18 U.S.C. § 2, Aiding and Abetting with respect to the --------------------------------
taxable years. On ---------------------, a Second Superseding Indictment was filed which
added to the earlier charges a charge for violation of Title 26 U.S.C. section 7201,
Willful Attempt to Evade or Defeat the Payment of Tax, for the --------------------------------
taxable years. On ------------------------, a jury found ------------------guilty of all charges.
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------.

--------------------

Like her husband, -------------------filed a Form 1040 for ------ claiming OID income of ------
-----------and -----------of income tax withholding. The tax return was processed by the
Service and a total refund of -----------was paid. On or about --------------------------, a
frivolous return penalty was assessed with respect to ----------------------purported --------
return. Subsequent to the filing of the ------ tax return, the taxpayer filed amended tax
returns for the--------and ------ tax years.

On or about -----------------------, -------- filed an amended ------ income tax return claiming
additional Form 1099-OID income of -------------and an identical amount of additional
withholding on the return. On a Schedule B, -------- listed interest income from ------------
---------------------------------------------------------------------------------------------------------------------
POSTS-109898-15                                          4

----------------------------------------------------------------------------------------------------. --------------
-------amended return was processed, but the requested refund of -------------was frozen.

On or about --------------------------, -------- filed an amended ------ income tax return
claiming additional Form 1099-OID income of -------------and an identical amount of
additional withholding on the return. She attached to her ------ amended return Forms
1099-OID designating income and nearly matching withholding amounts from -------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------. This amended return was not processed and the ----------
------------refund claimed on the amended return was not issued.

The entities named on the taxpayer’s Schedules B for the amended ------ and ------
returns and the purported original return for ------ confirmed that the amounts stated on
the Schedule Bs were the account balances or amounts available for credit. These
amounts were not income to ---------------and were not withheld from her as she reported
on her amended returns for ------ and ------ and her original ------ return. The only
interest income -------------------correctly stated on her amended tax returns for ------ and
------ was ----------and ---------, respectively, from ----------------------------------------.

-------------------was employed by --------------------------------------------------------------------------
-------, from -----------------------------------------------------------------------------. Her personnel
file indicates that she has received training in several courses regarding loans as well
as individual tax return and business tax return training.

After examination of -----------------------------through ------ tax years, adjustments were
made to correct her filing status. In addition, for-------, adjustments were proposed to
reverse the interest income and federal tax withholding associated with the false Forms
1099-OID.

----------------refused to cooperate with the Internal Revenue Service Criminal
Investigation unit and the revenue agent in this case. She ignored attempts to contact
her via telephone and letter. She refused to answer any questions by the Internal
Revenue Service Criminal Investigation unit when two special agents appeared at her
place of employment. She responded to a Letter 3176C, informing the taxpayer her
filings were frivolous, by submitting a document entitled “Memorandum of Law in
Support of 1099OID – Original Issue Discount.”

On ---------------------------, -------------------was indicted on charges under 18 U.S.C. § 287,
Filing False Claims with a Governmental Agency/ Filing A False Income Tax Return and
Title 18 U.S.C. § 2, Aiding and Abetting with respect to the ----------------and ------ taxable
years. She pled guilty to a violation of 18 U.S.C. § 287 for Filing A False Income Tax
Return and 18 U.S.C. § 2 for Aiding and Abetting related to ------. As part of that plea
agreement the government agreed to dismiss the remaining criminal charges for ---------
POSTS-109898-15                                          5

------------. -----------------------------------------------------------------------------------------------------
---------------------------------------------------------.

LAW AND ANALYSIS

    1. The returns -------------------filed for tax years --------------, and ------ and -----------
       ----------filed for ------ are likely valid.

The section 6663 fraud penalty cannot apply when a taxpayer has not filed a valid tax
return. See sec. 6664(b); Mohamed v. Commissioner, T.C. Memo. 2013-255.
Therefore, to determine whether ------- and -------------------are subject to the fraud
penalty under section 6663, we must first determine whether the purported returns they
filed for tax years --------------, and ------ constitute valid tax returns.

Courts have treated as valid returns that claim refunds on the basis of overstated
withholding. See, e.g. Feller v. Commissioner, 135 T.C. 497 (2010); Young v.
Commissioner, T.C. Memo. 2015-18. To be valid, a return must meet the following four
requirements: (1) it must contain sufficient data to calculate tax liability; (2) it must
purport to be a return; (3) it must be an honest and reasonable attempt to satisfy the
requirements of the tax law; and (4) it must be executed by the taxpayer under penalties
of perjury. See Beard v. Commissioner, 82 T.C. 766, 777 (1984). A return that is
incorrect, or even fraudulent, may still be a valid return if “on its face [it] plausibly
purports to be in compliance.” Badaracco v. Commissioner, 464 U.S. 386, 396-397
(1984).

The Forms 1040 filed by ------------------for --------------, and ------ and by -----------------------
for ------ meet the first three requirements of the Beard test. As to the first requirement,
the returns filed by the ---------- for the years at issue contain sufficient data to calculate
the ------------’ tax liability because, aside from the overstated withholding, the returns
were largely correct. As to the second and fourth factors, all the returns purported to be
returns and were executed under penalties of perjury.

