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Case Where Texas Ranchers Were Victorious in IRS Appeal

Dallas Appeals Officer Reverses IRS Decision
Allows Business Expenses and Ranching Losses for 2011 & 2012 and Abates the 20% Accuracy Related Penalty

If you have been contacted by the IRS concerning your business expenses and the losses reflected on your Federal income tax returns, you should contact a competent tax attorneyBack in 2014, I represented a Texas couple in connection with an Appeal from an IRS decision disallowing the Taxpayers’ business expenses and losses associated with the Taxpayers’ ranching operations for the tax years 2011 and 2012 as well as the assessment of the I.R.C. § 6662(a) 20% accuracy related penalty.

The client names have been changed due to confidentiality. The Appeal was successful and resulted in the allowance of 100% of the Taxpayers’ business expenses and losses associated with their ranching operations for the relevant tax years, as well as the abatement of the 20% accuracy related penalty. The Appeal resulted in a total tax savings of approximately $300,000.

The Facts of the Case

Kenneth Johnson* and Pamela Johnson* (the Taxpayers) are residents of the State of Texas with their principal place of domicile located in Brownwood. Mr. Johnson comes from a long line of ranchers and farmers. His grandfather came to Texas in a covered wagon and started raising cotton and cattle. The family tradition continued with his father and uncle and subsequently with Mr. Johnson.

In July 2001 the Taxpayers purchased, a 100 acre property located in Brownwood, Texas. The original property consisted of a 2,650 square foot home, barns, sheds, stock tanks, as well as corrals and a cattle chute. In November of 2002, the Taxpayers purchased the adjoining 120 acres. The Taxpayers subsequently leased an additional 403 Acres. The leased property has three stock tanks, is cross fenced and has corrals for working livestock. All of the foregoing was acquired with the intent of establishing a viable ranching operation, consistent with Mr. Johnson’s rich family history in ranching.

Beginning in 2010 and continuing through 2012, Central Texas experienced a severe drought. Farmers and Ranchers in this area saw their earthen tanks as well as rivers and creeks dry up. In order to survive many ranchers and farmers had to haul water to their livestock. In addition, due to the lack of rainfall, ranchers, including the Johnson’s, were forced to purchase more hay and feed to try and make it through the drought. Ultimately, many ranchers, including the Taxpayers, were forced to mitigate their losses by selling off their livestock. As a result of the drought, ranchers were faced with a shortage of breeding stock available for sale, which in turn, resulted in higher livestock prices. Consequently, ranchers required additional time in order to replenish their herds.

In addition to the Taxpayers’ ranching operations, Mr. Johnson* was employed full-time in the oil and gas industry. The Taxpayer and his wife also owned and operated several other enterprises including a sales and marketing and mud logging business and also owned several rental properties. For the Tax Years 2011 and 2012, the Taxpayers self-prepared and filed their joint Federal income tax returns. For the tax years 2011 and 2012, the Johnson’s Federal income tax returns reflected ranching losses in the amount of $342,326 and $483,705 respectively.

In June of 2013 the Taxpayers’ 2011 and 2012 Federal income tax returns were selected by the IRS for examination. The Johnson’s were not represented during the IRS examination which resulted in the IRS disallowing 100% of the Schedule F (Farming) business expenses and the ranching losses sustained during the years in question. In addition, the IRS assessed the I.R.C. § 6662(a) 20% accuracy related penalty. The predicate for the IRS assessment was based upon the principle that a taxpayer may not deduct expenses and losses associated therewith, where a legitimate business purpose and profit motive is absent. The IRS assessed $102,697 and $145,112 in additional income tax for the respective tax years 2011 and 2012. In addition, the IRS assessed the 20% accuracy related penalty in the amount of $23,963.00 and $29,022.00 for the two years in question.

The IRS auditor provided the Johnson’s with Form 4549 (Income Tax Examination Changes) outlining the proposed changes. Thereafter, the Taxpayers contacted and retained the services of Kathryn J. Earnhardt, a local certified public accountant, for purposes of filing a written request for reconsideration to the Income Tax Examination Changes with the IRS. Ms. Earnhardt’s filed the request for reconsideration, but the IRS determined that it would not alter Form 4549. The IRS response consisted of Letter 692 (Request for Consideration of Additional Findings) and Form 886-A (Explanation of Items).

