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November 12, 2014

2014-Issue 45–Have you relied on guidance from the Internal Revenue Service to analyze a situation, structure a transaction or obtain an instructional roadmap for completing your tax returns? To a seasoned tax professional, this question may seem rhetorical. However, according to a recent Tax Court decision, relying on certain IRS guidance may put you in an unexpected defenseless position, one that begs the thought “you have to be kidding me.” Unfortunately, this is no kidding matter. In April 2014, the Tax Court in Bobrow v. Commissioner (T.C. Memo 2014-21) held against a taxpayer for taking a position that the IRS has allowed for decades and clearly provides for in Publication 590 and proposed regulations under Section 408(d). For us tax professionals, the concept of tax authority and its hierarchy for reliance have been well branded into our minds. The Tax Court’s decision has placed an exclamation mark squarely in our paths and reminds us of what we have known (or should have known) all along: be careful of what you rely on, even if from the IRS.

The Tax Court’s holding brings to mind a humorous anecdote. In 1963, a letter written by Leo Mattersdorf, a close friend of Albert Einstein, appeared in Time magazine with the following assertion:

      From the time Professor Einstein came to this country until his death, I prepared his income tax returns and advised him on his tax problems.

Mattersdorf then proceeded to tell the following anecdote:

      One year while I was at his Princeton home preparing his return, Mrs. Einstein, who was still living, asked me to stay for lunch. During the course of the meal, the professor turned to me and with his inimitable chuckle said: “The hardest thing in the world to understand is income taxes.” I replied: “There is one thing more difficult, and that is your theory of relativity.” “Oh, no,” he replied, “that is easy.” To which Mrs. Einstein commented, “Yes, for you.”

Could Einstein truly have had difficulty understanding the tax law? That is debatable. However, there is widespread belief that our current tax system is unnecessarily complicated, and few expect that the newly elected Congress has the political votes or time to tackle comprehensive tax reform that will achieve the level of simplification sought by many. At the same time, there are increasing constraints being placed on the IRS’s internal resources and training budgets that, if left to continue, could adversely impact how the IRS is able to effectively carry out its responsibilities.

Setting the Table
Although technically correct, one cannot help but feel that the Bobrow decision somehow “cuts against the grain” — so much so that it grabbed the attention of the Board of Regents of the American College of Tax Counsel, a former IRS Commissioner and a former Assistant Treasury Secretary for Tax Policy. As tax professionals, we are constantly faced with a changing landscape, whether it is newly enacted laws, interpretations of existing laws or new tax forms (some of which carry hefty monetary penalties for failure to substantially comply). With the time constraints in our fast-paced world, we are often asked by our clients, supervisors and company stakeholders to find the right answer in the most expeditious fashion. There are many directions one can choose, and the one that often makes the most sense is to turn to the IRS. Throughout my professional career, I can clearly recall being on either end of these common questions:

  • Did you read the IRS form instructions and related publications?
  • Did you refer to the Q&A section on the IRS website?
  • Have you considered contacting the IRS Chief Counsel’s Office for clarity on the recent announcement?
  • What is the scope of the IRS directive and how might it apply to our situation?

It is par for the course for tax professionals to become intimately familiar with the guidance routinely issued by the IRS. Not only can the IRS be a valuable source of information, but the interactive relationship between the tax community and IRS arguably promotes a better system for all of us. Nevertheless, this reliance does have its boundaries and we, no matter the time constraints, should be cognizant of whether the guidance will truly hold water when the going gets tough.

The Bobrow Decision
The Tax Court in Bobrow addressed the ability of a taxpayer to effect multiple nontaxable “rollover contributions” from different traditional Individual Retirement Accounts (IRAs) within a one-year period without being subject to taxation (and potentially the 10 percent early withdrawal penalty). Our focus here is not so much the detailed rules applicable to IRAs, but to illustrate the difficult position that anyone (in this case an attorney specializing in tax) navigating through our complex tax rules can find himself in.

