CPAs Need To Know When To Call In Tax Attorney

Originally Published on forbes.com on April 11th,2012

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So I’m starting my list of most unfair tax decisions of 2012 with the recent Court of Claims decision Cadrecha v US.  (You can check out the list for 2011 here.)  Besides giving me injustice to rail against the case also makes an important practice point that will become more relevant as budget constraints continue to take service out of the Internal Revenue Service.  The practice point is that you need to call in the tax attorney before it is too late.  The case concerns a refund claim which I will briefly describe, but there is no controversy in the claim itself, it is all about process.

The Claim

Mutual life insurance companies are owned by the policyholders.  When a mutual insurance company converts to a stock company or, as they say, demutualizes, stock is issued to the policyholders.  Depending on how large the policies are, the stock can be quite valuable.  The issuance of the stock does not create taxable income.  Of course when the stock is sold the sale has to be reported.  When something is sold, you need to know what the basis is.  Many, probably most, practitioners and, more importantly, the IRS thought that the basis in stock obtained in a demutualization was zero.  So when Robert and Cynthia Cadrecha’s S Corporation sold stock in Principal Financial Group in 2003, they reported all the proceeds as gain.

Then they heard about the Fisher case, which sought to establish that stock obtained in a demutualization does have basis.  They took timely action:

Because of the potential effect Fisher could have on plaintiffs’ 2003 tax return, plaintiffs filed an amended income tax return on Form 1040X on March 20, 2007, which the IRS received on March 22, 2007.

This protective claim for refund was filed within three years from the date plaintiffs’ tax return was filed in accordance with the statute of limitations set forth in I.R.C. § 6511(a).

(Just a little note here. This is the advice I have been giving same sex couples who might benefit from the Gill decision.  The deadline for 2008 is almost on us.)

The Fisher case was ultimately decided in favor of the taxpayers so the Cadrechas received their refund of $26,679 and they all live happily ever after. – That is the fairy tale version.–  It is not what happened.

How The Claim Was Handled

On May 10, 2007, after the statute of limitations to file an amended return had expired,  the IRS sent plaintiffs letter 916C regarding their March 22, 2007 filing.  The letter explained that the IRS was unable to process plaintiffs’ claim because the “supporting information was not complete.” . The letter then invited plaintiffs to file “another claim” that included the name of the court case supporting plaintiffs’ claim for a refund and any additional information relevant to plaintiffs’ claim. . The IRS allowed plaintiffs thirty days from the date of the letter to submit the information it requested.  On May 17, 2007, plaintiffs replied to the IRS’s letter, indicating that Fisher was the case to which their protective claim for refund referred.

The IRS responded with two letters:

The first, dated June 26, 2007, explained that the IRS had not been able to resolve plaintiffs’ claim because the necessary research had not been completed. The letter advised plaintiffs that the IRS would contact them within forty-five days.  The second letter, dated August 13, 2007, advised plaintiffs that the IRS still had not resolved plaintiffs’ claim because of the IRS’s heavy workload and its inability to complete the applicable research. . The IRS’s letter informed plaintiffs that an additional forty-five dayswas required.

The IRS disallowed the claim on the grounds that it was late.  They later admitted that this was a mistake.  The IRS had considered the follow-up information to be the claim.  The statute expired for 2003 in April of 2007.  The original claim was filed in March.  The IRS disallowance notice has a very important paragraph.  The disallowance notice said they could appeal within the IRS.  It also indicated that they could sue in court for a refund noting that:

“The law permits you to do this within 2 years from the date of this letter. If you decide to appeal our decision first, the 2-year period still begins from the date of this letter.”

Nothing more was done until the Fisher decision was announced.  Then the taxpayers decided to try to perfect their original timely claim.  This is where it gets interesting, if you like to watch bureaucracy in inaction. I’ll just give you a brief sample:

On November 5, 2008, two days after plaintiffs filed the November 3, 2008 perfecting document, the IRS again responded to plaintiffs’ October 2008 letter stating that it was forwarding the letter to a different IRS officethat would contact plaintiffs within forty-five days. On December 3, 2008, the IRS replied to plaintiffs’ November 3, 2008 letter, which it received on November 7, 2008, explaining that the requisite research had not yet been conducted and that plaintiffs would be contacted within forty-five days.  On January 15, 2009, the IRS again responded to plaintiffs’ November 2008 letter, informing plaintiffs that their claim had been forwarded to the IRS’s Examination Department in Austin, Texas, and that the Examination Department would contact plaintiffs within forty-five days.  Plaintiffs wrote a letter to the IRS dated May 13, 2009 inquiring as to the status of their claim

The next month, on June 25, 2009, plaintiffs, through their Certified Public Accountant, contacted the Taxpayer Advocate Service requesting assistance with their 2003 tax refund claim.  The Taxpayer Advocate Service replied on July 7, 2009, informing plaintiffs that it had forwarded their inquiry regarding the status of their 2003 tax refund claim to the IRS and that plaintiffs would be contacted by August 7, 2009.

It actually goes on from there for quite a while with the claim going from one office to another.  The Cadrechas became frustrated:

Until this point, all correspondence between the IRS and plaintiffs was through plaintiffs’ certified public accountant. On April 19, 2010, Mr. Cadrecha personally wrote to the IRS asking for a resolution of his claim.  On August 22, 2010, Mr. Cadrecha sent a letter to the Taxpayer Advocate Service imploring it to “PLEASE help.

None of it mattered in the end.  The Cadrechas did not file with the Court of Claims until March of 2011.  The IRS notice of disallowance was wrong, but it had started the two year clock, which ran out in August of 2009.

……. nothing that the IRS does by way of reconsideration or administrative appellate review after issuing a notice of disallowance has any effect on the statute of limitations.

The Moral

In tax practice it is something of a judgment call as to when you should be using an accountant and when you need an attorney.  On a smaller case, there are practical limitations based on cost.  $26,679 is a lot of money in some contexts.  Based on very limited experience with cases that have gone to the Court of Claims, it is a very small amount for a Court of Claims attorney.  So probably having an accountant handle the initial filing and the discussions with the IRS was reasonable up to a point, but that notice of disallowance with the two year statute should have sent up a red flag.  If they are still jerking us around in 14 months or so, we need to bring in a lawyer and be prepared to file in court.  The CPA should have been aware of that.

You can follow me on twitter @peterreillycpa.