Mr. and Mrs. Johnson* thereafter contacted me and retained my services to represent the Taxpayers in connection with filing an Appeal with respect to the IRS assessments for 2011 and 2012. The issues presented for Appeal included the disallowance of the Schedule F business expenses, the disallowance of the losses from the Taxpayers’ ranching operations for the years 2011 and 2012 and the assessment of the I.R.C. § 6662(a) 20% accuracy related penalty.

In January 2014, my office prepared and filed a Protest Letter and Form 12203 (Request for Appeals Review) on behalf of the Johnson’s with the IRS Appeals office in Dallas, Texas. A conference was subsequently scheduled with the Appeals office in Dallas for March of 2014.I attended the conference together with the Johnson’s. We met with Mr. Robert Warfield, an attorney with IRS Appeals. During the conference, we discussed the issues presented and the Johnson’s provided credible testimony concerning profit motive in their ranching operations, as well as the circumstances related to the draught. At the conclusion of the conference Mr. Warfield informed the Taxpayers that they were entitled to 100% of the business expenses and ranching losses reflected on Schedule F for the tax years 2011 and 2012 and that those adjustments would be made to the Taxpayers’ account. In addition, Mr. Warfield also informed the Taxpayers that the 20% accuracy related penalty would be abated.

The experience gained from this case is as follows: If you started a business within the last five years and have continued to sustain losses, there is a risk that your returns will be selected for examination and subject to the IRS disallowing the both the business expenses as well as any losses. A self-employed Taxpayer needs to be able to establish that the business is viable as a going concern, and that a clear profit motive exists. Since no two cases are alike, it is important to have credible evidence regarding income patterns in your industry and that your expenses are in line based upon your income. If you have been contacted by the IRS concerning your business expenses and the losses reflected on your Federal income tax returns, you should contact a competent tax attorney to discuss the specific facts of your case, industry profit and loss statistics and the options available to you.

* The clients’ names have been changed for purposes of preserving the privacy of attorney client privilege. The facts of the tax law case are the same.

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Making Appeals to the IRS: What You Need to Know

How to Make an Appeal to the IRS: What You Need To Know

irs appeals are made at their headquarters. The Internal Revenue Service in washington d.c.Tax cases fall into two categories: 

First, where there is no dispute over the amount of tax that is due, the only remaining question is how the taxpayer will satisfy the outstanding liability. The taxpayer can pay the amount in full, enter into an Installment Agreement or submit an Offer in Compromise. Where the taxpayer is suffering from financial hardship, it may be possible to be placed in uncollectible status.

The second type of tax case involves a dispute between the IRS and the taxpayer. A taxpayer, with the assistance of an attorney, should consider each of the various methods for resolving a tax dispute and select the method that makes most sense. The Appeals process is one such method for handling disputes with the IRS, but by no means the exclusive method. The following is a brief discussion of the Appeals process and the basic rules of engagement.

The IRS Office of Appeals (“Appeals”) is tasked with the responsibility of resolving tax controversies without recourse to litigation. The Appeals Mission Statement provides that resolution of tax disputes should be fair and impartial both to the government and the taxpayer and in a manner that will enhance voluntary compliance and public confidence in the integrity and efficiency of the Service. I.R.M.8.1.1.1 (1) (10/23/07).

The cornerstone for the preservation of the integrity in the Appeals process is independence. In this regard, Congress reaffirmed its commitment to “ensure an independent appeals function” within the IRS.  RRA’98 § 1001(a) (4). In order to avoid undue influence or even the appearance of impropriety, exparte communications between Appeals and other IRS employees are prohibited.

IRS Appeals hear taxpayer disputes in a number of ways and may conduct a hearing at one of its campuses or field offices in person. Appeals may also hear taxpayer disputes by way of correspondence or telephonically.

Jurisdiction for Appeals is very broad and may cover a variety of matters, including deficiency determinations, collections, penalty abatements and trust fund recover penalties.  Taxpayer disputes are segregated into docketed and non-docketed cases.

