Thursday, January 21, 2010

Taxpayers take the IRS to court -- and actually win

It may be hard to believe, but it turns out that your chances of fighting the IRS in court -- and winning -- are actually better than getting hit by lightning (1 in 6,250),dying after a shark attack (9 in 152) or even having twins (3 in 100). In fact, the National Taxpayer Advocate's office found that over the course of a year, taxpayers won some portion or all of their cases roughly 14% of the time.

Taxpayers who were represented by counsel won about 20% of those cases, while those who represented themselves, referred to as pro se, prevailed in about 12% of them (download the entire report here). The predictable losers, with only a 6% success rate, were tax protesters who attempted to litigate based on frivolous arguments. On the other end of the spectrum, requests for "innocent spouse" treatment or other types of separation from joint liability were granted nearly 45% of the time.

Maryland Nurse Takes on the Tax Man

Among that sliver of people boldly taking on the IRS is Lori A. Singleton-Clarke, a nurse from Maryland, who fought the IRS in court, represented herself -- and won.

Singleton-Clarke's David and Goliath story began in 2006, when the IRS notified her that they would be auditing her 2005 tax return. On her federal income tax form for that year, she had reported $50,000 in income offset by a number of deductions, including $14,787 in educational expenses associated with her pursuit of an MBA/HCM (an MBA for health care management professionals) from the University of Phoenix, an online school. But the IRS wasn't buying it. After reviewing her filing, the IRS claimed she owed an additional $2,126 in income tax for 2005.

Singleton-Clarke agreed to eliminate some of her deductions but refused to budge on those related to her education expenses. After receiving several notices, including a Notice of Deficiency, Singleton-Clarke filed a challenge to the IRS in U.S. Tax Court. Since she couldn't afford an attorney, she represented herself.

In court, the IRS said that the educational expenses Singleton-Clarke claimed for deductions weren't sufficiently connected to her job as a nurse since an MBA isn't a nursing degree -- they cited Treas. Reg. 1.162-5(a), which states that, to be deductible, your expenses must be for education that either maintains or improves your job performance or is required by your employer or by law to keep your salary, status or job. The IRS specifically focused on the idea that the expenses can't be part of a program that will qualify you for a new job.

Singleton-Clarke argued that the educational expenses were indeed work-related. She had earned a bachelor of science degree in nursing from New York University in 1984 and had worked as a registered nurse at several hospitals and medical facilities for 24 years. She said she took the MBA courses at the University of Phoenix in order to gain greater credibility and make her more effective in her current position. After all, the University of Phoenix advertised the MBA/HCM degree as providing students "with the business management skills needed to manage successfully in today's health care delivery systems."

After reviewing Singleton-Clarke's job history, the Tax Court found that the MBA/HCM degree may have improved her preexisting skillset, but didn't qualify her for a new trade or business, as the IRS alleged. With that finding, the Tax Court allowed the expenses. You can read the Singleton-Clarke Tax Court opinion here.

Man Crashes Truck, Gets Cited for DUI and Beats the IRS

Like Singleton-Clarke, Justin M. Rohrs successfully represented himself in Tax Court after the IRS rejected a deduction that he made on his tax form and demanded that he pay additional taxes, plus a penalty.

Rohrs had taken a casualty loss deduction for his 2006 Ford F-350 pickup truck after he failed to properly negotiate a turn and went off the side of the road and into an embankment, totaling his truck. He was cited for the crash when his blood alcohol limit tested at .09, just over the legal limit in California.

Rohrs filed a loss with his insurance carrier, which was turned down. He then attempted to recover his loss by filing for a casualty loss deduction of $33,629 on his federal income tax return. The IRS disallowed the deduction and assessed a $6,230 federal income tax deficiency, plus a $1,246 penalty. Rohrs took the matter to court.

The pivotal question of the trial was whether Rohrs' drunk driving was considered a willful act. The IRS's case relied on Treas. Reg. 1.165-7(a)(3), which states that you can claim a casualty loss for damage to a vehicle only if the damage is not due to the willful act or willful negligence of a taxpayer.

After listening to Rohrs' testimony, the judge found that "[w]hile petitioner's decision to drive after drinking was negligent, that alone does not automatically rise to the level of gross negligence." The judge also said there was no evidence that Rohrs' drinking was the cause of the accident and ruled in his favor. (You can read the Rohrs Tax Court opinion here.)

Couple Discovers That Not All Tax Advice Is Right

Of course, pro se appearances don't always result in a win.

When Kenneth and Trudi Woodard filed a joint federal income tax return for 2004, they failed to include $150,000 in distributions from Kenneth's IRAs. The IRS subsequently assessed the Woodard's tax in the amount $27,606, plus a penalty. In response, the Woodards filed an appeal at Tax Court, representing themselves.

Kenneth told the court that he had relied on information that he claimed he found after a search on Google, and decided not to include the money on his tax return. Instead, he referred to the money as a "self-directed IRA" and claimed it wasn't reportable. He eventually agreed the income should have been reported, but argued the penalty shouldn't apply.

Relief from penalties can be granted in certain circumstances. Relying on third party tax advice may be a good excuse for abating a penalty so long as you use "ordinary business care and prudence." Unfortunately, Kenneth failed to provide the web site links he allegedly relied on, nor could he point to any other evidence that supported his claim. The court didn't believe he exercised ordinary business care and prudence when failing to report the IRA withdrawals. As a result, he lost the entire case. (You can read the Woodard Tax Court opinion here.)

Perseverance Will Help You Through

As encouraging as some of these cases may be, you can't rely on them to prove your own case. By law, a Tax Court opinion for a small case, or a dispute under $50,000, cannot be treated as precedent for other cases. There are, however, some good lessons to be learned from these taxpayers:
  1. Stick to your guns. When you believe you're making the right decision, don't be intimidated. A majority of the cases filed in Tax Court are filed by pro se taxpayers; if you don't have the money to pay for an attorney, don't assume your case is a lost cause.
  2. Be patient. It can take up to a year before your case is assigned a date once you file your petition. Singleton-Clarke didn't receive a favorable result until nearly three years after the IRS audited her return. Don't be put off by the passage of time. You might even take the time to try and resolve your case directly with the IRS; a majority of cases are settled before reaching Tax Court.
  3. Be thorough. A case can turn on facts and circumstances. Be sure you understand the argument from the IRS and that your facts support your answer. Don't leave out key facts or evidence. Even if the evidence isn't necessarily flattering, such as Rohrs' blood alcohol content, it's part of your story. You need to offer sufficient detail for the court to understand your position.
  4. Keep good records. When you get advice, write it down or ask your tax pro to put it in writing. Don't attempt, as Kenneth Woodard did, to rely on your memory.
  5. Know enough to know when you're in over your head. I'm certainly not going to tell you that you have to hire an attorney to beat the IRS. Singleton-Clarke and Rohrs have proven that's not true. But if you're overwhelmed or you feel you need help, get an attorney. The IRS will certainly have one on their side.

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