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.

read more...

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.

read more...

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.

read more...

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.

read more...

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.

******************

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.

******************

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).

read more...

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.

read more...

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.

 

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 1)

A. Lavar Taylor of the Law Offices of A. Lavar Taylor discusses this week’s important Hawkins v Franchise Tax Board decision in the Ninth Circuit. In the first post, Lavar discusses how other courts have approached the issue. In tomorrow’s post, Lavar discusses the Ninth Circuit opinion and describes why he believes its approach is correct.

In Hawkins v. Franchise Tax Board, — F.3d – (9th Cir. No. 11-16276, Sept. 15, 2014),  an opinion released on Monday that can be found here, the Ninth Circuit addressed the question of what the IRS and other taxing agencies must prove to establish that a tax liability cannot be discharged by an individual in a chapter 11 or chapter 7 bankruptcy because the debtor/taxpayer “willfully attempted in any manner to evade or defeat” a tax liability for purposes of section 523(a)(1)(C) of the Bankruptcy Code. Breaking ranks with the other Courts of Appeal which have addressed this issue, the Ninth Circuit construed this language in pari materia with the nearly identical language contained in section 7201 of the Internal Revenue Code, as interpreted by the U.S. Supreme Court in the case of Spies v. United States, 317 U.S. 492 (1943).

The Ninth Circuit’s holding in Hawkins departs from the holdings of virtually every other Court of Appeals to consider this issue.  Before discussing prior case law and why I believe that the Ninth Circuit reached the right result,  I want to warn readers that I am no innocent bystander on this issue.  I authored a brief as amicus curiae filed in the Hawkins case, and the Hawkins majority opinion’s discussion of the Spies case and its applicability to cases involving section 523(a)(1)(C) adopts the position I advocated in the brief as amicus curiae.  For those  interested in reading that amicus brief, it can be found here. The amicus brief includes a detailed discussion of the differences between sections 7201 and 7203 and the case law construing those two provisions.

read more...

Case Law in Other Circuits

Now to the case law in the other Circuits construing section 523(a)(1)(C) which preceded the Ninth Circuit’s holding in Hawkins. In Toti v. United States (In re Toti), 24 F.3d 806 (6th Cir. 1994), the Court was faced with a situation where the debtor had failed to timely file returns and had failed to pay the taxes owed, but, per the trial court, had not committed an “affirmative act” of evasion. The trial court held that the taxes were discharged because there was no willful attempt to evade or defeat the taxes in that situation. The Sixth Circuit on appeal, however,  reversed the trial court and held that Toti had “willfully attempted to evade or defeat the taxes” within the meaning of §523(a)(1)(C).

The Court attempted to justify its outright reversal of the finder of fact (as opposed to a remand to apply the legal standard adopted by the Sixth Circuit) by stating that the standard of “willfulness” under  section523(a)(1)(C) should be the same standard of “willfulness” used by the courts in imposing criminal liability under section 7203 of the Internal Revenue Code, as opposed to section 7201 of the Code.  The District Court’s ruling, which was affirmed by the Sixth Circuit, explicitly approved of the standard of “willfulness” used in imposing liability under section 6672 of the Internal Revenue Code.  141 B.R. 126 (E.D. Mich. 1993).

Other Courts of Appeal followed the rationale of Toti. The Eleventh Circuit, in Fretz v. United States (In re Fretz),  244 F.3d 1323 (11th Cir. 2001), reversed a finding by the trial court that the debtor had not attempted to evade or defeat the taxes in question. The debtor had failed to file his returns and had failed to pay the taxes owed. The Eleventh Circuit  held that this was sufficient to render the taxes non-dischargeable under §523(a)(1)(C) and that this section does not contain a requirement that the debtor engage in an affirmative act of evasion to render the taxes non-dischargeable. The Court stated as follows:

Thus, all the government must prove is that Dr. Fretz    (1) had a duty to file income tax returns and pay taxes; (2) knew he had such a duty; and (3) voluntarily and intentionally violated that duty.   244 F.3d at 1330.