Whether the purported returns were an honest and reasonable attempt to satisfy the
requirements of the tax law, in satisfaction of the third requirement, is a closer call. For
the frivolous filing penalty to apply, section 6702 requires that the purported return
contain information that “on its face indicates that the self-assessment is substantially
incorrect.” Sec. 6702(a)(1)(B). Because the Service assessed the section 6702
penalty, it determined that the Forms 1040 the ----------- submitted contained some
information that, on the face of the returns, indicated that the self-assessments were
incorrect. It’s arguable that if a return is so facially implausible that a section 6702
penalty applies, that return may also fail the third prong of the Beard test: that it be an
honest and reasonable attempt to satisfy the requirements of the tax code.

However, rarely, if ever, has a court found a purported return to be invalid solely for
failure to satisfy the third prong of the Beard test. See Sakkis v. Commissioner, T.C.
POSTS-109898-15                                6

Memo. 2010-256, *7. As we noted previously, the ----------- accurately reported most of
their tax information for the years at issue. The inclusion of falsely overstated
withholding information renders their returns inaccurate, but likely not invalid. See e.g.,
Feller v. Commissioner, 135 T.C. 497 (treating as valid returns which falsely reported
overstated withholding attributable to false OID income); Sadler v. Commissioner, 113
T.C. 99 (1999) (treating as valid returns which falsely overstated taxpayer’s income tax
withholding); Rice v. Commissioner, T.C. Memo. 1999-65 (same). Most likely, a court
would find that the returns are valid returns sufficient to give rise to liability for the fraud
penalty under section 6663, if there is an underpayment. To guard against the
possibility that the returns are not valid, the Service should include the section 6651(f)
fraudulent failure to file penalty as an alternative position in any statutory notice of
deficiency issued to the------------for the years at issue.

    2. Determination of an Underpayment on Original Returns

Section 6663 imposes a penalty of 75 percent on any underpayment attributable to
fraud. Sec. 6663(a). The Tax Court has repeatedly found that the overstatement of
withholding credits can give rise to an underpayment subject to the fraud penalty under
section 6663. See Feller, 135 T.C. 497; Sadler, 113 T.C. 99 (1999); Rice, T.C. Memo.
1999-65. Section 6664(a) defines an underpayment of income tax as the amount by
which the tax imposed exceeds the excess of (A) the sum of (i) the amount shown as
the tax by the taxpayer on his return, plus (ii) amounts not so shown that were
previously assessed (or collected without assessment), over (B) the amount of rebates
made. This definition can also be expressed using the following formula:

       Underpayment = W – (X + Y – Z)
       W = the amount of income tax imposed
       X = the amount shown as the tax by the taxpayer on his return
       Y = amounts not so shown previously assessed (or collected without
       assessment); and
       Z = the amount of rebates made

See Treas. Reg. § 1.6664-2(c); see also Feller, 135 T.C. 497 (2010) (upholding the
validity of the regulation, as applied to an underpayment resulting from overstated
withholding credits).

The amount shown as tax by the taxpayer on his return (X) is further defined as the tax
liability reported by the taxpayer on his return, reduced by any amounts shown by the
taxpayer as credits for tax withheld over any amounts actually withheld. See Treas.
Reg. § 1.6664-2(c). If a taxpayer reports withholding credits in excess of both the
reported tax liability and the amounts actually withheld, the X variable will be a negative
number.

The amount collected without assessment (Y) is the amount by which the total of the
estimated tax and other payments made before the return is filed exceed the tax shown
POSTS-109898-15                                       7

on the return. See Treas. Reg. § 1.6664-2(d). In “frozen refund” situations, i.e. where a
taxpayer has claimed a refund, but where the amount has not been refunded or credited
to the taxpayer, the Service has adopted the practice of treating the amount of the
frozen refund as a sum collected without assessment. In many cases, the net result will
be that the X variable and the Y variable will cancel each other out such that no
underpayment will exist.

The amount of rebates made (Z) is the amount of any abatement, credit, refund, or
other repayment made on the ground that the tax imposed was less than the excess of
the sum of the amount shown as the tax by the taxpayer on his return plus amounts not
so shown, but previously assessed or collected without assessment over rebates
previously made. See Treas. Reg. § 1.6664-2(e). If the Service erroneously makes a
refund of tax on the basis that a taxpayer claimed withholding of income tax in excess of
the amount of tax actually withheld, such refund is not a “rebate” made on the ground
that the tax imposed is less than the amount shown as tax by the taxpayer on the
return. Instead, it is an erroneous refund paid as a result of the amount shown as tax by
the taxpayer on his return and will not be taken into account in calculating the amount of
an underpayment under section 6664.

