When Does Underpayment Interest Begin When IRS Retroactively Revokes Corporation’s Tax Exempt Status

A recent case in Tax Court, CreditGuard of America v Commissioner, considers how interest on underpayments applies when there is a retroactive revocation of a corporation’s tax exempt status. In so doing it walks us though the provisions that impose interest on underpayments.

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I will simplify the facts to get to the issue. IRS began examining CreditGuard of America’s Form 990 for 2002 back in late December 2003. Fast forward (or slow forward) 9 years or so to February of 2012, and IRS retroactively revoked its tax exempt status for years starting January 1, 2002.

In revoking its status, IRS informed CreditGuard of America (CreditGuard) that it was obligated to file corporate income tax returns for years starting in 2002. When CreditGuard did not file its corporate income tax return for 2002, IRS helpfully filed a substitute for return and a statutory notice of deficiency. CreditGuard eventually petitioned the Tax Court and agreed to a stipulated decision for a deficiency of about $216,000. The stipulaion stated that “interest will be assessed as provided by law on the deficiency in income tax due from petitioner.”

IRS assessed the tax and interest of about $142,000 on the deficiency. In calculating the interest, the IRS used the start date of the underpayment interest as March 17, 2003, the due date of the 2002 corporate income tax return.

When CreditGuard did not pay the tax or interest, IRS commenced administrative collection and filed a notice of federal tax lien. In response, CreditGuard filed a CDP request seeking an offer in compromise, but also challenging the interest computation. According to CreditGuard, interest should have only run from 2012– the date of the IRS’s revocation of its tax exempt status.

The CDP case allowed the court to get to the merits of the interest issue. As a threshold issue, the court held that there was no prior opportunity to consider the interest calculation; while the Tax Court had limited jurisdiction to order a refund if the party in a case believes it has overpaid interest that does not give the court the power to determine the correct amount of interest in the first instance.

Once clearing that hurdle, the court turned to the interest issue, one of first impression in the Tax Court, leading to this being a division opinion. The taxpayer’s essential argument was straightforward: it had no obligation to file a corporate tax return in 2003; in fact that obligation only arose 9 years later when IRS revoked its status.

While there is a superficial appeal to CreditGuard’s argument, the Tax Court held that the statute mandates that interest ran from 2003:

Under section 6601(a), interest runs from the “last date prescribed for payment.” Under section 6151(a), the “last date prescribed for payment” is the date “fixed for filing the return.” Because the date fixed for filing petitioner’s 2002 Form 1120 was March 17, 2003, these provisions indicate that petitioner must pay interest on the unpaid tax “for the period from such last date to the date paid.” See sec. 6601(a).

To deflect that statutory reading, CreditGuard argued that the interest provisions that apply to “taxes not otherwise prescribed” under Section 6601(b)(5) applied to revocations. That section applies to taxes “payable by stamp and in all other cases in which the last date for payment is not otherwise prescribed.” For those taxes, the “last date for payment” is the date the liability for tax arises, a date that CreditGuard argued pushed the interest start date to 2012.

The Tax Court disagreed, holding that the corporate income tax was otherwise prescribed with a deadline (as per Section 6072(b)), and in any event, even if it were not, the liability for the tax arose during 2002, not when the IRS revoked its status or when it agreed to the stipulated decision in the Tax Court.

The part of the opinion addressing when the tax arose is a little like a dog chasing its tail, but as our good friend Professor Bryan Camp discusses in a thoughtful blogpost on Taxprof  it highlights the difference between a liability and an assessment. The liability arose back in the year the corporate income tax return should have been filed; the assessment that followed the Tax Court’s decision did not alter the essential time when the liability arose.

The opinion’s statement that retroactivity has real consequences is important. Its citation to Bergerco Can. v. U.S. Treasury Dep’t, Office of Foreign Assets Control, 129 F.3d 189, 192 (D.C. Cir. 1997) and its discussion of those consequences situate the nature of the court’s view of the issue and why the IRS position was right as policy matter:

To be sure, “until we devise time machines, a change can have its effects only in the future.” …. But the purpose of making a change retroactive is to suspend reality and invoke a counterfactual premise. Here, the premise is that petitioner was not in fact tax exempt during 2002 but rather was a corporation subject to the regular corporate income tax. Because petitioner did not actually pay that tax on the date prescribed for payment, it is liable for interest beginning on that date.

After the language cited above, the opinion does drop a footnote to Section 6501(g)(2), which provides that for sol purposes a corporation’s good faith filing of a Form 990 “shall be deemed the return of the organization” for purposes of starting the period of limitations on assessment.” That is an important point, as IRS cannot revoke status for stale tax years (absent the sol remaining open for other reasons). Yet, as the opinion notes, the interest provisions are designed to compensate the government for the use of money. By agreeing with the IRS that it should not have been tax exempt back in 2002, CreditGuard essentially agreed that it did not pay what it was required to pay had it properly reported its status in the first place. As a result, the court’s approach to make the government whole is consistent with the underlying purpose of the interest provisions.

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.

 

Why Would the Service Stop Me From Paying Someone Else’s Taxes?

