You probably use the term “snake oil” synonymously with “scam.” Yet the original snake oil was a traditional Chinese medicine, introduced to America by Chinese railroad workers in the 1860s, and included oil from the Chinese water snake. An analysis in 1989 determined that the water snake oil contained omega-3 fatty acids, which are known to reduce inflammation. Over the years, scammers converted truth into fraud by selling products that contained no oil from the water snake, leading to the current negative impression of the term.
The Original Issue Discount tax scam operates in a similar manner: Fraud based on a kernel of truth.
The truth is that when bonds and certain other debt instruments are issued at a price less than the full value, the discount, or difference, between the issue price and the redemption value is “original issue discount,” or OID. The discount is treated as income and is taxable. Financial institutions and businesses use Form 1099-OID, Original Issue Discount, to report the income. Among other information, the form lists the amount of original issue discount for the year and the amount of federal income tax withheld. A copy of Form 1099-OID goes to the IRS and to the taxpayer.
The fraud is the story that the US government maintains secret accounts for US citizens and that taxpayers can gain access to the accounts by filing a fake Form 1099-OID to justify a false refund claim on a corresponding tax return. These types of false refund claims have consistently made the IRS’s annual “Dirty Dozen” tax scam list, and were so prevalent that the IRS set up a task force in 2010. The task force helped reduce fraudulent claims from $24 trillion in 2009 to $1.2 trillion in 2010 according to GAO Report 11-142 .
In Office of Chief Counsel Memorandum 2016-40016, the question was whether an original federal income tax return containing false Form 1099-OID information was a valid return. The question arose because the IRS wanted to assess a fraud penalty (internal revenue code section 6663). That civil fraud penalty is assessed at 75% of the portion of the underpayment attributable to fraud, and can’t apply when a tax return is not valid.
To be valid, a return must contain sufficient data to calculate tax liability, purport to be a return, be an honest and reasonable attempt to satisfy the requirements of the tax law, and be executed by the taxpayer under penalties of perjury.
In the case at issue, the taxpayer claimed OID income and an identical amount of withholding and filed a return showing an overpayment of tax. The IRS issued the refund. Later, when the Form 1099-OID failed IRS information-matching procedures, the IRS assessed a $5,000 frivolous filing penalty (internal revenue code section 6702).
According to the IRS, the return met the first three requirements of the valid return test. The return contained sufficient data to calculate the tax liability because, aside from the overstated withholding, the return was largely correct. In addition, the return purported to be a return and was signed by the taxpayer (executed under penalties of perjury).
However, in order to assess the $5,000 frivolous filing penalty, the IRS had to determine that the purported return contained information that “on its face indicates that the self-assessment is substantially incorrect.”
The problem? If a return is so facially implausible that the $5,000 frivolous filing penalty applies, the return may also fail the third prong of the valid return test: that the return be an honest and reasonable attempt to satisfy the requirements of the tax code. A non-valid return means the 75% fraud penalty could not be assessed.
The issue: Is the return valid despite the assessment of the $5,000 frivolous filing penalty?
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It is likely that a court will consider the return in question to be valid, even if the return contains a frivolous position.
The section 6663 fraud penalty cannot apply when a taxpayer has not filed a valid tax return. Therefore, to determine whether the return is subject to the fraud penalty under section 6663, we must first determine whether the purported return constitutes a valid tax return.
Courts have treated as valid returns that claim refunds on the basis of overstated withholding.
To be valid, a return must meet the following four requirements:
(1) it must contain sufficient data to calculate tax liability;
(2) it must purport to be a return;
(3) it must be an honest and reasonable attempt to satisfy the requirements of the tax law; and
(4) it must be executed by the taxpayer under penalties of perjury.
A return that is incorrect, or even fraudulent, may still be a valid return if “on its face [it] plausibly purports to be in compliance.”
The filed form meets the first three requirements. As to the first requirement, the return filed contains sufficient data to calculate the tax liability because, aside from the overstated withholding, the return was largely correct. As to the second and fourth factors, the return purported to be a return and was executed under penalties of perjury.
Whether the purported return was an honest and reasonable attempt to satisfy the requirements of the tax law, in satisfaction of the third requirement, is a closer call. For the $5,000 frivolous filing penalty to apply, section 6702 requires that the purported return contain information that “on its face indicates that the self-assessment is substantially incorrect.”
Because the IRS assessed the section 6702 frivolous filing penalty, it determined that the form submitted contained some information that, on the face of the return, indicated that the self-assessments were incorrect. It’s arguable that if a return is so facially implausible that a section 6702 penalty applies, that return may also fail the third prong of the valid return test: that it be an honest and reasonable attempt to satisfy the requirements of the tax code.
However, rarely, if ever, has a court found a purported return to be invalid solely for failure to satisfy the third prong of the test.
Most likely, a court would find that the return is a valid return sufficient to give rise to liability for the fraud penalty under section 6663, if there is an underpayment. To guard against the possibility that the return is not valid, the IRS should include the section 6651(f) fraudulent failure to file penalty as an alternative position.