As If: Tax Court Holds that Restitution Assessment Does Not Attract Late Payment Penalties or Interest

This week in Klein v Commissioner the Tax Court in a division opinion held that assessments of restitution do not generate underpayment interest or late payment penalties. This is an important holding and a case of first impression.

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Section 6201(a)(4) gives the Service to power to assess restitution “in the same manner as if such amount were such tax.” Following a restitution assessment, Internal Revenue Manual provisions and Service policy has been to impose underpayment interest and late payment penalties on amounts that are unpaid similar to other unpaid tax.

To the facts at hand. In Klein, after some delay, the taxpayer fully paid the restitution, as well as interest that accrued pursuant to the statute in Title 18 that allowed for restitution. The taxpayer did not pay the separate Title 26 interest and late payment penalties that the Service imposed and assessed.

The IRS commenced administrative collection with respect to the unpaid interest and penalties. In a CDP proceeding the taxpayer challenged the Service’s right to impose underpayment interest and civil penalties, having claimed that it fully paid what was due.

The taxpayer had to clear the hurdle that she could challenge the Service’s imposition of penalties and interest in the CDP proceeding. The Court found that it was possible, noting that in a CDP proceeding, “underlying tax liability refers to the assessed liabilities that the IRS is seeking to collect via the challenged lien or levy.”

The opinion then considered the Service’s interest and penalty procedures in place for restitution assessments under the Internal Revenue Manual. The Tax Court held that the statutory language that gives IRS the power to assess restitution “as if” it were a tax does not transform the assessed restitution into a tax for purposes of the penalty and interest provisions. In doing so, the opinion discusses how the statute is drafted in the subjunctive mood.

For those who may have forgotten their Latin, the opinion explains what that means:

This clause is drafted in the subjunctive mood. Clauses of this type are commonly used to express a counterfactual hypothesis. See, e.g., Andrea A. Lunsford, The St. Martin’s Handbook 633 (5th ed. 2003) (describing the subjunctive mood as expressing “a wish, suggestion, requirement, or a condi- tion contrary to fact”). For example, assume a statute providing that certain per- sons (green card holders, perhaps) shall be treated “in the same manner as if they were citizens.” In such a statute, Congress would necessarily presume that such persons were not in fact citizens, providing merely that they should be accorded the treatment which citizens receive.

So as Alicia Silverstone in Clueless can attest, “as if” is an important phrase. As the opinion explains, the “as if” in the statute provides “the counterfactual hypothesis that restitution is a tax for the limited purpose of enabling the IRS to assess that amount, thus creating an account receivable on the taxpayer’s transcript against which the restitution payment can be credited.” It is treated like a tax but is not a tax.

In addition to parsing the statute, the opinion notes that the criminal concepts of tax loss and restitution do not neatly equate with the concepts of civil tax liability. In 2010 when Congress gave the IRS the power to assess (and collect) restitution it did not alter the fundamental distinction between the separate criminal and civil concepts.

To be sure, if the Service gets around to a civil examination, it can potentially generate an assessment that would be based on deficiency procedures. (for readers who would like more background on the interplay of the deficiency assessment procedures and the relatively new restitution assessment procedures see Keith’s post from this past spring discussing the issue here). If the Service were to conduct a civil examination and the amount assessed under deficiency procedures is both unpaid and exceeds what has previously been collected, it will be possible for Title 26 interest and civil penalties to start running.

 

When Can the IRS Reassess After Abatement

Guidance was issued on December 7, 2016, and released on March 31, 2017, regarding reassessment after abatement.  The Procedure and Administration Division of Chief Counsel’s office issued the guidance to an attorney in a field office.  The guidance addressed the following question:

“Whether the statute of limitations for assessment of the section 6651(a)(2) addition to tax for failure to pay remains open after an erroneous administrative First Time Abatement, such that the Service may reassess the addition to tax.”

The guidance concludes that the normal three year statute of limitations for assessment does not apply to the addition to tax imposed in 6651(a)(2) and, therefore, the IRS can reassess a failure to pay addition to tax at any time during the ten year statute of limitations for collection.  The guidance document, though relatively short, contains a couple of statute of limitations issues worth discussing.

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The facts giving rise to the opinion deserve brief mention.  In this case the taxpayer filed a joint return with her husband.  They reported the tax on the return but failed to pay the tax reported on the return.  Later they filed an amended return reporting more tax which they also failed to pay.  The taxpayer’s husband filed a bankruptcy petition but she did not.  The filing of the bankruptcy petition by one spouse causes the IRS to split the tax account from one master file account into two non-master file accounts.  Guest blogger Marilyn Ames discussed master file and non-master file accounts in an earlier post and understanding the differences is important in interpreting IRS transcripts.

Depending on the timing of the bankruptcy, the husband might have discharged the 6651(a)(2) liability.  For penalties and additions to tax, the provision governing discharge is found in BC 523(a)(7) and has a three year rule.  For the same reason, discussed below, that the normal assessment rules do not apply to the 6651(a)(2) liability, the three year rule is a little different in a failure to pay situation since the liability derives from post-return actions (or inactions.)  Whether the husband discharged this liability does not matter in this advisory opinion.  The opinion focuses on the wife’s liability.  Because she did not file bankruptcy, her husband’s discharge, if any, will have no impact on her.  He might discharge not only the 6651(a)(2) liability but the tax and the interest.  She would still have a liability for these amounts no matter how her husband’s bankruptcy treats them with respect to him.

Because she still owes this liability, she called the IRS and requested first time abatement.  Steve has written a couple of excellent posts on first time abatement (FTA), here and here, which have proven to be among the most popular posts of all time.  FTA more frequently occurs with late filing and not late payment but here the IRS person on the phone granted her FTA for late payment.  However, sometime after granting her FTA, the IRS determined that it made a mistake because “she had a penalty or addition to tax within the three years prior to the tax period at issue.”  I suspect the mistake related to the placing of her liability for the tax in a non-master file account.

