Frivolous Tax Returns Avoid Accuracy-Related Penalties – Houston Tax Attorneys

Our federal tax system depends on voluntary compliance by a large segment of taxpayers. Encouraging compliance, while deterring and punishing non-compliance, remains the IRS’s greatest challenge.

To meet this challenge, Congress has armed the IRS with a myriad of civil and criminal tax penalties. These penalties are designed to address different types of non-compliance, from simple mistakes to intentional fraud.

One might expect that these penalties would increase in severity as tax positions become more egregious–that a merely negligent position would face lesser penalties than an outright frivolous one. However, the recent case of Swanson v. Commissioner, T.C. Memo. 2024-105, shows how this may not always be the case. The case raises a counterintuitive question: could a taxpayer be better off by taking a completely frivolous position rather than one that is arguably valid but ultimately incorrect?

Facts & Procedural History

The taxpayer in this case was a high school teacher. He was paid $79,186 in 2018. On his 2018 income tax return, he claimed that his wages were not taxable income. He argued that they represented “capital” rather than wages and that capital is not subject to income tax. He included a Form 4852 (substitute W-2) reporting zero wages and stating that his job was his “source of capital.” As noted below, the courts have rejected these types of tax protester arguments.

The IRS audited the tax return and, not surprisingly, proposed an accuracy-related penalty under Section 6662(a). The tax adjustment and penalty ended up in the U.S. Tax Court. During the litigation, the IRS attorney filed a motion to ask the tax court to sanction the taxpayer by imposing a frivolous position penalty under Section 6673. The court opinion addresses whether the taxpayer was liable for Section 6662 or 6673 penalties.

About Accuracy-Related Penalties

The penalty in Section 6662 is the IRS’s go-to penalty when it comes to audit adjustments. It is rare to see a case when the IRS does not automatically propose this penalty.

The Section 6662 penalty is a 20% penalty on underpayments attributable to substantial understatements of tax or negligence. To understand this penalty, we have to consider both substantial understatements of tax and negligence, as either circumstance can trigger the penalty.

A. Substantial Understatement Penalty

The accuracy-related penalty can apply if there is a “substantial understatement.” For there to be an “understatement” the taxpayer has to file a tax return and the IRS has to audit the return or adjust the account to reflect a higher amount of tax.

The understatement is said to be “substantial” if the understatement exceeds the greater of 10% of the tax required to be shown on the return or $5,000. The amount is $10,000 for corporations.

There are nuances to these rules. For example, the understatement is reduced for any portion of the underpayment for which the taxpayer had “substantial authority.” Also, the understatement does not include amounts if the relevant facts were adequately disclosed on the return and there was a reasonable basis for the tax treatment. These rules recognize that some tax positions, while ultimately incorrect, are supported by enough authority that they should not trigger penalties.

In this case, the taxpayer’s wages of $79,186 would have generated a tax liability that likely exceeded the $5,000 threshold. However, the substantial understatement penalty did not apply because the tax court determined the return was invalid, as discussed below.

B. Negligence Penalty

Section 6662(c) and the regulations define “negligence” as any failure to make a reasonable attempt to comply with tax laws. The regulations provide examples of the types of conduct are negligent. An example is a taxpayer who fails to maintain proper books and records. The same goes for a taxpayer who cannot properly substantiate claimed tax deductions or tax credits.

The penalty is intended for taxpayers who claim tax positions that have little or no merit. This includes positions that would seem “too good to be true” to a reasonable and prudent person under the circumstances.

Courts have developed this standard further, holding that a taxpayer is negligent if they fail to exercise the level of care that a reasonable and ordinarily prudent person would exercise under similar circumstances. This standard recognizes that different taxpayers have different levels of sophistication and knowledge.

In this court case, the taxpayer’s position that wages were not taxable as income was so clearly contrary to established law that it went beyond mere negligence. Rather than making a reasonable attempt to comply with the tax laws (even if done negligently), he advanced an argument that had been repeatedly rejected by courts.

