On Appealing the IRS Tax Audit Results

At this juncture, the IRS and the association are merely talking, setting out their arguments over the application of IRS Revenue Ruling 70-604. At issue in the 2007 tax return is whether the association met the conditions necessary to exempt under 70-604 certain income known as carryforward funds from taxation? Neither party has sued the other, although that status may change if the parties are unable to come to any mutual agreement on the application of 70-604 and how much money is owed. In the event no such agreement is reached in these appeal discussions, litigation is the expected outcome. In that unlikely event, there is little doubt the IRS would prevail at trial.

In the unlikely event the board would like to launch an appeal to the U. S. Tax Court, the association has a major administrative hurdle to overcome. It first must gain the approval of the unit owners. Given the size, composition and disposition of the community to accept change, such a proposal would be dead on arrival. [For the applicable NRS citation, see the footnote at the end of this article.]

If we were employees rather than members of the association, it might sound reasonable to keep us in the dark about certain sensitive matters. Even as members, the board is authorized to deny us access to certain legal matters, but this is not a legal matter at this initial stage. Here we have the IRS making an argument in support of their determination, which argument you can read in full here. At the March board meeting we learned that members will not have access to the association’s argument in support of their response. While it’s reasonable to conclude the association has not agreed to accept the proposed $1.345 million tax deficiency, it would appear that the basis for the board’s decision is none of our business.

Some have argued that this IRS matter is not unlike a game of chess in which one’s opening gambit in the forthcoming battle on who will ultimately prevail is the all important move. Understandably, one is reluctant to reveal in advance their overall strategy to the opponent. However, that strategy is soon revealed as the play begins. And besides, the IRS has played this game a thousand times before. While it’s highly doubtful the board will achieve check mate, one quickly gets the impression that the real opponent here in keeping matters secret is not so much the IRS as it is our more vigilant homeowners who regard transparency as a virtue. The IRS is expected to respond no differently regardless of what information the board decides to withhold from the unit members. That the IRS response might be influence by some homeowner’s input sounds unreasonable and obsessive.

Some may regard the IRS as invincible and cannot be taken down. That opinion is wrong. If there is one word that is synonymous with IRS that word would be settlement. Whether the IRS position is vulnerable and would be motivated to settle on terms less than what they propose is yet to be seen. Realistically, though, a settlement favorable to the association is all that the association can hope for since the prospects of litigating the matter appear out of the question. That said, does the IRS have any incentive to settle? I think not. Assuming that litigation is not a viable option for the association, there is no reason for the IRS to settle on terms different from what they found due.

All can recall that the airways are flooded with invitations to call and reduce your tax liability by some great percentage or to get your liability cut down to as low as ten cents on the dollar. And lest we forget, Nevada is a well known haven for those like Irwin Schiff who, apparently from his prison cell for tax evasion, continues to propose that the IRS has no authority to collect taxes.

Since the board is unwilling to share their opposing argument, one is prevented from opining what that reluctance might mean. While not a good parallel to rely on, I cannot help remembering back to the defense strategy in the criminal trial of O. J. Simpson. While clearly guilty in the murder of two people, there was no one better to call on for help in attempting to defend Simpson than Barry Scheck, the renowned DNA expert and founder of the Innocence Project. Despite Simpson’s apparent guilt, Mr. Scheck and his partner were successful in raising some doubt in the receptive minds of those that really counted on Simpson’s ultimate fate, the jury. Whether the association’s tax experts Gary Porter and John Knobelsdorf will do for the association what Scheck and company did for Simpson is yet to be determined.

While citing privilege as a defense to keep their response secret, the board’s declaration appears to be on thin ice according to information from the office that administers enforcement of Nevada’s HOA statutes. Whether that advice will have any timely impact is unclear since those issues are not quickly resolved. In the meantime, we can ponder the potential success of the association over the IRS.

While IRS revenue rulings have the appearance of law, they are not. As one court mentioned, a revenue ruling is nothing more than the IRS’s litigation position. Moreover, courts are not obliged to adopt the view of the IRS in applying a revenue ruling since such rulings typically represent the IRS’s position with respect to a particular factual situation. Going for the IRS in our case is the fact that the association’s tax claims appear to parallel the factual situation described in Revenue Ruling 70-604 and in the Mission Heights HOA court decision that favored the IRS. Also in IRS’s favor is the fact that 70-604 has been on the books for over 40 years and the IRS Commissioner cannot afford to establish an unfavorable legal precedent.

Going against the IRS are two considerations: 1) limited efforts to enforce 70-604 over the years, notwithstanding the efforts of common interest property tax expert Gary Porter to augment the knowledge gap on his website; and 2) 70-604’s teeth have lost some of their bite as time has taken its toll on what remains of that original ruling to enforce, namely the provision that requires the association to return excess income.

It is well known that a court can just as well agree or disagree with the IRS. This is aptly illustrated in a 1999 case that IRS lost in the U. S. Tax Court. This is an interesting case in which the court ruled against the IRS on whether certain transfer fees were taxable income to the corporation. The IRS argued that such membership transfer fees were taxable income for services and accordingly did not qualify as contributions to capital. On the other hand, the corporation argued that such fees were contributions to capital and therefore were not taxable. The amount of the proposed tax deficiency over a three year period was just under $290,000. As an aside, the court got into an extended discussion about the requirements for earmarking funds for a specific capital purpose in order that such funds not to be taxed, an issue of potential interest for Sun City Anthem.

While the IRS relied on a number of cases and rulings in support of their position, the court ruled the IRS was wrong, relying instead on the corporation’s practices and intent that such transfer fees indeed qualified as contribution to capital. In the final analysis, the court was less persuaded by the alleged correctness of the IRS’s position and was more persuaded by the factual situation that appeared to support the plaintiff, the Board of Trade of the City of Chicago, or CBOT. For the more hardened observer of tax law, you can read this 39-page decision here.

According to NRS 116.31088, “the association shall provide written notice to each unit’s owner of a meeting at which the commencement of a civil action is to be considered at least 21 calendar days before the date of the meeting. Except as otherwise provided in this subsection, the association may commence a civil action only upon a vote or written agreement of the owners of units to which at least a majority of the votes of the members of the association are allocated.”