ARE ALLEGED ALTER EGOS, SUCCESSORS IN INTEREST AND/OR TRANSFEREES ENTITLED TO THEIR OWN COLLECTION DUE PROCESS RIGHTS UNDER SECTIONS 6320 AND 6330? PART 2

Today, guest blogger Lavar Taylor continues his discussion of the interplay of the laws regarding third parties liable for a tax debt and the ability of those third parties to obtain CDP rights. If you have not had the chance to read his initial post on this topic, you might want to take time to read that one before digging into this one. These posts not only explore the ability of these third parties to obtain CDP rights but help anyone not familiar with the various ways that the IRS can seek payment of a taxpayer’s liability to gain a better understanding of the collection process. Keith

In Part 1 of this series of blog posts, I explained how the relevant statutes and regulations, together with the rationale of the Court deciding Pitts v. United States in favor of the IRS, support the conclusion that persons/entities who are alleged by the IRS to be the alter ego, successor in interest, and/or transferee of the party who incurred the tax liability (“original taxpayer”) are entitled to their own independent Collection Due Process (“CDP”) rights under §§ 6320 and 6330 of the Code. In the present blog post, I explain why I believe that the IRS is speaking out of both sides of its mouth when it denies alleged alter egos, successors in interest, and transferees their own independent CDP rights under §§ 6320 and 6330.

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The IRS, in the current version of the Internal Revenue Manual (“IRM”), instructs revenue officers to treat partners in a general partnership which incurred unpaid federal taxes as “persons liable for the tax” for purposes of administratively enforcing the partnership’s unpaid tax liability. Per the IRM, these general partners are to be given CDP Lien and Levy notices under sections 6320 and 6330, in addition to the CDP Lien and Levy notices provided to the taxpayer partnership. Thus, IRM section 5.19.8.4.2(5)(08-05-2016), titled CDP Hearing Requests, provides in section (5) as follows:

If the tax liability involves a partnership, a request for a CDP hearing under IRC 6330 would cover all partners in the partnership. Under IRC 6320, the partnership and partners listed on the NFTL receive the CDP hearing notice. A partner with authority to represent the partnership could request a hearing for the partnership or a partner listed on the NFTL could request a CDP hearing as an individual partner.

Similarly, IRM 8.22.5.3.1.4(4) (03-29-2012), titled Determining Timeliness-Levy, provides that “[f]or partnerships, Collection may issue separate notices to individual partners as well as the partnership entity.” IRM Section 8.22.6.5 (03-29-2012), titled Partnership Liability, states as follows:

1. Under state law, general partners in partnerships are liable for taxes assessed against the partnership. In United States v. Galletti, 541 U.S. 114 (2004), the Supreme Court held the Service’s assessment against a partnership serves to make the general partner liable for the tax. While the Supreme Court did not address administrative collection, Galletti is consistent with the Service’s long-standing legal position that it can enforce a tax lien and take administrative levy action against a general partner based on the assessment and notice and demand directed to the partnership. See Chief Counsel Notice 2005-003 at http://www.irs.gov/pub/irs-ccdm/cc-2005-003.pdf .

2. A partner’s individual CDP hearing request:

— DOES NOT affect Collection’s ability to collect from the partnership or other individual partners’ assets

— DOES affect Collection’s ability to collect from that partner’s individual assets.

Chief Counsel Notice 2005-003 explains in detail the rationale for the IRS’s position that the IRS may pursue administrative collection action against general partners personally for taxes incurred by and assessed against the partnership itself. Essentially, the IRS takes the position that it may take advantage of state law to pursue collection of a tax liability against someone other the person who incurred the tax liability. That concept is not a new one – it is the bedrock of the Supreme Court’s decision in Commissioner v. Stern, 357 U.S. 39 (1958), which deals with the assertion of transferee liability under what is now section 6901 of the Code. In the case of a general partner of a general partnership, the IRS is using the relevant state’s version of the Uniform Partnership Act, which provides that general partners are personally liable for partnership debts.

Why is the IRS speaking out of both sides of its mouth when it grants partners in general partnerships their own CDP rights under §§ 6320 and 6330 with respect to taxes incurred by the partnership but denies those same CDP rights to alleged alter egos, successors in interest and transferees of the original taxpayer? Simply put, the IRS, in seeking to hold third parties liable as the alleged alter ego, successor in interest, and/or transferee of the original taxpayer, is invoking state law to hold a third party liable for the taxes of the original taxpayer.

Conceptually, there is no difference between the IRS invoking state law to hold a general partner of a general partnership liable for the partnership’s tax liability and the IRS invoking state law in an effort to hold someone other than the original taxpayer liable for that tax liability as an alleged alter ego, successor in interest, and/or transferee of the original taxpayer. While determining whether a person or entity is a partner of a general partnership is normally a simpler task than determining whether a person or entity is an alter ego, successor in interest, or transferee of the original taxpayer, both types of determinations involve the application of state law to a given set of facts to determine whether a third party can be held liable for taxes owed by the original taxpayer.

It is clear that state law governs the question of whether a third party can be held liable as an alter ego, successor in interest, and/or transferee of the original taxpayer for taxes assessed against the original taxpayer. See, e.g., Commissioner v. Stern, 357 U.S. 39 (1958) (transferee), Wolfe v. United States, 798 F.2d 1241, (9th Cir. 1986) (alter ego), TFT Galveston Portfolio, Ltd. v. Comm’r, 144 T.C. 96 (2015) (successor in interest), see also Fourth Inv. LP v. United States, 720 F.3d 1058 (9th Cir. 2013) (nominee). It seems to me that, if the IRS’s assertion of liability under state law to enforce a general partnership’s tax liability against a general partner of that partnership is sufficient to trigger CDP rights for the general partner, the IRS’s assertion of liability under state law to enforce a taxpayer’s tax liability against a third party as an alleged alter ego, successor in interest, or transferee should also be sufficient to trigger CDP rights for the alleged alter ego, successor in interest, or transferee.

In the Tax Court cases which we recently settled, the IRS argued that it was not being inconsistent in denying our client (which was an alleged alter ego/successor in interest of the original taxpayer) its own independent CDP rights while allowing those same rights to partners of general partnerships that incur tax liabilities. The IRS argued as follows:

The alter ego doctrine is used in federal tax cases to collect the liability of a taxpayer from a separate corporate entity that is operating to impair the government’s ability to satisfy the taxpayer’s legitimate tax liability. See Oxford Capital Corp. v. United States, 211 F.3d 280, 284 (5th Cir. 2000); Valley Fin. V. United States, 629 F.2d 162, 172 (D.C. Cir. 1980). Once respondent has determined that an entity is an alter ego, that entity’s assets may be levied upon for the debtor of the taxpayer because the law does not recognize the taxpayer and the alter ego entity as each having independent existence for purposes of debt collection. See Oxford Capital Corp., 211 F.3d at 284; see also United States v. Scherping, 187 F.3d 796, 801-02 (8th Cir, 1999).

There are two significant problems with the IRS’s argument (aside from the fact that the IRS’s argument fails to address successor in interest liability). First, there is both federal and California case law which makes clear that an entity is considered a valid, separate entity even when that entity is liable for a third party’s debt under the alter ego doctrine. In Wolfe v. United States, 798 F.2d 1241 (9th Cir. 1986), the Ninth Circuit upheld the application of the alter ego doctrine under Montana law against the shareholder of a corporate taxpayer. In doing so, the Ninth Circuit stated as follows:

Indeed, despite Wolfe’s contentions, it is not necessarily inconsistent to view a corporation as viable for the purpose of assessing a corporation tax, while disregarding it for the purpose of satisfying that assessment. Only those corporations that were established with no valid purpose are considered sham corporations, and thus not entitled to separate taxable status. See Moline Properties v. Commissioner, 319 U.S. 436, 439, 87 L. Ed. 1499, 63 S. Ct. 1132 (1943). A corporation could have a valid business purpose (giving it separate tax status), and at the same time be so dominated by its owner that it could be disregarded under the alter ego doctrine. Cf. National Carbide Corp. v. Commissioner, 336 U.S. 422, 431-434 & n. 13, 93 L. Ed. 779, 69 S. Ct. 726 (1949) (finding insignificant, for the purpose of determining whether a subsidiary corporation is entitled to separate taxable status, the fact that the owner retains direction of the subsidiary’s affairs, provides all of its assets, taxes all its profits, and exercises complete domination and control over its business). This view has been adopted by the Fifth Circuit. See Harris v. United States, 764 F.2d 1126, 1128 (5th Cir. 1985) whether or not [the corporation] was a separate taxable entity is not the same question as whether it was an alter ego for the purpose of piercing the corporate veil”).

Thus, Wolfe, and the cases cited in the Wolfe opinion, make clear that a corporation can be a valid, separate entity from the original taxpayer for purposes of the CDP procedures, even if the IRS is seeking to hold a corporation liable under the alter ego doctrine for the taxes owed by the original taxpayer.

Similarly, California law, upon which the IRS was relying in the now-settled cases we were handling in Tax Court, makes clear that a third party entity which is held liable as the “alter ego” of the original obligor remains a valid, independent entity for purposes of California law. In Mesler v. Bragg Management Co., 39 Cal. 3d 290 (1985), the California Supreme Court made this point very clear while holding that a parent corporation could be sued as the alleged alter ego of its subsidiary, even though the plaintiff had previously reached a settlement agreement with the subsidiary. The Court stated in relevant part as follows:

[W]hen a court disregards the corporate entity, it does not dissolve the corporation. “It is often said that the court will disregard the ‘fiction’ of the corporate entity, or will ‘pierce the corporate veil.’ Some writers have criticized this statement, contending that the corporate entity is not a fiction, and that the doctrine merely limits the exercise of the corporate privilege to prevent its abuse.” (6 Witkin, op. cit. supra, §5, at p. 4317; see, e.g., Comment, supra, 13 Cal. L.Rev. at p. 237.)

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The essence of the alter ego doctrine is that justice be done. “What the formula comes down to, once shorn of verbiage about control, instrumentality, agency, and corporate entity, is that liability is imposed to reach an equitable result.” (Latty, Subsidiaries and Affiliated Corporations (1936) p. 191.) Thus the corporate form will be disregarded only in narrowly defined circumstances and only when the ends of justice so require.

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It is not that a corporation will be held liable for the acts of another corporation because there is really only one corporation. Rather, it is that under certain circumstances a hole will be drilled in the wall of limited liability erected by the corporate form; for all purposes other than that for which the hole was drilled, the wall still stands. 39 Cal. 3d at 300-301.

To the extent that state law is relevant in this context, California law supports the conclusion that an alleged alter ego is a separate entity which is entitled to its own independent CPD rights. (For taxpayers located outside of California, and outside of the Ninth Circuit, the relevant case law will obviously be different.)

The second problem with the IRS’s argument is that the two cases which it cited both pre-date the CDP procedures, which took effect in January of 1999, following the enactment of RRA 1998 in July, 1998. The resolution of the question of whether an alleged alter ego, successor in interest, or transferee of the original taxpayer is entitled their own independent CDP rights will likely depend on the statutory interpretation of the CDP provisions, §§ 6320 and 6330. There are no cases which address this issue. And as is explained in Part 1 of this series of blog posts, the question of how to interpret §§ 6320 and 6330 is likely to be influenced by looking to §§ 6321 and 6331.

Notably, § 6331 refers to the need to provide a “notice and demand” before levy action may be pursued. This is a reference to “notice and demand” as set forth in IRC § 6303(a), which requires the IRS to provide “notice to each person liable for the unpaid tax, stating the amount and demanding payment thereof.” This notice must be sent to the person’s “last known address” within 60 days of the date on which the tax is assessed. Id. Failure to give a valid notice and demand renders void any levy action by the IRS and requires the IRS to refund all monies collected by levy. See Martinez v. United States, 669 F.2d 568 (9th Cir. 1981) (IRS was required to return all funds received by levy where IRS failed to give taxpayer a valid notice and demand under § 6303(a) prior to issuing levies). Failure to give a proper notice and demand also prevents the IRS from taking future administrative enforcement actions such as filing lien notices and issuing levies. See United States v. Coson, 286 F.2d 453 (9th Cir. 1963) (failure to send proper notice and demand to putative partner of a general partnership rendered tax lien void), United States v. Chila, 871 F.2d 1015 (11th Cir. 1989), cert. denied, 493 U.S. 975 (1989) (failure of the IRS to send a valid notice and demand to the taxpayer precludes the IRS from taking administrative collection action with respect to the unpaid taxes but does not prevent a suit to reduce the assessment to judgment), Blackston v. United States, 778 F.Supp. 244 (D. Md. 1991) (Marvin Garbis, J.).