When the IRS mistakenly abates a liability, it has a few good, but old, cases on which it relies to reverse the mistake and it cites to those cases in the advisory opinion.  The first case is Carlin v. United States, 100 F. Supp. 451 (Ct. Cl. 1951) which held that “if the Commissioner abates the assessment, it ceases to exist or to have any effect thereafter.  The Commissioner cannot subsequently rescind his actions or restore the assessment, but must rather make a new assessment unless, of course, the statute of limitations has previously expired.”  The second case always cited in these situations is Crompton-Richmond v. United States, 311 F. Supp. 1184 (S.D.N.Y. 1970) holding that “if the statute of limitations has not run, the IRS may simply make a new assessment of the tax liability that has been abated.”

These cases allow the IRS to essentially have a “do over” when it erroneously abatement a taxpayer’s liability; however, they limit the do over to the statute of limitations.  Although neither of the quotes in the preceding paragraph make precisely clear which statute of limitations it means, the relevant statute of limitations in these cases is the statute of limitations on assessment.  That gives the IRS a relatively short window within which to fix the problem.  The normal rule on the statute of limitations for assessment of three years from the due date of the return does not apply, however, if the liability comes from 6651(a)(2).

The guidance explains that the assessment period for a 6651(a)(2) liability cannot end three years from the due date (or filing date) of a return because this addition to tax runs for 50 months after the filing date.  During the 50 months after the filing date, the taxpayer gets hit with another liability under the statute for every month that passes based on the outstanding liability as of that month.  Because the assessment of this liability must extend past the normal three year period for assessment, the guidance concludes that the time period for assessment remains open for the ten year statute of limitations on collection.  As with the reassessment after abatement case law, the case law on this ten year statute of limitations is fairly thin and exists in lower court opinions.  The leading case is United States v. Estate of Hurd, 115 A.F.T.R.2d 2015-38 (C.D. Cal 2015).

So, the guidance concludes that because the statute of limitations on collection remained open in W’s case the IRS could reverse the abatement and reassess the liability against her.  The guidance is not surprising and does not break new ground but because this issue does not arise and get discussed very often the guidance is worth looking at if you have a reassessment situation.

 

Second Circuit Tosses Penalties Because of IRS Failure To Obtain Supervisor Approval

–Or, Tax Court Burnt by Second Circuit’s Hot Chai

Yesterday the Second Circuit decided a very important decision in favor of the taxpayer pertaining to the Section 6571 requirement that a direct supervisor approve a penalty before it is assessed.  In Chai v. Commissioner, the Second Circuit reversed the Tax Court, holding the Service’s failure to show penalties were approved by the immediate supervisor prior to issuing a notice of deficiency caused the penalty to fail.  In doing so, the Second Circuit explicitly rejected the recent Tax Court holdings on this matter, including Graev v. Commissioner, determining the matter was ripe for decision and that the Service’s failure prevented the imposition of the penalty.  Chai also has interesting issues involving TEFRA and penalty imposition that will not be covered (at least not today), and is important for the Second Circuit’s rejection of the IRS position that the taxpayer was required to raise the Section 6571 issue.   It is lengthy, but worth a read for practitioners focusing on tax controversy work.

PT regulars know that we have covered this topic on the blog in the past, including the recent taxpayer loss in the very divided Tax Court decision in Graev v. Commissioner.  Keith’s post on Graev from December can be found here.  For readers interested in a full review of that case and the history of this matter, Keith’s blog is a great starting point, and has links to prior posts written by him, Carlton Smith, and Frank Agostino (whose firm handled Graev and also the Chai case). Graev was actually only recently entered, and is appealable to the Second Circuit, so I wouldn’t be surprised if the taxpayer in that case files a motion to vacate based on the Second Circuit’s rejection of the Tax Court’s approach in Greav.

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Before discussing the  Second Circuit holding, I will crib some content from Keith, to indicate the status of the law before yesterday.  Here is Keith’s summary of the holding in Graev:

The Court split pretty sharply in its opinion with nine judges in the majority deciding that the IRC 6751(b) argument premature since the IRS had not yet assessed the liability, three judges concurring because the failure to obtain managerial approval did not prejudice the taxpayers and five judges dissenting because the failure to obtain managerial approval prior to the issuance of the notice of deficiency prevented the IRS from asserting this penalty (or the Court from determining that the taxpayer owed the penalty.)

That paragraph from Keith’s post regarding the holding doesn’t cover the lengthy and nuanced discussion, but his full post does for those who are interested.  The Second Circuit essentially rejected every position taken by the majority and concurrence in Graev, and almost completely agreed with the dissenting Tax Court judges (with a  few minor differences in rationale).

For its Section 6751(b) review, the Second Circuit began by reviewing the language of the statute.  It highlighted the fact that the Tax Court did the same, and found the language of the statute unambiguous, a conclusion with which the Second Circuit disagreed.

Section 6751(b)(1) states, in pertinent part:

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…[emph. added]

The Tax Court found the lack of specification as to when the approval of the immediate supervisor was required allowed the immediate supervisor to approve the determination at any point, even after the statutory notice of deficiency was issued or the Tax Court reviewed the matter.

The Second Circuit, however, found the language ambiguous, and the lack of specification as to when the approval was required problematic.  The Second Circuit stated “[u]understanding § 6751 and appreciating its ambiguity requires proficiency with the deficiency process,” and then went through a primer on the issue.  To paraphrase the Second Circuit, the assessment occurs when the liability is recorded by the Secretary, which is “essentially a bookkeeping notation.”  It is the last step before the IRS can collect a deficiency.  The Second Circuit stated the deficiency is announced to the taxpayer in a SNOD, along with its intention to assess.  The taxpayer then has 90 days to petition the Tax Court for review.  If there is a petition to the Court, it then becomes the Court’s job to determine the amount outstanding.  As it is the Court’s job to determine the amount of the assessment, the immediate supervisor no longer has the ability to approve or not approve the penalty.  The Second Circuit agreed with the Graev dissent that “[i]n light of the historical meaning of ‘assessment,’” the phrase “initial determination of such assessment” did not make sense.  A deficiency can be determined, as can the decision to make an assessment, but you cannot determine an assessment.

