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STATEMENT OF KATHLEEN M. NILLES, ESQ.
GARDNER, CARTON & DOUGLAS
SUBMITTED FOR THE RECORD TO THE COMMITTEE ON FINANCE

IN CONNECTION WITH ITS HEARINGS
ON
PENALITIES AND INTEREST
MARCH 8-9, 2000

I am a tax lawyer practicing in Washington, D.C. I have been involved in federal tax law for 15 years. Following law school, I worked for five years as a tax associate in private practice. Then I served as tax counsel to the Committee on Ways and Means, U.S. House of Representatives. As Ways and Means Tax Counsel, I was responsible for advising the Committee on tax compliance issues, including IRS penalties and interest.

Since leaving Government service in early 1995, I have represented a variety of clients as a tax partner in the law firm of Gardner, Carton & Douglas. I currently represent the Partnership Defense Fund Trust, an organization formed to defend the interests of individual investors in the partnerships described below.

In connection with the Finance Committee’s review of the penalty and interest provisions in the Internal Revenue Code, I would like to bring to the Committee’s attention a situation which has drastically affected the lives of thousands of taxpayers throughout the country. It is the kind of situation that this Committee attempted to address in the Internal Revenue Service ("IRS") Restructuring and Reform Act of 1998. To date, however, the IRS has failed to incorporate Congressional intent—both in its published guidance and in its actual administration of the tax law. Thus, I would urge Congress to consider whether stronger legislative measures are needed.

The Situation of the Individual Taxpayers Who Invested in Hoyt Partnerships

From 1977 through 1997, approximately 3,000 individuals and couples throughout the United States were induced to invest in one or more of over 100 separate partnerships set up by Walter J. Hoyt, a nationally recognized cattle breeder.

Twenty years later, many of these investors are confronting a fate much worse than the mere loss of their original investment in these now bankrupt partnerships. Pursuant to a complex fraud in which the partnerships' promoter inappropriately allocated a limited number of cattle among several partnerships resulting in excess deductions, many Hoyt investors have received tax, penalty and interest assessments totaling twenty to fifty times their original investment.

As a result of factors beyond their control, these individual investors—who are largely middle-class wage earners—now face IRS liabilities of $200,000 to $500,000. The enormity of these liabilities has caused great emotional distress and threatened many investors' financial and retirement security.

The Hoyt partnerships, although fraught with fraudulent misrepresentations and bookkeeping irregularities, were not a typical tax shelter. Mr. Hoyt and his family were nationally recognized cattle breeders. In the years 1984 to 1994, the cattle operations owned between 4,000 and 10,000 head of cattle. The cattle were kept on ten to twelve separate ranches owned by Hoyt partnerships with a combined acreage totaling over 500,000 acres, as well as on other leased land. The Hoyt investors could not have individually discovered the fraud. Indeed, it took IRS auditors and federal prosecutors years to develop sufficient evidence to verify their longstanding suspicions.

An IRS employee, with substantial experience on this case, recognized that the investors were "unwitting victims" of Walter J. Hoyt's fraud. Appeals Officer William McDevitt filed a statement in 1997 in which he described the taxpayers as "unwitting victims," "unsophisticated in tax matters," and "confused by the" Tax Court's 1989 decision in Bales v. Commissioner.^1/ The Bales case held that the partnerships were bona fide businesses and seemed to confirm most of Hoyt's assertions and theories.^2/

For several years after the IRS Criminal Investigation Division first began to investigate the Hoyt operations, Walter J. Hoyt was allowed to continue to conduct business as usual, to promote more partnerships, and to retain his role as the Tax Matters Partner ("TMP") for the approximately 118 separate partnerships he formed and promoted. In addition to failing to remove him as TMP, the IRS failed to take any of the following possible actions against him:

• The IRS failed to file an injunction against Mr. Hoyt as a tax return preparer. See IRC § 7407.
• The IRS failed to file an injunction against Mr. Hoyt as a promoter of an abusive tax shelter. See IRC § 7408.
• The IRS failed to disbar Mr. Hoyt from practice before the IRS as an "Enrolled Agent."^3/

Notwithstanding the Bales decision in October 1989, the IRS continued auditing the Hoyt partnerships, disallowing all claimed deductions and making adjustments consistent with the position that the partnerships constituted abusive tax shelters.

