Federal income tax is fun. Right?

[Famspear]

I have a client who received an IRS notice the other day regarding his 2013 Form 1040 tax return.

The IRS claims that his 2013 return is wrong. The IRS wants to charge him nearly $500 for the 3.8% “net investment income tax” imposed under section 1411 of the Internal Revenue Code, as enacted by section 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010, Public Law no. 111-152 (March 30, 2010).

Here is the only explanation provided by the IRS in the computer-generated notice:

The Health Care and Education Reconciliation Act of 2010 added a Net Investment Income Tax (NIIT) for tax years 2013 and subsequent [years]. The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates, and trusts. In general, net investment income includes interest, dividends, capital gains, rental and royalty income, non-qualified annuities, and income from businesses in which the taxpayer is not an active participant.

The 3.8% tax applies when you have investment income and your modified adjusted gross income exceeds the following:

$200,000 for single or head of household[;]

$250,000 for married filing jointly or qualifying widow(er)[;]

$125,000 for married filing separately[.]

Since we changed your investment income, we also changed the amount of Net Investment Income Tax due.

That’s it.

No explanation of specifically what item of “investment income” was changed, or why it was changed. No amount given for the amount of the change in “investment income.” No showing of any calculation used to arrive at the amount of the tax supposedly owed.

The client is an attorney practicing law as a partner in a law firm partnership. It is not a limited partnership. He receives a K-1 schedule from the partnership, and he incurs and pays self-employment tax with respect to the income.

Of course, I ran the numbers and it turns out that I come up with exactly the amount of the tax that the IRS says is owed if I treat his K-1 income from the partnership as being subject to the Net Investment Income Tax.

This is clearly erroneous.

The IRS is erroneously treating his law firm income as “section 1411 trade or business income” -- as income from a business in which the taxpayer is not an active participant.

Yet, clearly, he is an active participant. And his 2013 return shows that he is paying self-employment tax on that very income -- including the section 1401(b) tax. Under section 1411(c)(6), “net investment Income” does not include any item of income taken into account in determining self-employment income for a year for which a section 1401(b) tax is imposed.

Further, nothing in his return indicates or implies that the trade or business of the law firm is a “passive activity” within the meaning of section 469. And nothing in the return indicates that the trade or business of the law firm involves “trading in financial instruments or commodities” as defined in section 475(e)(2). The trade or business of the law firm cannot be a business “described” in section 1411(c)(2) which, in turn, means that his share of the law firm income cannot be “net investment income” as that term is used in section 1411(c).

Thus, he has not incurred the NIIT for 2013.

Thus, the IRS is wrong.

And some people think federal income tax isn’t fun!

[LaVidaRoja]

Very likely the program is screening for and Schedule K-1 income, and automatically treating it as 469 income. Clearly, the fact that it is subject to SE tax ought to negate this. However, any human oversight on these letters is being done by someone making close to minimum wage and required to process 100 letters per hour. Clearly, your letter of explanation should result in a letter stating no adjustment is necessary. A letter to Nina Olsen might also be a good idea. If this is systemic, there will be a lot of s**t hitting the fans.

[Arthur Rubin]

Is he then subject to the "Additional Medicare Tax" rather than the NIIT?

I'm not surprised. My tax software often makes the same mistake, unless overridden. The NIIT calculations often have to be overridden, as the law was passed in time for software to be fixed, but the guidelines weren't, and often require information not required nor asked for in previous years.

(LaVidaRoja's post appeared before my submission was complete.... Although he said some things better than I, I think my post still stands on its merits.)

[Famspear]

Very likely the program is screening for and Schedule K-1 income, and automatically treating it as 469 income. ...... If this is systemic, there will be a lot of s**t hitting the fans.

For sure. If systemic, then literally hundreds of thousands, maybe millions, of erroneous notices would be going out over the weeks and months ahead.

I'm betting (or maybe I should say I am hoping) that this was not something programmed into the IRS computer system as a whole.

Computer-generated IRS notices often are not models of clarity and specificity.

[Famspear]

Getting back to my client's 2013 return -- in mid-September we sent a letter to the IRS laying out the entire case regarding the erroneous assertion of the net investment income tax.

Of course, the IRS did not respond.