Applying the underpayment formula to -------------------- ------ Form 1040, the
underpayment would be calculated as follows. As far as we are aware, ---------------------
had no income tax liability for tax year ------, so the (W) variable, the amount of income
tax imposed, is ------.1 ------------------reported a tax liability of -----------on his ------ Form
1040 and, despite reporting income tax withholding of ------------, no income tax was
actually withheld from ------------------ for tax year-------. Therefore, the (X) variable for
his -------year will be the amount shown as tax on the return, ----------, minus the -----------
-------------he reported as income tax withheld, which equals -------------. The (Y) variable
for his ------ year is -------------because ------------------claimed a refund in the amount of --
------------, but the refund was frozen and no amount was refunded or credited. Finally,
the (Z) variable is also ------ because no rebates were made. Plugging these variables
into the formula results in no underpayment, as the X and Y variables cancel each other
out:

(W) amount of income tax imposed                                               ---

(X) amount shown as tax on the return                                           ------------

(Y) amounts not so shown previously assessed
    (or collected without assessment)                                            ----------

(Z) amount of rebates made                                                       --

1
 For the purposes of these calculations, we assume that ------- correctly reported no income tax liability for
tax year-------. However, if our assumption is incorrect and his liability for income tax for that year was
other than ------, the underpayment calculation will need to be adjusted accordingly.
POSTS-109898-15                                         8

Underpayment amount                                                                ---


This same analysis also yields an underpayment of ------ for ---------------------------return:

----------------------------Return

(W) amount of income tax imposed                                                   ---2

(X) amount shown as tax on the return                                               ----------

(Y) amounts not so shown previously assessed
    (or collected without assessment)                                               ---------

(Z) amount of rebates made                                                          --

Underpayment amount                                                                ---

We are unable to accurately determine the amount of any underpayments for the --------
-------------------returns because both --------and -------- reported taxable retirement
income for those years. It will be necessary first to determine the correct amount of
income tax imposed for those years before the underpayment amounts can be correctly
calculated. However, the underpayment amounts for those years can be determined
using the same methodology outlined above. We note that for the--------tax year,---------
--------- claimed a refund in the amount of -------------and that a refund in that amount was
issued. Although the exact amount of the underpayment will depend on the correct
amount of income tax imposed for tax year ------, ------------------will likely have an
underpayment for tax year ------. For the ------ year, -------------------claimed a refund in
the amount of ----------. Her claim for refund was frozen and no refund was issued to her
for the ------ year. Using the methodology above, it is likely that --------------------will have
no underpayment for tax year ------.

Section 6663 imposes a penalty of 75 percent of any underpayment attributable to
fraud. ----------------------------return likely gives rise to an underpayment, to which the
6663 fraud penalty is applicable. For the other years at issue – ------ and ------ for --------
and ------ for -------- – where no underpayment exists, the 6663 fraud penalty is
inapplicable. For those years, the Service could assess the section 6676 penalty on
erroneous claims for refund or credit.

    3. Determination of an Underpayment on Amended Returns



2
  As with ------, we assume that -------------------had no income and no income tax liability for tax year -------.
If his tax liability for tax year ------ was other than ------, the underpayment calculation will need to be
adjusted accordingly.
POSTS-109898-15                                    9

Amended returns differ from original returns in that a taxpayer is required to file an
original return, whereas amended returns are a matter of administrative grace. See
Badaracco, 464 U.S. at 393. And, as the Tax Court noted, “rejection of a claim for
refund or abatement in an amended return does not convert the disallowed claim into a
deficiency.” Fayeghi v. Commissioner, T.C. Memo. 1998-297, *4. Further, as explained
above, the Service has adopted the practice of treating the amount of a frozen refund as
a sum collected without assessment. Thus, underpayments cannot arise from false
refund claims that are not paid.

The appropriate penalty for this type of situation – where a taxpayer makes a false claim
for refund that is not paid – is the section 6676 penalty on erroneous claims for refund.
Section 6676 provides that, where a taxpayer makes a claim for refund that is
erroneous and without a reasonable basis,3 a penalty equal to 20 percent of the amount
erroneously claimed will apply. See sec. 6676(a). -----------------------------and---------
amended returns made claims for refund that were both erroneous and, as discussed in
the facts, without reasonable legal or factual basis. Consequently, those claims are
subject to the 20 percent penalty imposed by section 6676. If exam wants to assert a
penalty with respect to -----------------------------and ------ amended returns, the section
6676 penalty is the correct penalty to assert.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

                                                       -------     ------




        4




    ----------                                                              ---------


3
  Section 209 of the recent PATH Act, Pub. L. 114-113 Div. Q (2015), amended section 6676 by replacing
the phrase “reasonable basis” with the phrase “reasonable cause”. The PATH act does not specify an
effective date for that for that amendment. However, in the absence of any clear direction from Congress
with respect to effective date, a law is presumed to take effect on the date of its enactment, here
December 18, 2015. See Gozlon-Peretz v. United States, 498 U.S. 395, 404 (1991). Because -------------
------------ amended returns were filed before December 18, 2015, the reasonable basis exception, not the
reasonable cause exception, applies to her claims for refund.
4
POSTS-109898-15                              10

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writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-5197 if you have any further questions.