There is a further requirement that the IRS send a notice of intent to levy under IRC § 6331(d) at least 30 days before the IRS levies “upon the salary or wages or property of any person with respect to any unpaid tax.” This requirement, largely forgotten since the enactment of section 6330, has never been repealed. Its primary significance now is that the sending of this notice triggers an increase in the accrual rate of the failure to pay penalty under IRC §§ 6651(a)(2) and (a) (3). See IRC § 6651(d)(1).

The language of §§ 6303(a) and 6331(d) is similar to the language used in §§ 6320 and 6330. Yet we know that the IRS does not send a “notice and demand” for payment under § 6303(a) within 60 days of the date of assessment to alleged alter egos, successors in interest, or transferees who have not been separately assessed that tax liability. Similarly, we know that the IRS does not send § 6331(d) notices to alleged alter egos, successors in interest, or transferees prior to issuing levies against the property of alleged alter egos, successors in interest, or transferees. How is it that the IRS is able to take administrative collection action against alleged alter egos, successors in interest, and/or transferees without complying with §§ 6303(a) and 6331(d)?

The answer to that apparent conundrum may surprise you. While it is possible to argue that the IRS may take administrative collection action against alleged alter egos, successors in interest, and/or transferees who have not been separately assessed a tax liability without complying with the requirements of §§ 6303(a) and 6331(d), it is far from clear that this argument carries the day. There are other arguments, some of which, in my view, have not been properly articulated in recent years. Perhaps Pitts was incorrectly decided, and the IRS is not entitled to take administrative collection action against alleged alter egos, successors in interest, or transferees at all. That topic will be explored in greater detail in Part 3 of this series.

 

 

 

Are Alleged Alter Egos, Successors In Interest and/or Transferees Entitled to their Own CDP Rights?

Today, we welcome back guest blogger A. Lavar Taylor for what is the first in a series of posts.  Lavar’s practice is based in Southern California; however, he handles tax cases across the country.  His latest challenge involves representing individuals in CDP cases who are not the taxpayer. If successful, his latest venture will open up CDP to a group of individuals currently barred from using that procedure. Keith

Introduction

This blog post is the first in a short series of blog posts addressing the question of whether the IRS has been violating the Collection Due Process (“CDP”) procedures since they became effective in January of 1999 by refusing to extend CPD rights to alleged alter egos, successors in interest and/or transferees of the person/entity who/which incurred the tax, i.e., the original “taxpayer,” where no separate assessment has been made against the alleged alter ego, successor in interest and/or transferee.   The IRS would have the public, including tax professionals, believe that the answer to this question is “no,” that these persons are not entitled to their own CDP rights independent of the CDP rights of the original “taxpayer.” This blog post, along with several succeeding blog posts, will explain why the IRS may be wrong on this point.  These posts will also examine the potential procedural obstacles to the Tax Court rendering an opinion on the question of whether alleged alter egos, successors in interest and transferees are entitled to their own independent CDP rights.

These posts will also examine the argument that the IRS is not permitted to take administrative collection action against any of these “secondarily liable” persons at all, absent a separate assessment against them. This argument seems radical, even “protester-like,” on the surface. But if it turns out that these “secondarily liable” persons are not entitled to their own independent CDP rights, this argument is not at all far-fetched.

Why do I have an interest in these topics? Our office recently settled several cases pending in the Tax Court in which we had raised these issues. The Tax Court would have had the opportunity to address the question of whether an alleged alter ego/successor in interest is entitled to its own separate CDP rights under §§ 6320 and 6330, plus various related jurisdictional issues, had these cases not recently settled. Because those cases are now settled, the Tax Court cases are moot.

Because the question of whether alleged alter egos, successors in interest and transferees are entitled to their own independent CDP rights is an important, recurring issue, I am sharing with the tax procedure community the arguments that we made in our now-resolved cases, so that this issue can be raised by other taxpayers and can hopefully resolved by the Tax Court in another case. I use the term “hopefully” purposely. As this series of blog posts will demonstrate, it is an open question whether the Tax Court can acquire jurisdiction to decide the question of whether alleged alter egos, successors in interest and/or transferees are entitled to their own independent CDP rights.

The questions of a) whether the Tax Court can acquire jurisdiction to decide this issue and b) how alleged alter egos, successors in interest and/or transferees can maximize the chances of the Tax Court acquiring jurisdiction will be addressed in future blog posts.   In this blog post, I discuss the relevant statutes and regulations, along with a key case, which the government won, which strongly supports the conclusion that alleged alter egos, successors in interest and/or transferees are entitled to their own independent CDP rights.

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The Statutes

Section 6320 states that any “person described in section 6321” of the Code is entitled to CDP rights under §6320. Section 6320(a)(1). The “person” who is described in §6321 is “any person liable to pay any tax”. Thus, §6320 should apply if there is a “person, ” a tax is owed, and the “person” is “liable” for that tax. Section 7701(a)(1) defines the term “person” very broadly.

The language of §6330 appears to be broader than the language of §6320 in its application. It seemingly requires the IRS to follow the levy CDP procedures not just where the IRS intends to levy on property owned by the person who is liable for the unpaid taxes in question but also where the IRS wants to levy on property that is owned by a person other than the person who is liable for the unpaid taxes in question on which the IRS has a valid lien. Section 6330(a)(1) states that “[n]o levy may be made on any property or right to property of any person unless the Secretary has notified such person in writing of their right to a hearing under this section before such levy is made.”

Section 6331(a) of the Code permits the IRS to levy on “all [non-exempt] property and rights to property” of the “person liable to pay any tax” and on any property on which the IRS has a lien under Chapter 64 (which consists of §§6301 through 6344 of the Code). The ability of the IRS under§ 6331(a) to levy on property on which it has a tax lien, even if the property is not owned by the person who is liable for the unpaid tax liability, seemingly reinforces the notion that §6330 gives CDP rights to all “persons” who own property on which there is a tax lien, even if those persons are not personally liable for the unpaid taxes.

The Regulations

Ah, but what the Code seemingly gives, the regulations clearly tax away. Treasury Regulation §301.6330-1(a) provides in relevant part:

(3)Questions and answers. The questions and answers illustrate the provisions of this paragraph (a) as follows:

Q-A1. Who is the person to be notified under section 6330?

A-A1. Under section 6330(a)(1), a pre-levy or post-levy CDP Notice is required to be given only to the person whose property or right to property is intended to be levied upon, or, in the case of a levy made on a state tax refund or a jeopardy levy, the person whose property or right to property was levied upon. The person described in section 6330(a)(1) is the same person described in section 6331(a) – i.e., the person liable to pay the tax due after notice and demand who refuses or neglects to pay (referred to here as the taxpayer). A pre-levy or post-levy CDP Notice therefore will be given only to the taxpayer.

Q-A2. Will the IRS give notification to a known nominee of, a person holding property of, or a person who holds property subject to a lien with respect to, the taxpayer of the IRS’ intention to issue a levy?

A-A2. No. Such a person is not the person described in section 6331(a)(1), but such persons have other remedies. See A-B5 of paragraph (b)(2) of this section.

What the IRS has done in its regulations is to say that the term “any person” does not really mean any person, but instead means “any person liable for the tax under §6331(a).” While it seems to me that the language of the regulation is inconsistent with the statute on this point,  I will leave that discussion and that fight for another day.   It is not necessary for courts to strike down this regulation to reach the conclusion that alleged alter egos, successors in interest and/or transferees are entitled to their own independent CDP rights under §6330, although striking down this regulation would make it much simpler to reach that conclusion. Striking down the regulation, however, would have no effect on the question of whether alleged alter egos, successors in interest and/or transferees have CDP rights under §6320.

What do the regulations under section 6320 have to say? Here is the relevant portion of Treasury Regulation § 301.6320-1:

(a)Notification –

* * *

Q-A1. Who is the person entitled to notice under section 6320?

A-A1. Under section 6320(a)(1), notification of the filing of a NFTL on or after January 19, 1999, is required to be given only to the person described in section 6321 who is named on the NFTL that is filed. The person described in section 6321 is the person liable to pay the tax due after notice and demand who refuses or neglects to pay the tax due (hereinafter, referred to as the taxpayer). * * *

(b) Entitlement to a CDP Hearing

(2) * * *

Q-B5. Is a nominee of, or a person holding property of, the taxpayer entitled to a CDP hearing or an equivalent hearing?

A-B5. No. Such person is not the person described in section 6321 and is, therefore, not entitled to a CDP hearing or an equivalent hearing (as discussed in paragraph (i) of this section). * * *

These regulations track the language of § 6320, more so than the regulations issued under § 6330 track the actual language of that section.

So what lessons are to be drawn from the regulations as to what “persons” are entitled to CDP rights under §§6320 and 6330? The most important lesson is that, per the regulations, in order for a person to be entitled to CDP rights, they must be a “person liable for the tax” under § 6320 or a “person liable to pay any tax” under § 6331(a).

The Case of Pitts v. United States

With that lesson in mind, I now discuss the important case of Pitts v. United States, 515 B.R. 317 (C.D. Cal. 2014), aff’d, 668 Fed. Appx. 774, 2016 U.S. App. LEXIS 16287, 118 A.F.T.R.2d (RIA) 5644, 2016-2 U.S. Tax Cas. (CCH) P503992016 (9th Cir. 2016)(unpublished opinion), a case which Keith blogged about here.

Importantly, Pitts was a government victory.   The unfortunate fact that the Ninth Circuit buried its conclusion in an unpublished opinion does not lessen the importance of the case. (Note: I filed an amicus curiae brief with the Ninth Circuit in Pitts. My argument in that amicus brief will be discussed in detail in one of the later blog posts on this topic.)

In Pitts, a general partnership incurred unpaid employment taxes. Pitts was a general partner in the partnership. The IRS filed a notice of federal tax lien against Pitts, in her capacity as a general partner, without making a separate assessment against Pitts. Pitts later filed a chapter 7 bankruptcy petition. After obtaining a discharge, Pitts filed an adversary proceeding against the IRS, seeking, inter alia, to invalidate the tax liens evidenced by the notices of federal tax lien filed against her for the taxes incurred by the partnership.  The Bankruptcy Court upheld the validity of the liens, and Pitts appealed to the District Court.

The District Court, in a published opinion, affirmed the holding of the Bankruptcy Court. The District Court acknowledged that the case presented the question of whether the IRS could pursue administrative action against a general partner of a general partnership to collect taxes incurred by the partnership, a question left open by the Supreme Court in United States v. Galletti, 541 U.S. 114 (2004). (Note: I am very familiar with Galletti, because I was co-counsel for Galletti in the Supreme Court and authored almost all of the merits brief filed by Galletti.)

Pitts argued, unsuccessfully, that the IRS could not pursue administrative collection action against her to collect the employment taxes owed by the partnership without making a separate assessment against her under section 6672. She cited to the Supreme Court’s holding in Galletti that a general partner of a general partnership that incurs unpaid employment taxes is not the “employer” who incurs the tax and thus is not “primarily liable” for the partnership’s tax liability, even though the Supreme Court also held that Galletti was “secondarily liable” for those taxes by operation of state (California) law, which allowed the IRS to file a claim against Galletti in bankruptcy.

The District Court, in ruling for the government, characterized the government’s arguments as follows:

But the Government argues that contrary to Pitts’s argument, once the IRS assesses a tax against a general partnership, it need not separately assess the general partners in order to make them liable. The Government contends that since Pitts is liable for DIR’s debts under California law, the tax assessment against DIR for its unpaid employment-tax withholdings suffices to create a tax debt owed by Pitts to the IRS. The IRS further asserts that it did not have to proceed against Pitts under § 6672 but rather could separately pursue her under state law.