That is an incredibly misleading title.  You obviously can pay someone else’s taxes.  And, its fairly common to do so.  Executives often have their taxes on certain compensation paid by their employer.  I am sure it is also common for a relative to pay taxes for someone if they cannot pay it themselves.  Depending on the circumstances, this may create additional tax issues to work through.  For instance, if an employer pays tax for an employee, it will give rise to additional taxable income, on which you must pay tax…and if the employer pays that tax, it will give rise to taxable income, on which you must pay tax…and so on.  Here is an old Slate article discussing just this in the context of a Survivor winner Richard Hatch.  I vaguely recall he was sort of a jackass, and got dinged for tax evasion.   If a family member pays your taxes, it is likely a gift, giving rise to potential gift tax issues.

So, why the B.S. misleading post title?  Tax procedure.  The government released Legal Advice issued by Field Attorneys (LAFA) 20171801F earlier this month, which considered two questions:

  • May a person making a deposit under I.R.C. § 6603 for a potential transferee liability direct the Service to apply all or a portion of its deposit against the liability of another person liable for the same underlying liability?

  • If a person making a deposit is permitted to apply all or a portion of the deposit to the liability of another person liable, under these facts, may an attorney-in-fact for a person making a deposit under I.R.C. § 6603 direct the Service to transfer the deposit to pay another person’s tax liability?

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Based on the title you can probably guess the IRS position on this.  First, though, it might be worth a quick note on what a LAFA is, since this is probably the first time we have devoted a full post to one and perhaps the first time we have discussed them in general. This is advice written by field counsel for local field employees.  As it was not issued by the National Office, it is not Chief Counsel Advice (“CCA”).  We touch on CCAs somewhat frequently.  As defined by the Code, for disclosure purposes, CCAs are:

written advice or instruction, under whatever name or designation, prepared by any national office component of the Office of Chief Counsel which (i) is issued to field or service center employees of the Service or regional or district employees of the Office of Chief Counsel; and (ii) conveys… any legal interpretation of a revenue provision; any Internal Revenue Service or Office of Chief Counsel position or policy concerning a revenue provision; or any legal interpretation of State law, foreign law, or other Federal law relating to the assessment or collection of any liability under a revenue provision.

As such, CCAs often indicate the official IRS position on a matter.  Under the above definition, most field counsel advice is not required to be released, but sometimes the field counsel will seek review by the National Office.  The review probably (definitely?) still does not make the field advice a CCA, but it is generally released to the public anyway.

In the LAFA, the Service determined that no, the depositor could not direct the deposit to be used to pay the liability of another person liable for the tax underlying debt. Although that effectively answers both questions, since the second is contingent on the first, the LAFA also stated the transfer of a deposit could not be done by a POA if it were possible to transfer deposits.

So, what is going on here?  The LAFA is short on facts.  Those two pages are completely redacted.  It appears that there was transferee liability under Section 6901 from a transferor to a transferee (transferee 1), and then to another transferee (transferee 2).  I believe this was a subsequent transfer of the same assets, and transferee 2 was attempting to transfer its deposit to transferee 1. Section 6901 is a procedural provision that allows collection from a transferee based on liability under another federal or state law, so the liability could be for any number of reasons, and I am not sure what it was in this case.  The subsequent transferee, transferee 2, made a deposit for the potential tax outstanding under Section 6603, which allows for deposits to be made on potential outstanding tax.

In making the deposit, transferee 2 stopped interest from running on the potential tax debt, and potentially generated some interest payable to transferee 2 if the amount was returned (it also keeps things out of the refund procedures and statute of limitations).  Transferee 2 apparently was not the person who was going to end up paying the outstanding tax, and sought to transfer the deposit to the transferee 1, who presumably was going to pay the tax.  And, presumably had not made a deposit (or had not deposited sufficient funds).  Since transferee 2 could pay transferee 1’s tax debt, it seems conceivable that transferee 2 should be able to transfer its deposit to transferee 1.

The LAFA’s position, however, was that:

While a person making a deposit may direct the Service to use the deposit as payment of other of his liabilities, Rev. Proc. 2005-18 does not authorize a person to direct the Service to apply a deposit to pay another person’s liability.

Section 6603, which allows for deposits, states a “taxpayer may make a cash deposit…which may be used by the Secretary to pay any tax imposed…which has not been assessed at the time of the deposit.  Such a deposit shall be made in such manner as the Secretary shall prescribe.”  This language doesn’t necessarily preclude the transfer of the deposit to another taxpayer.

In the LAFA, the Service reviewed Rev. Proc. 2005-18 for the Service’s self-prescribed procedural rules under Section 6603.  The Rev. Proc. does have language that treats Section 6603 as allowing deposits for the taxpayer’s tax debts, and not that of others, or potentially shared debts.  It also states that the deposit does not constitute a payment until it is applied against an “assessed tax of the taxpayer.”  But, the Rev. Proc. does also allow the taxpayer to allocate deposit amounts against other assessments, and does not specify the assessments must be that of the taxpayer in other language.

