Schedule UTP and Criminal Penalties (9/21/13)

Lee Sheppard has an interesting article on privileges addressing issues in Wells Fargo & Company v. United States, 2013 U.S. Dist. LEXIS 78714 (D MN 2013).  See Lee A. Sheppard, The New Look of Privilege, 140 Tax Notes 1159 (Sept. 16, 2013).  Wells Fargo is a lengthy opinion with extensive analysis of privileges for Uncertain Tax Positions and tax accrual workpapers.  I do not link the opinion here or otherwise discuss it  because it is not relevant to the subject of this blog entry.

Addressing the Schedule UTP, Lee says in the article:

There is no penalty for failure to file a complete or accurate Schedule UTP. Indeed, there is no penalty for failure to file a complete return, as the IRS discovered during the offshore account imbroglio. There is a statutory penalty for failure to file a return at all (section 6651).

I want to address that statement, but first briefly describe the Schedule UTP.  See the IRS website for the Schedule UTP Form 1120, here.  The instructions provide:

Reporting Uncertain Tax Positions on Schedule UTP 

Tax positions to be reported.   

Schedule UTP requires the reporting of each U.S. federal income tax position taken by an applicable corporation on its U.S. federal income tax return for which two conditions are satisfied. 

1. The corporation has taken a tax position on its U.S. federal income tax return for the current tax year or for a prior tax year. 

2. Either the corporation or a related party has recorded a reserve with respect to that tax position for U.S. federal income tax in audited financial statements, or the corporation or related party did not record a reserve for that tax position because the corporation expects to litigate the position. 

A tax position for which a reserve was recorded (or for which no reserve was recorded because of an expectation to litigate) must be reported regardless of whether the audited financial statements are prepared based on U.S. generally accepted accounting principles (GAAP), International Financial Reporting Standards (IFRS), or other country-specific accounting standards, including a modified version of any of the above (for example, modified GAAP).

I want to question Lee's statement quote above.  As to a direct penalty for failure to file a complete or accurate Schedule UTP, this is the jurat for the Form 1120, corporate return:

Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. 

A knowingly -- willfully in criminal tax jargon -- false Schedule UTP would violate the jurat.  A knowingly incomplete or missing Schedule UTP would also violate the jurat and thus give rise to prosecution as tax perjury (Section 7206(1), here) and probably also could be charged as tax obstruction (Section 7212(a), here, and/or 18 USC 371, here (defraud / Klein conspiracy)).  And there are certainly other charges that might be considered (e.g., 18 USC Section 1001, here).

Moreover, in almost all cases in which such behavior would be material, a knowingly incomplete or missing Schedule UTP could be used in support of the various penalties that might apply to the related underreported taxes -- the 75 % civil fraud penalty and the accuracy related penalties.  Lee seems to acknowledge this in her following discussion.

The IRS may have to argue that a taxpayer may lack reasonable cause for a return position taken on the basis of a transaction that should have been reported but was not, because that might indicate the taxpayer did not act in good faith under section 6664(c)(1). Failure to file a required statement would probably not result in failure to file under section 6651. 

Taxpayers are behaving badly regarding Schedule UTP. Does the IRS have the statutory power to write its own penalty for failure to file an adequately completed Schedule UTP? It has the power to say what must be reported on a return (section 6011). It can effectively create an administrative sanction. It has been suggested that the IRS promise that it will not seek tax accrual workpapers if Schedule UTP is adequately compiled. (Prior analysis: Tax Notes, Apr. 1, 2013, p. 69 2013 TNT 64-4: Viewpoint.) 

Sure, some aggressive taxpayers will avoid disclosing anything if they can. These taxpayers -- let's face it, they're the ones who show up in court -- can be expected to continue to fight Schedule UTP on privilege grounds. The preamble to the enabling regulation states that the IRS is not asking for privileged material (T.D. 9510, reg. section 1.6012-2(a)(4)). 

But the IRS concomitantly may not know how to ask for what it wants. The IRS may be receiving inadequate Schedules UTP because it does not institutionally understand accounting presentation issues. Presentation is everything. Taxpayers have too much leeway on Schedule UTP. 

The IRS needs to make some changes to Schedule UTP instructions to get what it wants. (See Richard Harvey, "Schedule UTP: An Insider's Summary of the Background, Key Concepts, and Major Issues," 9 DePaul Bus. & Comm. L.J. 349 (2010-2011).) 

There is some suspicion Schedule UTP is causing taxpayers to reduce reserves and choose not to book reserves for some positions. The accounting standard has an exception for accepted administrative practice, and Schedule UTP preserves this exception, despite continuing confusion about what constitutes accepted administrative practice. 

If the taxpayer believes it has a more than 50 percent probability of prevailing either in settlement or litigation, and concludes that no reserve is required, taxpayers argue that no disclosure need be made on Schedule UTP. The Schedule UTP instructions seem to condone this nondisclosure. Some taxpayers take the position that no disclosure need be made even if a reserve was booked but not strictly required. 

Schedule UTP requires that the taxpayer disclose a position that it expects to litigate, but for which no reserve was booked. The IRS asked for a 50 percent probability of litigating -- even when the taxpayer may have booked no reserve for the position. There is a question about the level of compliance with this criterion. Sensible tax managers try not to litigate because it is hugely expensive. 

Although Schedule UTP requires taxpayers to use the same unit of account that is used for financial reporting, they can choose to aggregate their transactions for both purposes. Aggregation effectively would allow the taxpayer's shelter deals to be buried amid similar deals about which there is no uncertainty. The taxpayer would make no Schedule UTP disclosure of the combination. 

The IRS has not fixed these problems and others in Schedule UTP instructions. No administrative sanction for inadequately completed Schedules UTPs would be meaningful unless the IRS clarifies what it wants. Once that is done, a large number of taxpayers would comply, and the aggressive ones would remain aggressive. 

Well, gee, isn't the chronically underfunded IRS just looking for shortcuts? Wells Fargo accused the IRS of as much, noting that most of its uncertain tax positions for the pertinent years were already being audited. 

On the one hand, a tax return is a disclosure document, and the IRS has the power to say what must be disclosed. If the IRS figures out a way to get necessary information without violating legal privileges, then fine. On the other hand, the underfunding is deliberate -- and not a recent phenomenon at that. Americans want a show of tax enforcement, but not too much tax enforcement or collection.