The District Court then went on to address the question of whether the IRS can pursue administrative enforcement remedies to collect against Pitts. The Court stated as follows:

But for the IRS to properly record a tax lien as provided under § 6321, Pitts must only be “any person liable to pay any tax”—not necessarily the primarily liable “taxpayer” as Congress has defined that term in § 7701(a)(14) (defining “taxpayer” as “any person subject to any internal revenue tax”). The determination whether Pitts is a “taxpayer” does not establish the IRS’s ability to record a statutory lien under § 6321. Rather, the existence of her federal tax liability for “any tax”—regardless of how that liability arises—is the defining criterion of the tax lien’s validity. As the Court established above, Pitts is in fact liable under federal law for DIR’s unpaid employment-tax withholdings.

This District Court thus held that Pitts was a “person liable to pay any tax” for purposes of section 6321, even though Pitts’ liability for the tax was grounded on state law (California’s version of the Uniform Partnership Act), not based on federal law, such as section 6672.

The Ninth Circuit affirmed the holding of the District Court, albeit in a cowardly manner, via an unpublished opinion. The Court stated:

First, pursuant to the plain language of 26 U.S.C. § 6321, Pitts is a “person liable to pay any tax,” and a lien in favor of the government arises by operation of federal law. See In re Crockett, 150 F.Supp. 352, 354 (N.D. Cal. 1957) (California partner was liable for debts of partnership under state law; accordingly, partner was liable for entire amount of partnership’s employment taxes, and was “person liable to pay” under § 6321’s identically worded predecessor); see also Bresson v. C.I.R., 213 F.3d 1173, 1178 (9th Cir. 2000) (where the IRS relied on state law to establish an individual’s liability, “the government’s underlying right to collect money in this case clearly derives from the operation of federal law (i.e., the Internal Revenue Code)”).

Second, the United States may utilize administrative enforcement procedures to collect the debt from Pitts, because she is secondarily liable for DIR’s assessed debt. See United States v. Galletti, 541 U.S. 114, 122, 124 S. Ct. 1548, 158 L. Ed. 2d 279 (2004) (“After the amount of liability has been established and recorded, the IRS can employ administrative enforcement methods to collect the tax”). The United States is not obligated to make a second assessment against Pitts individually, because the consequences of its assessment attach to the assessed debt “without reference to the special circumstances of the secondarily liable parties.” Id. at 123.

So there you have it. A person who is “secondarily liable” for a tax liability under state law is a “person liable to pay any tax” under §6321. Presumably that person is also “any person liable to pay any tax” for purposes of § 6331.

It would seem to follow that, if a person who is “secondarily liable” for a tax liability under state law is subject to administrative collection action under §§6321 and 6331, such person is also entitled to the protections of the CDP procedures. That topic will be explored in greater detail in the next blog post.

 

What is a Prior Opportunity to Contest the Liability for Purposes of Collection Due Process?

Today, we welcome back guest blogger A. Lavar Taylor.  Lavar’s practice is based in Southern California; however, he handles tax cases across the country.  His latest challenge involves representing taxpayers seeking the opportunity to litigate the merits of their liability in the Tax Court in the context of Collection Due Process (CDP) cases.  The Tax Court has followed the IRS’s lead in its interpretation of prior opportunity to dispute a tax liability.  Both the Tax Court and the IRS deny taxpayers the opportunity to litigate the merits of the underlying liability in many circumstances in which the taxpayer had the opportunity for an administrative hearing even though that administrative hearing with Appeals could not lead to a court hearing.  Because of Lavar, three Circuit Courts of Appeal will soon hear oral argument on the question of what is a prior opportunity to dispute a tax liability which bars a taxpayer from challenging the merits of the underlying tax liability in a collect due process tax case under IRC 6330(c)(2)(B).  Last year when I wrote a new chapter on CDP for the Saltzman and Book treatise, IRS Practice and Procedure, I was struck by the number of unresolved CDP issues that still remain.  I consider this issue the most vexatious of the unresolved issues and the one where the regulations deviate to the greatest extent from the intent of the statute.  We will closely follow Lavar’s efforts and we have written on this before here and here.  If he can succeed in pushing back on the current interpretation of prior opportunity, he will open up for many taxpayers the chance to litigate large liabilities without the need to pay to litigate.  Keith

Back in February of this year, Carl Smith noted in a guest post  that three Circuit Courts of Appeal would be considering the question of the circumstances under which a taxpayer is barred from challenging the merits of the underlying tax liability in a Collection Due Process case under section 6330(c)(2)(B) because of a “prior opportunity” to contest the underlying liability.  Our firm was retained to handle these appeals.  Briefing in all three cases is now complete.  Oral argument in the 7th Circuit case is set for November 9.  Oral argument in the 10th Circuit case is set for November 14.  Oral argument in the 4th Circuit case is set for the last week of January.

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This issue is an important one.  For taxpayers who lack the resources to pay the disputed liability in full and pursue a suit for refund in District Court or the Court of Claims, particularly those taxpayers against whom the IRS may assess (or has already assessed) taxes and/or penalties without resorting to the deficiency procedures, resolution of this issue could determine whether they will ever be able to challenge in court the merits of those taxes or penalties. (The prior statement ignores the fact that taxpayers theoretically can file bankruptcy and commence an objection to the IRS’s proof of claim or an adversary proceeding under section 505 of the Bankruptcy Code.  Bankruptcy is not a feasible option for many taxpayers, however.)

For those taxpayers who have the means to both pay the disputed liability in full and litigate the merits of the liability in a refund suit in District Court or the Court of Claims, resolution of this issue will decide whether they can ever challenge the disputed liability in the Tax Court, which is procedurally more “taxpayer friendly” than District Court or the Court of Claims and is far less expensive in which to litigate than either of these other two fora.

The parties’ briefs are lengthy, although none of the attorneys involved on either side were paid by the word. The briefs are lengthy because resolving this issue in a proper manner requires a detailed knowledge of tax procedure that most appellate Judges lack.  I’m not going to summarize the briefs here, but copies of our opening brief, the government’s responding brief, and our reply brief in the 7th Circuit case can be found here, here, and here.

If you have the time, I strongly recommend reading the briefs.  They contain a number of surprises.  Of particular interest is the fact that the government is arguing that the taxpayers in these three cases are also barred by section 6330(c)(4) from challenging the merits of the liabilities.   This is a new development.  Section 6330(c)(4) has previously been interpreted by the IRS Office of Chief Counsel as only applying to collection-related issues, not to liability-related issues.  IRS Chief Counsel’s prior position, however, has not prevented the Department of Justice from arguing that section 6330(c)(4) prohibits the taxpayers-appellants in these three cases from challenging  the merits of the underlying liabilities.   There are other surprises in the briefs as well, but I leave it to the readers of this blog post to discover them on their own.

The fact that three Courts of Appeal will be considering these issues simultaneously creates the possibility of a Circuit split.   Indeed, the “split” could even be a “fracture,” with the possibility of each Circuit going its own direction.  Of course, we hope for a unanimous reversal of the Tax Court by all three Circuits.

The last interesting point is that I will get to spend Election Day in Chicago.  Having grown up in downstate Illinois, I’m familiar with the unofficial state slogan of Illinois, which is “Vote Early, Vote Often.”  I jokingly suggested to one of my colleagues that, having voted early here in California, my trip to Chicago might afford me the chance to vote more than once.  He responded that I should check to see whether the records show that I have continuously voted in Illinois since leaving the state almost 40 years ago.  He has a point.  When I’m not busy preparing for oral argument, I will check that out.

 

SECC Corporation v. Commissioner: How It Started, How It Ended, and What Might Happen Going Forward

Today is the last installment of Lavar Taylor’s three-part post on the SECC v Commissioner case, a case that is now a foundational case in understanding the Tax Court’s jurisdiction to hear employment tax disputes. The first two parts of this three-part post can be found here and here. In this post, Lavar explains the aftereffects of the opinion, including the IRS’s about-face on the issue, the likely reasons and consequences of the IRS position and the very successful ultimate resolution of the SECC case. Les 

Government Reaction to Tax Court Opinion

Speaking of appeals, I turn now to the government’s reaction to the Tax Court’s opinion in SECC. I’m certain that the IRS was just as surprised as I was at the outcome. I am also certain that they liked the outcome far less than I did. After all, I now had a chance to prove that the IRS should lose on the merits, without having to foray into District Court. (I’ve litigated a worker classification dispute in District Court before. See Vendor Surveillance Corp. v. United States, 97-2 U.S.T.C. ¶50,527 (9th Cir. 1997)(unpublished decision reversing award of attorney’s fees under section 7430 after taxpayer prevailed in a jury trial in a worker classification case). Trying this type of case in District Court is extremely expensive.) If SECC lost at trial, SECC could still appeal the decision on jurisdictional grounds.

The IRS, however, initially was not content to let the matter go to trial and then deal with the jurisdictional issue in a post-trial appeal. Rather, they told me, and the Tax Court, that they were considering seeking leave to file an interlocutory appeal of the jurisdictional issue to the Ninth Circuit. As seasoned tax controversy attorneys know, however, the IRS does not get to decide whether they will ask the Tax Court for leave to file an interlocutory appeal. Only the Solicitor General, after consulting with the Department of Justice Tax Division’s Appellate Section, gets to authorize the pursuit of an interlocutory appeal.

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Having worked in the General Litigation Division of the IRS National Office in the early 1980’s, where I carried the bags of the IRS attorneys who met with the attorneys from the Appellate Section of DOJ Tax Division, and having observed strenuous disagreements between these IRS and DOJ attorneys about whether to appeal an adverse ruling, I was quite familiar with the procedure that had to be followed in order to authorize an interlocutory appeal. I knew that lots of government attorneys would be involved and that there would be lots of meetings. Keith Fogg accurately described this process in parts 1 and 2 of The Room of Lies. I sat in the Room of Lies on many occasions, albeit as a lowly bag carrier. Based on my experience, I thought the process might take a few months, six months at most.

Time passed without any decision. In December of 2014, the IRS issued Chief Counsel Notices CC-2014-11 and CC-2015-1, in which IRS Chief Counsel’s Office formally announced to the world that they disagreed with the Tax Court’s holding in the SECC opinion. I waited some more. It was not until March of 2015 that the IRS formally advised the Tax Court that the decision had been made to not pursue an interlocutory appeal of the jurisdictional issue.

What happened? Apparently DOJ and the Solicitor General’s Office disagreed with the IRS. While no one has told me the story, I’m certain I could come up with a fairly accurate script of the conversations that took place. The attorneys in the IRS who were involved in drafting Notice 2002-5, supra, no doubt pushed hard for the SG to pursue an interlocutory appeal. They were vested in their “creation” (the Notice) and pushed hard for what they thought was a righteous cause.

The DOJ Appellate attorneys no doubt had significant reservations about pursuing an interlocutory appeal. The DOJ attorneys were likely concerned about the possibility that SECC might prevail on the jurisdictional issue in the Ninth Circuit. They were also likely concerned about the fact that the Ninth Circuit’s opinion in Charlotte’s Office Boutique, Inc. v. Commissioner, 425 F.3d 1203 (9th Cir. 2005), was, to say the least, somewhat in tension with the position argued by the Commissioner on the jurisdictional issue in the Tax Court. They may have also been concerned about the fact that the Ninth Circuit has not always been particularly kind to the IRS in section 530 cases. Regardless of why the government did not pursue an interlocutory appeal, I was now looking at a Tax Court trial, or, if the Tax Gods were with me, a settlement that my client could live with.

After learning that the IRS would not be pursuing an interlocutory appeal, I learned that the IRS was auditing the income tax returns of cable splicers in southern California. The IRS undoubtedly learned what I had previously learned, namely, that during the quarters at issue in the SECC case, the entire cable splicing industry in southern California treated the cable splicers as “dual status” workers, the same as SECC had done. Thus, the IRS was now aware that I could make a strong “industry practice” showing in support of my section 530 argument, in addition to showing that the IRS advised my client to do business the way that it did, and showing that my client consistently followed all information reporting requirements. The IRS may have also learned that the argument that the cable splicers were in fact independent contractors for all purposes had some merit.

