Updates on Collection Issues

The IRS has recently updated several matters that impact taxpayers in collection. This post pulls together some of the newly available information.  The areas discussed in this post are the financial standards, the updated offer in compromise booklet, the impact of the new law on amounts exempt from levy and the impact of the new law on the time to file wrongful levy claims.

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Financial Standards

On March 26, 2018 the IRS issued new financial standards to be used in collection cases.  The new standards provide guidance to individuals seeking to prepare a collection information statement in order to convince the IRS to grant an offer in compromise, an installment agreement, to make a currently not collectible determination or to otherwise decide the appropriate course of action in a collection case.  The financial standards have their roots in information published by the Bureau of Labor Statistics.  Congress also makes them applicable in bankruptcy cases for certain purposes.

Offer in Compromise

On March 25, 2018, the IRS issued a new Offer in Compromise Booklet. The updated booklet contains the following changes:

Form 656, Section 6, Filing Requirements – “I have filed all required tax returns and have included a complete copy of any tax return filed within 60 days prior to this offer submission.”

This is also addressed in the opening Q&A section under “Other Important Facts”:

“Note: If you have filed your tax returns but you have not received a bill for at least one tax debt included on your offer, your offer and application fee may be returned and any initial payment sent with your offer will be applied to your tax debt. Include a complete copy of any tax return filed within 60 days prior to this offer submission.”

WHAT YOU NEED TO KNOW, Q&A Section, Bankruptcy, Open Audit or Innocent Spouse Claim – “If you currently have any open audit or outstanding innocent spouse claim, wait for those issues to be resolved before you submit an offer.”

PAYING FOR YOUR OFFER – There is better highlighting of the Low-Income Certification option, with emphasis that low income certification means no money need be sent with the offer.

Because the IRS will not work an offer if a taxpayer has not complied with tax laws by filing all necessary returns, many taxpayers file returns immediately prior to the filing of an offer in compromise. The IRS does not always process past due returns with haste because it puts more focus on processing the currently due returns.  The new requirement that a taxpayer attach returns filed within 60 days of the submission of the offer allows the IRS offer group to avoid rejecting cases for lack of filing compliance and to get a view of the liabilities the taxpayer owes in advance of the actual assessment.

The warning about waiting for the resolution of outstanding audits or claims should be considered in the context that an offer in compromise acts as a closing agreement resolving all matters concerning the years covered by the offer. A taxpayer cannot go back and seek a refund after obtaining an offer and the IRS cannot go back and seek an additional assessment.  It is important to resolve all issues for the years covered by the offer but many taxpayers do not appreciate the scope of the offer with respect to the years it covers.

Low income taxpayers continue to receive a benefit when applying for an offer because they do not have to pay a fee for the offer or remit a percentage of the offer. Almost all practitioners know this but many individuals filing offers pro se may not appreciate this benefit and the new booklet tries to make it clearer.

Each of the changes seem appropriate and helpful.

Exemption from Levy

The exemption from levy is tied to the personal exemption. The personal exemption went up last year and the IRS has published guidance on how that change impacts the amount of the exemption from levy in a wage levy situation.  This creates a windfall for individuals subject to a wage levy that Congress probably did not think about when it passed the law.  Of course, windfall may be the wrong term when talking about a provision that can bring a taxpayer to their knees.  Here is the IRS description of the way the wage levy provisions will now work:

Public Law Number 115‐97, TAX CUTS AND JOBS ACT OF 2017, signed by President Trump on December 22, 2017, temporarily increases the basic standard deduction applicable to the 2018 taxable year [IRC § 63(c)(2); Rev. Proc. 2016‐ 55] across all filing categories:

  • From $6,350 to $12,000 for single individuals and married individuals filing separate returns;
  • From $9,350 to $18,000 for heads of households; and
  • From $12,700 to $24,000 for married individuals filing a joint return and surviving spouses.

The Act also suspends personal exemption deductions. Both changes, the increase in the standard deduction and the suspension of the personal exemption, are effective for taxable years beginning after December 31, 2017, and before January 1, 2026. These two changes impact how a recipient of a levy will figure the amount of income exempt from levy. Prior to the change in the law, the amount that was exempt from levy was calculated by taking into consideration both the standard deduction and the total exemptions of the payee. With the elimination of personal and dependency exemptions, a new method for determining the amount of income exempt from levy was needed.

As part of the Tax Cuts and Jobs Act, Congress amended §6334 to provide that from January 1, 2018 through December 31, 2025 employers and other recipients of levies would exclude from levy $4,150 per dependent per year in addition to the amount excluded based upon the standard deduction for the filing status of the person subject to levy. The amount exempt from levy each pay period is calculated by dividing the total amount exempt from levy for the year by the number of pay periods. Publication 1494, Table for Figuring Amount Exempt from Levy on Wages, Salary, and Other Income has been updated. Changes are also being made to Forms 668-W(c), 668-W(c)(DO), 668-W (ICS) and Form 668-W, Notice of Levy on Wages, Salary, and Other Income, along with the instructions.  Due to the increase in the standard deduction amount, in most cases, the taxpayer will have more take-home pay that is exempt from levy.

Employers or others receiving levies will need to figure the amount of income exempt from levy. To do so the recipient  must determine what the payee’s filing status will be (The amount exempt from levy is based upon the standard deduction for that filing status); the frequency of payments, Daily (260), Weekly (52), Bi-Weekly (26), Bi-Monthly (24), Monthly (12); and lastly, the number of dependents that the payee will claim. In this example, the employer knows that the employee will claim the married filing joint standard deduction and has two dependents.

STEP 1: Determine the filing status of the payee.