The tax court held that “because [the] petitioner failed to report both his wages and his rental income on the basis of frivolous legal positions, the Form 1040 is not an honest and reasonable attempt to satisfy the requirements of the tax law.”

This is based on the Supreme Court’s test in Beard v. Commissioner, which established that for a document to constitute a valid tax return, it must (1) contain sufficient data to calculate tax liability; (2) purport to be a return; (3) represent an honest and reasonable attempt to satisfy the requirements of the tax law; and (4) be executed by the taxpayer under penalties of perjury.

The taxpayer’s frivolous position that wages are not taxable income failed the third prong of this test–it was not an honest and reasonable attempt to comply with tax law. Because the document was not a valid return, it could not support the imposition of a Section 6662 penalty. As such, the court concluded that the taxpayer was not subject to the accuracy-related penalty.

The Frivolous Return & Position Penalties

Avoiding the accuracy-related penalty does not mean that the taxpayer is in the clear. A taxpayer advancing completely baseless arguments isn’t being careless–they are doing something qualitatively different that Congress addressed through Section 6702’s frivolous return penalty and Section 6673’s frivolous position penalty.

A. The Frivolous Return Penalty

Section 6702 allows the IRS to impose a $5,000 penalty for filing a frivolous tax return. Unlike the Section 6673 penalty described below, which requires tax court litigation, the IRS can assess this return penalty administratively.

The penalty applies to tax returns that reflect a position identified by the IRS as frivolous or which reflects a desire to delay or impede tax administration. It can even apply to a mentally incompetent person who might not otherwise be held legally liable for other penalties.

This penalty can apply even if the return is otherwise valid. For example, a return that correctly reports income but includes frivolous arguments in an attachment can trigger this penalty. The penalty can also apply to amended returns and requests for collection due process hearings that raise frivolous arguments. The IRS can assess multiple $5,000 penalties if the taxpayer files multiple frivolous returns or documents.

B. The Frivolous Position Penalty

Section 6673 allows the tax court to impose a penalty of up to $25,000 when a taxpayer maintains frivolous or groundless positions. Unlike the Section 6702 penalty, this penalty can only be imposed by the Tax Court, not by the IRS administratively. The purpose, as the court noted citing Takaba v. Commissioner, is “to compel taxpayers to think and to conform their conduct to settled principles before they file returns and litigate.”

The key distinction is that this penalty focuses on the taxpayer’s conduct during litigation, not just the filing of the return. The Tax Court can impose this penalty if it finds that:

The taxpayer instituted or maintained proceedings primarily for delay
The taxpayer’s position is frivolous or groundless
The taxpayer unreasonably failed to pursue available administrative remedies

The amount of the penalty – up to $25,000 – is discretionary and often reflects factors such as:

Whether the taxpayer has a history of raising frivolous arguments
Whether the taxpayer has been warned about frivolous positions
Whether the taxpayer has been previously sanctioned
The amount of court resources wasted

This penalty serves a different purpose than the Section 6702 penalty. While Section 6702 penalizes the act of filing a frivolous return, Section 6673 penalizes the persistence in advancing frivolous arguments after having the opportunity to abandon them. This is why the tax court often warns taxpayers during tax litigation that continuing to advance frivolous arguments could result in sanctions under Section 6673.

C. What Makes a Return “Frivolous?”

So what makes a position “frivolous?” The short version is that a frivolous position is one that has been repeatedly rejected by the courts or has no basis in law. The IRS maintains a list of these positions in Notice 2010-33. These positions are often advanced by tax protesters and include arguments such as:

Wages are not income because they are an equal exchange of labor for money
Only foreign-source income is taxable
The 16th Amendment was not properly ratified
Federal Reserve Notes are not legal tender
A taxpayer is not a “person” subject to tax
Filing a tax return is voluntary

Courts do not entertain these types of arguments because they have no basis in law and have been repeatedly rejected. When a taxpayer advances such arguments, they are not making a good faith attempt to comply with the tax laws. Rather, they are taking a position that is contrary to well-established law. This is different from a taxpayer who makes a mistake or takes an aggressive but colorable position on an unsettled area of tax law.