In 1993, the IRS and Mr. Hoyt as TMP settled the 1981 through 1986 partnership tax years. The settlements meant that essentially all claimed deductions and losses allocated to the investors from the partnership returns would be disallowed, while substantial income to the Hoyt family was minimized.

The individual partners first received notice of their 1981 through 1986 personal tax liabilities from the settlement (via Form 4549 computational adjustment notices) beginning in 1998. However, the National Taxpayer Advocate and the IRS Chief Operating Officer issued a Stay of Collection on February 2, 1999. The 1987 through 1996 tax years remain unresolved, with the selected dockets for the 1987 through 1992 tax years having been tried and awaiting an opinion of the Tax Court.

Recent Congressional Focus on the Hoyt Partnerships
W. Val Oveson, testifying as the IRS National Taxpayer Advocate at the recent Oversight Subcommittee hearing on penalty and interest reform, described the Hoyt situation (and others similar to it) as follows:

One of the problems taxpayers are bringing to the Taxpayer Advocate Service with increasing frequency involves TEFRA partnerships determined to be tax shelters. Taxpayers, as early as the 1970s and up through the 1990s, invested in a number of partnerships whose major, if not only, purpose was to shelter income from tax liability.^4/ For a number of reasons, audits of shelter cases can be quite extensive and Tax Court proceedings fairly lengthy. Thus, for taxpayers who do not settle these cases, but await the results of litigation, final resolution can leave them with liabilities dating back 10 years or more with penalty and interest accruals to match.

The enormity of these liabilities has caused taxpayers to seek assistance from a number of sources, including their Congressional representatives and various functional areas within the Service, including my office, to abate all or part of the accumulated liabilities or to suspend collection action. Some taxpayers have filed for bankruptcy protection. More than most, shelter cases can reflect the burden associated with the past and current penalty and interest structures. Very few taxpayers are prepared to pay or can pay penalty and interest accumulations that may date back to the 1970s.

Some say that these taxpayers should have known that the results of their investments were too good to be true. Nevertheless, I believe we should not focus on blame at this point. We need to work to get these taxpayers back into full compliance, possibly through installment agreements or the expanded offer-in-compromise criteria. I believe that tax shelters are an abuse of our system and the investors should be penalized. I also concede that the investors owe interest for the time they had the use of the government's money [see editor's note, below]. I question, however, whether it is the function of the government and our penalty and interest regimes to punish these taxpayers to the point that they become insolvent and unable to pay even a fraction of these liabilities.

Statement of W. Val Oveson, National Taxpayer Advocate, Internal Revenue Service, before the Subcommittee on Oversight, Committee on Ways and Means (January 27, 2000) (emphasis added).

[Webmaster's note: This Webmaster's note is not part of Ms. Nilles' document, but is important to make at this point. Mr. Oveson, whose actions have helped the defrauded investors, still misunderstood a key point when he made this remark. The investors never had use of the government's money.

Because of feed bills, "assessments," management fees, and other fees, the investors actually had less money each year than if they'd not had the "tax breaks" at all. In any given year, 75% to 125% of the tax refund went to Jay Hoyt, and then Mr. Hoyt's various fees absorbed significantly more --enough to wipe out any "tax savings" and then some, all while the IRS silently looked on.

Not only did the investors lose money this way (while thinking they were investing long-term), but many of them converted their IRAs to Hoyt IRAs and lost those as well. One investor's records show he is $30,000 deeper in the hole than he'd be if the IRS had stopped Hoyt per their own regulations. Is it acceptable to charge this man $250,000 interest and penalties on a net loss of $30,000 the IRS was required to prevent? This is the kind of insanity Kathleen Nilles is speaking out against.]