The IRS has long held in published guidance that the “one year” rule applicable to nontaxable rollover contributions applies on an IRA-by-IRA basis. This interpretative guidance was put to the test in Bobrow. In this case, the Tax Court came to a different conclusion by holding that the one-year rule applied on an aggregate basis (not IRA-by-IRA) based on the plain language and history of the statute. Consequently, the Court upheld assessments for additional income tax and a 20 percent accuracy-related substantial understatement penalty under Section 6662. The taxpayer’s efforts to mitigate the penalty assessment were unpersuasive for a variety of reasons (e.g., failure to disclose the position, he should have known better given his professional status as a tax attorney, etc.).

The Tax Court did not address Proposed Regulation Section 1.408-4(b)(4)(ii) and IRS Publication 590 in its holding, both of which clearly supported the taxpayer’s filing position. As would be expected, the taxpayer filed a motion for reconsideration with the Tax Court. At the same time, reputable industry groups and high-profile individuals from the tax community voiced concern in an effort to protect the public’s confidence in the tax system. The motion was ultimately ruled as moot as a result of a settlement reached by the IRS and the taxpayer. Nevertheless, in its denial of the motion, the Tax Court took the opportunity to warn us of the dangers of relying on an IRS publication because it is not “binding precedent” and does not constitute “substantial authority” for any position.

In the response to the decision, the IRS (likely embarrassed by the ordeal) issued Announcement 2014-15, which stated its intention to update Publication 590, withdraw Proposed Regulation Section 1.408-4(b)(4)(ii), which conflicted with the Tax Court’s interpretation of the law, and apply the Tax Court’s interpretation for rollover distributions made after December 31, 2014.

The Lesson: Inequality Does Exist
The lesson from Bobrow is abundantly clear: not all tax guidance is created equal. A recap of the hierarchy of tax law may be useful here. The tax law is derived from two types of sources: primary and secondary authority.

  • Primary authority: All three branches of the U.S. government and related agencies make tax law commonly referred to as primary authority. The Internal Revenue Code (IRC) is the highest source of the law. The interpretations of the IRC provided by the executive and judicial branches of government are next on the ladder of hierarchy. In the executive branch, the Treasury Department and the IRS National Office interpret the IRC through a number of means: final regulations, temporary regulations, proposed regulations, legislative history, revenue rulings, revenue procedures, private letter rulings, publications, filing instructions and various other published materials. In general, only final and temporary regulations carry the full force and effect of the law. The remaining sources vary in importance and have limitations on how each can be cited as precedent or used to avoid penalties. The judicial branch interprets the application of the law through the Tax Court, District Courts, Court of Federal Claims, Court of Appeals and Supreme Court.
  • Secondary authority: All other sources of tax information not described as primary authority make up secondary authority. These sources generally consist of unofficial guidance such as treatises, journals and newsletters. 

The distinction between primary and secondary authority is particularly relevant for avoiding the accuracy-related underpayment of tax penalty of Section 6662, provided the position was not properly disclosed on a tax return. Avoidance of the penalty is predicated on meeting the “substantial authority” standard, which places a premium on analysis, research and the maintenance of contemporaneous written documentation to support conclusions and the primary authorities relied upon.

Is it reasonable to presume that reliance on any IRS guidance or proposed regulation that supports a filing position insulates one from penalties under Section 6662? Unfortunately, the answer to this question was not addressed “head on” by the Tax Court in Bobrow and may ultimately depend on facts and circumstances. Nonetheless, these sources of IRS guidance clearly have served, and will continue to serve, a purpose for taxpayers and tax professionals alike. Because of their utility, many of us routinely rely on these sources with impunity, with the expectation that they accurately explain the laws that we seek (and are expected) to follow. Whether the Tax Court’s decision will alter the way we use IRS guidance remains to be seen. However, Bobrow should serve as a reminder that because the IRS is fallible, we must handle our personal tax matters and tax matters for those we represent with the diligence and utmost care that they demand.

Alvarez & Marsal Taxand Says:
It is clear that the understanding of taxes referenced by Einstein requires more than how to crunch numbers. As tax professionals, we are expected to hold ourselves to a higher standard, whether by our internal or external stakeholders, and constantly justify our value to our business organizations. To that end, all those who contribute to the tax function need to understand the hierarchy of tax authority and avoid the temptation to obtain the quick answer. There is a time and place for using less rigorous approaches to finding an answer, and certain guidance provided by the IRS may suffice. However, more often than not, correctly applying the tax law requires taking the time to corroborate the answer with other sources. The stakes are just too high…caveat utilitor! 

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.

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