STEP 2: Find the amount exempt from levy based upon how often taxpayer is paid:

Married Filing Jointly:

STEP 3: The taxpayer is entitled to exclude $4,150 per year per dependent. This chart shows the amount that can be excluded each pay period based upon pay frequency. The amount from far the right-hand column for the correct pay frequency will need to be multiplied by the number of dependents to arrive at the total amount exempt from levy that is attributable to the payee’s dependents.

Amount Exempt from Levy per Dependent:

Step 4:

Amount Exempt from levy from Bi-Weekly Pay:

Add the amount exempt per pay period based upon the payee’s filing status, plus the amount exempt per pay period per dependent to arrive at the total amount of take-home pay that is exempt from levy. A taxpayer that is married, files jointly, is paid $1,500 bi-weekly, and claims two dependents will receive $1,242.32 and will have $257.68 ($1,500-$1242.32) levied.

Wrongful Levy Claims

IRC § 6343(b) previously required taxpayers to make a wrongful levy claim within nine months of the taking of the property. For some people, this time frame was too short because they did not even learn about the taking during that time.  In response, Congress increased the amount of time taxpayers have to seek the return of property when they believe the IRS has wrongfully taken their property while trying to collect from a taxpayer.

Public Law 115-97, the Tax Cuts and Jobs Act extends the period for making an administrative claim to two years and if the taxpayer makes an administrative claim during that period the time to bring suit is extended for 12 months from the date of filing of the claim or for six months from the disallowance of the claim, whichever is shorter. The change applies to levies made after December 22, 2017, and to levies made prior to that date if the nine month period under the prior law had not yet expired.  The IRS issued IR-2018-126 to discuss the change and has revised Publication 4528 to reflect the change.

 

Requesting Innocent Spouse Relief

The National Taxpayer Advocate posted a blog detailing the impact of the change in the time period for requesting innocent spouse relief as a result of the litigation concerning the regulation under IRC 6015(f). The result of the study regarding the volume of the requests made after the change in the regulation makes clear that opening the time period for requesting relief under (f) from two years to the full period of the statute of limitations on collection has not had a material impact on the number of requests for innocent spouse relief. This information refutes concerns raised by the IRS in the litigation that opening up the time period would open the floodgates of cases seeking 6015 relief. The IRS makes similar floodgate arguments in the equitable tolling cases with similar empirical data to support its claim.

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For those not familiar with the issue, the 1998 Restructuring and Reform Act significantly changed the innocent spouse provisions and created three forms of relief available under subsections (b), (c) and (f) of IRC 6015. The legislation capped the time period for taxpayers to claim relief under (b) and (c) but was silent regarding (f) relief. The IRS promulgated regulations providing a two year period for seeking relief under (f) to match the time period under the other subsections. Low income taxpayer advocates Paul Kohlhoff and Bob Nadler attacked the regulation in the case of Lantz v. Commissioner, 132 T.C. 131 (2009), rev’d, 607 F.3d 479 (7th Cir. 2010). Although they convinced the Tax Court that this provision of the regulation was contrary to the statute, the Seventh Circuit reversed and upheld the regulations. Two other circuits upheld the regulations and cases were pending in other circuits when a letter from numerous members of Congress convinced the IRS to reverse its position and pull the regulation. [As a side note, the IRS issued Rev. Proc. 2013-34 following its change in course but has yet to publish a new regulation despite seeking comments several years ago.]

Since (f) relief is available to individuals who cannot obtain (b) or (c) relief, one of the IRS arguments in support of the two year limit on (f) relief was that it was necessary in order to avoid an end-run around the time limitation and open the door to a high volume of innocent spouse requests. The statistics published in the NTA’s blog suggest that the IRS fears of a high volume of requests due to the expanded time frame have not materialized. The relatively flat number of requests for relief before and after the change in the regulation suggest no need exists for Congress to amend (f) in order to protect the integrity of the innocent spouse statute.

The lack of any material change suggests that most individuals seeking relief do so relatively shortly after learning of their liability for a tax debt they believe they should not owe. My own experience with individuals seeking this relief supports this conclusion. Most of the time these individuals have ended the marriage and they seek to correct the problem as soon as possible. This is not something about which they procrastinate. The receipt of the IRS notice and demand letter individually and the prospect of facing the IRS collection system usually drive them to seek relief as soon as possible.

The post by the NTA also contains statistics concerning the percentages related to granting of innocent spouse relief. These statistics show a recent decline in the number of cases in which the IRS has granted relief. The statistics match the anecdotal concerns of advocates requesting innocent spouse relief. It is not clear if the quality of the requests has gone down, the review has become tougher or some other factor has influenced the rate at which the IRS grants these requests. As with most matters, it does make a difference if the individual is represented. I would be curious if statistics exist showing whether the number of requests from individuals representing themselves have increased or if the decline in acceptance of these requests reflects an across the board decline. My clinic usually gets involved in these cases when the individuals learn of the clinic after filing a Tax Court petition. Finding a way to have qualified individuals seeking this relief to come to clinics at an earlier stage in the process might improve the success rate of those seeking innocent spouse relief.

 

 

Who Can Issue a Notice of Deficiency?

Two years ago the Eighth Circuit reversed a Tax Court decision in a case involving a tax protestor because the IRS did not prove that the person signing the notice of deficiency had the authority to do so. I blogged about it here and predicted that the case would return to the Eighth Circuit after the Tax Court saw to it that the person issuing the notice had the delegated authority to do so.  On May 16, 2018, the Eighth Circuit issued an opinion upholding the Tax Court’s decision on remand that the person signing the notice of deficiency had the authority to do so.  The outcome is exactly what I predicted in my prior post but worthy of mention to close the loop.  Because of the post-Graev challenges to penalty approval, it is possible that there will be an uptick in other challenges to IRS action.  The Muncy case serves as a reminder that the IRS must follow a prescribed process in issuing the notice of deficiency (and other similar notices), that taxpayers can challenge the authority of the person issuing the notice and that the IRS must go through the steps to prove that it followed the rules even though going through those steps is burdensome.  It also serves as a reminder that these challenges will generally not prevail.