D. The IRS’s Frivolous Return Program

The IRS has a team that is tasked with identifying and processing frivolous tax returns. This is handled by the IRS service center when returns are filed.

When a return is identified as potentially frivolous, it is routed to the Frivolous Return Program in the Campus Operations unit. This specialized unit reviews the return to determine whether it contains positions identified as frivolous in Notice 2010-33 or otherwise reflects a desire to delay or impede tax administration. This allows the IRS to track patterns and identify emerging frivolous arguments.

Once a return is identified as frivolous, several things may happen:

The IRS may freeze any claimed refunds
The return may be adjusted to reflect the correct tax liability
The Section 6702 penalty may be assessed
The taxpayer may be referred for potential criminal investigation
The return preparer, if any, may be investigated for potential penalties

The IRS also maintains a database of taxpayers who have filed frivolous returns. This helps identify repeat offenders and can influence penalty determinations in future cases, as demonstrated by the court’s consideration of the taxpayer’s history in this case. These actions are all handled by the service center and generally not by the IRS auditor who is assigned to work the tax return if it is pulled for audit. This is a key aspect of how one might navigate these penalties.

Navigating the Various Penalties

In this case, the court imposed the maximum $25,000 penalty under Section 6673. The court noted that the taxpayer had a long history of taking frivolous positions regarding his tax liability and had been previously sanctioned by both the tax court and the Eleventh Circuit. Despite these prior sanctions and repeated warnings, the taxpayer continued to advance arguments that courts had uniformly rejected. The taxpayer’s persistence in the face of clear precedent and prior sanctions led the court to impose the maximum penalty.

However, the interplay of these penalty provisions creates an interesting strategic consideration. Consider a modified version of the facts: A taxpayer files a frivolous return asserting wages are not taxable income. The IRS examines the return and proposes only the accuracy-related penalty, not the Section 6702 frivolous return penalty. When the case reaches tax court, instead of persisting with the frivolous argument, the taxpayer argues only that the Section 6662 penalty cannot apply because the return was invalid under Beard. Following the reasoning in this case, the court would likely agree that no valid return was filed, meaning no accuracy-related penalty could apply.

By abandoning the frivolous position before litigation, the taxpayer could potentially avoid both the Section 6673 penalty (which requires maintaining the position in court) and the accuracy-related penalty (which requires a valid return). This seems to create a counterintuitive result where filing a frivolous return might lead to a better outcome than filing a merely negligent return.

This is not to say that taxpayers should plan on filing frivolous tax returns. The IRS has many other tools to combat frivolous positions, including the Section 6702 penalty, civil fraud penalties, and in egregious cases, criminal prosecution. As such, this article is focused on how one might proceed if they have already filed such a return and the IRS has audited the tax return or made adjustments to it.

Takeaway

This case shows the distinction between different penalties for false or incorrect tax returns. A taxpayer who makes an honest mistake due to the complexity of the tax law may face a 20% accuracy-related penalty. The same is true for a taxpayer who takes an aggressive but arguably supportable position that is ultimately rejected. However, paradoxically, a taxpayer who takes a completely frivolous position may escape the accuracy-related penalty altogether. Then they would just have to avoid the Section 6673 penalty by not maintaining their position during litigation.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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Charitable Deductions for Defective Inventory – Houston Tax Attorneys

Manufacturers and retailers frequently face the challenge of handling defective or obsolete inventory that cannot be sold. This situation often results in waste. The inventory has some utility or value, but the benefit of repurposing or rehabilitating the inventory is often outweighed by the cost of handling or repurposing the inventory.

Examples are easy to envision, such as a clothing manufacturer with items that are mis-sewn and unsuitable for sale under a major brand or grocery stores and restaurants with day-old food items that cannot be sold.

While simply writing off inventory or taking a tax loss is one option, there may be a more beneficial alternative—donating it to charity. The tax code provides specific provisions to encourage this practice, aiming to prevent waste and incentivize for-profit businesses to consider options beyond disposal. For certain C corporations, these provisions include an enhanced charitable deduction that can make donating inventory even more advantageous.