The Second Circuit then looked to the legislative history, and found the requirement was meant to force the supervisor to approve the penalty before it was issued to the taxpayer, not simply before the bookkeeping function was finalized.  The Court further stated, as I noted above, if the supervisor is to give approval, it must be done at a time when the supervisor actually has authority.  As the Court noted, [t]hat discretion is lost once the Tax Court decision becomes final: at that point, § 6215(a) provides that ‘the entire amount redetermined as the deficiency…shall be assessed.”  The supervisor (and the IRS generally) can no longer approve or deny the imposition of the penalty.  The Court further noted, the authority to approve really vanishes upon a taxpayer filing with the Tax Court, as the statute provides approval of “the initial determination of such assessment,” and once the Court is involved it would no longer be the initial determination.  Continuing this line of thought, the Second Circuit stated that the taxpayer can file with the Tax Court immediately after the issuance of the notice of deficiency, so it is really the issuance of the notice of deficiency that is the last time where an initial determination could be approved.

This aspect of the holding is important for two reasons.  First, the Second Circuit is requiring the approval at the time of the NOD, and not allowing it to be done at some later point.  Second, this takes care of the ripeness issue.  If the time is set for approval, and it has passed, then the Court must consider the issue.

Of potentially equal importance in the holding is the fact that the Second Circuit stated unequivocally that the Service had the burden of production on this matter under Section 7491(c) and was responsible for showing the approval. It is fairly clear law that the Service has the burden of production and proof on penalties once a taxpayer challenges the penalties, with taxpayers bearing the burden on affirmative defenses.   The case law on whether the burden of production exists when a taxpayer doesn’t directly contest the penalties is a little more murky (thanks to Carlton Smith for my education on this matter).  The Second Circuit made clear its holding that the burden of production was solely on the Service, and the taxpayer had no obligation to raise the matter nor the burden of proof to show the approval was not given.  The Service had argued the taxpayer waived this issue by not bringing it up earlier in the proceeding, which the Second Circuit found non-persuasive.

As to the substance of the matter, the Second Circuit held the government never once indicated there was any evidence of compliance with Section 6751.  Since the Commissioner failed to meet is burden of production and proof, the penalty could not be assessed and the taxpayer was not responsible for paying it.  A very good holding for taxpayers, and we would expect a handful of other case to come through soon.  Given the division within the Tax Court, and the various rationales, it would not be surprising to see other Circuits hold differently.

Procedure Grab Bag: CCAs – Suspended/Extended SOLs and Fraud Penalty

My last post was devoted to a CCA, which inspired me to pull a handful of other CCAs to highlight from the last few months.  The first CCA discusses the suspension of the SOL when a petition is filed with the Tax Court before a deficiency notice is issued (apparently, the IRM is wrong on this point in at least one spot).  The second touches on whether failing to disclose prior years gifts on a current gift tax return extends the statute of limitations for assessment on a gift tax return that was timely filed (this is pretty interesting because you cannot calculate the tax due without that information).  And, finally, a CCA on the imposition of the fraud penalty in various filing situations involving amended returns.

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CCA 201644020 – Suspension of SOL with Tax Court petition when no deficiency notice

We routinely call the statutory notice of deficiency the ticket to the Tax Court.  In general, when a taxpayer punches that ticket and heads for black robe review, the statute of limitations on assessment and collections is tolled during the pendency of the Tax Court case.  See Section 6503(a).  What happens when the petition is filed too soon, and the Court lacks jurisdiction?  Well, the IRM states that the SOL is not suspended.  IRM 8.20.7.21.2(4) states, “If the petition filed by the taxpayer is dismissed for lack of jurisdiction because the Service did not issue a SND, the ASED is not suspended and the case must be returned to the originating function…”  But, Chief Counsel disagrees. Section 6503(a) states:

The running of the period of limitations provided in section 6501 or 6502…shall (after the mailing of a notice under section 6212(a)) be suspended for the period during which the Secretary is prohibited from making the assessment or from collecting by the levy or a proceeding in court (and in any event, if a proceeding in respect of the deficiency is placed on the docket of the Tax Court, until the decision of the Tax Court becomes final), and for 60 days thereafter. (emph. added).

Chief Counsel believes the second parenthetical above extends the limitations period even when the Tax Court lacks jurisdiction because no notice of deficiency was issued.   The CCA further states, “Any indication in the IRM that the suspension does not apply if the Service did not mail a SND is incorrect.”  Time for an amendment to the IRM.  I think this is the correct result, but the Service likely had some reason for its position in the IRM, and might be worth reviewing if you are in a situation with the SOL might have run.

CCA 201643020

The issue in CCA 201643020 was whether the three year assessment period was extended due to improper disclosure…of prior gifts properly reported on prior returns.  In general, taxpayers making gifts must file a federal gift tax return, Form 709, by April 15th the year following the gift.  The Service, under Section 6501(a) has three years to assess tax after a proper return is filed.  If no return is filed, or there is not proper notification, the service may assess at any time under Section 6501(c)(9).

In the CCA, the Service sought guidance on whether a the statute of limitations was extended where in Year 31 a gift was made and reported on a timely filed gift tax return.  In previous years 1, years 6 through 9, and 15 prior gifts were reported on returns.  On the year 31 return, however, those prior gifts were not reported.  That information was necessary to calculate the correct amount of tax due.

Section 6501(c)(9) specifically states:

If any gift of property the value of which … is required to be shown on a return of tax imposed by chapter 12 (without regard to section 2503(b)), and is not shown on such return, any tax imposed by chapter 12 on such gift may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time. The preceding sentence shall not apply to any item which is disclosed in such return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature of such item.

Chief Counsel concluded that this requires a two step analysis.  Step one is if the gift was reported on the return.  If not, step two requires a determination if the item was adequately disclosed.  Counsel indicated it is arguable that the regulations were silent on the omission of prior gifts, but that the statutory language was clear.  Here, the gift was disclosed on the return, and the statutory requirements were met.  The period was not extended.  I was surprised there was not some type of Beard discussion regarding providing sufficient information to properly calculate the tax due.

