Frivolous-tax-return penalty sustained
The Tax Court held that a taxpayer’s tax return reporting zero wages and zero taxable income was by definition a frivolous tax return as articulated in Notice 2010-33.
Facts: The taxpayer, Ruben Varela, filed Form 1040EZ, Income Tax Return for Single and Joint Filers With No Dependents, for tax year 2017, which reported zero wages and zero taxable income, claimed the standard deduction, and sought a refund of $1,373 (composed of $508 in federal income tax, $701 in Social Security tax, and $164 in Medicare tax withholdings). Attached to his return were four Forms 4852, Substitute for Form W-2, Wage and Tax Statement, or Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. The Forms 4852 also reported zero income or wages and included a statement that the amounts were derived from the “[r]ecords from the party identified as ‘payer’ on line 5.” Varela’s 2017 IRS transcripts, however, showed $11,311 in wages and $1,436 in cancellation-of-debt income.
The IRS notified Varela by letter that his purported 2017 return “claimed one or more frivolous positions” and that if he did not file a corrected return within 30 days, the IRS might assess a penalty under Sec. 6702(a) for filing a frivolous return. In response to Varela’s assertion that his 2017 return did not take a frivolous position, the IRS issued Form 8278, Assessment and Abatement of Miscellaneous Civil Penalties. The Form 8278 imposed a $5,000 penalty under Sec. 6702(a) citing “ARG CD 44” in the remarks section.
Subsequently, the IRS issued a notice of deficiency for Varela’s 2017 tax year in the amount of $8,633. Varela petitioned the Tax Court challenging the deficiency. Without trial, the case was resolved, with the Tax Court entering a stipulated decision that “there is no deficiency in income tax due from, nor overpayment due to, the petitioner” for 2017. As a result, Varela’s 2017 $1,373 overpayment credit was transferred to a different tax year, but only for $508, the amount of his federal income tax withholding. The remaining $865 of his refund claim ($701 in Social Security tax and $164 in Medicare tax withholdings) was denied.
In August 2021, the IRS issued Notice CP90, Notice of Intent to Seize Your Assets and of Your Right to a Hearing, to Varela for the Sec. 6702(a) penalties it had assessed for tax years 2005 and 2017. Varela disputed the penalties and timely requested an administrative hearing. After the hearing, the IRS Independent Office of Appeals issued a notice of determination sustaining the proposed levy. In May 2024, Varela and the IRS executed a stipulation of settled issues, which removed the penalty for 2005 but not for 2017.
Issues: Sec. 6702(a) imposes a $5,000 civil penalty on taxpayers that file a frivolous tax return. In order for the penalty to be imposed, three conditions must be met: (1) a person files what purports to be a return of a tax imposed by Title 26 of the U.S. Code; (2) the purported return either does not contain information on which the substantial correctness of the self-assessment may be judged, or it contains information that on its face indicates that the self-assessment is substantially incorrect; and (3) the taxpayer’s conduct is based on a position that the IRS has identified as frivolous under Sec. 6702(c) or reflects a desire to delay or impede the administration of federal tax laws. Sec. 6702(c) states that the IRS will prescribe and periodically revise a list of positions it has identified as frivolous.
Citing Callahan, 130 T.C. 44 (2008), the court began its analysis by noting that it “generally looks to the face of the document to determine whether a purported return is ‘frivolous.’” Additionally, if the IRS has identified the position as frivolous, a taxpayer’s good-faith belief in the correctness of their tax position is not a defense to the penalty (Hudson, 766 F.2d 1288 (9th Cir. 1985) (per curiam)). Furthermore, when imposing a Sec. 6702(a) penalty, the IRS bears the burden of production and the burden of proof regarding a taxpayer’s liability (Secs. 6703(a) and 7491(c)).
Although Varela conceded that the documents he submitted purported to be an income tax return, he argued that the IRS had not met its burden of proof. In particular, he asserted that the IRS had failed to show that his 2017 return was substantially incorrect on its face pursuant to Sec. 6702(a)(1)(B) and later argued that it would not be possible to meet this burden since he owed no underlying tax liability for 2017.
The court agreed that the stipulated decision entered earlier in the case had concluded that Varela owed no federal income tax for 2017. However, the court further explained that it was not persuaded by this argument because he still owed Social Security and Medicare taxes for which he was incorrectly claiming a refund.
Relying on Whitaker, T.C. Memo. 2017- 92, the court noted that “[a] taxpayer need not have an underlying liability for the IRS to assess a section 6702(a) penalty, so long as the return meets the statutory definition of a frivolous tax submission.” It further emphasized that it has “consistently characterized returns that report zero wages or income as both substantially incorrect” and as not containing “information on which the substantial correctness of the selfassessment may be judged” (Grunsted, 136 T.C. 455 (2011)).
Varela then argued that the IRS had not adequately identified a position it had identified as frivolous. Specifically, he asserted that the reason for the penalty identified on the Form 8278 as “ARG CD 44” did not correspond with a relevant reason identified in Section III(44) of Notice 2010-33. The IRS explained that the ARG CD 44 code on the Form 8278 referred to an “argument code” in Internal Revenue Manual (IRM) Exhibit 25.25.10-1(44) (Dec. 15, 2022), not Notice 2010-33. The IRM argument code can be traced back to Sections III(1)(e) and (22) of Notice 2010- 33 as frivolous. Furthermore, the court stated, “Section 6702(a)(2)(A) requires only that the position be identified as frivolous by the Secretary, and there is no requirement that Form 8278 cite the applicable position from Notice 2010- 33” (Jaxtheimer, T.C. Memo. 2019-164, aff’d, 854 F. App’x 263 (10th Cir. 2021)). Ultimately, the court concluded that all the statutory requirements were met and that Varela’s 2017 tax return was frivolous under Sec. 6702(a).
Next, the court considered whether Appeals had abused its discretion in sustaining the collection action and whether the IRS manager’s review and signature satisfied the supervisory-approval requirements of Sec. 6751(b)(1). The court held that the Form 8278 complied with Sec. 6751(b)(1) and that its review of the administrative record revealed no abuse of discretion by Appeals. As a result, the court upheld the IRS’s determination.
Finally, the court examined whether it should impose a $25,000 Sec. 6673(a)(1) penalty related to instances where “it appears to the Court that the taxpayer instituted or maintained the proceeding primarily for delay or that the taxpayer’s position in the proceeding is frivolous or groundless.” As Varela had not been warned in any prior case about using the arguments that he did in the current case, the court declined to impose the penalty but warned “that a penalty may be imposed in future cases before this Court should he continue to pursue these misguided positions.”
Holding: The court held that Varela’s purported 2017 tax return met all the statutory requirements of a frivolous tax return articulated in Sec. 6702 and that the IRS was correct in imposing the $5,000 Sec. 6702(a) penalty, since the Service had met its burden of proof.