Taxpayers were already frustrated with the old rules. And now with the new tax law, they must learn to deal with a slew of additional rules that may befuddle them and accidentally get them into trouble, often in ways that result in IRS penalties or extra payments. But smart taxpayers can save money by learning lessons from past challenges to IRS rulings—whether those challenges resulted in taxpayer victories, defeats or mixed outcomes.
Here are some notable cases from recent years that went to the US Tax Court and the lessons they provide on how to avoid tax problems while saving money in the future…
File and File Again
When arguing cases with the IRS, it’s important to refile all pertinent financial information and documents at every step of the process. After losing their home in foreclosure and facing serious medical expenses, a retired couple stopped paying taxes, which eventually totaled $60,000. They claimed hardship and offered to settle. But when it came time to review their case, the IRS officer did not have access to papers the pair had already submitted at the outset of the case, and they were turned down.
The facts: The IRS issued a notice to James and Tina Loveland that it intended to seize their assets because of unpaid taxes. The Lovelands provided all of the financial information requested by the agency and proposed a compromise settlement, but the IRS officer rejected the offer. Then, instead of asking for an appeals hearing, the Lovelands offered to negotiate a multiyear installment plan to satisfy the IRS, but that effort failed, too. The IRS then filed a tax lien against the Lovelands’ property. At that point, the couple asked for a hearing and requested that the IRS reconsider its rejection of their most recent offer.
Critically, never along the way did the Lovelands resubmit the financial information that they had submitted when they had originally proposed a settlement.
IRS Position: The agency refused to review the Lovelands’ second offer because the couple had previously decided not to appeal.
In addition, the IRS declined to consider their proposed installment agreement or their claim of economic hardship because the Lovelands had not resubmitted the necessary financial information along with the proposal.
Tax Court Ruling: Although they chose not to appeal, the Lovelands had not in fact engaged in a hearing or an administrative proceeding in a meaningful way, so the IRS had no right to deny their offer for a compromise on that count.
Moreover, the court ruled that the IRS had abused its discretion by declining to consider the compromise offer, the proposed installment plan and the claim of economic hardship. It remanded the case to an appeals office for consideration “consistent” with its opinion. The case is pending, but because it has been sent to an appeals office with implicit criticism of the IRS ruling, the Lovelands are undeclared victors—at least so far.
Lesson: Despite the apparent victory, the couple should have submitted full and complete information the second time, depriving the agency of an excuse to rule against them for lack of proper paperwork.
Loveland and Loveland v. Commissioner, 151 Tax Court No. 7 (2018)
Act in Good Faith
Changes in tax laws have muddled the rules surrounding many real estate transactions and deductions, largely as a result of the 2008–2009 financial crisis. Relying on tax software is not a fail-proof fallback in complicated real estate situations, as one California couple found. The court took that into consideration when dismissing some penalties—a taxpayer victory.
The facts: Karl and Christina Simonsen bought their Northern California townhouse in 2005 for nearly $695,000 with the help of a mortgage. Five years later, under financial stress, they moved out to convert it into a rental property. Subsequently, the couple sold the property to a third party for less than the outstanding balance on the mortgage. In such a “short sale,” the bank takes the proceeds, agrees to forgive the debt on the property and frees the seller from future payment obligations.
The Simonsens, relying in part on popular but possibly outdated tax software, said that the short sale and the bank’s subsequent debt forgiveness were separate transactions. First, they reported the steep loss on the sale as a deduction. Second, they excluded from their calculations the money they received from the sale under a 2007 law addressing cancellation of debt income. Such income, used to pay off part of the mortgage, was not taxable, the Simonsens reasoned.
IRS Position: The short sale and debt cancellation were one transaction. So there was no loss and no cancellation of debt income to exclude from their tax bill. Accordingly, the Simonsens were liable for nearly $70,000 in income tax on the debt cancellation based on what they would have owed if they hadn’t deducted a loss on the sale and accounting for the income they received on the sale. In addition, they faced a penalty of nearly $14,000.
Tax Court Ruling: The short sale and debt cancellation were in fact one transaction—the latter was dependent on the former. And the cancellation of debt income was not excludable. In short, the court agreed with the IRS position that there was neither a gain nor a loss on the sale of the property for tax purposes, and they owed the $70,000.
However, the court also ruled that the Simonsens were not liable for a $14,000 penalty. That was in part because they had acted with reasonable cause and in good faith—especially given the murkiness of the rules and the confusion generated by the tax software.
Lesson: First and foremost, taxpayers should be alert to the tax consequences of short sales and foreclosures. In particular, changes made in the run-up to and after the 2008–2009 financial crisis can trip up any number of calculations, including the cancellation of debt income. Also be aware that information from tax software may not be definitive, especially if you are not using updated online versions. Opportunity: Penalties stand a decent chance of being dismissed, especially if petitioners can show that they are acting in good faith.
Simonsen and Simonsen v. Commissioner, 150 Tax Court No. 8 (2018)
With ongoing changes in health-care insurance, one of the easiest ways to run afoul of IRS regulations is by tripping over Affordable Care Act (ACA) rules.One key point—and this applies to all kinds of tax-related cases—is that even if you lose on the main argument, there’s a decent chance that the court will throw out often-steep additional penalties that the IRS frequently seeks. And that’s definitely a taxpayer victory.
The facts: In 2014, Californians Steven and Robin McGuire received a $7,092 health-care insurance tax credit under the ACA, based on their combined income level. Robin was not working when they got the credit but soon started a job that raised their combined income, making them ineligible for the credit. The pair quickly alerted the California health-care insurance exchange, which for unknown reasons never responded.
The McGuires made multiple attempts to notify and otherwise engage with the exchange. However, with no response, they did not switch to what they later argued would have been a much lower-cost policy than the one that was being subsidized. Critically, the couple made no mention of that $7,092 subsidy on their tax return.
IRS Position: The IRS demanded that the McGuires repay the $7,092 credit in full, even though the state exchange had failed to respond to the couple’s inquiries. Moreover, the IRS levied an “accuracy-related penalty”—generally 20% of the underpayment, or an estimated $1,418 in this case—because they didn’t report the credit on their return.
Tax Court Ruling: The court ruled mostly in favor of the IRS, acknowledging that despite the California exchange’s lack of response, the court was not meant to address issues of fairness and forced the McGuires to pay back the $7,092 credit in full.
However, the court—without explaining precisely why—ruled against the accuracy-related penalty that the IRS sought. So the McGuires were off the hook for that amount.
Lesson: Navigating the tax consequences of the ACA is tricky, and the bureaucracies running the system may not be efficient. Lack of response does not negate a consumer’s obligation to communicate change of status. Nor will bureaucratic glitches prevent you from facing hefty payments if things go awry.
However, appealing IRS rulings in such complicated cases may result in the elimination of what often are substantial and onerous penalties.
McGuire and McGuire v. Commissioner, 149 T.C. No. 9 (2017)