CCA 201640016

Earlier this year, the Service also released CCA 201640016, which is Chief Counsel Advice covering the treatment of fraud penalties in various circumstances surrounding taxpayers filing returns and amended returns with invalid original issue discount claims.  The conclusions are not surprising, but it is a good summary of how the fraud penalties can apply.

The taxpayer participated in an “Original Issue Discount (OID) scheme” for multiple tax years.  The position take for the tax years was frivolous.  For tax year 1, the Service processed the return and issued a refund.  For tax year 2, the Service did not process the return or issue a refund. For tax year 3, the return was processed but the refund frozen.  The taxpayer would not cooperate with the Service’s criminal investigation, and was indicted and found guilty of various criminal charges.  Spouse of taxpayer at some point filed amended returns seeking even greater refunds based on the OID scheme, but those were also frozen (the dates are not included, but the story in my mind is that spouse brazenly did this after the conviction).

The issues in the CCA were:

  1. Are the original returns valid returns?
  2. If valid, is the underpayment subject to the Section 6663 fraud penalty?
  3. Did the amended returns result in underpayments such that the penalty could apply, even though the Service did not pay the refunds claimed?

The conclusions were:

  1. It is likely a court would consider the returns valid, even with the frivolous position, but, as an alternative position, any notice issued by the Service should also treat the returns as invalid and determine the fraudulent failure to file penalty under Section 6651(f).
  2. To the extent the return is valid, the return for which a refund was issued will give rise to an underpayment potentially subject to the fraud penalty under Section 6663. The non-processed returns or the ones with frozen refunds will not give rise to underpayments and Section 6663 iis inapplicable.  CC recommended the assertion of the Section 6676 penalty for erroneous claims for refund or credit.
  3. The amended returns did not result in underpayments, so the Section 6663 fraud penalty is inapplicable, but, again, the Service could impose the Section 6676 penalty.

So, the takeaway, if a taxpayer fails to file a valid return, or there is no “underpayment” on a fraudulent return, the Service cannot use Section 6663.  See Mohamed v. Comm’r, TC Memo. 2013-255 (where no valid return filed, no fraud penalty can be imposed).  In the CCA, Counsel believed the return was valid, but acknowledged potential issues with that position.  Under the Beard test, a return is valid if:

 four requirements are met: (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. See Beard v. Comm’r,  82 T.C. 766 (1984). 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.” Badaracco v. Comm’r, 464 U.S. 386 (1984).

The only prong the CCA said was at issue was the third prong, that the return “must be an honest and reasonable attempt to satisfy the requirements of the tax law.”  As the taxpayer had been convicted of Filing False Claims with a Government Agency/Filing A False Income Tax Return, Aiding and Abetting, and Willful Attempt to Evade or Defeat the Payment of Tax, it is understandable why you would question if the returns were “an honest and reasonable attempt to satisfy the requirements of the tax law.”  Further, the Service had imposed the frivolous filing penalty under Section 6702, which only applies when the return information “on its face indicates that the self-assessment is substantially incorrect.”

The CCA notes, however, it is rare for courts to hold returns as invalid solely based on the third prong of Beard, but clearly there would be a valid argument for the taxpayers in this situation.  The CCA acknowledges that by stating “[t]o guard against the possibility that the returns are not valid, the Service should include the Section 6651(f) fraudulent failure to file penalty as an alternative position,” so the taxpayer could pick his poison.

As to the underpayment, Counsel highlighted that overstatements of withholding credits can give rise to an underpayment under the fraud penalty.  The definition was shown as a formula of Underpayment = W-(X+Y-Z).  W is the amount of tax due, X is the amount shown as due on the return, Y is amounts not shown but previously assessed, and Z is the amount of rebates made.  Where the refund was provided, the penalty could clearly apply.  In “frozen refund” situations, the Service has adopted the practice of treating that amount as a sum collected without assessment, which can cancel out the X and Y variables so no underpayment for the fraud penalty will exist.

But, as shown above, even if the fraud penalty may not apply, the Section 6651 penalty will likely apply if the return is invalid, or the frivolous position penalty under Section 6702 may apply.

Collecting Partnership Debt from General Partners

The 9th Circuit recently sustained the district court which sustained the bankruptcy court in the case of Pitts v. United States.  The taxpayer sought a determination that the taxes claimed against her in the bankruptcy proceeding were discharged.  The courts determined that the taxes were not discharged, rejecting various arguments that she presented.  The case breaks no new legal ground but serves to highlight how the IRS collects from general partners.  If you have this issue, you might look at IRM Part 5, specifically 5.1.21, 5.17.7, and 5.19.14.

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Ms. Pitts was the general partner of DIR Waterproofing. DIR failed to pay its employment taxes including both trust fund and non-trust fund portions. The IRS would typically make some effort to collect from the partnership and then seek to collect from the partners. The opinion does not describe the efforts made here, but the IRS did issue a notice of federal tax (NFTL) against Ms. Pitts. In these situations the IRS does not go through a separate assessment process for Ms. Pitts but uses the assessment made against the partnership in order to pursue collection against her. The NFTL would reference the partnership debt although it would make clear that the lien is against her. Because the debt arose through the partnership, she argued that it was a state law debt and the IRS was limited to collect as a state law creditor. The 9th Circuit made three separate explanations of why her arguments failed.

First, the court pointed out that under IRC 6321 Ms. Pitts was a person liable to pay any tax and, as such a person, a lien arises under federal law which attaches to all of her property and rights to property once the IRS makes demand for payment and payment is not made. This is federal law and not state law creating the lien. The court cited several cases in support of its position.