Instead, the IRS issued a statutory notice of deficiency, dated November 9, 2015. In the 90 day letter, the IRS again claims that it made an adjustment to the investment income. Yet, neither the 90 letter nor the original notice states what the amount of the income adjustment is, why the adjustment was determined, how it was computed, or how the related net investment income tax was computed. Nothing. Zero. Zilch.

The only relevant verbiage in the 90 day letter is a general description of how the net investment income tax works, and the following cryptic statement:

Since we changed your investment income, we also changed the amount of Net Investment Income Tax due.

Next step will probably be to go to the IRS Appeals Office. Typically, IRS appeals officers can actually think.

EDIT: I suspect that due to systemic incompetency at the IRS, our September letter is languishing in a file somewhere, waiting to be read by a human.

[LaVidaRoja]

Something I learned as an Appeals Officer for the IRS: If the IRS sends you an addressed envelope for your reply, you MUST use that envelope. It is bar-coded so that it will be routed to the correct section of the Service Center. If the information you are providing won't fit in the envelope, affix the envelope provided to the larger envelope you use to send in your information. We were having to handle the petitions to the stat notices sent out by the Service Center. Frequently, the taxpayer HAD provided the information. It just didn't catch up to the admin file until the case landed in Appeals.

[Famspear]

Something I learned as an Appeals Officer for the IRS: If the IRS sends you an addressed envelope for your reply, you MUST use that envelope. It is bar-coded so that it will be routed to the correct section of the Service Center. If the information you are providing won't fit in the envelope, affix the envelope provided to the larger envelope you use to send in your information. We were having to handle the petitions to the stat notices sent out by the Service Center. Frequently, the taxpayer HAD provided the information. It just didn't catch up to the admin file until the case landed in Appeals.

Oh, good tip. I can't remember whether I "sort of" used to "know" that a long time ago, and maybe forgot, or what.

[Famspear]

Here's another one.

I’m handling a case right now where a taxpayer had filed a 2015 Form 1040 return showing a disposition of an entire interest in a rental real estate property – a passive activity. The problem was that the return failed to deduct the unused section 469(b) passive activity loss carryover from 2014 and prior years – which was a huge amount, and which (when properly accounted for) creates a large 2015 net operating loss to be carried back to (and deducted in) 2013 and 2014. I did not prepare the return. The return was prepared by a very well-known national tax preparation firm (not a CPA firm).

So, I had the client file an amended 2015 return showing the deduction of the section 469(b) passive activity loss carryover, under Internal Revenue Code section 469(g), which provides, in part:

(g) DISPOSITIONS OF ENTIRE INTEREST IN PASSIVE ACTIVITY.--If during the taxable year a taxpayer disposes of his entire interest in any passive activity (or former passive activity), the following rules shall apply:

(1) FULLY TAXABLE TRANSACTION.--

(A) IN GENERAL.--If all gain or loss realized on such disposition is recognized, the excess of—

(i) any loss from such activity for such taxable year (determined after the application of subsection (b)), over

(ii) any net income or gain for such taxable year from all other passive activities (determined after the application of subsection (b)),

shall be treated as a loss which is not from a passive activity.

Because the loss is treated as a loss which is not from a passive activity, the passive activity loss deduction limitation does not apply for the year of the disposition. In other words, the unused passive activity loss carryover is generally fully deductible in the year in which the taxpayer disposes of his entire interest in the property.

The application of section 469(g) was clearly explained in detail in the amended return.

The amended return was selected for examination, and the job was assigned to a Tax Compliance Officer (TCO) at the Internal Revenue Service. I provided the TCO with a copy of the amended return, and I explained how section 469(g) works in detail, both on the phone and in a letter to her.

The TCO denied the deduction for the passive activity loss carryover, and this is the entire text of her explanation for this, from her examination report:

Passive losses can only be offset against passive income. A passive activity is one involving the conduct of a trade or business in which you do not materially participate, or any rental activity unless the requirements of section 469(c)(7) of the Internal Revenue Code are meet in tax years beginning after December 31, 1993.

“Rental activities of any kind, regardless of material participation, are considered passive activities unless the requirements of section 469(c)(7) are met in tax years beginning after December 31, 1993.

“We have adjusted your passive activity loss as shown [ . . . ]

She also denied the deduction for the operating loss from the property generated in the year of disposition.




Of course, her statements are standard boilerplate verbiage that recites some of the basic rules about passive losses – but the verbiage has nothing to do with how a passive loss is treated in the year of disposition of the entire interest.