The Government’s Change in Views: The Agreement with the SECC Holding

Near the end of 2015, the IRS issued Chief Counsel Notice CC-2016-002. In this Notice, the IRS announced to the world that it was now in agreement with the Tax Court’s holding in the SECC case! About this time, I had a telephone conversation with the IRS attorney handling the case. As the result of this telephone conversation, I submitted a formal settlement offer to the IRS. The amount of the offer? A total of $25,000 in taxes, spread out over all of the quarters in question. In return, my client would concede that the workers in question were employees for all purposes of Subtitle C during the quarters at issue. (Such a result would have been metaphysically impossible had the case gone to trial. That is why settlements were invented.) Not too long thereafter, the offer was accepted. A similar story played out in the one other case handled by our office that had not previously settled. The SECC case was over.

So what happened? Why the change in position by the IRS on the jurisdictional issue? While no one from the IRS has even hinted to me why this happened, I don’t think it is too hard to surmise why the change in position took place. With the change in position, it is very unlikely that the IRS will ever “blow” a statute of limitations in an employment tax case, and it is unlikely that the Tax Court’s holding in SECC will be reversed by a Court of Appeals any time soon.

It appears from the Tax Court’s opinion in SECC that, once a “determination” is made by the IRS under section 7436(a), the statute of limitations on assessment is suspended. While there may be some practical problems in determining when that suspension begins and ends, the IRS can avoid having to deal with those kinds of issues by requiring taxpayers to sign written extensions of the statute of limitations prior to the earliest possible expiration of the statute of limitations on assessment or, if no written extensions are forthcoming, by issuing a notice of determination to the taxpayer under section 7436(b) prior to the earliest possible expiration of the statute of limitations on assessment. Most taxpayers will sign the statute extensions, in the hope that the case will eventually settle.

The number of Tax Court petitions that will be filed prior to the issuance of a Notice of Determination under section 7436(b) will be small. Most taxpayers will want to try to settle with the Office of Appeals before going to court, and most cases handled by the Office of Appeals will settle. It is very unlikely that rational taxpayers will file a Tax Court petition prior to the issuance of a Notice of Determination under section 7436(b) with the idea that they will thereafter challenge the jurisdiction of the Tax Court on the grounds that no Notice of Determination was issued. Such a taxpayer, after losing on the jurisdictional issue in Tax Court, would then have to appeal the Tax Court’s ruling to a Court of Appeals after going to trial or settling the case. It is unlikely that any appeal would be filed after a settlement has been reached.

Compare that situation with the situation that would have resulted if the IRS had not acquiesced in the Tax Court’s ruling in SECC and had instead continue to argue that no Notice of Determination was required to be issued in cases such as SECC. The Ninth Circuit would have eventually ruled on the jurisdictional issue. If they had ruled in favor of SECC, the employment tax world would again have been thrown into a state of chaos. Statutes of limitations would have been “blown.” Uncertainty regarding the Tax Court’s jurisdiction would have continued, pending an eventual ruling by the Supreme Court in SECC or in some future case. The Supreme Court’s ruling might not have come until after a Circuit split developed. Uncertainty when it comes to the jurisdiction of the Tax Court is not a good thing.

Uncertainty would still have lingered even if the Ninth Circuit had sustained the Tax Court, because the IRS would have continued to challenge the Tax Court’s ruling in SECC. That uncertainty would not have been a good thing.

It is certainly possible that, at some point in the future, a Court of Appeals will have occasion to rule on the jurisdictional issue decided in the SECC case. In any appeal from a decision in a 7436 case where the Tax Court petition was filed without the issuance of a Notice of Determination under section 7436, the Court of Appeals will have an independent duty to determine whether the Tax Court had jurisdiction below. It is possible that the situation will play out in a manner similar to how the case law played out after the IRS acquiesced in the Tax Court’s holding in Fernandez v. Commissioner, 114 T.C. 324 (2000), that it had jurisdiction to review determinations under section 6015(f), only to see the Ninth Circuit later hold that the Tax Court lacked jurisdiction to review such determinations in Commissioner v. Ewing, 439 F.3d 1009 (9th Cir. 2006). But even if that were to happen, the IRS’s recent acquiescence in the Tax Court’s holding in SECC will create much less chaos and uncertainty in the near future than if the IRS had not acquiesced in that holding.

The Resolution of the SECC Case

The IRS’s acquiescence in the Tax Court’s holding in SECC, however, came with a price for the government. In order to avoid having SECC possibly upset the apple cart by appealing the jurisdictional issue to the Ninth Circuit, the IRS had to settle the SECC case (and the related case) on terms that would ensure that SECC would not appeal the jurisdictional issue. To its credit, the IRS did just that. Regardless of the IRS’s motivation for settling on the terms that it did, my own view is that the result in the case was a fair one given the unusual facts of the case, even though the taxpayer had to wait a long time for that result.

Note, however, that future litigants with issues similar to the issues raised in the SECC case will face obstacles not faced by SECC. The IRS, in Chief Counsel Notice CC-2016-002, supra, has indicated that it intends to challenge arguments by taxpayers that they are entitled to section 530 relief or are entitled to section 3509(a) rates in cases with fact patterns similar to the fact pattern in SECC. While I think that Chief Counsel is taking a position that is wrong both legally and from a standpoint of fairness to taxpayers who face situations similar to the situation faced by SECC, that topic is for another day.

Looking Ahead to Future Disputes and a Nod to the Professionalism of the Government Counsel

Perhaps the most interesting cases going forward will focus on when a “determination” has taken place or, more likely, will focus on when the suspension of the statute of limitations on assessment begins and ends. In cases where the IRS has used the “belt and suspenders” approach of obtaining written extensions of the statute of limitations, statute of limitations issues are not likely to arise. But in cases where the IRS relies solely on the Tax Court’s interpretation of section 7436 in SECC to keep the assessment statute of limitations on assessment open, statute of limitations issues could arise. Notably, these issues could arise either in Tax Court litigation or in District Court refund litigation. Thus, it is possible that District Courts will be issuing rulings on statute of limitations issues in situations in which the resolution of the statute of limitations issue will turn on whether the Tax Court decided the jurisdictional issue correctly in SECC.

In closing, I would like to tip my cap to the government counsel with whom I worked in the SECC case and related cases. Their professionalism was greatly appreciated, even when we vehemently disagreed with each other’s legal positions. I would also like to tip my cap to Robert Horwitz and Barry Furman. Robert, who has moved on from our firm after growing tired of driving from Santa Monica to Orange County and back every day for almost 20 years, worked by my side as we crafted our arguments in the SECC case. Barry, who was co-counsel with me, and lead trial counsel, some 22 years ago in the Vendor Surveillance case mentioned earlier, served as a sounding board for our case strategy. Both of these fine attorneys were of great help to me in handling this matter.

SECC Corporation v. Commissioner: How It Started, How It Ended, and What Might Happen Going Forward

In yesterday’s post guest poster Lavar Taylor set the table for the dispute before the Tax Court in SECC v Commissioner, a case that considers the Tax Court’s jurisdiction to hear employment tax disputes under Section 7436. Today Lavar walks us through the Tax Court’s surprising resolution of the dispute. Les

If you read Part 1 of this post, you now understand what I meant when I said that the SECC case was a tax procedure nerd’s dream and a client’s nightmare. The tax procedure issues in the case were ubiquitous. Things were about to get even more interesting.

On April 3, 2014, the Court issued a reviewed opinion in SECC Corporation v. Commissioner, 142 T.C. 225 (2014)(“SECC”). At the time the Court released its opinion, I was meeting with an IRS Appeals Officer in another case. Someone from the IRS interrupted that meeting to tell me that I had “won” the SECC case, without explaining the contents of the Court’s opinion. Of course, regardless of how the Court ruled, the case would not be over. Given the IRS’s vigorous advocacy of its position, I anticipated they would appeal if the Court granted our motion to dismiss for lack of jurisdiction. I returned to my office, eager to find out exactly how I had “won” the case.

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The Majority Opinion

The Tax Court issued a reviewed opinion in the SECC case, with the majority opinion (authored by Judge Colvin and joined by 14 other judges) denying both parties’ motions to dismiss and holding that the Court had jurisdiction to determine the merits of the disputed employment tax liabilities. The majority opinion properly noted that it has an independent duty to determine whether it has jurisdiction, even where both parties argue that the Court lacks jurisdiction, and that the Court owes no deference whatsoever to the IRS’s view, whether expressed through regulations or otherwise, as was the case in SECC, see Notice 2002-5, 2002-1 C.B. 320, that the Court lacks jurisdiction over the case.

The majority opinion then held that the Tax Court had jurisdiction to determine the merits of the disputed employment tax audit deficiencies even though the IRS had never issued a Notice of Determination under section 7436(b). The majority opinion pointed out that section 7436(a) gives the Tax Court jurisdiction if there is a “determination” made as the result of an audit and there is an actual controversy regarding whether workers are employees for purposes of Subtitle C or whether the taxpayer is entitled to relief under section 530. That subsection says nothing at all about a “notice of determination.”

Per the majority opinion, the legislative history of section 7436 makes clear that a mere “failure to agree” regarding the result of an employment tax audit could constitute a “determination” under section 7436(a) which would trigger a taxpayer’s right to file a Tax Court petition. Once there has been a “determination,” the taxpayer’s right to file a petition with the Tax Court to challenge the results of the employment tax audit is limited only when the IRS issues a Notice of Determination by certified or registered mail under section 7436. When that happens, the taxpayer must file a petition within 90 days after the date of that notice in order to invoke the Tax Court’s jurisdiction. Thus, per the majority opinion, section 7436 is similar to the statutory scheme governing refund claims. Under that scheme, the taxpayer has the right to go to court at any time after a refund claim has been filed and six months have passed since the filing of the claim, but the taxpayer’s right to go to Court has a two year time limitation once the IRS issues a formal denial of the claim for refund.

The majority opinion also noted that Congress, in section 7436(d), failed to make the principles of section 6212 applicable to determinations under section 7436(a). Rather, Congress incorporated only “the principles of subsections (a), (b), (c), (d), and (f) of section 6213, section 6214(a), section 6215, section 6503(a), section 6512, and section 7481” as applying to proceedings brought under section 7436. The majority opinion also noted that the principles of these sections were to apply in the same manner as if the Secretary’s determination described in subsection (a) were a Notice of Deficiency (emphasis added).

Thus, per the majority opinion, it is a “determination” under subsection (a) of 7436, and not the Notice of Determination under section (b), that triggers, among other things, the taxpayer’s right to file a Tax Court petition and the related restrictions on assessment and collection of the employment taxes which are the subject of the dispute between the IRS and the taxpayer who is being audited. It would appear that the “determination” under subsection (a) also starts the suspension of the statute of limitations on assessment. More on how that might work later.

As for applying these principles to SECC’s case, the majority opinion held that SECC’s petition was timely because the IRS had never sent SECC a Notice of Determination by certified or registered mail as required by subsection 7436(b). There had previously been a “determination” under section 7436(a) in connection with an audit and there was an actual controversy when Appeals issued their letter dated April 15, 2011, and SECC was entitled to file a Tax Court petition at any time thereafter until the 90th day after a notice was sent to SECC by certified or registered mail.

The Concurring Opinion

A concurring opinion, authored by Judge Halpern and joined by eleven other Judges, joined the majority opinion “without reservation” and noted that the majority reached the correct conclusion as a matter of tax policy. Judge Halpern noted that sustaining the IRS’s position would “improperly permit the Commissioner to determine, in his sole discretion, whether a taxpayer shall have access to this Court in order to resolve [a worker classification dispute such as the dispute between SECC and the Commissioner].” Judge Halpern went on to say:

Were we to adopt respondent’s position, the Commissioner, by refusing to issue a notice of determination, would be able to deny the taxpayer access to this Court, which he may be tempted to do whenever he feels his chance of success on a worker classification or RA ’78 sec. 530 issue is better in either the District Court or the Court of Federal Claims than this Court. There is no basis in section 7436 or as a matter of policy for granting the Commissioner this “forum shopping” discretion, and it would thwart the obvious congressional intent embodied in that provision to permit taxpayers, in their discretion, to litigate, in this Court, worker classification and RA ’78 sec. 530 issues that the Commissioner has raised on audit.