The LAFA concludes though that while transferee liability is derivative of the transferor’s liability, multiple transferees may be liable for different debts, which it believed was evidence that transferees should not be able to transfer deposits.  Further, the Service’s own current guidance does not allow for such a transfer, which it deemed was sufficient reason to preclude the deposit transfer.  The guidance essentially says transferee 2 needs to request the deposit back, and then use the funds to pay the debt of transferee 1.  This does not, however, stop the underpayment interest of transferee 1 from accruing (although transferee 2 might be entitled to overpayment interest, if certain requirements were met – the overpayment and underpayment rates, however, are not necessarily the same.  For those who wish to learn more about deposits, payments, and interest rates, Chapter 6.06 and Chapter 11.05 of SaltzBook were recently updated and they cover these topics in great detail).

As to the POA issue, the guidance indicates that, even if a deposit could be transferred, the Form 2848 does not specifically allow for that action, and therefore would not be authorized.

So, what does this mean?  You clearly can pay someone else’s taxes, but the Service position is that a deposit cannot be shifted between taxpayers.  The reasoning is based on the Service’s own guidance, and not the statute.  For multiple parties potentially responsible for the same tax, to stop interest from running each will need to make a deposit of his, her, or its own maximum liability amount.

A Botched CDP Notice Leads to a Timely 6404 Interest Abatement Petition

Sometimes cases arrive in Tax Court in the most unusual way, and the case of Estate of Sager v. Commissioner is one such case.  On February 17, 2017, the Tax Court entered an order determining that it did not have jurisdiction over the case for purposes of reviewing a Collection Due Process (CDP) decision by Appeals following an equivalent hearing but that it did have jurisdiction over the case for purposes of reviewing an interest abatement “final determination” made as a part of the CDP decision.  It is nice that the Estate of Sager got into the door of the Tax Court on the interest abatement issue.  Whether this will cause the IRS to argue in the future that documents not necessarily, or perhaps not clearly, intended to serve as final determinations of interest abatement will trigger the running of the statutory period for filing petitions for interest abatement remains to be seen.

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The tax year at issue in this case is 1997 and the return for that year was timely filed by the decedent, pursuant to extension, on July 27, 1998.  The IRS issued a notice of deficiency for that year on November 10, 2011.  I cannot determine from the order why the notice was timely but that does not seem to be an issue that concerned anyone.  A Tax Court petition was untimely filed in response to the notice of deficiency leading to the eventual assessment of $108,130.  Following assessment the normal collection actions took place, including the assignment of the case to a revenue office.  The revenue office eventually issued a notice of intent to levy on August 29, 2012; however, petitioner appears not to have filed a Tax Court petition in response to this notice.  On September 22, 2012, the revenue officer sent a CDP notice of filing the federal tax lien.  Petitioner did respond to the CDP lien notice and filed a request for a CDP hearing on October 24, 2012.

Petitioner noted in the request that more than 30 days had passed but asserted that the CDP notice was delivered to an invalid address.  In the end, the Tax Court determined that the CDP lien notice was sent to the wrong address.  Although the Court does not address the issue in the Order, the sending of a CDP lien notice to the wrong address raises an issue regarding the continued validity of the lien notice.  The IRS must send a CDP lien notice to the taxpayer within five days after the filing of the notice of federal tax lien.  What impact does sending an invalid notice have?  It seems that the Tax Court could never have jurisdiction over the CDP issues because of the invalid notice.  Because by the time the Tax Court gets to the issue of the validity of the notice and of the notice of federal tax lien almost a year from the filing of the petition had passed and because during that year the parties had resolved the lien issue, the Court did not dwell on the issue of the invalidity of the CDP notice.  The Internal Revenue Manual provides that, in general, if the IRS sends an invalid notice it must send a substitute notice and the Tax Court in Bongam v. Commissioner, 146 T.C. No. 4 (2016) held that a substitute notice of determination was proper after the mailing of an inappropriate motion..

Here, the address on the notice was the address at which petitioner’s former partner lived.  She brought the notice to petitioner on the 29th day after the notice was issued.  That did not provide the petitioner with enough time to file a timely request for a CDP hearing.  For notices of deficiency, the Tax Court has a rule that a notice mailed to the wrong address can become a valid notice if the notice makes it way to the taxpayer in time for the taxpayer to file a timely Tax Court petition.  Under that case law, learning of the CDP notice on the 29th day would not validate the CDP notice.  It is not clear that getting the wrongly addressed CDP notice to the taxpayer would save the CDP notice.  I will leave the issue for another post where the issue is clearly raised, but wanted to point out the issues lurking in this case before returning to the interest abatement determination.

When it received the untimely CDP request, the IRS gave the taxpayer an equivalent hearing.  During the equivalent hearing, the Settlement Officer (SO) considered the merits of liability and reduced the liability.  Because this action did not necessarily bear on the outcome before the Tax Court, the order gives few details that allow me to know how the taxpayer persuaded the SO to consider the merits.  It appears from the dismissal of the untimely petition in Tax Court of the effort of the taxpayer to litigate the notice of deficiency that the taxpayer had a prior opportunity to litigate the tax.  I surmise that the taxpayer was able to show the SO in a simple, straightforward way that the assessment was wrong and the SO was willing to address the issue even though not compelled to do so by the CDP process.  Les talked about this in a recent post in which the SO was unwilling to fix an easily recognizable mistake.  I have had spotty success seeking to get a merits adjustments from an SO where the taxpayer had a prior opportunity but the adjustment was easy to fix.  If I am correct about what happened here, it shows at least one SO who was willing to fix something simple and save the taxpayer time as well as other IRS employees.