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Mr. Muncy tried to cheat on his taxes, got caught and was convicted of a willful attempt to evade and defeat his taxes for 2004. The IRS sent him a notice of deficiency dated September 7, 2011 signed on behalf of the IRS Commissioner by Ms. Miller who was a Technical Services Territory Manager at the time.  She signed the notice pursuant to Delegation Order 4-8, as set out in IRM 1.2.43.9 (February 10, 2004).  There are many delegations orders in the IRM which are constantly being updated.  The IRS does a good job of following the IRM with regard to the delegation orders but it is certainly possible that it could make a foot fault.  A mistake in signing notices of deficiency could have a broad impact on the validity of assessments since the person signing the notices usually signs a large number of them.

In the initial visit of this case to the Eighth Circuit, as described in the prior post, the Eighth Circuit was unconvinced that the IRS had provided the necessary proof that the person who signed the notice of deficiency had the authority to do so. The opinion did not suggest that the IRS had made a mistake but simply that the appropriate level of proof was lacking.  So, it sent the case back to allow the IRS to put on proof that the person signing the notice was properly authorized to do so and the IRS put on that proof.

After the remand of this case, the Tax Court looked closely at Ms. Miller’s authority to sign the notice of deficiency and determined in T.C. Memo 2017-83 that she had the requisite authority under the delegation order to sign the notice.  It made the following determination:

Petitioner contends that respondent’s deficiency determinations for tax years 2000 through 2005 are “null and void” because the notice of deficiency was not “issued and sent by a duly authorized delegate of the Secretary.” Petitioner’s argument regarding the authority of IRS employees is similar to those we have previously rejected, held to be without merit, and characterized as frivolous. See e.g., Roye v. Commissioner, at *15, *16 n.6; Cooper v. Commissioner , T.C. Memo. 2006-241, 2006 WL 3257397, at *2.  We nonetheless address petitioner’s contention in accordance with the U.S. Court of Appeals for the Eighth Circuit’s instructions that we establish jurisdiction over the present matter.

Statutory notices of deficiency are valid only if issued by the Secretary of the Treasury or his delegate. Kellogg v. Commissioner, 88 T.C. 167, 172 (1987); see secs. 6212(a), 7701(a)(11)(B), (12)(A)(i).  The technical services territory manager position is part of the Small Business/Self-Employed (SB/SE) division of the IRS.  SB/SE territory managers were specifically delegated the authority to send notices of deficiency in Delegation Order No. 77 (Rev. 28), 61 Fed. Reg. 30937 (June 18, 1996) (effective May 17, 1996). See, e.g., Tarpo v. Commissioner, T.C. Memo. 2009-222, 2009 WL 3048627, at *4 (holding an IRS employee with the title “Technical Services Territory Manager” had the authority to sign and issue notices of deficiency, thus conferring jurisdiction on this Court). That delegated authority was reauthorized without substantive changes in Delegation Order 4-8, IRM pt. 1.2.43.9.  Ms. Miller undoubtedly has the authority to sign and issue notices of deficiency. See, e.g., Batsch v. Commissioner, T.C. Memo. 2016-140, at *9 (stating a valid notice of deficiency was signed by the “Technical Services Territory Manager,” pursuant to Delegation Order 4-8). We therefore hold that we have jurisdiction.

After the Tax Court went to the trouble to address the delegation order, the Eighth Circuit expended little effort in affirming the Tax Court the second time around. It found Mr. Muncy relied on an overly technical reading of the delegation order and that the IRS had complied with the delegation order in having Ms. Miller sign the notice of deficiency.  So, Mr. Muncy now has a big assessment and we have a roadmap for how the Tax Court approaches cases in which the taxpayer challenges the proof of delegation order to the person signing the notice.

Chai Ghouls and Jeopardy Assessments

In an order dated May 21, 2018 (brought to my attention by Bryan Camp) denying the IRS motion to reopen the record, in the case of Joseph C. Becker & Marcy Grace Castro, et al., v. Commissioner, Judge Holmes highlights another version of the impact of the Graev issue involving IRC 6751 that we have discussed so frequently in our blog. Judge Holmes calls these cases Chai ghouls after the Second Circuit decision that led the Tax Court to reverse its position in Graev and which put IRC 6751 in play in many cases pending in Tax Court after trial and awaiting decision at the time the Court reversed itself regarding its ability to enforce that provision in deficiency cases. (I will not link to all of the prior posts on this issue but put Chai or Graev into our search function and have at it if you are new to this topic.)

In Becker the Court encounters a new Chai ghoul because Becker involves a jeopardy assessment. Most of the Becker group of consolidated cases have docket numbers that go back to 2012 which means they rival in time the Fumo cases I describe below. In addition to the order linked above in which Judge Holmes refuses to reopen the record, he also issued a 52 page opinion on May 21 and an order for a Rule 155 computation meaning each party won and lost part of the case.

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Before I discuss the treatment of the penalties in Becker, I commend you to read the posts in the case of Fumo v. Commissioner (there are two related dockets) if you need to know more about jeopardy cases or just look at the docket sheet if you are interested in a really slow moving jeopardy case with a Tax Court life similar to the Becker case. I started writing about the Fumo case, which originates in Philadelphia and features a former state senator whose story dominated the Philadelphia Inquirer for much of the time I was at Villanova, shortly after we began the blog almost five years ago. In the first year of the blog when we were sometimes searching for things to write I wrote five posts on this case: here, here, here (Note that if you go to the Tax Court docket room do not pull out your smart phone and start taking pictures of the file as I describe in this post. The Court now has signs up warning you not to do this. So much for the man from UNCLE.), here and here.

