The client had lost a great deal of money in the real estate meltdown. He wanted to file bankruptcy, but there was a problem: His secretary had failed to mail his tax return back in 2006 for the 2005 tax year. This return showed he owed about $400,000 in tax.
When a return hasn’t been filed, the IRS goes out and tries to get it from the taxpayer. After some amount of effort, the IRS gives up and writes its own tax return for the debtor and files it. It then assesses the tax on the return it wrote, and tries to collect it. Oh, and the taxpayer-debtor cannot discharge that particular tax debt in bankruptcy.
The IRS-written return is called a “substitute for return,” or SFR. As one might guess, it does not give the best tax treatment to the taxpayer: it assumes single filing status, receipt of all income found on 1099s, and no deductions against that income.
Our client had sold (or lost at foreclosure) a bunch of land. The IRS filed its SFR showing that the client owed $12 million in tax. It hadn’t yet assessed the tax – assessment is an official term that means something close to judgment; it gives evidence of finality.
We got involved, and urged the taxpayer to file his return. He had already given a xeroxed copy of it to the IRS; the IRS, however, needs an original signature on it.
At around the same time, the taxpayer realized that he could carry back net operating losses (NOLs) from the 2008 tax year to further lower his 2005 tax return (he had $13.8 million in NOLs for 2008). This would lower his self-reported $400,000 tax debt to about $80,000. So he filed an amended return for the 2005 tax year by mailing it to the Fresno Service Center, and attached a signed copy of the first two pages of his original 2005 tax return.
A week later, he met with the revenue agent and handed her another signed copy of his 2005 tax return. This one included about 300 pages of schedules, statements, and worksheets.
The revenue agent didn’t do anything with the hand-delivered return; it stayed in her files. She maintained that he had not filed a return, and even if he had, he needed to substantiate the whole thing in her audit. This meant showing the original purchase price of the real property and all investments that went into it, thus verifying the adjusted basis.
The client has a 300-sq.ft. storage room filled floor to ceiling with old financial data, including, someplace in those hundreds of boxes, verification of his adjusted basis in the properties he sold in 2005. He didn’t really have the funds to pay an accountant or attorney to go through and figure it all out.
So the client was stuck. He could file bankruptcy, and he would come out with a $12 million tax debt on the other end. He could fight the IRS audit and lower the $12 million figure to something more reasonable, but that would cost him several hundred thousand dollars in legal fees he could not afford.
Over the course of several years, we kept asking the IRS if it would accept either the mailed-in return or the hand-delivered return as a filing. The revenue agent (the line auditor) said she did not consider it filed; the appeals officer said he could not revisit this issue; the field attorney (stationed in Thousand Oaks) said she thought there was no question about it, because the IRS has “discretion” not to accept a return once an audit has begun. Is that your final answer?, I kept asking, and no one would commit.
Finally, the line attorney sent the issue to the IRS’s national office. There, an attorney whose expertise is limited to one or two sections of the Internal Revenue Code (such attorneys are affectionately referred to as “codeheads”) determined that the client had actually filed a return when he mailed the amended return to Fresno.
Whew. The client could agree to a $12 million tax assessment, and then wipe it out in a bankruptcy eight months later.
But in the meantime, the revenue agent had decided to open up the 2008 tax year for audit. After all, that year had generated a $13.8 million loss; was this loss for real?
She scheduled a date for the audit. Bring all the supporting documents to show this $13.8 million loss, she said. We’ll start at 8:30.
The client showed up with three banker’s boxes of documents, and three thick bound notebooks. The notebooks held the returns for all his entities, entities whose gains and losses flowed into his personal tax return.
“I hope to resolve all the issues in this audit today,” the auditor said. My client laughed. He showed her that the $13.8 million loss came from 40 different entities; here are their returns, he said, pointing to the notebooks.
Then he pulled out the boxes. He went to the first loss transaction on his 2008 return, and pulling documents out of the three banker’s boxes, recreated the adjusted basis for that transaction. The other 39 transactions? “I’ll have to go back to the storage unit and pull the boxes for those,” the client said.
We explained how the other numbers got on the tax return. Then we left the revenue agent alone with the documents for the one transaction.
At 4 o’clock, we came back. The revenue agent had discussed the matter with her supervisor and verified the one transaction to her satisfaction. Based on the obvious cooperation of the taxpayer, and the involvement of professionals in the tax return preparation, she deemed it highly likely that the other transactions scanned out correctly too.
She did find a $700,000 mistake involving a retirement plan. And she could not allow the 2008 NOLs to carry back to 2005 because some specific form had not been mailed in time. But she was willing to accept the original 2005 return as filed, with no changes to it; and she was willing to allow $13.1 million in NOLs for the 2008 tax year to carry back and forward to other tax years.
The client will file bankruptcy, and will probably lose all his NOLs there. But he will be able to discharge $400,000 in tax for the 2005 tax year, and move on with his life.
All told, it was a $25 million day in front of the IRS.