The beginning of some of Judge Holmes’ Tax Court opinions resemble screenplays. Take the opening paragraph from last week’s Leslie v Commissioner.
These cases arise from the unhappy end to a marriage. Maria Leslie got $5.5 million from her former husband under an agreement that said it would be taxable to her and deductible to him. She sent part of it–about $400,000–to an internet scamster who claimed he would invest it for her in an African diamond scheme but who made off with the money. She says the $5.5 million was a nontaxable property settlement and the $400,000 was a theft loss. She also says the IRS should have considered her request for an alternative to forced collection of her tax debt.
A colleague of mine in the Villanova graduate tax program sent me the link to this opinion because of its bringing to life some of the issues we teach in our introductory income tax class. Tax and tax procedure can be dry, especially to outsiders, but Judge Holmes knows and shows these cases have a very real human dimension.
Back to the Leslie case itself. I will simplify the facts and procedural aspect of the case to highlight the main procedural issues, which relate to whether mental illness constitutes reasonable cause and whether IRS counsel can supplement Appeals’ explanation as to why it rejected a collection alternative.read more...
There were a few years where Leslie received payments under the divorce agreement from her ex-husband, a good portion of which was contingent on a fee her ex, a lawyer, was due to get from his work in a class action suit stemming from the Enron mess. (That litigation eventually led to a $50 million fee for her ex, by the way).
As her marriage broke down and following the divorce, Leslie began to suffer from major psychological illnesses. The opinion notes she had a “lengthy battle with a myriad of psychological and mental-health problems. She began suffering–and currently suffers–from severe major depression, and from schizoaffective disorder dependent-personality disorder. Her condition darkened once the marital- separation negotiations began in 2003, and she began to plan her own death.” The mental health issues led Leslie to an involuntary psychiatric stay and a long list of medications that the opinion notes Leslie was on for many years.
One of the consequences of the upheaval in Leslie’s life was that she did not tend to her tax affairs. She filed many of her returns late, though for most of the years she initially reported the payments from her ex as taxable alimony. She did not report the losses from her diamond misadventures. With unpaid assessments stemming from the alimony and late filed returns, the case gets to Tax Court via CDP, and in the CDP proceeding she filed amended returns claiming the payments from her ex were property distributions and thus nontaxable. She also filed a return claiming the losses from her diamond investment were theft losses. That was important because the theft loss rules treat those losses as ordinary and also allow the victim to carry the losses back and forward as essentially net operating losses.
The opinion has a terrific discussion about the difference between taxable alimony and nontaxable property settlements, and also whether the scamming (which involved a promise of a million dollars if Leslie coughed up $400,000 to help “export” the diamonds) resulted in a theft loss deduction or just a loss stemming from a bad investment. I will not spend time here on the property/alimony or theft loss issues, though note that the IRS prevailed on the alimony issue (with the case turning on the conclusion that under California law the requirement for the ex to make the payments would have terminated if Leslie died even though the agreement did not so provide) but lost on the theft loss issue (because under California law the parting of her money amounted to theft by false pretenses).
The opinion also discusses a couple of interesting procedural issues. To those I turn.
Late Filing and Reasonable Cause
The IRS also assessed late filing penalties. At issue was whether her mental illness amounted to reasonable cause. The opinion discusses how incapacity can amount to a defense to the late filing penalty, with the taxpayer having to show that a mental or emotional disorder “rendered [her] incapable of exercising ordinary business care and prudence during the period in which the failure to file continued.” (citing Wilkinson v. Commissioner, T.C. Memo. 1997-410). Despite the many troubles Leslie was facing the opinion concluded that she did not meet that standard:
But the standard is a tough one to meet, and we did not see enough evidence of her inability to manage her other business affairs during this time. She was, for example, living in substantial part on the income from eight rental properties she got in the divorce, which required her active involvement in their management. We acknowledge she had problems doing this, but because she was still able to live on this income we find that her ability to “carry on normal activities” was not so impaired as to be an inability. See id [Wilkinson v Comm’r]. This is not enough to excuse a late filing.
This is a tough outcome, and when I read the earlier parts of the opinion describing Leslie’s medication and hospitalization I thought it was enough to support reasonable cause. As the opinion notes, however, many cases that explore incapacity emphasize how the illness relates to an inability to manage affairs outside the tax world. Given that Leslie was apparently actively managing her rental properties, or able to sufficiently delegate the responsibilities from the rental business, she came up short.
Chenery and CDP
The other part of the opinion dealt with Leslie’s request for an installment agreement at CDP. Appeals’ determination rejected the request, though it did so with little explanation. At Tax Court, IRS sought to explain why Appeals was within its considerable discretion to reject the collection alternative. That ran smack into the Chenery principle. We have discussed SEC v Chenery, and how taxpayers are pushing its application in deficiency cases. See, for example, Tax Court Rules that APA and Administrative Law Principles Do Not Bar IRS From Amending Answer and Asserting New Grounds for Deficiency and Stephanie Hoffer and Chris Walker’s guest post A Few More Words on Ax and the Future of Tax Court Exceptionalism.
Essentially, Chenery stands for the proposition that the courts are not supposed to allow agencies to argue a new reason for their determination, or justify agency actions based upon arguments or issues that were not properly made below. While the Tax Court is less than bullish on its use in deficiency cases, its use in CDP cases involving collection issues is more entrenched.
At Tax Court, IRS argued that the settlement officer acted within his discretion in not allowing a collection alternative because Leslie did not provide information about the cost of her life and health insurance premiums. Unfortunately for the IRS, the determination made no reference to the missing premium information:
The Commissioner does argue on brief here that the SO was within her discretion to deny collection alternatives because Leslie didn’t supply information about her health- and life-insurance premiums. This was, however, just about the only financial information that Leslie didn’t supply. Even more important, this specific failure–a failure to supply complete information about health- and life- insurance premiums–is not cited in the notice of determination as a reason for refusing to consider an alternative to enforced collection. In reviewing notices of determination, we follow the Chenery doctrine.
After setting out the IRS’s failure, the opinion then proceeds to give effect to Chenery in CDP:
Applying Chenery in a CDP case means that we can’t uphold a notice of determination on grounds other than those actually relied upon by the IRS officer who made the determination. See Chenery I, 318 U.S. at 87-88; Spiva v. Astrue, 628 F.3d 346, 353 (7th Cir. 2010) (agency has the responsibility to articulate its reasoning); Salahuddin, 2012 WL 1758628, at *7 (“[O]ur role under section 6330(d) is to review actions that the IRS took, not the actions that it could have taken”). Those grounds must be clearly set forth so that we do not have to guess about why an officer decided what he did. See Chenery II, 332 U.S. at 195.
As the opinion notes, Leslie had previously submitted a 433 A, and the SO’s failure to prepare an allowable expense worksheet rendered the determination and the SO’s actions overall as not rational:
This makes the determination not rational, in contrast to the run-of-the-rejection-mill case where a taxpayer submits no information or leaves out assets.
The upshot is a remand, where Appeals will have to provide more personalized analysis of Leslie’s finances and work with her to try at least see if an installment agreement is possible. The opinion stands as a reminder between the considerable differences in the procedural posture of deficiency cases from CDP cases. In deficiency cases, IRS still has considerable leeway in making arguments in Tax Court that were not made below. In CDP cases, the Tax Court will be much more vigilant in keeping IRS to what it previously said. It is not enough for the IRS to be right; it has to be right because it was what Appeals considered and explained previously.