The recent IQ Holdings v. Commissioner, T.C. Memo. 2024-95, case provides an opportunity to consider this issue and, although not addressed in the case, the enhanced inventory deduction.

Facts & Procedural History

The taxpayer in this case is a C corporation. It manufactured aerosol consumer products through its subsidiary. The part of the case relevant to this article is the taxpayer’s inventory.

The taxpayer ended up with two sets of defective inventory: its own branded products that had become rusted and damaged, and WD-40 products that had a design defect making them non-compliant with Department of Transportation regulations. The total cost basis of this inventory was approximately $4.7 million.

The company formed a non-profit focused on healthcare products in 2012. While waiting for IRS approval of the organization’s tax-exempt status, the taxpayer made a seller-financed sale of the inventory to the non-profit. The plan was to forgive the loan once tax-exempt status was granted. However, by the time approval came in 2014, the inventory had further deteriorated and the taxpayer changed course by reversing the sale to the non-profit and deducting the inventory by reducing cost of goods sold.

The IRS conducted an audit and proposed several adjustments. One of the adjustments was to the cost of goods sold deduction for the inventory adjustment. The IRS dispute ended up in tax court and this court opinion was just an order on a motion for summary judgment. The inventory issue gets into how the rules apply when the inventory may have no value. The court will likely take that issue up further in this litigation, but for purposes of this article, we are just focused on the fact pattern of the C corporation with defective inventory and how that can benefit some taxpayers–which isn’t the issue that the court will eventually decide in this case.

The Accrual Method Requirement

Before getting into the charitable deduction rules, it’s important to understand that inventory donations for businesses primarily involve accrual method taxpayers.

The accrual method requires taxpayers to report income when earned and expenses when incurred, regardless of when payment is received or made. This method aims to match income and expenses in the proper tax year. For example, if a business performs services in December but isn’t paid until January, the income is reported in December under the accrual method. The same goes for expenses. If the taxpayer purchases inventory, they generally deduct the cost of the inventory when the item is sold.

Compare this to the cash method, where income is reported when received and expenses are deducted when paid. The cash method is generally simpler and preferred by most small businesses as it matches the actual cash flow.

Most taxpayers prefer to use the cash method and look for ways to qualify. There are several reasons for this, such as the need to maintain accounting records which often requires the business to hire a proper accountant. The other major consideration is inventory which has several nuanced requirements, as noted above. Accrual method taxpayers cannot immediately deduct inventory costs when purchased. Instead, these costs are capitalized and later deducted through costs of goods sold when the inventory is actually sold.

So who has to use the accrual method? Generally, C corporations (other than qualified personal service corporations) must use the accrual method if their average annual gross receipts exceed $27 million. Other businesses may have to use the accrual method if they maintain inventory that is a material income-producing factor in their business.

General Charitable Deduction Rules for Property

With that understanding, we can turn to the charitable deduction rules. These rules are found in Section 170.

Section 170 provides for an income tax deduction for charitable contributions made during the tax year to qualifying organizations. For corporations, the deduction is generally limited to 10% of taxable income (with adjustments), with any excess carried forward for up to five years.

For property donations, additional requirements apply beyond those for cash donations. These include:

The property must be owned by the taxpayer at the time of contribution
The contribution must be complete and irrevocable
The property must be properly valued
For certain property valued over $5,000, a qualified appraisal is required
The taxpayer must maintain reliable written records of the contribution

The amount of the deduction depends on several factors, including the type of property donated and its potential tax treatment if sold.

When a business donates appreciated property to charity, there is a basis limitation that applies. Generally, the deduction is limited to the taxpayer’s basis in the property. However, if the property would have generated long-term capital gain if sold (such as stock held more than one year), the deduction is for fair market value. However, for inventory and other ordinary income property, the deduction is usually limited to basis. This is because inventory, by definition, generates ordinary income rather than capital gain when sold. The basis limitation prevents businesses from claiming a deduction for appreciation that would have been taxed as ordinary income if the inventory had been sold instead of donated.