The Dissenting Opinion

Judges Goeke and Kerrigan dissented. They stated that the structure of section 7436 indicates that the Court should treat a worker classification determination as if it were a deficiency determination in an income tax case. They expressed concerns that the majority’s approach will result in administrative problems. They posed a number of questions which they thought did not have appropriate answers under the approach taken by the majority, such as whether the IRS would be able to assess a disputed employment tax deficiency after the IRS made a “determination” (without sending a Notice of Determination under section 7436(b)) but the taxpayer failed to file a Tax Court petition within 90 days of the date of the determination. Thus, in their view, the Tax Court should not have jurisdiction over a worker classification case unless the IRS has issued a notice of determination under section 7436(b). Since the parties agreed that no such notice had been issued to SECC, the dissenters would have dismissed the petition for lack of jurisdiction.

As for whether the IRS should have issued a Notice of Determination, the dissenters stated that the Court should not have “delved” into the administrative record to determine whether the IRS had made a “determination” under section 7436(a). Rather, they would have permitted the IRS to decide unilaterally when its examination warrants the issuance of a Notice of Determination, leaving the IRS to bear the consequences associated with making an invalid assessment if it turned out that the IRS was in fact required to issue a Notice of Determination before assessment of the employment tax deficiencies.

The dissenters left little doubt about how they viewed the merits of the dispute. They viewed the case as a pure accountable plan case and believed that the majority’s approach set a “dangerous precedent” which would allow any taxpayer in an accountable plan case to make the arguments that SECC made and transform its case into a worker classification dispute. The dissenters stated that “[t]he IRS could have reasonably concluded that the worker classification arguments were frivolous and did not justify a determination.”

Wait a minute. Stop the presses. Did the dissenters call my arguments frivolous? FRIVOLOUS? My arguments have been called many things over the past 35 years: “creative,” “clever,” “aggressive,” “too cute by half,” even that dreaded five letter word – “wrong.” But my arguments had never before been called “frivolous.” Perhaps the only thing worse would have been if Justice Scalia had called my arguments “legalistic argle-bargle.” See Windsor v. United States, 570 U.S. ___, 133 S.Ct. 2675, 2709 (Scalia dissenting). (Fortunately I escaped that fate. Justice Scalia, like all the other Justices, ignored the amicus brief I filed in the Windsor case.)

I can’t let that characterization of my arguments by the dissenting Judges go unchallenged. Was it “frivolous” to argue that the cable splicers were true independent contractors when the Fifth Circuit had previously held that similarly situated cable splicers were independent contractors? I don’t think it was. Was it “frivolous” to argue that, in the alternative, my client was entitled to section 530 relief when, among other things, a) the entire cable splicing industry in southern California treated the cable splicers the way SECC treated them during the periods in question, b) SECC had always complied with the rules regarding the issuance of information returns such as Forms 1099, c) the IRS had previously told SECC to treat the cable splicers the way they did, and d) there was absolutely no case law which addressed the question of whether SECC was entitled to section 530 relief where it had treated the workers as “dual status” workers for tax reporting purposes? I don’t think it was. Was it “frivolous” to argue in the alternative that the taxes owed by SECC should have been computed based on section 3509(a) rates when SECC believed (based on advice given by the IRS itself) that it had been doing things properly? I don’t think it was. Was it “frivolous” to argue in the alternative that the taxes owed by SECC should have been reduced under section 3402(d)? I don’t think it was.

I really don’t think that the dissenters thought that statement through before they wrote it. And I certainly hope that if any of their friends or neighbors ever run a business and receive a bill from the IRS for $1.5 million in taxes as the result of doing business in the manner in which they were told to do business by the IRS, the dissenters would urge their friends or neighbors to use all arguments at their disposal to fight that bill, just as SECC did. Frivolous? Bah, humbug! I’ll fight that characterization to my dying breath. (Now Keith and Les understand why I did not want to write this post until the case was over.)

Now that I have vented my spleen, I have a more important point to make about the dissent. The dissenters’ suggestion that the IRS can ignore the rules just because the IRS (or a Tax Court Judge) believes that a taxpayer’s argument is frivolous is an extremely dangerous idea that, if adopted by the IRS and the Courts, could seriously damage our voluntary compliance system. The fact that the government must follow proper procedures, and can be held accountable if it fails to do so, is as much a bedrock of our voluntary compliance system as is the willingness of taxpayers to voluntarily file their tax returns and (usually) file an income tax return that consists of non-fiction instead of fiction.

The government doesn’t convict criminal tax defendants and throw them in jail without a trial just because the IRS or a Judge thinks that their arguments are “frivolous.” Instead, the government gives them a trial, along with an opportunity to appeal the result at the trial if they don’t like the outcome of the trial. Nor do we allow the IRS to assess income tax deficiencies without issuing a Notice of Deficiency just because the IRS or a Judge believes that the taxpayer’s arguments are “frivolous.” Rather, the IRS must first issue the taxpayer a Notice of Deficiency, and the taxpayer can file a petition and seek a trial in the Tax Court. If the taxpayer does not like the result there, they can appeal to the Courts of Appeal. And sometimes it turns out that an argument that the lower court thought was “frivolous” turns out to have been a winning argument.

Even where taxpayers lose, and lose badly, however, the taxpayer can say that they had their day in court, and third-party observers can take comfort in the fact that, should they ever end up in a wrestling match with the IRS, the IRS (and the courts) will give them a fair shake by following the rules, instead of bending the rules whenever they don’t think much of the taxpayer’s arguments. When taxpayers are convinced that the IRS does not follow the rules and/or the Courts don’t follow the rules, they are less likely to comply with the law.

In the third and final part, I will discuss the aftermath of the SECC opinion, including the reasons and consequences of the IRS position and the ultimate resolution of the case.

 

SECC Corporation v. Commissioner: How It Started, How It Ended, and What Might Happen Going Forward

In this three-part post, we welcome back Lavar Taylor, who discusses one of the more interesting procedural cases of the past few years, SECC v Commissioner. As Congress has expanded the types of cases that the Tax Court may consider, the court, the IRS and taxpayers themselves often struggle to apply ambiguous rules to complex real life situations. The SECC case involves the extent of the Tax Court’s jurisdiction to hear employment tax disputes under Section 7436. Lavar, counsel for SECC and a gifted lawyer with a deep knowledge of procedural issues, takes us through the issues he and his client confronted, the arguments that both parties raised, the somewhat surprising Tax Court opinion, and the underlying concerns that led to the IRS settling SECC and eventually issuing a Notice expressing its agreement with the decision. Les

When the Tax Court issued its opinion in SECC Corporation v. Commissioner, 142 T.C. 225 (2014)(“SECC”), no one was more surprised than I was. After all, how often does the Tax Court hold that it has jurisdiction over a case when both parties have filed motions to dismiss the petition for lack of jurisdiction (albeit based on different grounds). The Tax Court’s opinion in SECC radically altered the landscape on the question of when the Tax Court has jurisdiction under section 7436 of the Internal Revenue Code (“Code”) to resolve worker classification disputes which affect the amount employment, withholding, and unemployment taxes for which an employer (or putative employer) may be liable under the Code. (Worker classification disputes can also arise in income tax deficiency proceedings, but SECC was not an income tax deficiency case.)

Not long after the Tax Court issued its opinion in SECC, Les Book and Keith Fogg asked me whether I would do a guest blog post about the SECC opinion. Because the Tax Court’s opinion in SECC did not resolve the litigation, however, I respectfully declined their invitation. I told them that I did not want to say anything about the opinion until the case concluded. I did, however, indicate that, subject to the approval of my client, I would do a blog post once that case (and two similar cases in which no published decisions or orders were ever issued by the Court) was resolved.

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That day has finally arrived. The SECC case has now settled (as have the other two cases), and the stipulated decisions in all of these cases are now final. Those of you who are already familiar with the opinion in SECC understand that, now that the SECC case is resolved and the Tax Court’s stipulated decision is final, the Ninth Circuit Court of Appeals will never opine on the question of whether the Tax Court had jurisdiction in SECC. Whether the Courts of Appeal might rule on that jurisdictional issue in a future case is a topic I discuss later.

This post is the first of three posts discussing the SECC opinion. Part 1 discusses how the case arose and the arguments made by the parties leading up to the issuance of the Court’s opinion in 2014. Part 2 discusses the majority, concurring, and dissenting opinions in the case.  Part 3 discusses the case’s aftermath, the resolution of the case, and the practical effect of the case going forward.

How the Case Arose

The SECC case was a tax procedure nerd’s dream – and a client’s nightmare. Few other cases have taxed my knowledge of tax procedure as this case did. Not all of the tax procedure issues in the case were addressed in the Tax Court’s opinion, as you will see.

The case started innocently enough with an employment tax audit of the company’s Forms 941 for the 1st quarter of 2005 through the 4th quarter of 2007. SECC had cable splicers who it paid two different ways during the quarters at issue. First, the company paid “wages” to the splicers for their labor. These “wages” were reported as wages on the company’s Forms 941, and Forms W-2 were timely issued to all of the splicers. Second, the company paid “rent” to the splicers for their specialized equipment and tools. The equipment and tools generally took the form of specially equipped trucks that were rather expensive to buy. The splicers owned the specially equipped trucks, and there were rental agreements signed by the parties under which SECC paid “rent” to the splicers for the use of their truck. The “rent” that was paid by SECC to the splicers was reported on Forms 1099 that were timely issued to the splicers. SECC’s tax compliance record, from SECC’s perspective, was spotless.

Those of you who deal with employment taxes by now have probably started muttering phrases like “What about an accountable plan?” There was no accountable plan during the quarters at issue. What there was, however, was an employee of SECC (a former employee by the time of the IRS employment tax audit) who had, prior to 2005, called the IRS for instructions on how SECC should treat the “rent” payments to the splicers. This employee, after describing the “dual” arrangement with the splicers to the IRS over the phone, was told by the IRS that the dual status of the workers was proper, and that the “rent” payments should be reported on Forms 1099 issued to the splicers, while the “wages” should be reported on Forms W-2 issued to the splicers. SECC dutifully followed the advice given by the IRS employee.

The company had even undergone an income tax audit prior to the start of the employment tax audit, in which the Revenue Agent asked for copies of the company’s employment tax returns. The company emerged from that income tax audit with a “no change” audit report, believing that the company was correctly reporting both the “wages” and the “rent” paid to the splicers.

Then came the employment tax audit. At the conclusion of that audit, the Revenue Agent issued an audit report reclassifying as “wages” all of the “rent” paid to the splicers during all twelve quarters in the audit. Taxes were computed using the maximum rates, with no adjustments under section 3509. No consideration was given to section 530 of the Revenue Act of 1978. There was no discussion of possibly reducing the assessment under section 3402(d). The proposed employment tax assessments were roughly $1.2 million, plus proposed penalties, and statutory interest. Had these proposed liabilities been sustained, they would exceed $2 million today.

Both Parties’ Arguments At Exam and Appeals

At that point, my firm was retained. We filed a timely protest, arguing, inter alia, that a) the splicers should have been treated as independent contractors for all purposes (i.e., that the payments to the splicers that had been treated as “wages” for employment tax purposes were not in fact “wages” for employment tax purposes because the splicers were actually independent contractors), b) alternatively, the splicers were “dual status” workers, i.e., they were independent contractors with respect to the rent payments even if they were employees with respect to the “wage” payments, see Rev. Rul. 82-83, 1982-1 C.B. 151, c) in the event the splicers were employees with respect to the “wage” payments, section 530 provided complete relief from the proposed assessments, d) in the alternative, section 3509(a) rates applied, or e) in the further alternative, that the assessments should be reduced under section 3402(d) because the splicers had paid their own income taxes on the “rent” income.

The argument that the splicers were independent contractors for all purposes was potentially meritorious. The Fifth Circuit had previously held in Thibault v. BellSouth Telecommunications, Inc., 612 F.3d 843 (5th Cir. 2010), a case not directly involving any tax issues, that cable splicers were independent contractors.

