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Essner v. Commissioner (T.C. Memo. 2020-23)

On February 12, 2020, the Tax Court issued a Memorandum Opinion in the case of Essner v. Commissioner (T.C. Memo. 2020-23). The issues presented in Essner were whether the petitioner failed to report distributions from an inherited IRA and whether the IRS subjected the petitioner to a duplicative inspection of his books and records relating to his 2014 tax year in violation of IRC § 7605(b).

Background

In 2013 the petitioner’s mother died, and he inherited an IRA that she had, in turn, inherited from her late husband, petitioner’s father. After the petitioner inherited the IRA, he took distributions from it in both 2014 and 2015. Specifically, the petitioner received distributions of $360,800 and $148,084 in 2014 and 2015, respectively. Believing that the distributions were tax-free (thanks, Google), the petitioner engaged a return preparer for his 2014 and 2015 returns, but he did not inform his return preparer that he had received IRA distributions in 2014 and 2015 and did not ask for guidance from his return preparer on the tax treatment of such transactions.

The IRS received Forms 1099-R (Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.), reporting the IRA distributions to the petitioner. The IRS’s Automated Underreporting (AUR) program generated two notices informing the petitioner that it had detected a discrepancy between records of payments made to him and the amount of taxable income he reported on his 2014 income tax return. The petitioner responded, stating in a handwritten note that he disagreed with the proposed changes. Being the heartless computer system it is, the AUR generated a statutory notice of deficiency (SNOD) regarding the 2014 tax year, from which the petitioner timely petitioned the Tax Court for a redetermination.

This was not, however, the end of the petitioner’s interaction with the IRS. Concurrently with the review by the AUR program, petitioner dealt with an individually directed examination of his 2014 and 2015 tax years. Two months prior to the automatically generated SNOD, the petitioner received a Letter 3572, informing petitioner that his 2014 tax return had been selected for examination and requesting that petitioner provide copies of his 2013 through 2015 income tax returns. Ostensibly, the Letter 3572 focused on various reported travel, meal, and legal expenses but did not mention the IRA distribution discrepancy that the AUR program had already identified.

Apparently ignorant of the 2014 SNOD that the AUR had generated, the IRS continued its examination and ultimately sent a Letter 915 to the petitioner attaching the examination report and proposing adjustments related to the 2014 tax year. The RAR did not reflect the adjustment relating to the petitioner’s IRA distribution in 2014. Thus, the petitioner sent a letter to the IRS requesting that it provide a copy of the original report to confirm that the IRA distribution petitioner received in 2014 was not taxable. Ultimately, the IRS issued a SNOD relating to his 2015 tax year, and the petitioner, once again, timely petitioned the Tax Court for a redetermination.

The Unnecessary Examination Provision – IRC § 7605(b)

The petitioner argued that the IRS should be barred from assessing the proposed deficiency for 2014, because it violated IRC § 7605(b) by conducting a second inspection of petitioner’s books and records for 2014. In part, IRC § 7605(b) provides that a taxpayer must not be subjected to unnecessary examination or investigations, and only one inspection of a taxpayer’s books of account shall be made for each taxable year unless the taxpayer requests otherwise or unless the IRS, after investigation, notifies the taxpayer in writing that an additional inspection is necessary. Digby v. Commissioner, 103 T.C. 441, 446 (1994).

Looking Behind a Notice of Deficiency – The Narrow IRC § 7605(b) Exception

Generally, the Tax Court will not “look behind” the notice of deficiency to see what occurred during the course of an examination. See Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324, 327 (1974). However, the petitioner’s IRC § 7605(b) argument opens a narrow exception to that rule; therefore, facts relating to the examination for petitioner’s 2014 tax year—and only his 2014 tax year—are material to these cases.

The IRC § 7605(b) Restriction in Practice

The Supreme Court has explained that IRC § 7605(b) imposes “no severe restriction” on the IRS’s power to investigate taxpayers. United States v. Powell, 379 U.S. 48, 54 (1964). As such, the Tax Court reads the restriction narrowly. See De Masters v. Arend, 313 F.2d 79, 85-86 (9th Cir. 1963). Mere communication with the taxpayer does not fall within the scope of IRC § 7605(b). Seidel v. Commissioner, T.C. Memo. 2005-67, *13.

Additionally, IRC § 7605(b) does not limit the IRS’s ability to assemble and consult third-party records related to a taxpayer’s tax liability. See Hubner v. Tucker, 245 F.2d 35, 38-39 (9th Cir. 1957). Nor does it limit the IRS’s ability to review already-filed tax returns in his possession. See Estate of Sower v. Commissioner, 149 T.C. 279, 289 (2017).

The Tax Court notes that the petitioner’s interactions with the IRS “would be confusing to an ordinary taxpayer.” Various offices of the IRS contacted petitioner without coordination, without clarity as to what the other parts were doing, and without providing petitioner a clear explanation as to why the IRS was “speaking out of many mouths.”

Although the taxpayer ought not to have been subjected to such a “byzantine” examination, the Tax Court is simply not empowered to “police what ought to have occurred in an examination.” Instead, it must only consider whether the letter of IRC § 7605(b) was violated. See Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324, 327 (1974).

Under IRC § 7605(b), the AUR program’s matching of third party-reported payment information against petitioner’s already-filed 2014 tax return is not an examination of petitioner’s records. See Hubner, 245 F.2d at 38-39. Therefore, the Tax Court held, no second examination of petitioner’s books and records could have occurred, regardless of the concurrent actions of the more human branch of the IRS, the Examination division.

Bright Line Rule

While understanding the petitioner’s frustration at the utter failure of the right hand of the IRS to know what the left hand was doing, the “failure to coordinate and communicate” within the IRS, alone, does not violate IRC § 7605(b).

Original opinion: (T.C. Memo. 2020-23) Essner v. Commissioner

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