Next, the court found that the IRS can use all of its administrative enforcement tools because she is secondarily liable on this debt. The court cited to a Supreme Court decision, United States v. Galletti, 541 U.S. 114 (2004) that may have caused Ms. Pitts to make the arguments she made here but which should also have suggested to her that these arguments would likely fail. In Galletti, similarly situated taxpayers to Ms. Pitts went into bankruptcy where the IRS filed a proof of claim based on the assessment against the partnership in which they were general partners. The Gallettis argued that no debt existed against them because the IRS had not made an assessment against them (and the statute of limitations on assessment of the partnership debt had run by the time of the bankruptcy.) In that case, the bankruptcy court, the district court, and the 9th Circuit agreed with the Gallettis. These opinions relied upon the definition of ‘taxpayer’ in IRC 7701 and looked to the separate nature of the partners as taxpayers from the partnership. The IRS pushed the case to the Supreme Court, which held that the IRS did not need to make a separate assessment because the Gallettis were liable under state law as general partners of the partnership.

Writing for a unanimous Court, Justice Thomas said:

“Under a proper understanding of the function and nature of an assessment, it is clear that it is the tax that is assessed, not the taxpayer. See §6501(a) (“the amount of any tax … shall be assessed”); §6502(a) (“[w]here the assessment of any tax”). And in United States v. Updike, 281 U. S. 489 (1930), the Court, interpreting a predecessor to §6502, held that the limitations period resulting from a proper assessment governs “the extent of time for the enforcement of the tax liability,” id., at 495. In other words, the Court held that the statute of limitations attached to the debt as a whole. The basis of the liability in Updike was a tax imposed on the corporation, and the Court held that the same limitations period applied in a suit to collect the tax from the corporation as in a suit to collect the tax from the derivatively liable transferee. Id., at 494-496. See also United States v. Wright, 57 F. 3d 561, 563 (CA7 1995) (holding that, based on Updike‘s principle of “all-for-one, one-for-all,” the statute of limitations governs the debt as a whole).

Once a tax has been properly assessed, nothing in the Code requires the IRS to duplicate its efforts by separately assessing the same tax against individuals or entities who are not the actual taxpayers but are, by reason of state law, liable for payment of the taxpayer’s debt. The consequences of the assessment–in this case the extension of the statute of limitations for collection of the debt–attach to the tax debt without reference to the special circumstances of the secondarily liable parties.”

Ms. Pitts wants the courts to recognize that the assessment only applies to her because of the operation of state law and since it is the operation of state law causing her to become liable she wants the debt treated as state law debt and not tax debt with the exceptions to discharge applicable to tax debts. The 9th Circuit, perhaps still remembering the Galletti outcome, does not allow her to split hairs in this manner. State law plays an important role in creating the liability but her liability is for a federal tax debt.

The 9th Circuit rejects her argument that state law creates the statute of limitations. It also rejects her argument that the continuation by the IRS of its efforts to collect this debt violates the discharge injunction. I did not go back and read the earlier opinions to see the age of the debt. The trust fund portion of the partnership’s unpaid employment taxes will always be excepted from discharge because B.C. 507(a)(1)(C) will always make this a priority debt in bankruptcy and that will always make it excepted from discharge under B.C. 523(a)(1)(A). The non-trust fund portion of the partnership employment tax debt should become dischargeable for bankruptcy petitions filed more than three years after the employment tax return due date, assuming it timely filed the returns. The court engages in no analysis of this issue making me think that she is not entitled to a discharge of the non-trust fund portion; however, depending on the timing of the debt and the bankruptcy petition, this portion of her debt could potentially be discharged in her bankruptcy just as in the bankruptcy of the partnership itself.

This case demonstrates how the IRS will proceed to collect from a general partner. It simply uses the assessment against the partnership to open the full range of administrative collection tools given to it under the Code. The effort by Ms. Pitts to use the Galletti opinion to argue that the operation of state law which lets the IRS go after the general partners without a separate assessment should also limit the IRS in its ability to collect. The 9th Circuit rejects that limitation on the power of the IRS in this situation and, I think, its decision is correct. The issue brings up in another context the interplay between state law which creates certain rights and obligations and the federal tax collection law which builds upon the state created rights and obligations.

Procedure Grab Bag – Foreign Tax Credits

Two cases dealing with foreign tax credits, with very different litigation records; one being denied cert by SCOTUS (Albemarle, which we’ve covered before) and one tossed on summary judgement in the District Court (Estate of Herrick) with the taxpayer prevailing on making a late election where no late election was permissible.  The second case has pretty interesting regulatory interpretation.

No SCOTUS

The first has been covered here on PT before on at least two occasions.  SCOTUS has denied cert in Albemarle Corp. v. US.  When the Federal Circuit reviewed the case, I wrote the following in a SumOp:

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Hopping in the not-so-wayback-machine, in October of 2014, SumOp covered Albemarle Corp. v. US, where the Court of Federal Claims held that tax accruals related back to the original refund year under the “relation back doctrine” in a case dealing with the special statute of limitations for foreign tax credit cases.   As is often the case in SumOp, we did not delve too deeply into the issue, but I did link to a more robust write up.  It seems the taxpayers were not thrilled with the Court of Federal Claims and sought relief from the Federal Circuit.  Unfortunately for the taxpayer, the Fed Circuit sided with its robed brothers/sisters, and affirmed that the court lacked subject matter jurisdiction because the refund claim had not been made within the ten year limitations period under Section 6511(d)(3)(A).   This case deserves a few more lines.  The language in question states,  “the period shall be 10 years from the date prescribed  by law for filing the return for the year in which such taxes were actually paid or accrued.”   When the tax was paid or accrued is what generated the debate.