The Office of Appeals ultimately sustained the results of the audit report and notified SECC by letter dated April 15, 2011 that the proposed employment tax liabilities would be assessed as proposed by the Examination Division. The history of the case between the date of the submission of the protest to the audit report and the decision by the Office of Appeals to sustain the results of the audit report is itself rather lengthy. I don’t describe that history in detail here, because that history is not legally relevant to the outcome of the case.

Suffice to say, however, I was not in a good mood by the time Appeals sustained the results of the audit report. Despite the fact that a) the case was handled by three different Appeals Officers, b) the case was returned to the Examination Division for factual development, and c) at one point in time I suggested that Appeals request Technical Advice on the question of whether section 530 relief is available in situations where the taxpayer has treated workers as “dual status” workers for employment tax purposes, the case was never factually developed by the IRS. (Examination returned the case to Appeals without requesting any information from us and without doing any additional work.) It appeared to me that no serious effort was made by anyone in the IRS to look at the issues which were raised in the protest.

I was in an even less charitable mood after the IRS sent bills to SECC totaling roughly $1.5 million, without first issuing a Notice of Determination under section 7436. I picked up my Code and read section 7436, which can be read in relevant part (subsections (a) – (d)) here.

My reading of section 7436 was that the IRS was required to send a Notice of Determination to SECC before assessing any additional employment taxes in this situation. After all, there was a dispute as to whether the splicers were independent contractors or employees and, even if they were employees as to the “rent” payments, there was a dispute as to whether section 530 applied. I discovered, however, that the IRS did not share my view on that point.

In Chief Counsel Advice Memo 200009043 (January 4, 2000), the IRS Chief Counsel’s Office discussed the circumstances under which the IRS believed it was required to issue a Notice of Determination under section 7436 before assessing additional employment taxes against a taxpayer. The memo discussed at length the circumstances under which Chief Counsel’s Office believed there was (or was not) an “actual controversy” within the meaning of section 7436(a) which required the IRS issue a Notice of Determination under that section.

It is clear from reading this Chief Counsel Memo that there had been a debate within Chief Counsel’s Office about the definition of the term “actual controversy.” It is likewise clear that, if a person (whether a worker or a corporate officer) had been treated as an “employee” for employment tax purposes, i.e., the person had been treated by the taxpayer on a Form 941 as having been paid “wages,” Chief Counsel’s Office position was that the IRS was not required to issue a Notice of Determination to the taxpayer before assessing additional employment taxes against the taxpayer based on “non-wage” payments that had been made to the person(s) who had been treated as an employee for employment tax purposes.

I thought the reasoning of the Chief Counsel Memo was faulty. The fact that a person had been treated as an “employee” on a taxpayer’s employment tax return did not preclude that person from being treated as an independent contractor with respect to payments to that person which were not treated as “wages” for employment tax purposes. Situations involving “dual status” workers had been addressed by the IRS for a number of years. See Rev. Rul. 82-83, supra. Furthermore, the Chief Counsel Memo failed to address the fact pattern in the SECC case, where, in response to the issuance of the audit report, SECC took the position that the amounts reported as “wages” on the relevant Forms 941 were not wages at all because the workers in question were independent contractors.

Notwithstanding our disagreement on this point, there was another key point on which I agreed with the IRS. The IRS had previously concluded that the IRS must issue a Notice of Determination under section 7436 before the Tax Court can exercise jurisdiction under section 7436. See Notice 2002-5, 2002-1 C.B. 320 and Notice 98-43, 1998-2 C.B. 207. The Tax Court also apparently agreed with this conclusion in Henry Randolph Consulting v. Commissioner, 113 T.C. 250, (1999), see also Charlotte’s Office Boutique, Inc. v. Commissioner, 425 F.3d 1203 (9th Cir. 2005), affirming 121 T.C. 89 (2003). For what it was worth (which turned out to be nothing), I also agreed with this conclusion.

Based on our belief that the IRS should have issued a Notice of Determination under section 7436 to SECC before assessing additional employment taxes and our belief that the Tax Court could not exercise jurisdiction under section 7436 unless the IRS first issued a Notice of Determination under that section, we decided that the appropriate course of action was for SECC to file a petition with the Tax Court and then seek to dismiss the petition based on the failure of the IRS to issue a valid Notice of Determination prior to assessing the additional taxes against SECC. We hoped that the Court would analogize to the line of cases that permits taxpayers to file a petition and then seek to dismiss that petition for lack of jurisdiction where the IRS failed to issue a valid notice of deficiency to the taxpayer because the notice of deficiency was not sent to the taxpayer’s last known address. See O’Brien v. Commissioner, 62 T.C. 543 (1974). While there were other potential judicial remedies available to challenge the procedural validity of the audit assessments, those other potential remedies posed difficulties. I discuss other potential remedies and the difficulties associated with these potential remedies below.

The Issues Before the Tax Court 

The petition in SECC was filed in February of 2012. (For those of you wondering whether the petition was filed after what we believed was the expiration of the statute of limitations on assessment for the quarters at issue, the answer is yes, it was. Interestingly, the IRS had earlier concluded that the filing of a Tax Court petition under section 7436 by a taxpayer, where the IRS had previously failed to issue a Notice of Determination under section 7436(b) did NOT suspend the running of the statute of limitations on assessment. Chief Counsel Memoranda 200240042, June 28, 2002.) Both parties filed motions to dismiss for lack of jurisdiction.

The IRS argued that the Tax Court lacked jurisdiction because the IRS had never issued a Notice of Determination under section 7436. They further argued that the IRS had not made any “determination” within the meaning of section 7436 but that, if the notice to SECC that the Office of Appeals was sustaining the audit report was a “determination” within the meaning of section 7436, the petition was untimely because it had been filed more than 90 days after the date of the notice.

The IRS also argued that the Tax Court lacked jurisdiction to rule on the question of whether the IRS was required to issue a Notice of Determination to SECC under section 7436 prior to assessing the additional taxes against SECC. Per the IRS, because it was agreed by the parties that no Notice of Determination had been sent to SECC, the Court simply had no jurisdiction to say anything other than it lacked jurisdiction due to the failure of the IRS to issue a Notice of Determination. That argument was troubling to me.

SECC argued that the Tax Court, in dismissing the petition for lack of jurisdiction, was required to address the question of whether the IRS was legally required to issue a notice of determination under section 7436 prior to making the large audit assessments against SECC. In support of that position, SECC cited to Rosewood Hotel, Inc. v. Commissioner, 275 F.2d 786 (9th Cir. 1960).

In Rosewood, the taxpayer filed a petition that was unquestionably late, but the taxpayer argued that the Notice of Deficiency was invalid because it had not been sent to the taxpayer’s last known address. The Tax Court dismissed the petition for lack of jurisdiction as being untimely, without addressing the question of whether the Notice of Deficiency had been sent to the taxpayer’s last known address. On appeal, the Ninth Circuit vacated the dismissal order and remanded the case with instructions to the Tax Court to decide the question of whether the Notice of Deficiency had been sent to the taxpayer’s last known address. By analogy, SECC argued that the Tax Court was required by Ninth Circuit case law to address the question of whether the IRS was required to issue a Notice of Determination to SECC prior to assessing the deficiency in employment taxes.

SECC also argued that, if the Tax Court were to hold that it did not have jurisdiction to rule on whether the IRS was required to issue a notice to SECC under section 7436 prior to assessing the additional taxes, SECC might lack an effective judicial forum in which to challenge the procedural validity of the audit assessments against SECC. First, the Ninth Circuit has held that taxpayer may not use a quiet title action under 28 U.S.C. section 2410 to challenge an income tax deficiency assessment by claiming that the IRS did not send a valid Notice of Deficiency to the taxpayer. See Elias v. Connett, 908 F.2d 521 (9th Cir. 1990), accord, PCCE v. United States, 159 F.3d 425 (9th Cir, 1998), contra, Robinson v. United States, 920 F.2d 1157 (3rd Cir. 1990). Arguably, the Ninth Circuit would similarly bar SECC from challenging the validity of the employment tax assessments through a quiet title action.

Second, the Ninth Circuit has held that, where the IRS has illegally assessed and collected an income tax deficiency in violation of the restrictions on assessment contained in what is now section 6213 of the Code, a taxpayer may not obtain a refund of the taxes illegally assessed and collected in violation of these restrictions unless the taxpayer can demonstrate that the taxpayer is owed a refund based on the merits of the tax liability. Van Antwerp v. United States, 92 F.2d 871 (9th Cir. 1937), contra, United States v. Yellow Cab Company, 90 F.2d 699 (7th Cir. 1937). Thus, in a refund suit, SECC would not be able to challenge the validity of the employment tax assessments unless the government counterclaimed for a judgment of the unpaid portion of these assessments. I previously handled a refund suit where the government purposely did not file a counterclaim in response to the complaint that we filed, in order to prevent our office from the litigating the procedural validity of an assessment under section 6672 of the Code. I have no doubt whatsoever that the government would have not filed a counterclaim for the unpaid portion of the employment tax audit assessments against SECC had we attacked the validity of those assessments in a refund suit. Thus, in the refund suit, we would not have been able to challenge the procedural validity of the assessments.

Third, the Ninth Circuit has held that, where the IRS has illegally assessed income tax deficiencies in violation of the restrictions on what is now section 6213(a) of the Internal Revenue Code, but the taxpayer has not yet paid the illegally assessed taxes, a taxpayer MAY be entitled to injunctive relief. Ventura Consolidated Oil Fields v. Rogan, 86 F.2d 149 (9th Cir. 1936), cert. denied, 300 U.S. 672 (1937). But the Ninth Circuit has also held that no injunctive relief is available unless the taxpayer can show BOTH irreparable injury AND an inadequate remedy at law. Cool Fuel, Inc. v. Connett, 685 F.2d 309 (9th Cir. 1982). Whether SECC would have been able to sustain that burden was at best unclear. My own experience is that the ability of a taxpayer to carry that kind of burden often depends on the proclivities of the judge assigned to the case.

While SECC acknowledged that it might be able to challenge the validity of the unpaid assessments in the context of a Collection Due Process case, the IRS had not conceded that point in the litigation. Also the filing of a lien notice against the company for such a large amount could have effectively destroyed the company, rendering meaningless the ability to challenge the procedural validity of the assessments in a Collection Due Process case.

While the company conceivably could have challenged the validity of the audit assessments in a Chapter 11 bankruptcy, see Bunyan v. United States, 354 F.3d 1149 (9th Cir. 2004), that course of action was not a realistic possibility.

SECC thus argued that, because the IRS had been required to issue a Notice of Determination under section 7436 prior to assessing the additional taxes and had failed to do so, the Tax Court should dismiss the petition for lack of jurisdiction based on the failure of the IRS to issue a valid Notice of Determination prior to assessing the taxes against SECC.

After the parties completed their briefing on the motions to dismiss, the Tax Court issued an Order directing the parties to brief the following two questions: 1) whether a letter from the Office of Appeals indicating that the case with Appeals was being closed constitutes a “determination” under section 7436, and 2) if the Court has jurisdiction under section 7436, what remedies might be available to petitioner in the Tax Court case. Much of the ink spilled in response to this Order regurgitated what was previously argued by the parties. For differing reasons, both parties argued that the IRS had never issued a proper Notice of Determination.

SECC also included the following comments in its supplemental brief:

The language of sections 7436(a) and (b)(2) is somewhat ambiguous. Under one possible reading, subsection (a) would grant the Court jurisdiction over a petition to determine the correctness of the Respondent’s determination at any time after a formal “determination” is made by the IRS, even though a “notice of determination” is never issued under subsection (b)(2). Under this reading, subsection (b)(2) operates only to establish the outer time limit by which an action must be filed in Tax Court to challenge the IRS’s “determination.” The deadline would only be fixed after respondent mails a “notice of determination” to the putative employer. Thus, if a “determination” is made by the Commissioner, but the Commissioner does not issue a “notice of determination,” the putative employer could theoretically file a Tax Court petition at any time after the “determination” is made. Whether the statute of limitations on assessment would ever run under this interpretation of the statute is an issue that is discussed below.

