The Adventures of Don Dubious in Fantasy-land

[Famspear]

In this case, Don Dubious actually attached a copy of the "note" to the LLC's return -- possibly because of a misconception that this act of "disclosure" would protect him. However, what he did was to volunteer some of the very information that the IRS might end up using against him to assert the 40% civil penalty -- with no corresponding advantage for him in terms of avoiding that penalty (since he did not use Form 8275 and did not make an adequate disclosure).

Drafting an adequate disclosure statement to avoid a section 6662 penalty generally is not an endeavor that should be attempted without professional assistance.

[Famspear]

Well, the Internal Revenue Service has completed its examination and has issued the Revenue Agent Report. The IRS concluded that the "debt" was really ordinary income that should have been reported on the Form 1065 return. What a surprise.



In my description, I changed a lot of the facts and amounts, but let's just say that Don Dubious might be looking at a tax deficiency of over $480,000 (can't say for sure, since I'm not privy to his personal Form 1040 returns).

Plus, the IRS has stated that the 20% penalty under section 6662 will apply. No mention by the IRS (yet) of the 40% nondisclosure penalty, or the 75% civil fraud penalty. But there will be penalties for failure to timely pay, and there will of course be the interest charges.

EDIT: Under section 6662(b), the 20% or 40% penalty (whichever might become applicable) would not apply to the extent that the 75% civil fraud penalty were to be imposed.

[LaVidaRoja]

If there is no fraud penalty on the initial report, absent VERY unusual circumstances, there will not be one.

[Famspear]

If there is no fraud penalty on the initial report, absent VERY unusual circumstances, there will not be one.

But, the Revenue Agent Report is only for the partnership return, the Form 1065, which technically is not even a "tax return". It's a type of "information return," since the partnership itself incurs and pays no Federal income tax. The Revenue Agent's Report used the term "fraud" or "constructive fraud" several times to describe what happened.

I'm thinking that the 75% fraud penalty would be imposed only on the returns that reflect a tax, such as Form 1040 returns for partners who are individuals. I presume (without knowing for sure) that the Form 1040 returns for all the partners in this case (and all of them happen to be individuals) are also under IRS examination.

So, I'm thinking that perhaps there could still eventually be a 75% civil fraud penalty to be imposed -- but just on the Form 1040 returns for those who were actually aware that their K-1s were fraudulent.

[LaVidaRoja]

I don't know. Perhaps fraud would have to be at least mentioned in the 1065 report. The problem with the civil fraud penalty, is that the IRS would need to be able to establish that the parties reporting the 1065 transactions on their 1040's KNEW that the K-1's were fraudulent. Don Dubious, possibly. The other partners? Maybe, maybe not.Is the LP subject to TEFAP?

[LaVidaRoja]

Sorry - TEFRA partnership proceedings

[Famspear]

Yeah, I should clarify.

Non-TEFRA, small partnership, and they didn't make the election to be TEFRA.

EDIT: That is, the LLC, treated as a partnership (the one in which the understatement of income was made) is non-TEFRA.

The Limited Partnership (a related party to the LLC) is TEFRA, but I haven't seen the Revenue Agent Report for that entity (and probably never will).

[Famspear]

A juicy tidbit from the Revenue Agent Report on the LLC/partnership (the one that understated its income based on the phony "debt'):

The IRS was auditing both the LLC and the LP. The IRS found that the LP reported a "guaranteed payment to partner" to its general partner (which of course was the LLC) and took a deduction for it -- yet, the LLC did not report the amount as income (over $200,000).

[LaVidaRoja]

OK< this is going to get to be fun! (for the RA)

[Famspear]

OK< this is going to get to be fun! (for the RA)

Oh yeah!

And, the actual fact situation is even worse than what I have described here in this thread. As I noted above, I changed some of the facts (to protect confidentiality, etc.).

[Famspear]

It is now about a year later.

The IRS has examined the 2013 Form 1040 tax returns of one or more of the partners. At least one 90 day letter has been issued in 2017, with the recipient (Ned Know-it-all, another partner in the LLC) having filed a Tax Court petition.

Ned Know-it-all is contesting a year 2013 tax deficiency of over $80,000, plus an asserted a failure to timely file penalty of over $20,000 and a section 6662(a) penalty of over $15,000.

Did I say "failure to timely file"?

Yes, it seems that Ned Know-it-all did not file his 2013 Form 1040 return until March 2016 -- several months after the IRS had begun its examination of the 2013 Form 1065 return of the LLC (and Ned was fully aware of the pendency of the exam). Of course, he filed that Form 1040 return based on the massively understated income figure reported on the completely erroneous 2013 schedule K-1 from the LLC -- the K-1 that failed to properly reflect his share of the acquisition fee income of the LLC.

[Famspear]

Don Dubious has now filed a Tax Court petition. He did not file his 2012 and 2013 Form 1040 tax returns until December 2016 -- after the IRS had begun examining him. In the statutory notice of deficiency that resulted in the Tax Court filing, the IRS has asserted over $300,000 in taxes and penalties for 2012 and 2013 -- most of this as a result of the mis-reporting of (i.e., the failure to report) his share of the aforementioned 2013 income of the LLC/partnership.

[Famspear]

Curiously, in the cases of both Don and Ned, the IRS has not asserted any civil fraud penalties -- even though it should have been clear that both of them knew they were filing false returns. The IRS asserted the penalties for failure to timely file and the section 6662(a) negligence penalties.

EDIT: corrected a typo.