In the case, a Belgium subsidiary and its parent company, Albemarle entered into a transaction, which they erroneously thought was exempt from tax, so no Belgian tax was paid.  Years in question were ’97 through ‘01.  In 2002, Albemarle was assessed tax on aspects of the transaction in Belgium, and paid the tax that was due.   In 2009, Albemarle filed amended US returns seeking about $1.5MM in refunds due to the foreign tax credit for the Belgian tax.  Service granted for ’99 to ’01, but not ’97 or ’98 because those were outside the ten year statute for claims related to the foreign tax credit under Section 6511(d)(3)(A).  Albemarle claimed that the language “from the date…such taxes were actually…accrued” means the year in which the foreign tax liability was finalized, which would be 2002 instead of the year the tax originated.  Both the lower court and the Circuit Court found that the statute ran from the year of origin.  The Circuit Court came to this conclusion after a fairly lengthy discussion of what “accrue” and “actually” mean, plus a trip through the legislative history and various doctrines, including the “all events test”, the “contested tax doctrine”, and the “relation back” doctrine.  The Court found the “relation back” doctrine was key for this issue, which states the tax “is accruable for the taxable year to which it relates even though the taxpayer contests the liability therefor and such tax is not paid until a later year.” See Rev. Rul. 58-55.  This can result in a different accrual date for crediting the tax against US taxes under the “relation back” test and when the right to claim the credit arises, which is governed by the “contested tax” doctrine.

At that time, McDermott, Will and Emery posted some “Thought Leadership” (I’ve hated that term for a long time, but the summary is extensive and helpful), which can be found here.  The final paragraph of their advice is right on the mark, indicating there is no circuit split, so there likely would be no SCOTUS review.  It also provides great additional parting advice, stating:

Taxpayers in similar situations wishing to take positions contrary to the Federal Circuit’s decision, and without any option other than litigation, may want to file suits in local district court to avoid the negative precedent. Taxpayers may also want to consider filing protective refund claims in situations where it does not appear that a tax payment to a foreign jurisdiction will actually be made (and there will be enough time to file a formal refund claim with the IRS) within 10 years from the date the U.S. federal income tax return was filed to avoid the situation in Albemarle.

Not so late election

The second foreign tax credit case is the Estate of Herrick v. United States from the District Court for the Central District of Utah, where an estate filed late income tax returns seeking a refund for a decedent who had resided and worked in the Philippines for a number of years.  The taxpayer failed to file income tax returns during that period, under the mistaken belief that no income tax would be due because of credits for the foreign tax he was paying (not how that works).  The Service created SFRs, and assessed and collected over a $1MM in tax for the years in question.  The taxpayer sought summary judgement on its refund claim, which the IRS was contesting, arguing the taxpayer was not entitled to the credit or exclusion for foreign income taxes or that there were insufficient facts to establish that he was entitled to the same.

Under Section 911, some taxpayers living and working abroad in some circumstances can exclude a portion of the foreign earned income, and under Section 901, there is a credit for foreign tax that is paid, which can be applied against US income tax (as most of our readers know, under Section 61, the United States generally treats all income of its citizens, wherever earned, as being taxable income—these provisions help to reduce the potential for double taxation with the other jurisdictions).

As to the second claim, that insufficient evidence was available regarding the credits, the IRS position largely applied to one year.  For all other years, the taxpayer had showed copies of its returns, copies of his employer’s information related to him for the years in question, and the taxing authority in the Philippines verified all the information, including payment.  For one year, only a copy of the return and the employer’s information was available.  The Court found this was sufficient evidence to show proof of payment.

The second argument the Service made was that the taxpayer could not obtain the foreign earned income exclusion under Section 911 because the taxpayer had not made the election on a timely filed return or within one year of a timely filed return.  See Treas. Reg. 1.911-7(a)(2)(i).  Seems damning.

The Court, however, stated that the Service was only looking to subsections (A) through (C), and not giving consideration to subsection (D) in the Regulations allowing for elections to made when:

(D) With an income tax return filed after the period described in paragraphs (a)(2)(I) (A), (B), or (C) of this section provided –

(1)  The taxpayer owes no federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached either before or after the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion; or

(2)  The taxpayer owes federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 or a comparable form attached before the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.

The Court found the first prong under (D) did not apply.  The taxpayer claimed that it did not owe any federal income tax, because the IRS had already assessed and collected an amount over the total amount outstanding.  The Court stated, however, the fact that no tax was due at the time of filing was not the question, and the determination was whether any tax was due for the year, which had been the case but the Service had already collected that amount via levy.

The Court, however, held that the second prong did apply.  The Court found the Service had not discovered the failed election.  The Court found the Service had determined the taxpayer failed to file returns for the years in question, but that was not the same as discovering the taxpayer failed to make the election (would anyone be surprised if the Service doesn’t concede this point in other jurisdictions?).  This allowed the taxpayer to make the election on the late filed returns.

Calculating Interest When the IRS Makes a Restitution Based Assessment

The case of United States v. Janean Del’Andrae provides further insight into what happens when the IRS makes an assessment based on a restitution order.  We have talked about restitution based assessments previously here and here.  This relatively new basis for assessment came into being with the passage of the Firearms Excise Tax Improvement Act of 2010 and the creation of IRC 6201(a)(4) allowing assessment based on restitution orders in criminal cases.  Some of the kinks are still being worked out and this case illustrates one of the kinks.  The district court’s decision to award attorney’s fees in this context confuses me and other aspects of the opinion confuse me.  That confusion may make for a confusing and disjointed post and I apologize.  The facts developed in the opinion do not seem to warrant an attorney’s fees award against the government here but I will circle back to that at the end.  Getting to the result of what interest the taxpayer owes following a restitution based assessment provides the most important aspect of this case.

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As the Court explains in the case, the new basis for assessment did not immediately cause the IRS to make assessments using this procedure. The IRS waited for instructions from its lawyers on what to do and those instructions initially came out in Chief Counsel Notice 2011-18.  Two years later in Chief Counsel Notice 2013-12 additional guidance was provided.  The Court states that “procedures for the assessment process were not officially developed until the Chief Counsel Notice 2013-12 was issued on July 31, 2013.”  That statement does not make sense to me because the 2013 notice does not deal with assessment procedures but rather with the process of how to handle a restitution case in litigation.  I think the Court may have misstated the purpose of this notice and the timing of the procedures for dealing with restitution based assessments.  The Notice issued in 2011 deals much more directly with assessment procedures.  Both of these notices are Chief Counsel notices designed to give guidance to Chief Counsel lawyers and not necessarily to the IRS.