I looked up the Fumo cases as I wrote this post to see if anything had happened or if it continued on as one of the world’s slowest moving jeopardy cases. It continues on. There is an order from two years ago denying a motion for summary judgment filed by the IRS and there are regular status updates but Mr. Fumo still has his money (I assume he still has it and is carefully preserving it to pay to the IRS should he ultimately lose) and the IRS is still trying to get Tax Court approval of the assessment and file a notice of federal tax lien. Children are over half way through elementary school who were born when this matter started. Not all jeopardy cases move with alacrity. Because of its age, I wonder if the IRS obtained the proper approvals for the penalties it is asserting in this case and if it obtained them before making the jeopardy assessments (see discussion below.) Chai and Graev were not even a glimmer in Frank Agostino’s eye when the Fumo and Becker cases began.

So, in the Becker case the trial occurred prior to the Tax Court’s decision in Graev III and the IRS filed a motion to reopen the record to put on evidence that it obtained approvals appropriately, or not. The order denying the right to reopen the case lays out the events in chronological order and then works through the various penalties at issue in the case. The Court starts with the “or not” part of the IRS motion.

IRC 6662(c) Penalties for 2007, 2008 and 2009 and Section 6662(d) Penalty for 2010

The IRS conceded that it had no evidence of complying with IRC 6751. This made the Court’s work easy.

Fraud Penalties for 2007, 2008 and 2009

The IRS attached an affidavit from the immediate supervisor of the agent but here’s where the jeopardy assessment aspect of the case comes into play. Section 6751(b)(1) requires that:

No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.

In jeopardy assessment cases the IRS makes the assessment first and provides the notice of deficiency later. The statute makes no mention of or exception for jeopardy. Even under Graev II the Tax Court would have acknowledged jurisdiction over the penalty provisions in a jeopardy case and the Court says the IRS should have known it had the burden at the time of trial to show it made the appropriate approvals in a jeopardy case; however, that proves not to be the biggest problem that the IRS faces. The penalty approval form it submitted to the Court showed that the approval occurred twelve days after the jeopardy assessment. The timing of the approval is fatal to the validity of the assessment and it would not matter if the Court reopened the record to allow in the evidence or not. Since the evidence regarding this part of the penalty approval could not change the outcome of the case, the Court said it could not justify the reopening of the case.

Section 6662(d) Penalties for 2007, 2008 and 2009 and Section 6663 Penalty (Fraud) for 2010

The penalty for 2009 was raised by Chief Counsel but no approval form by the Chief Counsel supervisor was submitted and that proves fatal to the penalty for that year to the Court. The penalty approval forms for the other penalties appeared to the Court to have been done in a timely and proper manner; however, the Court still declines to reopen the record to permit the IRS to submit those forms. It finds that the IRS should have submitted these forms at the time of trial.

The outcome with respect to the penalties for which the IRS could submit proper approval forms follows the outcome reached by Judge Holmes in four cases he decided immediately after the issuance of the opinion in Graev III and which we blogged alluding to happy holidays for the petitioners. The IRS cannot have been surprised with this result though it is no doubt disappointed. This will not be the last case involving an attempt to reopen the record of a case closed long ago. The jeopardy aspect of this case provides instruction in an area not explored by prior opinions.

Where is This Going

The IRS will continue to struggle with the Graev issue in cases before it began thinking carefully about how to timely approve penalties, how to preserve the record of the approval and how to present the record. The Court will continue to struggle as well. The decision not to allow reopening the record here seems at odds with a decision at almost the same time in Sarvak v. Commissioner, T.C. Memo 2018-68 and related order. It also stands in some contrast to the decision in Dynamo Holdings (brought to my attention by Les) where Judge Holmes discussed how the IRS does not bear the burden of production with respect to penalties in a partnership-level proceeding and how taxpayer failing to raise issue hurt it:

Our conclusion that the Commissioner does not bear the burden of production under section 7491(c) does not necessarily mean that the Commissioner’s motion to reopen the record should be denied. A taxpayer may raise the lack of supervisory approval as a defense to penalties, Graev III, 149 T.C. ___, and if that issue were validly raised, the Commissioner might want to supplement the record to respond. But Dynamo GP did not raise the lack of penalty approval in its petition, at trial, or on brief. It was not until the Court directed the parties’ attention to Graev III, after the record was closed and the case was fully submitted, that petitioners challenged the sufficiency of the written penalty approval in the record. And even then, Dynamo GP did not seek to reopen the record to dispute whether penalty approval occurred. Consequently, we consider the defense to have been waived. Rule 151; Petzoldt v. Commissioner, 92 T.C. 661, 683 (1989).

 

 

 

Equitable Recoupment Applied in Collection Due Process Case

We have alluded to equitable recoupment in a few posts but not written much about it. In EMERY CELLI CUTI BRINCKERHOFF & ABADY, P.C., v. Commissioner, T.C. Memo 2018-55, the issue arises in the collection context. The application of the principle here seems so clearly equitable that I am a bit surprised that the IRS argued against its application. The Court applied equitable recoupment to credit one entity with the employment taxes paid by another. It also relieved the entity of the penalties related to the non-payment of the employment taxes, placing the entity in the same situation it would have been had it made the payments itself.

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Read the opinion for the precise details of how it happened, but a law firm lost a partner and gained a partner. In the process, it moved from one business entity to another. Although the new business began operating at the beginning of 1999 (yes, this case goes back to a quarter of employment taxes payable almost 20 years ago), an existing entity paid employment taxes for the quarter that should have been paid by the new entity. In 2006, the IRS questioned the new entity on the non-payment of the employment taxes for the quarter at issue. The entity tried to explain the overlap in entities and the payment by a related entity of the taxes; however, its explanation failed to stop the IRS from making an assessment.

