Tax Court rules for gamblers in interpretation of federal modification

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The Indiana Tax Court granted partial summary judgment to two professional gamblers who received unwanted adjustments to their adjusted gross income tax liabilities after the court concluded the Indiana Department of State Revenue’s interpretation of federal modification was unreasonable.

Between the years of 2005 and 2007, professional gamblers Tony and Shirlena Smith timely filed their federal income tax returns and reported that they received income and deductions associated with their gambling trade.

But a disagreement arose with the Internal Revenue Service regarding its audit findings and adjustments on a revenue agent report it produced for the Smiths for those years. The matter was eventually settled with a Form 870-AD “Offer to Waive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Overassessment,” which reflected adjustments to the Smiths’ federal tax liabilities for 2005 through 2007 that were contained on separate tax forms that accompanied the Form 870-AD.

When the Indiana Department of State Revenue discovered the federal audit several years later, it expanded its own audit to include the years of 2005 through 2007 and ultimately adjusted the Smiths’ adjusted gross income tax liabilities during that time based on the federal adjustments in the revenue agent report.

The Smiths argued that the department’s adjustments should have reflected the Form 870-AD adjustments rather than those made in the revenue agent report, and subsequently amended their Indiana income tax returns. The department denied the Smiths’ protest, resulting in the couple’s motion for partial summary judgement with the Indiana Tax Court.

Specifically, the Smiths argued they were entitled to partial summary judgment because I.C. sections 6-3-4-6 and 6-8.1-5-2 mandate that the department’s modifications to their Indiana AGIT liabilities for the years at issue must be consistent with their Form 870-AD adjustments.

Judge Martha Blood Wentworth granted the Smiths’ motion in Tony W. Smith and Shirlena Smith v. Indiana Department of State Revenue, 49T10-1605-TA-13, declining to defer to the department’s interpretation of “federal modification” to mean a federal revenue agent report. The court found that interpretation to be unreasonable, while also providing insufficient authority of a generally applicable interpretation.

First, the court declared it was unconvinced that the department provided evidence indicating its generally applicable interpretation of the term “federal modification,” particularly because the department had not exercised its authority to interpret the term in a duly promulgated regulation as required by statute.

The tax court further found that the department’s interpretation conflicted with the plain language of I.C. § 6-3-4-6, and that a revenue agent report alone lacks the finality required by the statute.

“If a federal RAR constituted a ‘federal modification’ for purposes of Indiana Code § 6-3-4-6(c), as the Department urges, a taxpayer may have to notify the Department of each sequential federal step on the path to concluding the federal audit, which would result in unnecessary and overly burdensome compliance and administration for both the Department and the taxpayer,” Wentworth wrote.

“Determining which federal document provides the finality required under Indiana 9 Code § 6-3-4-6(c) is a fact sensitive inquiry. Here, the execution of the Form 870-AD proves the Smiths’ RARs lack the finality that results in the actual changes to their federal or Indiana adjusted gross income,” Wentworth continued. “Moreover, the Smiths have taken no steps to further challenge the Form 870-AD.”

Therefore, the court concluded that the modifications made to the AGIT liabilities by the department must be confined to the modifications made by the IRS reflected on the Form 870-AD. In a footnote, however, Wentworth wrote that the issues regarding the correctness of the department’s assessments remain reserved for trial.  

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