The SO did not agree to abate interest.  The order does not describe why the taxpayer felt interest should have been abated.  Given the unusual timing of the issuance of the notice of deficiency, perhaps the lengthy delay in working the case had something to do with the request.  The taxpayer made a $50,000 payment during the CDP equivalent hearing process.  Because of the adjustments the SO made and the payment, the taxpayer essentially satisfied the liability; however, the SO issued a decision letter at the conclusion of the equivalent hearing setting out the adjustment to the tax and denying interest abatement.

The taxpayer filed a petition in Tax Court within 30 days of the issuance of the decision letter.  The IRS moved to dismiss since it had not issued a determination letter.  Essentially, it argued that the late filing of the request for a CDP hearing precluded the Tax Court from having jurisdiction.  The low income taxpayer clinic at Rutgers Law School entered the scene at this point and argued that the Tax Court had jurisdiction over the interest abatement aspect of the case.  The IRS conceded that the Tax Court “may” have jurisdiction over the interest abatement request while continuing to argument that it did not have jurisdiction over the CDP request.  The taxpayer argued that his case met the unusual conditions for treating a decision letter as a notice of determination and that the Tax Court did have jurisdiction over his case.  The Tax Court disagreed and distinguished this case from the very short line of cases holding that the Tax Court has jurisdiction over a CDP matter after the issuance of a decision letter.

While disagreeing with petitioner on the issue of jurisdiction over the CDP aspect of the case, the Tax Court held that the decision letter could serve as a final determination with respect to interest abatement.  In Gray v. Commissioner, the Tax Court previously held that a CDP determination letter could serve as the basis for a final determination regarding interest abatement.  The order in Sager takes the next logical step and holds that a decision letter can also serve that purpose.  The petition filed here came well within the 180 period after the notice of final determination.  The Court finds that “Respondent has not asserted nor proven that the decision letter was not meant to be a final determination on Mr. Sager’s interest abatement request.”  Therefore, the Court found it had jurisdiction to hear the interest abatement request and ordered the parties to file status requests regarding the interest abatement issue.

The order follows the Tax Court’s longstanding practice of finding jurisdiction in those situations in which the petitioner comes to the Court within the established time frames in the applicable statutes.  Not only had the Court made a similar holding regarding a CDP determination letter in the Gray case, but it has made similar decisions in other contexts as well.  I wrote recently about one in the whistleblower context.  The decision here allows the petitioner to move forward for a determination on interest abatement without going the more ordinary route of filing a Form 843.  This is good news for this taxpayer and good news generally unless the IRS can argue that this type of informal final determination precludes the taxpayer from seeking interest abatement if the taxpayer does not realize that the informal final determination closes the door when it goes unrecognized and the taxpayer does not act quickly in response to it.

Tax Court Holds that Points Paid on Interest Only Refinancing Not Deductible

This week in Singh v Commissioner the Tax Court in a summary opinion held that a taxpayer was not entitled to deduct the amounts paid in respect of points on a refinancing of a principal residence. Determining whether interest on a home is deductible is complicated by the reality that for many taxpayers information returns or settlement statements may not completely or accurately indicate the amount that can be deducted.

One such issue relates to when consumers are paying interest on a modified mortgage; as we have discussed before (see. e.g. a guest post by Dave Vendler discussing the issue and related litigation) the Form 1098 that most financial institutions issue does not reflect the amounts that were attributable to the accrued but unpaid interest at the time of the modification. This is an issue that is currently the subject of an IRS guidance project (a copy of the American Bankers Association and Mortgage Bankers Association comments on the proposed guidance can be found here). [As an aside I will moderate a panel discussion on that topic at the ABA Tax Section May meeting in DC as part of the Individual and Family Committee].

Singh does not involve a modified mortgage though does spin off of some of the challenges that many Americans faced following the great recession. In Singh the taxpayer refinanced two mortgages on his principal residence with an interest only loan that was for an indefinite period.

Part of the costs that Singh paid included points on the interest only refinancing. To the extent that the points represent interest taxpayers may deduct the points over the course of the loan (assuming of course that the interest is otherwise deductible). This sweeps in Section 461(g), which requires a cash basis taxpayer to amortize prepaid interest over the life of the loan, just as if the taxpayer were on the accrual method of accounting. Section 461(g)(2) provides an exception to the amortization requirement in 461(g)(1) and allows a taxpayer to deduct the payment of certain points if they were paid “in connection with the purchase or improvement of, and secured by, the principal residence of the taxpayer.”