Oversight Subcommittee Chairman Amo Houghton highlighted the Hoyt investors' situation in his Opening Statement at that same hearing to illustrate the heavy burden of compounded interest on tax liabilities that take years to resolve:

I doubt that there is anyone on this panel who hasn't heard more than one heartbreaking story from constituents who find themselves facing crushing back taxes, penalties and interest payments because they were unable to comply with a tax code they have no hope of understanding. Albert Einstein once said that compounded interest is the most powerful force in the universe. Taxpayers whose interest payments far exceed their underlying taxes can well appreciate the truth of his words.

Just yesterday my staff met with representatives of a group of investors who were defrauded by an enrolled agent. His promotional materials targeted working people, promising them "quality investments for folks that dream about owning a piece of the country."

* * * * *

Today, nearly all of the investors face back taxes, penalties and interest—going back in some cases to the 1970s—because their deductions were disallowed. One of the investors, Ed Van Scoten, says the IRS is trying to collect about half a million dollars from him. "Who are they trying to kid?" he asks. "They could never get $500,000 from me if I worked five lifetimes."

In some cases individual investors first received notice from the IRS of their 1981-1986 tax liability beginning in early 1998. The interest clock was running all this time.

The unscrupulous will always prey on the unsuspecting, but something is seriously wrong with a penalties and interest regime that adds to the problems faced by the victims of this sort of scam.

Statement of Congressman Amo Houghton (R-NY), before the Oversight Subcommittee of the Committee on Ways and Means (January 27, 2000).

Congressional Mandate to Expand Offer in Compromise Criteria
Section 7122 of the Internal Revenue Code authorizes the IRS to settle tax cases with taxpayers under appropriate circumstances for less than the full amount of tax, penalties and interest owed. In the IRS Restructuring and Reform Act ("RRA") of 1998, Congress amended Section 7122 and directed the Secretary to prescribe guidelines to determine when an offer-in-compromise should be accepted. See Code § 7122(c) as added by Section 3462 of the RRA. The legislative history of this amendment clearly indicates what members of the tax-writing committees wanted the IRS to address:

• The Conference Report of the 1998 RRA directs that "the IRS [in formulating these rules] take into account factors such as equity, hardship, and public policy where a compromise of an individual taxpayer’s income tax liability would promote effective tax administration." H. Conf. Rep. No. 599, 105th Cong., 2d Sess. 289 (1998) (emphasis added).

• The legislative history also specifies that the IRS should utilize this new authority "to resolve longstanding cases by forgoing penalties and interest which have accumulated as a result of delay in determining the taxpayer’s liability." Id.

Consideration of factors such as equity and public policy represents a significant expansion of the traditional grounds for settling tax cases. Formerly, offers-in-compromise were limited to two situations: (1) doubt as to liability and (2) doubt as to collectibility.

IRS Proposed Regulations on Expanded Offer in Compromise Tests
On July 21, 1999, the IRS issued proposed regulations which clearly do not incorporate the Congressional mandate of encouraging offers-in-compromise in longstanding cases in which penalties and interest have accumulated as a result of delay. Instead, the regulations continue the traditional focus on economic factors while giving short shrift to equity and public policy considerations. Specifically, the regulations provide that if there are no grounds for compromise based on doubt as to collectability or liability, a compromise may be entered into to promote effective tax administration when:

(i)collection of the liability will create economic hardship; or

(ii)regardless of a taxpayer's financial circumstances, exceptional circumstances exist such that collection of the full liability will be detrimental to voluntary compliance by taxpayers; and

(iii)compromise of the liability will not undermine compliance by taxpayers with the tax laws.

Temp. Reg. § 301.7122-1T(b)(4)(i) through (iii).

The regulations provide specific factors for determining when the first and third prongs are satisfied, but no specific factors are provided for determining when the second prong—"exceptional circumstances"—may be satisfied. Unfortunately, the temporary and proposed regulations only offer two examples of cases of "exceptional circumstances:"

(i)the first involves a taxpayer who suffered a serious illness and was unable to manage his financial affairs during such time; and

(ii)the second example involves a case where a taxpayer relied on incorrect advice from the IRS in an informal E-mail response concerning the rollover period for an IRA account.