The taxpayer eventually received a CDP notice and requested a hearing. At the hearing, it explained to the Appeals employee what had happened. The Appeals employee wanted a more detailed explanation of the two entities and how they overlapped. It gave the taxpayer 10 days to provide the explanation. The entity failed to provide it within 10 days and the Appeals employee set up the case for issuance of a determination letter sustaining the IRS decision to levy. A detailed letter arrived at Appeals shortly after the Appeals employee set up the case to have the determination letter issued and 11 days before the determination letter was issued. The Appeals employee did not look at the letter, considering the matter closed from their perspective, and the determination letter issued. The taxpayer filed a petition in Tax Court.

In Court, the IRS argued that the standard of review of the determination letter should be abuse of discretion. The taxpayer argued the review should occur on a de novo basis. The Court side-stepped the issue holding that the outcome would be the same under either type of review. The Court found that the principle of equitable recoupment applied and the payments by the overlapping entity should be applied to the entity before it. In discussing the standard of review before getting to the merits of the argument, the Court chastised Appeals for not looking at and considering the detailed explanation provided by the taxpayer. It stated:

First, we note that the administrative record includes not only material that the settlement officer reviewed but also material that was available for his review. See Thompson v. U.S. Dept. of Labor, 885 F.2d 551, 553-556 (9th Cir. 1989); West v. Commissioner, T.C. Memo. 2010-250, slip op. at 11 n.11. Moreover, at the time of Emery PC’s CDP hearing, the Internal Revenue Manual (IRM) instructed Appeals employees conducting such hearings to “[c]onsider information received after the due date for supplying information but prior to issuance of the Notice of Determination/Decision Letter.” IRM pt. 8.22.2.2.4.11(1)(c) (Oct. 30, 2007); see Shanley v. Commissioner, T.C. Memo. 2009-17, slip op. at 15 (noting the de facto extension of time for submitting information arising from the requirement in IRM pt. 8.22.2.2.4.11(1)(c) that an Appeals employee consider information submitted before the issuance of a notice of determination). It is undisputed that Emery PC submitted substantial information and supporting [*22] documents 11 days before the notice of determination was issued and that the settlement officer did not consider the submission. The submission included two letters with extensive attachments. In view of the fact that these materials were available for the settlement officer’s review, and that IRM guidelines instructed him to review them, we find that the two letters and their attachments are part of the administrative record.

The Court then applied the principles of equitable recoupment to the facts of this case.

Element 1: time-barred overpayment

The Court found that the record established that the related entity overpaid its employment taxes and that, at the time of this case, its ability to obtain a refund for the overpaid taxes was barred by the statute of limitations.

Element 2: same transaction, item, or taxable event

The taxpayer argued that the overpayment by the overlapping entity and its own underpayment arose out of the same transaction. The Court commented on the position of the IRS regarding this argument:

Respondent misconstrues what constitutes a taxable event for this purpose. In our view, the taxable event in the case of employment taxes is not the [*27] Commissioner’s assessment of tax but instead the employer’s payment of wages, which in general triggers the employer’s obligation to withhold and/or to pay Social Security taxes, hospital taxes, and income tax withholdings — the employment taxes at issue in this case. See generally secs. 3102, 3111, 3402, 3403. Thus the taxable event here was the payment of wages to the eight employees of the law firm during the latter 75 days of 1Q 1999 (i.e., wage payments made after the first payment of wages on January 15, 1999). The law firm’s employees received wages biweekly and accordingly there were five such payments to seven and then, after the first two payments, eight employees during this 75-day period. Each of the five payments of wages by Emery PC was a separate taxable event triggering an employment tax liability. Thus, strictly speaking, there were 5 taxable events (or 38, if the seven, then eight, employees are disaggregated) in which Emery PC incurred an employment tax liability that was paid by Emery LLP, and for which respondent both seeks to retain the tax paid by Emery LLP and also to collect it from Emery PC. For each of these 5 (or 38) taxable events, in the absence of equitable recoupment, respondent will have collected employment tax twice on the same payment of wages — albeit with respect to 5, or 38, separate taxable events. All of the wage payments were to the same employees during the same taxable period. Cf. Rothensies v. Elec. Storage Battery [*28] Co., 329 U.S. 296 (declining to treat excise taxes paid on battery sales in different taxable years as arising from the same transaction for purposes of equitable recoupment). Thus, the components of the time-barred overpayment and the employment tax liability that respondent seeks to collect in each instance arose from the same taxable event, albeit 5 or 38 of them. Because the employment taxes that respondent seeks to retain and to collect, respectively, arose from the same payments of wages to the same employees during the same taxable period, we conclude that the requirement that the two taxes arise from the same taxable event has been satisfied.

Element 3: inconsistently subjected to two taxes

The Court found that the taxation of the employment tax had occurred twice under inconsistent theories in a manner that satisfied this element.

Because the Court found that all of the elements of equitable recoupment applied, it granted the taxpayer relief on this basis.

After doing so, the Court went on to address the penalties applied and determined that the taxpayer should not be subjected to penalties for failure to pay the employment taxes since the overlapping entity had made those payments. Because the Court was unsure if an exact match existed between the payments made by the overlapping entity and the payments due from the taxpayer, it did not completely rule for the taxpayer. It reserved the possibility that the IRS could show some of the employment taxes remained unpaid.

The application of equitable recoupment to these facts seems logical and prevents an injustice to the taxpayer who otherwise would have had to pay these taxes twice. The objection of the IRS to this outcome is not immediately clear to me but I have not read its briefs. I would have hoped that under these circumstances the IRS would have looked for a way to assist the taxpayer rather than to tax it twice.