This limitation on inventory donations created a disincentive for businesses to donate inventory to charitable organizations. Congress addressed this issue by adding Section 170(e)(3), which provides an enhanced deduction for certain inventory donations.

The Enhanced Deduction Under 170(e)(3)

Section 170(e)(3) provides an exception to this general rule. This deduction is only available for C corporations and is only helpful for those that are on the accrual method.

A C corporation can claim an enhanced deduction for inventory donations if:

The donation is to a public charity (not a private foundation);
The property will be used solely for care of the ill, needy, or infants;
The charity cannot charge for the donated items;
The donor receives a written statement from the charity confirming these requirements; and
If the property is regulated (like food or drugs), it meets applicable regulations.

The enhanced deduction amount is tax basis plus half of the appreciation. So the fair market value minus tax basis. These combined amounts cannot exceed twice the amount of the tax basis. This creates a significant opportunity for businesses with defective or obsolete inventory.

Definition of Ill, Needy, and Infant

To qualify for the enhanced deduction the property must be used solely for the care of the “ill, needy, or infants.” The regulations provide detailed definitions for each of these categories:

The regulations define an “ill person” as one requiring medical care. This includes individuals:

Suffering from physical injury
With significant impairment of a bodily organ
With an existing handicap (whether from birth or later injury)
Suffering from malnutrition
With a disease, sickness, or infection significantly impairing physical health
Partially or totally incapable of self-care (including due to old age)
With mental illness if hospitalized/institutionalized or if the illness constitutes a significant health impairment

A “needy person” is defined as one who lacks life’s necessities involving physical, mental, or emotional well-being due to poverty or temporary distress. Examples include:

Those financially impoverished due to low income
Individuals temporarily lacking food or shelter
Victims of natural disasters (like fires or floods)
Victims of civil disasters
Those temporarily not self-sufficient due to sudden crisis
Refugees or immigrants experiencing language, cultural, or financial difficulties
Former prisoners or mental institution patients who are not self-sufficient

The regulations define an “infant” as a minor child, as determined under the laws of the jurisdiction where the child resides. The “care of an infant” means performing parental functions and providing for the child’s physical, mental, and emotional needs.

It should be noted that the donated property must either be transferred directly to these individuals or retained for their care. No other person may use the contributed property except as incidental to the primary use in caring for the ill, needy, or infants. However, the charity may transfer the property to relatives, guardians, or other individuals if it makes reasonable efforts to ensure the property will primarily benefit the intended recipients.

An Example of the Numbers

Using and modifying the facts from the court case cited above as an example, let’s say the taxpayer established a public charity that provides hygiene products to the needy and donated its defective inventory to the charity. Assuming:

Inventory basis: $4.7 million
Fair market value (if not defective): $7 million

The potential enhanced deduction would be the lesser of:

Basis + 1/2 appreciation ($4.7M + $1.15M = $5.85M) or
2 × basis ($9.4M)

Here, the taxpayer could have claimed a $5.85 million deduction, significantly more than the $4.7 million tax basis that would be allowed to deduct as a reduction to costs of goods sold under the general rules.

However, the IRS may take issue with using defective inventory’s fair market value. The regulations suggest using the FMV at the time of contribution, so if the inventory is truly defective, its FMV might be much lower than $7 million. This could affect the calculation and could lead to a dispute with the IRS. This is why one has to take care to document the value if they are going to try to benefit from this enhanced tax deduction.

The Takeaway

The charitable deduction can mean that defective or obsolete inventory can have some value for taxpayers. For those that qualify, the enhanced charitable deduction under Section 170(e)(3) should be considered before simply writing these amounts off. While there are requirements to qualify, including getting proper documentation from the charity, this provision can turn a business challenge into an enhanced tax deduction while helping those in need. As with the taxpayer in this case, creating a charititable organization specifically for this purpose and tax planning can help unlock this benefit for just about any taxpayer.