For taxpayers who seek to refinance years after the original purchase or who do not use proceeds of a refinancing to substantially improve the residence, the immediate deduction exception in Section 461(g)(2) provides no help. When is a refinancing close enough to the original purchase to be eligible for the 461(g)(2) immediate deduction? There is a well-known 8th Circuit case from 1990, Huntsman v Commissioner, that provides guidance for taxpayers seeking a deduction for points. In Hunstman, the 8th Circuit allowed an immediate deduction, emphasizing that the taxpayer refinanced to extinguish short-term loans from the original purchase, rather than just seeking to get a lower interest rate or accomplish other financial goals. That connection in Hunstman allowed the taxpayer to take advantage of the Section 461(g)(2) exception on the points paid on the refinancing.

This brings us back to Singh. A refinancing arising (and points paid on that refinancing) many years after the original purchase differs from Huntsman. In addition, the Tax Court noted that Singh could not deduct the points even under the general Section 461(g)(1) authority, which treats the points as amortized over the life of the loan, as Singh’s loan was for an interest only loan for an indefinite period.

The upshot for Singh was no deduction, and accuracy-related penalties for good measure. This is a a good reminder that the deductibility of interest on residences is sometimes not just a matter of plugging in information off a form 1098 or settlement document.  I suspect there is a great deal of confusion and error in this area of the tax law.

Update on Issues Relating to Financial Institutions Underreporting Mortgage Interest to Millions of Consumers

One of the most viewed posts on Procedurally Taxing in the last year or so was one that discussed a lawsuit alleging that Bank of America intentionally and systematically understated millions of dollars in homeowners’ mortgage interest payments following loan modifications. Earlier this year the lead attorney on that lawsuit, David Vendler of Morris Polich & Purdy, wrote a two-part post An Update on the Lawsuit Against Bank of America for Failing to Issue Accurate Interest Information Statements. When we last heard about the issue the IRS was seeking input through the Industry Issue Resolution program. Today David tells us that that the IRS has terminated that IIR project and added it to its list of guidance priorities for 2016-17. The issue is one with major implications for millions of consumers. The bankers are obviously well-represented in the guidance process. As David discusses there is a strong need for IRS and Treasury to hear how financial institutions should be required to report the payment of interest payments following loan modifications and other transactions like short sales when consumers are effectively paying substantial amounts of interest but not receiving information from banks that would allow them to determine whether the interest is deductible. Les

To all of you tax professionals reading this, I need your help.  Some of you may recall my two-part post regarding whether 26 U.S.C. section 6050H requires lenders and mortgage servicing entities to report payments of “capitalized” mortgage interest they receive from borrowers on IRS Form 1098 so that the borrowers can then deduct those payments.  The issue literally involves billions and billions of dollars in mortgage interest deductions that millions of American homeowners are losing because of the failure of their mortgage servicers to properly report.  As described in my prior posts, the situation arises in the contexts of negative amortization/Option Arm loans as well as loan modifications.  It also, however, arises with short sales, which was not discussed in my prior posts.  (Basically, if you look at the 1099-C that the consumer receives following a short sale, you will note that box 2 (which requires the reporter to indicate how much of the debt being cancelled is mortgage interest) is generally left blank.  This means that all of the cancelled debt is principal.  This is correct since mortgage notes generally require allocation of payments to interest before principal.  But in the short sale context, while the banks and mortgage servicers are correctly reporting the amounts of debt being cancelled, they are not reporting the other side of the transaction on Form 1098, which is the amount of interest being paid from the sales proceeds.  This amount can be in the tens of thousands of dollars)

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Anyway, following my bringing lawsuits against certain banks arising from their failure to properly report their customers’ interest payments, the American Bankers Association and the Mortgage Bankers Association requested the IRS to address the issue.

In late December 2016 the IRS responded that it would address the issue via its Industry Issue Resolution (“IIR”) program.  This program, however, does not provide for public comment and I was afraid that the banks and the IRS would simply arrive at “guidance” that would conclude that section 6050H was ambiguous as to whether it required payments of capitalized interest to be reported.  This way, even if the IRS concluded that I was correct about the reportability of the interest, the banks could then use the “guidance” announcing that there was an ambiguity to “prove” that they did nothing wrong in not previously reporting  payments of capitalized interest.

In fact, however, there really is no ambiguity.  The law is very clear and can be stated in a single paragraph.  21 U.S.C. section 6050H unambiguously requires banks and mortgage servicers to report on Form 1098 the “aggregate” of all mortgage interest they receive in a year (if that amount is over $600).  The Supreme Court has held that “interest” unambiguously refers to money that has been charged for the use of money.  Deputy v. DuPont, 308 U.S. 488 (1940).  Case law further uniformly holds that payments of capitalized mortgage interest (whether in the loan modification context or the negative amortization loan context) are payments of mortgage interest that can be deducted in the year of payment.  See Copeland v. C.I.R., T.C. Memo. 2014-226, (capitalized pre-loan modification interest held deductible as mortgage interest in the year of payment); Smoker v. C.I.R., 2013 WL 645265 *6 (Tax Ct. 2013) (same holding in the negative amortization loan context) [note Les discussed Copeland on PT  here].  Since capitalization of interest does not change its character as interest (Motel Corporation v. Commissioner of Internal Revenue, 54 T.C. 1433, 1440 (1970)), payments of capitalized mortgage interest are part of the “aggregate” mortgage interest that banks and mortgage servicers “receive” and thus are required to be reported on Form 1098 by the plain and unambiguous language of section 6050H.  Indeed, it was for this very same reason why 26 CFR § 1.6050S-3(b)(1) specifically requires that payments of capitalized student loan interest be reported on Form 1098-S.  There is simply no logical distinction that can be made between the reportability of payments of capitalized student loan interest and capitalized mortgage interest.

