Taxpayer, an ophthalmologist in Texas, got caught up in a microcaptive tax shelter. Ultimately, the IRS disallowed the taxpayer’s deductions and assessed an aggregate deficiency over $1.7 million against the taxpayer for the tax years 2013 through 2016, and also assessed the taxpayer nearly $400,000 in penalties for those years, consisting of a 40% penalty in 2013 and 20% penalties in 2014 to 2016. Ouch!
The taxpayer filed a case in the U.S. Tax Court contesting the deficiencies and the penalties, alleging among other things that the IRS had not correctly followed the necessary procedure in assessing the penalties; mainly, that the IRS agent who assessed the penalties did not secure timely written approval from their supervisor.
In a highly technical opinion that probably only the most hardcore tax practitioner could even contemplate enjoying the U.S. Tax Court held that the IRS agent who assessed the penalties had not obtained all the necessary supervisory approval for 2013, and so some of those penalties were kicked out, but the IRS agent did follow the correct procedure for 2014 to 2016 and so those penalties were allowed to stand.
The practical upshot of this opinion is that the U.S. Tax Court is continuing to affirm the penalties assessed by the IRS in microcaptive transactions, both the 20% accuracy-related penalty and the 40% tax shelter penalty (a/k/a “nondisclosed noneconomic substance transaction”), where the IRS can show that the proper procedures were following in assessing those penalties. But it also demonstrates that the U.S. Tax Court will not hesitate to kick out those penalties where the IRS doesn’t follow the procedural steps in the right order. The rules that the IRS agents have to follow are arguably as complex as the tax code itself, and over the long haul of an examination it is probably easier for agents to trip themselves on some minor this-or-that than to make it through without any errors.
This opinion also illustrates the type of cases that the U.S. Tax Court has before it: An ophthalmologist in Texas paying a couple of million in insurance premiums over four years? C’mon man. A case like that is a loser out of the gate, and about the only thing that the taxpayer can do is to assert hyper-technical arguments about the IRS not following the rules and hope that something sticks (as it did here for part of the penalties for one tax year). Considering the high fees for tax lawyers to even get these arguments before the U.S. Tax Court, it doesn’t seem like a particularly good bet and probably in many cases the taxpayers should simply cut their losses by paying what they owe (including penalties) and move on.
I have no idea what legal fees the taxpayer was charged in this case, but would guess that it was well into six-figures. But even spending just $100,000 to avoid maybe $50,000 in penalties doesn’t seem like such a hot deal. Of course, you’ve got to remember that a lot of the folks who got into these deals to begin with weren’t paying much attention to either the math or common sense from the outset, which is exactly why they got burned. These captive owners might not have been in pari delicto with the promoters who got them into these microcaptive deals, but they were almost certainly at least delicto in a goodly number of cases.
There are probably a lot more of these foot-fault type opinions that are probably going to come out of the U.S. Tax Court in the next few years. Don’t expect me to report on each and every one of them, as my own sanity simply will not permit that, but if some really juicy opinion regarding penalties or procedure comes down then I will try to let you know.
Patel v. CIR, T.C. Memo 2020-133 (Sept. 22, 2020), full opinion below: http://captiveinsurancecompanies.com/cases/patel/Patel_Opinion_200922.pdf