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There would be significant practical problems if the Court were to hold that taxpayers can file a petition at any time after respondent makes a “determination,” even though respondent has not issued a “notice of determination.” First, there could be significant disputes about what constitutes a “determination” which triggers the right of a taxpayer to file a Tax Court petition. Would a preliminary audit report be a “determination”? An audit report? A decision by the Office of Appeals? Something else? **** If the IRS made a “determination” but never issued a “notice of determination,” the period for filing a Tax Court petition could last indefinitely.

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There would also be a related problem involving the statute of limitations on assessment that would be caused by such an interpretation of section 7436. Under section 7436(d), the principles of various other provisions of the Code, including sections 6213(a) and 6503(a), apply as if the “determination described in subsection (a) were a notice of deficiency.” If a taxpayer could file a Tax Court petition once the IRS has made a “determination,” an issue would arise as to whether it is the making of a “determination” or the issuance of a “notice of determination” that operates to suspend the running of the statute of limitations on assessment.

The parties’ supplemental briefs were filed in August of 2013. At the time SECC filed its supplemental brief, I had a very bad case of heartburn. Why? In one of the related cases involving the same issue that was present in the SECC case, and in which the operative facts were almost identical to the facts in the SECC case, the Tax Court had granted the IRS’s motion to dismiss for lack of jurisdiction in May of 2013 in an unpublished Order. That jurisdictional issue had been briefed in that case in a manner similar to the briefing in the SECC case. That Order adopted the arguments made by the IRS on a wholesale basis, and the petition was dismissed for lack of jurisdiction, without the Court addressing the question of whether the IRS was required to issue a Notice of Determination prior to making the employment tax audit assessments against the petitioner. How and why that Order was issued, I don’t know.

Of course, a motion for reconsideration was promptly filed. The parties settled in to wait for the Court to issue an opinion in the SECC case and to see how the Court would deal with the motion for reconsideration in the related case. Given the Court’s ruling in the unpublished Order in the related case, I was concerned about how the Court would ultimately rule, even though I strongly believed that the IRS had improperly assessed the employment tax audit deficiencies against my clients.

 

 

 

 

 

Update On The “Late Return” Dischargeability Litigation: 9th Circuit To Hold Oral Argument in Smith Case

We welcome back A. Lavar Taylor who updates us on developments in the Ninth Circuit regarding whether a late-filed return is a return for purposes of the discharge rules in the Bankruptcy Code. Les

Those of you who are private practitioners who deal with the question of whether a “late-filed” tax return is or is not a “return” for purposes of section 523(a) of the Bankruptcy Code undoubtedly rejoiced when you read the recent opinion of the Ninth Circuit Bankruptcy Appellate Panel in United States v. Martin, 542 B.R. 479 (9th Cir. BAP 2015), issued on December 17 of last year. Keith Fogg previously discussed that opinion here, which also contains links to the underlying cases as well as links to prior PT posts on the issue. At long last, an appellate court rejected the position adopted by the Fifth Circuit (McCoy v. Miss. State Tax Comm’n (In re McCoy), 666 F.2d 924 (5th Cir. 2012), the Tenth Circuit (Mallo v. I.R.D. (In re Mallo), 774 F.3d 1313 (10th Cir. 2014), and the First Circuit (Fahey v. Massachusetts Dep’t of Revenue (In re Fahey), 779 F.3d 1 (1st. Cir. 2015).

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From my own perspective, the Bankruptcy Appellate Panel’s opinion in the Martin case seems to get “right” most everything that the three Court of Appeals opinions got wrong. The “one day late” interpretation of section 523(a) adopted by the three Court of Appeals opinions is nonsensical from a practical standpoint. That interpretation actually creates a disincentive for taxpayers, who for any reason fail to file a tax return on time, to promptly get into compliance by filing their “late” return(s) as soon as possible. Why is that so? Consider the following hypothetical, which might take place in a jurisdiction that is subject to the “one day late” rule set forth in McCoy.

Taxpayer comes to you in December of 2015 and tells you that they have not filed their 2014 federal income tax return. They have a long, sad story, involving a sick family member, a car accident and the loss of their home to a foreclosure sale. The foreclosure sale generated a large capital gain, which in turn has generated what will be a large income tax liability for 2014 once their 2014 tax return is filed. The taxpayer tells you their 2014 tax liability is far more than they will ever be able to pay and asks you whether it will ever be possible to discharge their 2014 tax liability in bankruptcy if they are not able to resolve the 2014 tax liability through an offer in compromise.

You advise them that, if they immediately file their 2014 tax return, they will not ever be able to discharge their 2014 income tax liability in bankruptcy because their late-filed Form 1040 can never qualify as a “return” for purposes of section 523(a) of the Bankruptcy Code. You also tell them that they probably will be better off if they wait for the IRS to open up an audit of their 2014 tax year (as the IRS will certainly do since the lender issued a Form 1099 to your client as the result of the foreclosure sale), then do nothing in response to the audit notice and wait for the IRS to issue a notice of deficiency, then file a Tax Court petition, and finally enter into a stipulated Tax Court decision with the IRS agreeing on the amount of taxes owed. The reason they will probably be better off is that the stipulated Tax Court decision very likely will qualify as a “return” for purposes of the Bankruptcy Code. Once the Tax Court decision has been entered, they can wait two years and then possibly discharge the tax liability through a chapter 7 bankruptcy.

If the taxpayer in this hypothetical believes that filing bankruptcy will likely be the only way that they might be able to resolve their 2014 income tax liability, the taxpayer might not immediately file their 2014 income tax return but instead might wait for the IRS to show up and issue a notice of deficiency and then file a Tax Court petition and settle the case. A rule which encourages taxpayers to engage in this type of conduct is utterly absurd. Yet, outside of the Ninth Circuit, many courts are adopting such a rule.

The Smith Case: Description

Inside the Ninth Circuit, the Ninth Circuit Bankruptcy Appellate Panel’s opinion in the Martin case will not be the law in the Ninth Circuit for much longer. On May 12 of this year, the Ninth Circuit is scheduled to hear oral argument in the case of  IRS v. Smith (In re Smith), 527 B.R. 14 (N.D. Cal. 2014), appeal pending (9th Cir. No. 14-15857). The Smith case was decided in favor of the IRS at the District Court level, so the appeal to the Ninth Circuit is by the taxpayer.

The facts of the Smith case are fairly typical for cases involving a late-filed income tax return. Smith failed to timely file his 2001 federal income tax return. The IRS began an audit of Smith’s 2001 tax year. The IRS prepared a SFR and issued a notice of deficiency for the 2001 year to Smith on March 27, 2006. Smith did not file a Tax Court petition, and the IRS assessed the liability as determined by the IRS. In May of 2009, Smith filed a Form 1040 for the year 2001 reporting a higher income tax liability than the liability determined by the IRS. Smith waited two years after he filed the Form 1040 and then filed a chapter 7 bankruptcy petition. He obtained a discharge and then filed an adversary proceeding to determine whether his 2001 tax liability was discharged.

The Bankruptcy Court held that the taxes were discharged, but the District Court reversed. The reasoning of the District Court is interesting, because the Court purported to follow the test set forth in Beard v. Commissioner, 82 T.C. 766, 774-79, 1984 (1984), aff’d, 793 F.2d 139 (6th Cir.1986)), and then misapplied that test. The Court concluded as follows:

In examining the holdings of the various courts, the reasoning therefore, and the language of section 523(a)(1)(B) itself, the Court finds that the majority position on this issue is the correct one. Since the hanging paragraph in Section 523(a)(1) does not completely define the term “return,” it is appropriate for the Court to look to long-established authority concerning the definition of “return” under “applicable nonbankruptcy law,” primarily the Tax Code.10 Similarly, the hanging paragraph does nothing to undermine the four-factor test or years of jurisprudence following Beard. Consistent with the Tax Code’s standards for a “return,” as stated in Beard and the Ninth Circuit’s decision in Hatton, the meaning of “return” must take into account the late-filers’ evidence of a good faith attempt to comply with the tax laws. Where, as here, the taxpayer and bankruptcy debtor fails to comply with self-assessment and payment of tax obligations until years after the IRS has initiated action, created a substitute return, assessed and begun collection proceedings, the Court simply cannot find his conduct to be “an honest and reasonable attempt to comply with the tax law.” This approach does not mean, as Debtor argues, that the “honest and reasonable attempt” factor creates a per se rule barring taxpayers from filing returns once the IRS has created a substitute return. To the contrary, this prong of the test is meant to consider each case on its particular facts, an approach which necessarily precludes a per se determination.

Thus, the Court did not apply the rule that had been adopted by McCoy and discussed McCoy only in footnote 6 of its opinion. In that footnote the Court noted that the IRS had not argued that the rule set forth in McCoy should apply and indicated that the Court was not following McCoy. Neither Mello nor Fahey had been decided by the Courts of Appeal when the District Court issued its opinion.

The Smith Case: Analysis

In my view, the District Court was correct in applying the Beard test but completely misapplied the fourth factor set forth in Beard. The “honest and reasonable attempt to satisfy the requirements of the tax law” discussed in Beard focused exclusively on the document sent to the IRS, not on the conduct of the taxpayer prior to sending that document to the IRS. The Beard Court stated as follows:

The Supreme Court test to determine whether a document is sufficient for statute of limitations purposes has several elements: First, there must be sufficient data to calculate tax liability; second, the document must purport to be a return; third, there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and fourth, the taxpayer must execute the return under penalties of perjury.

It is important to consider the factual circumstances under which this test has been applied. In Florsheim Bros. Drygoods Co. v. United States, 280 U.S. 453 (1930), at issue was whether the filing of a “tentative return” or the later filing of a “completed return” triggered the statute of limitations. A corporation had filed a tentative return along with a request for an extension of time to file a return which was later filed. The Court found that the filing of the tentative return was not in the nature of a “list,” “schedule,” or “return” required by tax statutes. It was designed to meet a peculiar exigency and “Its purpose was to secure to the taxpayer a needed extension of time for filing the required return, without defeating the Government’s right to prompt payment of the first installment  [of tax].” The statute plainly manifested a purpose that the period of limitations was to commence only when the taxpayer supplied the required information in the prescribed manner — the completed return.

The Court recognized that the filing of a return that is defective or incomplete may under some circumstances be sufficient to start the running of the period of limitation. However, such a return must purport to be a specific statement of the items of income, deductions, and credits in compliance with the statutory duty to report information and “to have that effect it must honestly and reasonably be intended as such.” (Emphasis added.) Thus, the filing of the tentative return was not a return to start the period of limitation running.

This issue of whether the document was a return for the statute of limitation purposes was again before the Court in Zellerbach Paper Co. v. Helvering, 293 U.S. 172 (1934). Justice Cardozo, speaking for the Court, said:

Perfect accuracy or completeness is not necessary to rescue a return from nullity, if it purports to be a return, is sworn to as such * * * and evinces an honest and genuine endeavor to satisfy the law. This is so even though at the time of filing the omissions or inaccuracies are such as to make amendment necessary. [Zellerbach Paper Co. v. Helvering, supra at 180. Citations omitted.]

It is apparent from the language quoted immediately above that the reasons for the taxpayer’s delay in filing a Form 1040 with the IRS are NOT relevant for purposes of determining whether that particular Form 1040 is a “return” under the Beard test.

The circumstances surrounding the preparation of the Form 1040 will normally be relevant to determining whether the taxpayer has engaged in an “honest and genuine endeavor” to comply with the law. For example, if the taxpayer, in preparing the Form 1040, merely parroted the numbers on the IRS SFR instead of relying on the taxpayer’s own books and records, the taxpayer may not have engaged in an “honest and genuine endeavor” to comply with the law. But the fact that the taxpayer ignored IRS notices, including a notice of deficiency, and did not file a Form 1040 until the IRS starting taking collection action is not relevant to the question of whether the taxpayer has met this particular requirement of the Beard test.

The fact that the Form 1040 is filed late, whether before or after the IRS has made an SFR assessment, may have other consequences under the Bankruptcy Code, either under the “late filing” rule set forth in section 523(a)(1)(B)(ii) or the “attempt to evade or defeat” rule set forth in section 523(a)(1)(C). But the delay in filing the Form 1040, and the reasons for that delay, should be ignored for purposes of determining whether the Form 1040 is a “return,” unless the delay is somehow relevant to the contents of the Form 1040. The District Court’s ruling is thus based on an incorrect reading of the Beard test.