After a bunch of submissions on my part to the IRS requesting to be included in the IIR process, the IRS has just last week declared that it is terminating the IIR process and will address the issue of the reportability of capitalized interest on Form 1098 by formal rulemaking.  I see this as very good news insofar as the public, including you, will have an opportunity to comment.  I further fully expect that whatever rule the IRS eventually publishes will be consistent with all of the law above since this was the conclusion the IRS reached on the reportability of student loan interest way back in 2004.  That said, I expect that there will be heavy pressure from the banks and mortgage servicing entities to push for a rule that is “prospective-only” as was done with the student loan interest rule back in 2004.  This will hurt consumers tremendously.  Banks should instead be required to issue corrected Forms 1098 to all consumers which will (retrospectively) inform them of the interest that was not reported to them and allow them to file an amended return (if the statute of limitations has not expired) to recover his/her deduction.  Further, if consumers are really to be helped, the IRS should include in its rule an exception to the statute of limitations (based on the fact that because of the bank’s misreporting, the consumer was unaware of the potential for amendment previously), or allow consumers to take the prior deductions in the current tax year.    There simply is no justification for a prospective-only rule precisely because the question of the reportability of payments of capitalized interest has already answered.  The mortgage industry just ignored that answer for the sake of reporting convenience.

So, what I would like from anyone who feels equipped to do so is to write to the IRS (prior to the official public comment period which comes after a proposed rule is formally announced) and let them know your thoughts.   Comments can be sent directly to Thomas.West@treasury.gov prior to the formal public comment period.  Further, if any of you have any questions, please address them to me at dvendler@mpplaw.com

Sixth Circuit Follows Second on Overpayment Interest for Not-for-Profit Corps

In late April of this year, I wrote a post on the Second Circuit case, Maimondies, where the Court determined if a not-for-profit corporation that was exempt from income tax under Section 501(c)(3) was a “corporation” for overpayment and underpayment interest rates.  The same issue was decided by the Sixth Circuit in August in United States v. Detroit Medical Center.

The issue in Detroit Medical is that “corporations” under Section 6621(a)(1) receive interest at a lower rate  that non-corporations on overpayments of tax.  The not-for-profit corporation had an overpayment of employment taxes paid on medical residents (exact same issue as Maimondies) and believed it should receive interest at the non-corporate rate.  Detroit Medical’s argument is based on a blend of policy arguments and statutory construction.   The IRS disagreed, arguing a corporation is a corporation, profit or not.  Here is the issue as stated by the Court:

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Consider our task today. The question at hand sounds simple enough: Should a nonprofit corporation be treated like a for-profit corporation when it comes to the interest it receives on overpaid taxes? Now consider the question in the context of the Internal Revenue Code:

(a) General rule:

(1) Overpayment rate. The overpayment rate established under this section shall be the sum of—

(A) the Federal short-term rate determined under subsection (b), plus

(B) 3 percentage points (2 percentage points in the case of a corporation).

To the extent that an overpayment of tax by a corporation for any taxable period (as defined in subsection (c)(3), applied by substituting “overpayment” for “underpayment”) exceeds $10,000, subparagraph (B) shall be applied by substituting “0.5 percentage point” for “2 percentage points.”

(2) Underpayment rate. The underpayment rate established under this section shall be the sum of—

(A) the Federal short-term rate determined under subsection (b), plus

(B) 3 percentage points.

. . .

(c) Increase in underpayment rate for large corporate underpayments

(1) In general. For purposes of determining the amount of interest payable under section 6601 on any large corporate underpayment for periods after the applicable date, paragraph (2) of subsection (a) shall be applied by substituting “5 percentage points” for “3 percentage points”.

. . .

(3) Large corporate underpayment. For purposes of this subsection—

(A) In general The term “large corporate underpayment” means any underpayment of a tax by a C corporation for any taxable period if the amount of such underpayment for such period exceeds $100,000.

(B) Taxable period. For purposes of subparagraph (A), the term “taxable period” means— (i) in the case of any tax imposed by subtitle A, the taxable year, or (ii) in the case of any other tax, the period to which the underpayment relates.

What starts as a basic question gets less basic the more one reads. Yes, this is a tax case. Some complexities—different rules for overpayments and underpayments, different interest rates for different taxpayers, some exceptions to some rules—come with the territory. But the first sign that the author of this provision was not thinking of his readers appears in the parenthetical of the flush paragraph: “To the extent that an overpayment of tax by a corporation for any taxable period (as defined in subsection (c)(3), applied by substituting ‘overpayment’ for ‘underpayment’) exceeds $10,000, subparagraph (B) shall be applied by substituting ‘0.5 percentage point’ for ‘2 percentage points.’” The meaning of this exception turns on a cross reference to another subsection that applies to the opposite form of payment mentioned in the first subsection but only for “C corporation[s],” not “corporations” in general.