Here, the taxpayer’s restitution order occurred in 2012. The delay of the IRS in implementing procedures for restitution assessments creates problems that ultimately lead to the award of attorney’s fees against the IRS but I am uncertain that the Court quite got the timing right in attributing the problem to the 2013 notice.  The place to focus on IRS procedures is not notices issued by Chief Counsel’s office but changes to the Internal Revenue Manual.  Here, the provisions for restitution based assessments first appeared in IRM 5.19.23 on June 6, 2014, and IRM 4.8.6 in October 7, 2014.  The new IRM provisions followed the Interim Guidance on Criminal Restitution Procedures issued in SBSE 04-0214-0013 dated February 5, 2014 Except for how this impacts the decision on attorney’s fees, it is not especially relevant but does create more confusion in trying to follow the opinion.

Janean Del’Andrae pled guilty to one count of tax evasion. The opinion is not clear about the count to which she pled or how many counts with which she was charged.  The IRS charged that she not only evaded her personal income taxes for the year 2005 but also that she participated in evading the taxes of Del-Co Western Corporation, a company in which she and her husband were officers.  The court makes a passing reference to payroll taxes but the remainder of the opinion seems to make it clear the evasion of corporate income taxes was the problem.  The sentencing court ordered restitution in the amount of $138,509.50 calculated to cover the corporate taxes for 2004 ($49,845.37) and 2005 ($38,307.13) as well as her individual income taxes for 2005 ($48,357.00).  The judgment against her was entered on July 11, 2012, and she stroked a check that day for the full amount of the restitution (making her an unusual defendant, most of whom do not have the money to pay the tax at this stage of their case) and tendered it to the clerk of court.  On September 17, 2012, the IRS received the payment.

The opinion does not state what happened next but maybe nothing happened. On September 12, 2014, the court granted defendant’s Motion to Enforce Plea Agreement and issued an order requiring the IRS to give the defendant credit for the restitution payment.  The order required the IRS to credit the payment on July 11, 2012 even though it took the court over 60 days to deliver the check to the IRS.  It appears the IRS was significantly delayed in making the assessment probably because it took the IRS a long time to develop the assessment procedures for restitution based assessments.  I agree that the defendant should get credit from the date of payment but wonder how the payment of the interest on the money for those 60 days was credited between the judicial and executive branches.

The court states that the IRS eventually assessed the appropriate amount of taxes. It also assessed interest on the taxes from the due date of the returns until July 11, 2012, when it gave credit to the defendant and the corporation for the payment of the taxes.  The assessment of interest occurred without using the deficiency procedures which seems appropriate under these circumstances.  The defendant continued to dispute the correct amount of the corporate liability for 2005 so the IRS did not assess the liability for that period.  One of the problems with this opinion is that the Court’s description of events does not use the terms that one might expect or use them with sufficient precision to allow me to know exactly what happened.  It is clear, however, that in March 2015 the corporation made a payment towards its 2013 liability.  In doing so it overpaid the 2013 liability by $65,917.  The IRS latched onto the overpayment and used it toward additional corporate and personal tax liabilities.  The use of this overpayment creates the focus of the litigation.  Defendant filed a motion for an order to show cause seeking answers concerning the application of the payments.  The balance of the opinion essentially focuses on how the IRS did and should have used the overpayment and why its actions were right or wrong.

The restitution order contemplated that the IRS would charge interest and penalties but did not order the payment of these amounts or spell them out in any way. The defendant argues that the IRS should not assess interest for the time prior to the date of the restitution order.  The defendant further argues that the IRS should follow deficiency procedures in order to assess interest on a tax liability determined by a restitution order.  The IRS argues that interest runs from the due date of the return for restitution payments as it does for all liabilities and further argues that the use of deficiency procedures is unnecessary to assess interest on the amount listed in a restitution order.  The court agreed with the IRS that interest on restitution assessments need not follow the deficiency procedure but may occur in the same manner as the assessment of the underlying tax assessed pursuant to the restitution procedure.

The second issue concerns the application of the overpayment on the 2013 corporate taxes to the personal liability of the defendant. The court says that the IRS argued that the application of a corporate payment to the personal liability of the individual is proper because “Defendant [the individual] and Del-Co are jointly and severally liable for the tax and related interest that Defendant evaded.”  The court further states that the IRS argued, “the joint and several liability arises because Defendant agreed to pay restitution for the loss caused by her evasion of Del-Co’s taxes.”  I am unconvinced that the IRS argued the case in the way described by the court.  If it did I am confused.  It is possible the IRS made an alter ego argument.  Whatever was argued, the court found that the defendant and the corporations were not jointly and severally liable and that the IRS should not take payments on the corporate account and apply them to the individual liability.  If the IRS position reflects a legal conclusion that every time an individual is convicted and restitution is ordered based on corporate and individual liabilities this type restitution order allows it to move money between the individual and corporate accounts, then this decision represents a repudiation of that position.  If the IRS was simply arguing here that, based on these facts, the finances of the corporation and the individuals merged, the IRS lost a factual argument.

After reaching this conclusion the Court found that “because the IRS delayed the application of Defendant’s restitution payments and may have improperly applied Del-Co’s overpayment to Defendant’s tax account, the Defendant incurred unnecessary costs to clarify the IRS’s actions” and therefore costs and attorney’s fees were ordered against the United States. The delay in applying the payments here seems to have resulted from the implementation of a new statute and did not harm petitioners.  I do not see that as a basis for awarding fees.  To the extent that the IRS inappropriately applied the payment of the corporation, I feel the court should have provided more information about the steps that were taken to fix the wrongful application before the court proceeding as a prerequisite to the award of attorney’s fees.