 

 

 

Mr. Smith Continues to Suffer from His Failure to File and Other Updates on Late Filed Returns

I have not written about the one day late rule in bankruptcy cases for some time. The litigation has cooled off, but the final fate of the issue remains unresolved. See prior posts on the issue here, here, here, here, and here if you need a reminder of the problems taxpayers suffer in bankruptcy when they fail to timely file their returns. While the tide seems to have turned against the one day rule which set up an absolute bar to discharge, taxpayers in circuits other than the 1st, 5th, and 10th still suffer the consequences of filing late as well. Mr. Smith is one.

Mr. Smith brought the case that is currently the leading opinion regarding the discharge of taxes on a late filed return in the 9th Circuit. Though the 9th Circuit declined to adopt the one day rule, it still found that Mr. Smith did not discharge his tax liability in a case in which the IRS had filed a substitute for return before he filed Form 1040 for the year at issue. In a case decided on March 7, 2018, the District Court for the Northern District of California turned back Mr. Smith’s latest effort to rid himself of the liability stemming from failing to timely filing his 2001 return and having the IRS do it for him.

In addition to recounting Mr. Smith’s latest travail, I discuss two recent lower court opinions on the failure to timely file issue.

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Mr. Smith failed to timely file his 2001 return, eventually leading to the IRS preparing a substitute for return. Seven years after his return was due and three years after the IRS assessed a liability based on the SFR, he filed a Form 1040 reporting about $40,000 more than the IRS assessed. After submitting the Form 1040, he waited more than two years before filing his bankruptcy petition. The IRS agreed with Mr. Smith that the $40,000 liability shown on the late filed Form 1040 was discharged but argued that the liability shown on the SFR was not. The 9th Circuit agreed with the IRS.

Having taken his case to the Circuit Court and lost, Mr. Smith now returns to the bankruptcy court with new arguments in an attempt to rid himself of the tax assessment created by the SFR. First, he argues that since the 9th Circuit found his Form 1040 was a nullity he is entitled to “an abatement of taxes since the IRS lacked authority to assess the additional tax amount of $40,095 based on the Form 1040” he filed seven years late. Second, he argues that because he is forever barred from filing a 2001 return, he should receive declaratory judgment relief that he need not comply with I.R.C. 6012. Third, he moves for a class action seeking a declaratory judgment for all taxpayers who failed to timely file a return resulting in an SFR who lacked reasonable cause and another class action for those taxpayers who filed Form 1040 that did not constitute a return.

The bankruptcy court found that Mr. Smith lacked standing to bring this action. It also found there is no actual controversy with respect to the $40,095 assessment. Additionally, the court pointed out that even if he had standing to sue, I.R.C. 6404(b) states that “no claim for abatement shall be filed by the taxpayer in respect of any assessment of any tax imposed under Subsection A.” Further, the court found that the Anti-Injunction Act also bars the relief he sought and no waiver of sovereign immunity exists. The arguments put forth by Mr. Smith basically allowed the bankruptcy court to touch almost all procedural bases for dismissing a case.

The bankruptcy court shows no sympathy for Mr. Smith since he created his own problem, he moves to almost tax protestor like arguments, and he provides the court with no legal basis for granting the relief he sought. The case demonstrates the frustration of owing a non-dischargeable tax especially when it would have been relatively easy for the taxpayer to avoid the problem. The case also shows the limitations of trying alternative arguments to the straightforward discharge argument under B.C. 523(a)(1)(B) as well as the limitations of seeking to bring a class action to stop the IRS by seeking a declaratory judgment.

Smith shows the limitations of continuing to fight about the discharge when taxpayer files a late return. Two cases on this issue were recently decided, Word v. IRS and IRS v. Davis, in which taxpayers filing late returns did not receive a discharge. These cases deserve brief mention in the continuing saga of the two decade old issue.

In Wood, the taxpayers filed a chapter 7 petition on May 29, 2015. The issue turned on whether their 2010 return was filed. Mr. Wood passed away before the trial occurred. Mrs. Wood testified that they routinely prepared and filed their returns over a 20 year period and that Mr. Wood, a CPA, would prepare it, discuss it with her, and then file it. She presented a filed extension and a copy of the return signed by her and her husband on September 19, 2011; however, the IRS denied ever receiving the return. The IRS put on testimony of a bankruptcy specialist who searched the IRS records and found no evidence of a return. The Court found that Mrs. Word’s testimony about what happened could not overcome the IRS records regarding lack of receipt. Mrs. Wood was hampered in presenting her case because her husband had handled the mailing of the return. The Court expressed sympathy but could not get past the absence of evidence to overcome the presumption of regularity in the IRS records.

Based on the fact that the issue arises in the bankruptcy context, I presume that the taxpayers filed the return, or planned to file the return, without remittance or with only partial remittance; however, I would have liked some discussion about that fact. It seems that she should have known about the remittance aspect of the case and that would have made her story more convincing. The couple also owed for 2009 and may have filed the 2009 return without remittance as well since no mention is made in the opinion of audits. Almost no returns have prior credits exactly equal to the liability shown on the return. Taxpayers generally talk about the monetary consequences of filing a return and anticipate results based on those consequences, e.g., anticipating a refund check or anticipating an immediate bill. The discussions surrounding the money may have provided her with more detail about the mailing of the return with which she could have persuaded the bankruptcy court or the absence of those discussions may have been persuasive.

The Wood case does not present the same issue as Smith and the line of cases involving late filed returns. Rather, it presents the straightforward issue of whether the taxpayers filed a return. Although a slightly different issue, the issue of whether the taxpayer filed a return in the first place regularly presents itself in these cases.