The Sixth takes a strict statutory construction look at the statute, first determining if the entity is a “corporation”, finding if the statute does not specifically define a term fully then Congress intends to adopt its customary meaning.  The Court found “corporation” generally includes not-for-profit corporations, looking to Chief Justice Marshall 1819 holding in Trustees of Dartmouth College v. Woodward.  The Second Circuit had cited to this case, and, not to be outdone, the Sixth Circuit decided to look even further back through legal history, citing to the 1612 holding in The Case of Sutton’s Hospital where the nonprofit was treated as a corporation.  And, to the writings of William Blackstone in 1753, who listed three general types of corporations, including charitable or “eleemosynary” as he termed them.  The Court then looks to various places in the Code where charitable entities are referred to as corporations, and various other everyday uses of the term.

Finding the entity was clearly a “corporation”, the Court then looked to the hanging language and the reference to (c)(3).  There the Court held that the parenthetical modified only the taxable period, and not the remainder of the paragraph, so the c-corporation language did not modify (a)(1) to only apply to c-corporations.  The Sixth Circuit provides a lengthy discussion about why this is the correct statutory interpretation, which is similar to that in the Second Circuit holding.

The Court does note that this is a strange statutory design, to have the nonprofit receiving less interest than Warren Buffett, musing that perhaps Congress had not thought it through because nonprofits don’t pay income tax.

In the final paragraph, the Court does note that it is in agreement with the Second Circuit (the first reference to the case).  This is probably on appeal in other circuits at this point, as it appears there were a lot of nonprofit hospitals in the same position following Mayo.  As the Tax Court has previously held that the S-corporations were not subject to the lower rate based on the same provisions, there is at least some potential for another circuit to hold differently regarding not-for-profits, providing a split.  We shall see.

Seventh Circuit Reverses in King Interest Abatement Case

Last week the Seventh Circuit reversed the Tax Court in King v Commissioner, holding that the Tax Court was incorrect in concluding that the Service abused its discretion in not abating the late Mr. King’s interest that accrued on employment tax liabilities. We have discussed the case before, most recently with Carl reviewing the oral argument in Interest Abatement Based on “Unfair” Assessment and Stephen discussing the Tax Court opinion in A Pro Se King Royally Wins Interest Abatement on Employment Taxes

I will excerpt heavily from our prior posts and the Seventh Circuit opinion and offer a few observations.

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The Issue and Tax Court Resolution

As Carl and Stephen discussed, this was an odd interest abatement case, arising through CDP and applying Section 6404(a) rather than the explicit interest abatement provision found in Section 6404(e). The dispute centered on interest that the IRS charged that was attributable to unpaid employment taxes and in part erroneous information that the IRS had given King. An IRS employee told King it would grant him an installment agreement; it later decided that King’s collection potential was too high to warrant an installment agreement. King paid the tax but argued that he should not have paid the interest that ran from the date of the erroneous information about the installment agreement until his later payment as he would have paid earlier had he known he was not going to be given an installment agreement.

Carl discussed how the employment tax context took this case out of the explicit interest abatement regime in Section 6404(e) and how it came to Tax Court via CDP:

King is an employment tax Collection Due Process (CDP) case based on a notice of federal tax lien (NFTL).  The only issue left in the case on appeal is interest abatement under IRC § 6404(a).  That’s not a typo for § 6404(e).  § 6404(e) allows abatement of interest with respect to taxes that are deficiencies (income, estate, and gift), not employment taxes, where there have been unreasonable IRS errors or delays.  By contrast, § 6404(a) provides: “The Secretary is authorized to abate the unpaid portion of the assessment of any tax or any liability in respect thereof, which–(1) is excessive in amount, or (2) is assessed after the expiration of the period of limitation properly applicable thereto, or (3) is erroneously or illegally assessed.” While § 6404(a) abatement clearly authorizes abating tax, the IRS agrees that “any liability in respect” of the tax includes interest.

Stephen set out King’s argument and the Tax Court’s resolution of the case:

Mr. King claimed that the interest was excessive because of the various delays created by the IRS.  The Service position on this matter is that “excessive” is essentially a restatement of the third option of “erroneously or illegally assessed.”  The Service has lost on this matter before in the Tax Court in H&H Trim & Upholstry v. Commr, TC Memo 2003-9, and Law offices of Michael BL Hepps v. Comm’r, TC Memo 2005-138, so this is not breaking new ground, but good reinforcement of a taxpayer friendly ruling.  The Tax Court in the previous cases had interpreted “excessive” to “include the concept of unfairness under all of the facts and circumstances.”  A bit broader than simply erroneously or illegally assessed.   In H&H Trim, the taxpayer was able to show the interest would not have accrued “but for” the Services dilly-dallying.  In King, the Service argued that the prior case law was incorrect, but also argued that the taxpayer could have made a voluntary payment to stop the interest and was requesting an installment agreement, which would have incurred interest.  The Court essentially held that the taxpayer showed he would have perfected the installment agreement and paid it the underlying amount more quickly but for the IRS taking its sweet time and failing to follow its own IRM procedures in responding to the taxpayer’s IA request (albeit imperfect), and abatement was therefore appropriate.  As to the voluntary payment, the Tax Court stated that Section 6404(a) has no language barring abatement when a portion of the error or delay could have been attributable to the taxpayer (Section 6404(e) has that language).  Even if the taxpayer could have made the payment, the failure to do so did not alleviate the IRS’s requirement to abate