I take away from this case the reinforcement of the IRS position that interest may be assessed on restitution assessments in the same summary manner as the assessment of the tax itself. The application of payments issue, if it reflects a legal position asserted by the IRS in restitution cases, represents a victory for taxpayers.  Because I am unconvinced that the IRS was arguing this as a legal matter, I think that the application of payments issue is simply a factual determination that must be determined on a case by case basis.  There will be many more cases exploring the restitution assessment procedure as this becomes more common.  I hope they offer a clearer view of what the parties presented but even in the murky view offered by this case, the issue of interest in restitution cases gets a little clearer.

Summary Opinions for November

1973_GMC_MotorhomeHere is a summary of some of the other tax procedure items we didn’t otherwise cover in November.  This is heavy on tax procedure intersecting with doctors (including one using his RV to assist his practice).  Also, important updates on the AICPA case, US v. Rozbruch, and the DOJ focusing on employment withholding issues.

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I’ve got a bunch of Jack Townsend love to start SumOp.  He covered a bunch of great tax procedure items last month.  No reason for me to do an inferior write up, when I can just link him.  First is his coverage of the Dr. Bradner conviction for wire fraud and tax evasion found on Jack’s Federal Tax Crime’s blog.  Why is this case interesting?  Because it seems like this Doc turned his divorce into some serious tax crimes, hiding millions offshore.  He then tried to bring the money back to the US, but someone in the offshore jurisdiction had flipped on him, and Homeland Security seized the funds ($4.6MM – I should have become a plastic surgeon!).  His ex is probably ecstatic that the Feds were able to track down some marital assets.   I am sure that will help keep her in the standard of living she has become accustom to.

  • I know I’ve said this before, but you should really follow Jack Townsend’s blogs.  From his Federal Tax Procedure Blog, a write up of the Second Circuit affirming the district court in United States v. Rozbruch.  Frank Agostino previously wrote up the district court case for us with his associates Brian Burton and Lawrence Sannicandro.  That post, entitled, Procedural Challenges to Penalties: Section 6751(b)(1)’s Signed Supervisory Approval Requirement can be found here.  Those gents are pretty knowledgeable about this topic, as they are the lawyers for the taxpayer. As Jack explains, the Second Circuit introduces a new phrase, “functional satisfaction” (sort of like substantial compliance) as a way to find for the IRS in a case considering the application of Section 6751(b) to the trust fund recovery penalty.
  • The Tax Court in Trumbly v. Comm’r  has held that sanctions could not be imposed against the Service under Section 6673(a)(2) where the settlement officer incorrectly declared the administrative record consisted of 88 exhibits that were supposed to be attached to the declaration but were not actually attached.  The Chief Counsel lawyer failed to realize the issue, and forwarded other documents, claiming it was the record.  The Court held that the Chief Counsel lawyer failed to review the documents closely, and did not intentionally forward incorrect documents.  The Court did not believe the actions raised to the level of bad faith (majority position), recklessness or another lesser degree of culpability (minority position).  Not a bad result from failing to review your file!
  • This isn’t that procedure related, but I found the case interesting, and I’ve renamed the Tax Court case Cartwright v. Comm’r as “Breaking Bones”.  Dr. Cartwright, a surgeon, used a mobile home as his “mobile office” parked in the hospital parking lot.  He didn’t treat people in his mobile home (which is good, because that could seem somewhat creepy), but he did paperwork and research while in the RV.  Cartwright attempted to deduct expenses related to the RV, including depreciation.  The Court found that the deductions were allowable, but only up to the percentages calculated by the Service for business use verse personal use.  I’m definitely buying an Airstream and taking Procedurally Taxing on the road (after we find a way to monetize this).
  • The IRS thinks you should pick your tax return preparer carefully (because it and Congress have created a monstrosity of Code and Regs, and it is pretty easy for preparers to steal from you).
  • Les wrote about AICPA defending CPA turf in September.  In the post, he discussed the actions the AICPA has been taking, including the oral argument in its case challenging the voluntary education and testing regime.  As Les stated:

The issue on appeal revolves whether the AICPA has standing to challenge the plan in court rather than the merits of the suit. The panel and AICPA’s focus was on so-called competitive standing, which essentially gives a hook for litigants to challenge an action in court if the litigant can show an imminent or actual increase in competition as a result of the regulation.

On October 30th, the Court of Appeals for the District of Columbia reversed the lower court, and held that the AICPA had standing to challenge the IRS’s Annual Filing Season Program, where the IRS created a voluntary program to somewhat regulate unenrolled return preparers.  The Court found the AICPA had “competitive standing”, which Les highlighted in his post as the argument the Court seemed to latch on to.   For more info on this topic, those of you with Tax Notes subscriptions can look to the November 2nd article, “AICPA Has Standing to Challenge IRS Return Preparer Program”.  Les was quoted in the post, discussing the underlying reasons for the challenge.

  • Service issued CCA 201545017 which deals with a fairly technical timely (e)mailing is timely (e)filing issue with an amended return for a corporation that was rejected from electronic filing and the corporation subsequently paper filed.  The corporation was required to efile the amended return pursuant to Treas. Reg. 301.6011-5(d)(4). Notice 2010-13 outlines the procedure for what should occur if a return is rejected for efiling to ensure timely mailing/timely filing, and requires contacting the Service, obtaining assistance, and then eventually obtaining a waiver from efiling.  There is a ten day window for this to occur.  The corporation may have skipped some of the required steps and just paper filed.  The Service found this was timely filing, and skipping the steps in the notice was not fatal.  The Service did note, however, that efiling for the year in question was no longer available, so the intermediate steps were futile.  A paper return would have been required.  It isn’t clear if the Service would have come to the same conclusion if efiling was possible.
  • Sticking with CCAs, in November the IRS also released CCA 201545016 dealing with when the IRS could reassess abated assessment on a valid return where the taxpayer later pled guilty to filing false claims.   The CCA is long, and has a fairly in depth tax pattern discussed, covering whether various returns were valid (some were not because the jurat was crossed out), and whether income was excessive when potentially overstated, and therefore abatable.  For the valid returns, where income was overstated, the Service could abate under Section 6404, but the CCA warned that the Service could not reassess unless the limitations period was still open, so abatement should be carefully considered.