What the Future Holds

No one knows what the Ninth Circuit will do in the Smith case, but we can expect a ruling sometime prior to the end of this year, likely during the late summer or early fall months. For those of us practicing in the Ninth Circuit, or in Circuits other than the three Circuits that have already ruled on this issue, what do we tell our clients who are affected by the judicial disarray on this issue? Realistically, we must tell them is that, if they file bankruptcy now, we don’t know what is going to happen and they are at risk that their tax liabilities will not be discharged. That is true even for taxpayers living in Circuits other than the First, Fifth, Ninth and Tenth Circuits.

If the Ninth Circuit issues an opinion that is inconsistent with the opinions of the three other Circuits that have ruled on this issue, it is possible that this issue will be resolved by the Supreme Court sometime in 2017. Of course, the Ninth Circuit could still rule against the taxpayer while disagreeing with the other Circuits. The chances of Supreme Court review may be greater if the Ninth Circuit splits with the other Circuits by ruling for the taxpayer.

If the Ninth Circuit follows McCoy, then a review of the Ninth Circuit opinion by the Supreme Court is unlikely. The only remaining hope for taxpayers will be either that another Circuit that has not yet ruled on this issue rules in a way that creates a split in the Circuits or that there is a legislative change to the statute. In addition, if the Ninth Circuit follows McCoy, a short term practical question will be whether the Department of Justice and the IRS abandon their position that the rationale used to decide McCoy is wrong. That possibility, coupled with the possibility of Supreme Court review if the Ninth Circuit does not follow McCoy, is why it may be unwise for any practitioners practicing outside of those Circuits who have ruled on this issue to advise their clients who are contemplating using bankruptcy to discharge tax liabilities where the underlying returns were late filed anything other than: “We just don’t know whether your tax liabilities (other than penalties, see McKay v. United States, 957 F.2d 689 (1992), ) will be discharged.”

 

What Constitutes An Attempt To Evade Or Defeat Taxes For Purposes Of Section 523(a)(1)(C) Of The Bankruptcy Code: The Ninth Circuit Parts Company With Other Circuits (Part 2)

In yesterday’s post A. Lavar Taylor discussed the case law in other circuits and the bankruptcy opinion in Hawkins v Franchise Tax Board. Today’s post turns to the Ninth Circuit and its decision to part ways with the other circuits. Lavar explains why he believes for both legal and practical reasons the Ninth Circuit’s view is correct. Les

Now I turn to why the Ninth Circuit reached the correct result in Hawkins by concluding that “improper” expenditures, by themselves, do not constitute an attempt to evade or defeat a tax liability. There are both legal and practical reasons why the Ninth Circuit’s holding in Hawkins is the correct one.  I first discuss the legal reasons.

The Legal Reasons Why the Ninth Circuit Is Correct

The Ninth Circuit noted that the purpose of a bankruptcy discharge is to give an individual debtor a “fresh start.” It noted that this “fresh start” philosophy argues for a more narrow  interpretation of the “attempt to evade or defeat” exception from discharge. The Ninth Circuit also concluded that both the structure of section 523(a) of the Bankruptcy Code and its legislative history support a narrow reading of the “attempt to evade or defeat” exception to discharge.

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The Ninth Circuit also took note of the Supreme Court’s holding in Kawaauhau v. Geiger, 523 U.S. 57 (1998), in which the Supreme Court narrowly construed the term “willfully” for purposes of section 523(a)(6) of the Bankruptcy Code.

But the key to the Ninth Circuit’s ruling is the fact that the Supreme Court, in Spies v. United States, 317 U.S. 492 (1943),  held that a mere willful failure to file a return, coupled with a mere willful failure to pay the tax, does not constitute a willful attempt to evade or defeat the tax for purposes of section 7201 of the Internal Revenue Code. Section 7201 uses language almost identical to the language in section 523(a)(1)(C) of the Bankruptcy Code.  The Supreme Court held in Spies that the taxpayer must take some sort of “willful commission” (in addition to the willful omissions), or engage in an “affirmative act,” in an effort to evade the tax, in order to commit tax evasion under section 7201.  Whether a particular act taken by a taxpayer is an affirmative act taken in an effort to evade the tax is to be decided by the trier of fact.

Because the language in section 523(a)(1)(C) of the Bankruptcy is virtually identical to the language in section 7201 of the Internal Revenue Code, it makes sense to construe section 523(a)(1)(C) in the same manner in which the Supreme Court construed section 7201 of the Internal Revenue Code in Spies.  The elements discussed above in  in the Fretz case, which were used by Judge Carlson in the Hawkins case and were used by all other Courts of Appeal to consider this issue, are elements required to convict a taxpayer of a willful failure to file or a willful failure to pay under IRC section 7203. See, e.g., United States v. Tucker, 686 F.2d 230 (5th Cir. 1982).

Section 7203 uses very different language than the “willful attempt in any manner to evade or defeat” language contained in IRC §7201 and Bankruptcy Code section 523(a)(1)(C).  The failure by Congress to incorporate the language of IRC §7203 into section 523(a)(1)(C) of the Bankruptcy Code, coupled with the incorporation into section 523(a)(1)(C) of the language contained in section 7201, indicates that the holdings of the other Courts of Appeal were in error.

The Practical Reasons Why the Ninth Circuit is Preferable  

The Ninth Circuit’s approach is also preferable for practical reasons.  The most obvious practical problem for courts relying on the standard used in other Circuits is determining in a principled manner what expenditures by the debtor are “unnecessary” once the duty to pay the taxes arises. Only a principled approach can provide future guidance to courts,  future litigants, debtors who wish to avoid a fight over whether they attempted to evade or defeat the taxes that they owed, and professionals who advise debtors who wish to avoid this fight.

Judge Carlson offered precious little principled guidance  on how to decide what expenditures are “unnecessary” in other factual contexts. We know that a “nuanced approach” should be used, depending on the debtor’s pre-existing income and lifestyle, but we know very little about how to define those “nuances” or about how to apply those “nuances” in future cases where the taxpayer’s circumstances differ from those of Mr. Hawkins.

Can a debtor pay for extraordinary medical expenses for a parent or for a beloved pet, at the expense of not paying their taxes? What about paying modest private school tuition for their children? What about paying tuition for the debtor to obtain an advanced degree in the hopes that the debtor will obtain a much higher paying job? Does the potential level of earnings once the degree is earned make a difference?  Can the debtor pay to go on any vacations at all? What if the debtor’s therapist recommends that the debtor take a vacation because of stress related to a difficult marriage or related to financial difficulties?

What about debtors who owe business debts? Will some of these debts be deemed “necessary” and other “unnecessary?”  Will it matter if payment of the business debt will give rise to a tax deduction which would reduce the amount of taxes owed? If a debtor pays state taxes without paying federal taxes, is that an attempt to evade or defeat the federal taxes? If the debtor pays federal taxes without paying state taxes, is that an attempt to evade or defeat the state taxes? What about payment of alimony and child support?

For those debtors who are living a good lifestyle but are greeted by an overwhelmingly large tax liability, how long do they have to reduce their expenditures before their pre-existing level of expenditures becomes “unnecessary?” Six months?  A year? If they attempt to sell their expensive house and find no buyers at a reasonable price after a year, are debtors required to sell at a fire sale or to stop paying their mortgage?

If the debtor reasonably believes that he owns property that will  appreciate enough for him to fully pay his taxes within several years, must the debtor lower his or her level of living  expenses while waiting for  the property to appreciate? Will the expenses paid while waiting for the property to appreciate be deemed to be “excessive” through hindsight if property values suddenly and unexpectedly decline?

The number of questions regarding “necessary” and “unnecessary” expenses which could arise under the standard employed by Judge Carlson and other Circuits is virtually limitless. Under this standard, courts, debtors and their counsel can look forward to innumerable Circuit splits on all of the exciting issues mentioned immediately above, among many others.

Simply put, if the standard for determining whether a taxpayer/debtor has attempted to evade or defeat the tax is whether the taxpayer/debtor made “inappropriate” expenditures, there is no principled way for courts  to draw the line between what expenditures are “appropriate” and what expenditures are “inappropriate.”  Cases will be decided based on the whims and fancies of individual judges, each of whom will have their own sense of what expenses are “appropriate” and what expenses are “inappropriate.” One judge may conclude that it was entirely proper for a taxpayer to spend $25,000 furthering their education in an effort to significantly increase their earnings capacity instead of paying the money over to the IRS, while another judge may conclude that the taxpayer attempted to evade or defeat the tax by spending $25,000 on educational expenses instead of paying the $25,000 over to the IRS.

In addition, IRS and other tax agencies could invoke the “attempt to evade or defeat” exception merely because they do not like the way the debtor/taxpayer spent their money. Such a standard carries with it a significant potential for abuse of taxpayers by tax agencies.  The potential for abuse drastically decreases if tax agencies are required to prove the traditional elements of tax evasion in order to invoke the “attempt to evade or defeat” exception in section 523(a)(1)(C).

Under the standard used by Judge Carlson, it is impossible for tax professionals to advise their clients on whether the clients can make certain expenditures, assuming that the use of bankruptcy to discharge tax liabilities is  a possibility at the time the advice is solicited.  If the standard used by Judge Carlson applies, no competent professional will ever offer meaningful advice on this subject out of fear of the potential consequences of giving incorrect advice.

The Dissent

As a final note, I have several comments about the dissenting opinion in Hawkins. First, this dissent makes a statement that is downright scary. At page 17 of the Slip Opinion, the dissent states:

At the family court hearing, Hawkins’ bankruptcy attorney “testified that Hawkins’ intent was not to pay the tax debt, but to discharge it in bankruptcy. . . .” Id., p. 19. This testimony is a strong indication of a willful intent to avoid the payment of taxes by hook or by crook.

I am troubled by the dissent’s language, given that, at the time the statement was made by the attorney, Hawkins was insolvent and lacked the ability to pay the taxes in full. (I will ignore the fact that this statement regarding Hawkins’ intent was not made by Hawkins himself.) In addition, 3DO was in financial difficulties and headed for chapter 7. Planning to discharge taxes in bankruptcy at a time when you are insolvent and lack the ability to pay the taxes in full is not an attempt to evade or defeat a tax liability. And Hawkins paid to the IRS and the FTB many millions of dollars between the date of that statement and the date of the bankruptcy petition.

I am also troubled by the dissent’s conclusion that the majority opinion “gives Hawkins a pass.” The majority opinion does no such thing. The majority remands the case so that the trial court can apply the correct legal standard. The trial court may now have to decide the issue previously ducked by Judge Carlson (who has now retired from the bench), namely, whether Hawkins acted with intent to defraud in filing the tax returns in question. At a minimum, the trial court will have to decide whether the actions taken by Hawkins leading up to his chapter 11 bankruptcy were taken with Spies-type intent to evade the tax liability.  Hawkins has not been given a “pass.”  Rather, his conduct is going to be judged under the appropriate legal standard, rather than under a standard that is no standard at all.

For those of you who disagree with my statement that the standard relied upon by Judge Carlson (and by the dissent and by other Circuits) is no standard at all, I invite you to carefully review Judge Carlson’s opinion and tell me how you would apply the “standard” set forth in that opinion to the vast majority of taxpayers whose financial circumstances are much more modest than those of Mr. Hawkins.  I’ve read and re-read Judge Carlson’s opinion.  All I can take away from that opinion is that some expenditures are “appropriate,” some expenditure are “inappropriate,” that Bankruptcy Judges must take a “nuanced approach” in deciding which expenditures are “appropriate” and “inappropriate” for purposes of determining whether the debtor “attempted to evade or defeat” a tax liability, and that, if you continue spending “too much” money in the face of known tax liabilities for “too long,” you will have engaged in an “attempt to evade or defeat” the tax liabilities, regardless of your motives for spending that money.

How you apply that standard to all other taxpayers other than Mr. Hawkins in a principled manner I haven’t a clue. Which is why I believe the Ninth Circuit got it right in Hawkins.