In Davis, the IRS brings an appeal of a bankruptcy court decision and the district court reverses based on the Third Circuit’s recent decision regarding late filed returns. Mr. Davis failed to timely file his 2005 and 2006 returns. The IRS prepared SFRs and made assessments based on the SFRs. Subsequently, he filed Forms 1040 for the two years, waited more than two years, and filed his chapter 7 bankruptcy petition on July 12, 2012. After receiving his chapter 7 discharge, he filed a chapter 13 petition on August 11, 2014. The fight over the impact of the chapter 7 discharge arose in the chapter 13 case when the IRS filed a proof of claim asserting a tax due on 2005 and 2006. The bankruptcy court held that filing the Forms 1040 and waiting two years before filing bankruptcy allowed him to discharge the taxes. Subsequent to the bankruptcy court’s decision discharging the tax debt for the late filed returns, the Third Circuit issued its opinion in Giacchi v. United States, 856 F.3d 244 (3d Cir. 2017). In that opinion, blogged here, the Court found that filing a Form 1040 after the IRS made an assessment based on an SFR did not meet the part of the Beard test requiring “an honest and reasonable attempt to comply with tax law.” The Third Circuit did not say that a debtor in these circumstances could never satisfy the fourth prong of the Beard test, but it provided no guidance on how a debtor might do so.

The IRS argued in the Davis appeal that his case did not involve close facts and the district court agreed. The most interesting aspect of the case may not involve the application of Giacchi, but how the IRS was able to take the appeal. I have not gone back to read the motions filed but it appears that the debtor may have kept open the time for the IRS to bring an appeal of the bankruptcy court decision by seeking to directly appeal to the Third Circuit in the original case and then failing to follow through, but in the process keeping the door sufficiently open to allow the IRS to appeal the adverse bankruptcy decision to the district court. The short shrift the district court gives to the arguments of Mr. Davis suggests that in the Third Circuit the fact pattern of an SFR assessment prior to the filing of the Forms 1040 may be fatal to the attempt to discharge the liability.

 

Son of Boss Case Shows Limitations of Reliance on Tax Advisors to Avoid Penalty

Son of Boss cases seem to go on forever. In Palm Canyon X Investments, LLC, AH Investment Holdings, LLC, Tax Matters Partner v. Commissioner, No. 16-1334 (D.C. Cir. Feb. 16, 2018), the D.C. Circuit affirmed with a per curiam opinion the decision of the Tax Court to sustain the 40% penalty imposed under IRC 6662 for a 400% misstatement of basis. The case does not break new ground but does serve as a reminder of the limitation of the defense of reliance on counsel.

The taxpayer raised as a defense the existence of reasonable cause citing IRC 6664(c)(1). The basis asserted for the reasonable cause grounded in reasonable reliance on the advice of a “competent and independent professional advisor.” We have written recently, here and here, on the perils of using an expert witness who did not have sufficient independence from the transaction. Today’s case demonstrates the same problem when relying on a professional to avoid an otherwise applicable penalty. In the Palm Canyon case, the taxpayer not only relied on professionals who lacked independence but failed to rely on professionals who did. The existence of the case points to the high dollars at stake in the penalty and the wealth of the taxpayer to push the fight this far.

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The Son of Boss tax shelter came into existence over two decades ago. It involved artificially inflating basis in a partnership interest in order to get a tax write-off for artificial losses created upon dissolution. The D.C. Circuit cited to a 20 year old decision invalidating a transaction based on this scheme. So many people invested in the scheme that the IRS issued Notice 2000-44 specifically warning taxpayers that the use of this scheme could result in the imposition of the type of heavy penalty at issue here. By the time it issued this Notice, several cases already existed sustaining the legal position of the IRS.

The taxpayer here went looking for a tax shelter in 2001. The taxpayer had an accountant and a lawyer. These individuals looked at the Son of Boss tax shelter offered to their client and advised him that the generic tax opinion provided by the shelter promoter was “aggressive.” The D.C. Circuit’s opinion does not say whether they provided the taxpayer with a copy of the IRS Notice or copies of the cases that had already determined this type of shelter would not work. The taxpayer decided to purchase the shelter and paid a $325,000 fee for doing so. He claimed a $5,000,000 loss reducing his tax liability from $1,500,000 to nothing which would have been a great bargain had the IRS not disallowed the loss in full and imposed the 40% penalty.

At the circuit court level, the taxpayer did not dispute the unlawful nature of the transaction but argued only that the reliance on the lawyers and the tax advisors who prepared their advice for those selling the scheme provided a basis for removing the penalty for reasonable cause. The court quickly went through five reasons why the taxpayer could not succeed with a reasonable cause argument.

First, the Notice issued by the IRS expressly warned against doing what he did and did so over a year before he bought into the scheme. The existence of the notice “makes proof of reasonableness in this case an especially steep uphill battle.”

Second, the taxpayer’s reliance on the advice of individuals connected with the promotion of the scheme is “objectively unreasonable.”

Third, the taxpayer could not rely on the advice of his accountant whose role here was to investigate the bona fides of the promoter and not to provide tax advice. Additionally, to the extent that the taxpayer’s accountant did provide tax advice it was that the claimed benefits of the scheme were “too good to be true.”

Fourth, the taxpayer could not rely on the advice of his own lawyer as a shield from the penalty because his lawyer was skeptical of the transaction. Like the accountant, the taxpayer’s lawyer limited his due diligence to the scheme’s players and not to the substance of the transaction.

Fifth, the tax opinions provided by the promoters did not pass muster. The opinions were not based on “all pertinent facts and circumstances” relating to the taxpayer, and the parties giving the opinions were part of the promotion team.

Perhaps the only surprises in this opinion are that the taxpayer bought the shelter in the first place, given the information about the scheme available at the time of purchase, and that 17 years later he is still fighting about the penalty when the denial of penalty relief here follows consistent patterns of prior opinions on this subject. While it’s easy to be dismissive of the case, this is a sophisticated taxpayer. The case not only provides guidance on when a taxpayer cannot rely on professional advice to avoid a penalty but insight on the power of pull of the tax shelter scheme that it would motivate someone to fight this long after the conclusion of the transaction and in the face of high odds.