An Appeal is typically generated in response to a proposed audit or examination adjustment. After the examiner completes the audit or consideration of a refund request, the taxpayer will be given the opportunity to file a protest with Appeals. Typically, Exam will issue what is known as a “30 day letter,”unless the statute of limitations has less than nine months to go until expiration. In such cases, Exam will not issue a 30 day letter since Appeals will not accept a case with less than six months left on the statute of limitations.  When faced with the expiration of the statute of limitations, however, it is not uncommon for Appeals to solicit Form 872 from the taxpayer as a means of extending the statute.

In most cases, the taxpayer will need to file a formal written protest with Appeals. Smaller cases involving $25,000 or less may be subject to a small case request process that does not require a formal protest letter.

In cases where there is less than nine months left on the statute of limitations and the taxpayer refuses to sign an extension of the statute of limitations (Form 872), Exam will issue a Notice of Deficiency, which is sometimes referred to as a”90 day Letter.” The issuance of a 90 day letter will toll the statute of limitations. In addition, the filing of a tax court petition with the U.S. Tax court will further toll the statute of limitations until 150 days after the Tax Court Decision is final.

If the taxpayer wants to contest a revenue agent’s proposed adjustments, the taxpayer can:

  1. File a protest, resulting in a non-docketed Appeals case;
  2. Pay the proposed deficiency, file a claim for refund and, if that claim is denied, file a protest at that time;
  3. Request early referral under Rev. Proc. 99-28;
  4. File a Tax Court petition in response to a statutory Notice of Deficiency (90 day letter) and go to Appeals in docketed status; or
  5. Request Fast Track (Rev. Proc. 2003-40 for LB&I taxpayers and Announcement 2006-61 for SB/SE taxpayers).

The protest letter is filed with the examining agent within 30 days of receipt of the 30 day letter.  If the taxpayer needs additional time, an extension may be granted, but any request by the taxpayer should be made in writing.  In response to the taxpayer’s protest letter, the Agent will prepare a written response. The Agent will send both the protest letter and the Agent’s response, together with the case file to Appeals.

Thereafter, Appeals will contact the taxpayer to schedule a conference, generally within 60-90 days of the taxpayer’s filing of the protest letter.

In preparation for the Appeals conference, the taxpayer should be prepared to discuss the factual disputes, applicable law, and any additional research or the facts that need to be developed.

Following the initial conference, Appeals will expect the taxpayer to make the first settlement offer.  In developing a settlement offer the taxpayer needs to be realistic. He must determine the maximum concession he is willing to make, while at the same time gauging what Appeals would likely accept. If the taxpayer is sincerely interested in settling, the offer has to be reasonable.

Appeals will attempt to bring about a settlement based upon what the probable outcome would be if the parties were to litigate. In cases where there is substantial uncertainty as to how a court would decide the matter, the parties will be expected to make concessions to reflect the strength or weakness of each position. In some cases, the parties will agree on a split issue settlement, where the parties stipulate to a percentage or dollar amount of the adjustment or the tax that is due.

There are certain instances where filing an Appeal may not be advisable, particularly where there are sensitive issues and where there is a possibility that Appeal may uncover additional issues.

If the parties are unable to successfully negotiate a settlement, the taxpayer, in non-docketed cases, has the option of going to non-binding mediation, as an additional step in which to try and settle the case. It is important to note that mediation is not an available alternative in collection cases or in cases where the taxpayer did not act in good faith.

In addition to non-binding mediation, a taxpayer may elect to arbitrate following unsuccessful Appeals negotiations. The arbitrators are selected from an approved list of arbitrators. Unlike mediation, an arbitration decision is binding and considered final.

The takeaway here is that the Appeals process is one alternative available to the taxpayer as a means of resolving a tax dispute. It is by no means, however, the exclusive method for addressing a tax dispute. A decision to file an Appeal should only be made after thoughtful consideration and discussions with an experienced tax attorney for purposes of identifying the relevant and material facts of the case, assessing the taxpayer’s strengths and weaknesses, and developing an Appeal’s strategy designed to bring about the best possible outcome.

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