Temp. Reg. § 301.7122-1T(b)(4)(iv)(E) (examples 1 and 2).

The regulations provide a third example that involves embezzlement of payroll withholding taxes. This example could be viewed as illustrating equitable considerations in the case of a victimized taxpayer. However, the example is classified as a financial hardship example because paying the accumulated taxes, penalties and interest would cause the taxpayer's business to fail. Temp. Reg. § 301.7122-1T(b)(4)(iv)(D) (example 4).

In practice, the IRS continues to view "exceptional circumstances" with the same narrowly focused lens as it always has. In the IRS view, the overriding factor is the taxpayer's ability to pay (i.e., financial hardship). This exclusive focus on financial factors to the exclusion of equitable considerations is evidenced in a recent letter from the IRS Chief Counsel's Office to Representative John M. McHugh (R-NY) in response to his inquiry about how the IRS planned to deal with Hoyt investor partners facing large interest accumulations:

Taxpayers may at any time enter into an offer in compromise with regard to their tax liability. We understand that, in many cases, taxpayers will be unable to pay their liability in full, and an offer in compromise based on doubt as to collectibility will be considered under the established procedures for such a request. There are no special rules for Hoyt Partnership investors....

Letter of Deborah A. Butler, Assistant Chief Counsel (Field Service), Internal Revenue Service to The Honorable John M. McHugh (June 4, 1999). Thus, although Congress specified in the 1998 RRA that the IRS should consider equity and public policy and to resolve "longstanding cases" by foregoing penalties and interest, neither the Treasury Department nor the IRS has shown any inclination to provide for significant interest abatement based on equitable considerations or exceptional circumstances.^5/

Conclusion
Where innocent taxpayers are victimized by a tax shelter promoter and the process of adjudicating the tax liabilities takes as long as 20 years, equitable factors are strongly present. The broader issue raised by the fraud perpetrated on the Hoyt partnership investors is how such equitable considerations should be taken into account in determining whether a portion of a taxpayer's total liability (e.g., the interest) should be compromised or abated.

In 1998, Congress determined that interest abatement should be part of the new offer-in-compromise procedures in certain situations. As noted above, Congress directed the IRS to take into account factors like "equity" and "public policy." However, two years later, the IRS has yet to develop reasonable guidelines to facilitate offers in compromise that give proper attention to these factors.

If the IRS continues to exhibit resistance to Congressional intent, Congress may want to revisit the issue in a legislative context. The Joint Committee on Taxation staff has recommended that abatement of interest be utilized if a "gross injustice" would otherwise result if interest were to be charged. It is anticipated that such authority would be used infrequently. Although I believe that the IRS already has the authority to address situations of gross injustice under the expanded offer-in-compromise authority of RRA 1998, enactment of a new statutory remedy may be necessary.

Footnotes

^1/Statement of Appeals Officer William McDevitt, Appeals Supporting Statement (Dec. 23, 1997).

^2/In Bales v. Commissioner, T.C. Memo 1989-568, the Tax Court found that a Hoyt cattle partnership was not an abusive tax shelter; however, the Court also held that certain deductions for expenses in excess of the partners' actual investment should be disallowed.

^3/From the late 1970s until 1997, Mr. Hoyt used his continued Enrolled Agent status as proof that he was a legitimate tax advisor. The IRS finally removed Mr. Hoyt's Enrolled Agent status in 1997 and as TMP in 1999.

^4/Note: Although Mr. Oveson's statement generally describes the situation of the Hoyt investors, the Hoyt partnerships do not fit the definition of a tax shelter (i.e., an organization whose major or exclusive purpose is to shelter income).

^5/At the Ways and Means Oversight Subcommittee hearing on January 27, 2000, Treasury Tax Legislative Counsel Joseph Mikout testified: "...Treasury's position remains that it is appropriate that situations involving abatement of interest be narrowly drawn."

DC01/327821.1

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