So far, her manager has not responded to my written request for a conference, and has not answered my phone calls.

This one may require a formal written protest, and a review by an IRS Appeals Officer.

[LaVidaRoja]

I agree. Sounds like Appeals-bound. Of course, since the IRS has been cutting staffing by attrition, Appeals Officers who understand how to apply the Code (or even read it) may be very few and far between. I don't think anyone I worked with in Appeals is still with the Service. Good luck! (These are also the type of thing that Nina Olsen can use in reporting to Congress)

[Famspear]

I agree. Sounds like Appeals-bound. Of course, since the IRS has been cutting staffing by attrition, Appeals Officers who understand how to apply the Code (or even read it) may be very few and far between. I don't think anyone I worked with in Appeals is still with the Service. Good luck! (These are also the type of thing that Nina Olsen can use in reporting to Congress)

(sigh.....) It seems that more and more of the veterans are retiring from many positions at the Internal Revenue Service, and I think that not much new hiring and training is happening -- or not enough to maintain the standards. This makes it harder on taxpayers who need to have things resolved, which in turn makes my job, um.... more interesting (hey, let's stay positive!).

[The Observer]

This makes it harder on taxpayers who need to have things resolved, which in turn makes my job, um.... more interesting (hey, let's stay positive!).

Then you might be headed to court after Appeals.

[Famspear]

This makes it harder on taxpayers who need to have things resolved, which in turn makes my job, um.... more interesting (hey, let's stay positive!).

Then you might be headed to court after Appeals.

Update!

A few minutes ago, I got a call from the manager -- and I had a conference call with him and the TCO who handled the exam.

Now, here are some details I left out of my explanation earlier in this thread: The taxpayer's 2013 and 2014 tax returns had been examined a couple of years ago -- by the same TCO who handled the 2015 exam. The passive activity loss carryover amount from 2014 -- the amount deducted on the 2015 amended return -- had actually been computed by the TCO, and had been mentioned in her exam report for 2013 and 2014, as a loss that could be carried forward to 2015.

So, on the phone a few minutes ago, we went through the whole thing again, and the manager instructed the TCO to go back and confirm that the passive activity loss carryover amount from 2014 shown on the amended 2015 return is in fact the same amount she had computed and included in her exam report for 2013 and 2014. The manager instructed her that the loss carryover -- plus the current loss generated in 2015 -- would be deductible on the 2015 return, as the property was subject to a complete disposition in 2015.

So, barring some other problem cropping up, we might not have to go to Appeals on this particular issue.

Another weird aspect of this case was that when the TCO issued her 30 day letter, she issued it in the form of a denial of a year 2015 refund claim. The thing is, the amended 2015 return did not even include a refund claim. The original return did. The refund had already been paid to the taxpayer after the original return was filed. The only purpose of the amended 2015 return was to establish that the passive losses were deductible in full, thus generating the year 2015 net operating loss to be carried back to 2013 and 2014, to greatly reduce the tax deficiencies that had been determined at the close of the 2013/2014 exam.

You see, last year the Service had issued a 90 day letter based on the result of the 2013/2014 exam, and the taxpayer had come to me for help. A Tax Court petition was filed, and the IRS Appeals Officer has more or less agreed with my game plan: Substantiate the large net operating loss generated in 2015, carry the loss back to 2013 and 2014 (perhaps without even having to file amended returns for 2013 and 2014!), and come to an agreement on a much lower tax for 2013 and 2014. If we can settle, we can have the Tax Court case dismissed, let the IRS assess the revised tax amounts, and I can help the taxpayer work out a payment plan with the Service.

The manager says that it will take six to eight weeks to get this to the IRS Appeals Officer who is working the 2013 and 2014 years. Meanwhile, Chief Counsel's Office says that if it gets to be mid-July without a settlement, we may need to at least have a Branerton conference. (The trial date is set for later this year.) So, we may be cutting it a little close, but I am hoping we can work this out without having to ask the Court for a continuance.

We shall see.

[Famspear]

I just noticed that I never did finish the story that began at the opening of this thread -- regarding the erroneous IRS treatment of K-1 income of a partner in a law firm partnership. I ended up filing a Form 911 with the IRS Taxpayer Advocate, and the matter was corrected fairly quickly -- resolved without having to go to Appeals.