Seventh Circuit Reverses

In a relatively brief opinion, after getting over a mootness hurdle (King died shortly after the appeal was lodged) the Seventh Circuit reversed the Tax Court, giving three reasons:

The first is the vagueness of “unfairness” as a criterion for abatement; the word is an invitation to arbitrary, protracted, and inconclusive litigation.

Second, extending as it does an invitation to taxpayers to delay paying taxes, the nebulous standard of “unfairness” could result in a significant loss of tax revenues.

And third, we’ll see that the Tax Court’s approach is inconsistent with a valid regulation promulgated by the Treasury Department.

Judge Posner, no fan of vague standards or multiple factors, was explicit in his dislike of using unfairness as a standard and Tax Court precedent that so allowed:

Elaborating the first point briefly, we note the embroidery that the Tax Court, quoting from its earlier opinion in H & H Trim & Upholstery Co. v. Commissioner, T.C. Memo. 2003‐9, at *2, wove into its opinion in the present case on the basis of its touchstone of “unfairness under all of the facts and circumstances”—its belief that the “word ‘excessive’ takes into account the concept of what is fair, or more appropriate here, unfair,” and its approving references to a dictionary’s definition of “excessive” as “whatever notably exceeds the reasonable, usual, proper, necessary, just, or endurable” (what on earth is “endurable” doing in this list?) and to “just” as meaning “equitable” and “equitable” as meaning “fair.” This terminological potpourri can provide no guidance to taxpayers, their advisers, IRS agents, or the Tax Court. It’s a monkey wrench tossed into the machinery of tax collection.

The opinion also has a nod to Chevron and agency deference, as Judge Posner explains in discussing the third reason why the Seventh Circuit thought the Tax Court was wrong:

The Supreme Court has said that “filling gaps in the Internal Revenue Code plainly requires the Treasury Department to make interpretive choices for statutory implementation at least as complex as the ones other agencies must make in administering their statutes.” Mayo Foundation for Medical Education & Research v. United States, 562 U.S. 44, 56 (2011). The interpretive choice in this case is found in the regulation defining the statutory term “excessive in amount” to mean “in excess of the correct tax liability.” 26 C.F.R. § 301.6404–1(a), Treas. Reg. § 301.6404–1(a). As there is no indication that the IRS is misinterpreting its regulation, there is no need for us to consider the possible inroads that recent Supreme Court decisions have made into “Auer deference” (judicial deference to agencies’ interpretations of their own regulations), inroads discussed for example in Michael P. Healy, “The Past, Present and Future of Auer Deference: Mead, Form and Function in Judicial Review of Agency Interpretations of Regulations,” 62 Kansas Law Review 633 (2014).

Some Brief Thoughts

This was a case that mattered a lot to IRS for the broader precedent, as the amount of interest at issue was minimal. As Carl discussed, this case went up to the Seventh Circuit without the benefit of a taxpayer brief or oral argument. Some background on the interest abatement provisions makes this perhaps not as clear as Judge Posner concludes. In 1986, where Congress enacted the first interest abatement provision, Congress wrote then that it intended the provision at subsection (e) to be used in situations where an error or delay in performing a ministerial act resulted in the imposition of interest, and the failure to abate interest “would be widely perceived as grossly unfair”.  S. Rep. 99-313, 1986-3 (Vol. 3) C.B. 1, 208.  Later in 1998, Congress inserted the word “unreasonable” before “error or delay” to provide a judicial review standard, but did not say that the prior legislative history language about unfairness was now obsolete.  Indeed, in King, Judge Posner quoted from H & H Trim, which quoted a dictionary definition of “excessive” as including “whatever notably exceeds the reasonable” (i.e., is unreasonable).

If interpreting “excessive” in 6404(a) as “unfair” would be unworkable, it seems odd that “unfair” is exactly what Congress thought the courts should be looking to as a standard for review of interest abatement cases under Section 6404(e).  If he is correct that “the vagueness of ‘unfairness’ as a criterion for abatement; [is that] the word is an invitation to arbitrary, protracted, and inconclusive litigation”, then perhaps the opinion should discuss how such a criteria has operated for 30 years without a problem to tax administration in Section 6404(e).

It is possible that this is not the last of time we will see this issue. I am aware that practitioners have used an H&H Trim unfairness argument successfully at times with counsel to generate abatements, even on case involving income taxes. We will see whether the Tax Court will stick to its guns on this issue. The Service appeal and victory in this case is a pretty good indicator that the Service is now focused on and opposed to such arguments.