 

IRS Claims in Bankruptcy

A pair of recently decided cases address the validity and the amount of the claim of the IRS in bankruptcy.  Each case offers a small lesson on such claims.  In In re Yuska, No. 14-01504 (N.D. Iowa April 6, 2018), the debtor attacked the IRS claim because the bankruptcy specialist checked the wrong box on the claim form.  In United States v. Austin, No. 17-6024 (B.A.P. 8th Cir. April 9, 2018), the court determined the value of the IRS secured claim, secured by virtue of a chose in action held by the debtor.  Neither case reaches a surprising result, though the bankruptcy court’s decision in Austin, overturned by the Bankruptcy Appellate Panel in the case discussed here, did produce a surprising result and one which the IRS appealed on a valuation matter because of the legal issue involved.

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In Yuska, the debtor owed the IRS over $1 million, which the court had previously determined in an adversary proceeding.  From the court’s description of Mr. Yuska’s arguments, I believe he qualifies as a tax protestor.  In this follow-up matter, he attacks not the validity of the underlying liability but the validity of the claim of the IRS filed in the proceeding.  He argues that in preparing the claim, the IRS bankruptcy specialist checked the box on the claim indicating that she was the creditor rather than checking the box that she was filing the claim as an agent of the creditor.

The first argument of the IRS in the case sought a decision based on res judicata due to the prior adversary proceeding determining Mr. Yuska’s liability.  The court did not base its decision on its prior determination regarding the amount of the liability but looked instead to the basis for objecting to a claim.  It held that the following bases for objecting to a claim exist:

1) The claim is unenforceable against the debtor and property of the debtor;
2) The claim is for unmatured interest;
3) The claim is for a tax assessed against property of the estate and exceeds the value of the interest of the estate in such property;
4) The claim is for services of an insider or attorney of the debtor and exceeds the reasonable value of such services;
5) The claim is for a debt that is unmatured on the date of the filing of the petition and that is excepted from discharge under section 523(a)(5) of this title;
6) The claim is the claim of a lessor for damages resulting from the termination of a lease of real property and meets other criteria;
7) The claim is the claim of an employee for damages resulting from the termination of an employment contract and meets other criteria;
8) The claim results from a reduction due to late payment in the amount of an otherwise applicable credit available to the debtor in connection with an employment tax on wages, salaries, or commissions earned from the debtor; or
9) The proof of such claim is not timely filed…

The court found that unless the objecting party meets one of these objections, the court shall determine the amount of the claim and shall allow such claim in that amount.  Here, the complaint of the debtor raises a technical issue related to the preparation of the claim form.  The IRS agrees that the employee checked the wrong box but argues that this technical deficiency does not invalidate the claim.  The court pointed out that Bankruptcy Rule 3001(a) requires that a claim conform substantially with the official form published by the rules.  The court finds that the form filed by the IRS substantially complies with the rules, that common sense should not disallow a claim based on a small technical failure, and that the debtor himself recognized in his pleadings that the IRS employee was not the true claimant against the estate.  So, it determines that the IRS has a valid and binding claim.

In Austin, the debtor had a workman’s comp lawsuit pending at the time of filing the bankruptcy petition.  Prior to the filing of the petition, the IRS had filed a notice of federal tax lien.  So, the IRS would have a secured claim in the value of the lawsuit (minus the attorney’s fees for bringing the suit.)  The issue presented is the value of the suit.  The issue can regularly arise in bankruptcy cases; however, cases attacking the value are not commonly reported.

In their schedules, the debtors listed the suits as contingent and unliquidated exempt property and valued the claims at $0.00.  Debtors objected to the secured claim of the IRS assigning value to the lawsuits and argued initially that the value of the IRS lien in these suits was $0.00.  The bankruptcy court determined that the suits had some value and overruled the objection.  While that litigation was pending, the debtor negotiated a settlement netting $15,661.00 after attorney’s fees.  The IRS learned of the settlement and amended its claim to reflect that amount as the value of its secured claim.

The debtors’ objected to the amended secured claim of the IRS, arguing that the value of the claim was not equal to the amount of the settlement.  They attached an affidavit of their attorney who “opined that the worker’s compensation claims had a nuisance value of $3,000 on the petition date.”  The IRS responded that this affidavit was not substantial evidence contradicting their claim and that under B.C. 502 the claim is presumed correct unless an objection to the claim is filed and supported by substantial evidence.

The court found that “substantial evidence means ‘more than a mere scintilla.  It means such relevant evidence as a reasonable mind might accept as adequate to support a conclusion.’  Substantial evidence requires financial information and factual arguments.  Here the Smallwood Affidavit does not contain the financial or factual information necessary to support Mr. Smallwood’s opinion of value.”  Debtor’s attorney basically argued that they did not have much of a case and only by his skill did he obtain a settlement of over $20,000.  The court points out that no matter how wonderful Mr. Smallwood was it was the debtors’ claim that formed the basis for the recovery.  It also found that presenting evidence by way of affidavit prevented the IRS from its opportunity to cross examine.  It stated that “allowing a valuation of a tort claim without a reasonable factual basis encourages abuse.”

So, the court found the debtors failed to present substantial evidence sufficient to overcome the presumption of validity in the claim.  The court did not discuss the fact that a secured claim is not static in value.  Even if the value of the tort claim was $3,000 at the outset of the case, the value of the claim could rise if the property to which the lien attach rises in value.  The case provides an interesting glimpse at the amount of proof needed to win an objection regarding the value of property but I wanted it to also discuss the ability of a secured claim to rise or fall in value.  That ability is why creditors seek to lock in value through cash collateral proceedings at the outset of a bankruptcy case.