The Seventh Circuit has ruled in a similar manner. See United States v. Fegley (In re Fegeley), 118 F.3d 979, 984 (3d Cir. 1997).  Most recently, the Tenth Circuit followed this logic in holding that taxes were not dischargeable.  Vaughn v. Comm’r (In re Vaughn),  – F.3d –  2014 WL 4197347 (10th Cir. 2014). [Ed note: Keith discussed Vaughn here] Additional opinions on this issue from other Courts of Appeal are discussed in the Ninth Circuit’s opinion.

The Bankruptcy Opinion

Before discussing why the Ninth Circuit reached the correct result in Hawkins, it is useful to review the opinion of Bankruptcy Judge Carlson.  Judge Carlson’ opinion can be read here. Judge Carlson wrote in part as follows:

William M. “Trip” Hawkins (Trip) is a very sophisticated businessman. He received an undergraduate degree in Strategy and Applied Game Theory from Harvard College, and an M.B.A. from Stanford University. He was an early employee of Apple Computer, where he rose to director of marketing. In 1982, he left Apple and became one of the founders of Electronic Arts, Inc. (EA), which became the largest supplier of computer entertainment software in the world. By 1996, Trip had a net worth of approximately $100 million, primarily from his holdings of EA shares.

*  * *

In 1990, EA created a wholly owned subsidiary, 3DO, for the purpose of developing and marketing the devices on which computer games are played. Trip Hawkins left EA to run 3DO. 3DO went public in 1993. In 1994, Trip began to sell large amounts of his EA common stock to invest heavily in 3DO.

The story from that point forward is not unfamiliar to practitioners who have represented those taxpayers who “invested”  in various “products” hawked by certain tax professionals. Hawkins invested in the FLIP and OPIS tax shelter products and claimed losses from these “investments.” These losses  were used to offset large gains generated from the sale of EA stock. The IRS then audited the income tax returns of Hawkins for the years 1996 through 2000, and Hawkins retained highly respected counsel to represent him in the audit. Hawkins attempted to participate in the settlement program announced in IRS Announcement 2002-97, but he was told that he was not eligible for that program.

In the meantime, Hawkins’ investment in 3DO was going south. He loaned over $12 million to this company. The net result was that 3DO filed a chapter 11 bankruptcy in May of 2003, and the bankruptcy was converted to a chapter 7 (liquidation) later that year.

There was more bad news for Hawkins. In July of 2003, he received a revenue agent’s report from IRS asserting that he owed roughly $16 million of taxes and penalties for the years covered by the audit.  Hawkins had previously divorced his first wife. Trying to make lemonade out of lemons, in July of 2003 Hawkins filed a motion in the family law court to reduce child support payments due under the existing order, citing the fact that he owed the IRS and FTB over $25 million combined and his mounting losses associated with 3DO.  The family law court granted Hawkins partial relief but required him to place certain assets in trust for his children and imposed a judicial lien on those assets in an effort to protect them from seizure by IRS and FTB.

Hawkins consented to the assessment of the IRS tax deficiencies in December, 2004, and the IRS assessed the deficiencies in March, 2005. The California FTB assessed their “piggyback” audit deficiencies in September of 2005. In October of 2005, Hawkins submitted an Offer in Compromise to the IRS. This OIC was ultimately rejected.  In July of 2006, Hawkins sold a residence, and the IRS received $6.5 million from this sale.  The FTB received $6 million as the result of levies on financial accounts in August of 2006.

In September of 2006, Hawkins filed a chapter 11 bankruptcy petition. He confirmed a plan of reorganization in July, 2007. The IRS received roughly $3.4 million under the plan. But substantial amounts remained due and owing to both the IRS and the FTB after consummation of the chapter 11 plan. Hawkins then filed suit to determine whether the unpaid taxes owed to IRS and FTB were discharged in the Chapter 11 bankruptcy.

In the litigation, the IRS made two arguments in support of its position that the unpaid tax liabilities had not been discharged.  First, they argued that Hawkins had filed fraudulent returns by claiming the tax shelter losses on those returns. Those of you who are familiar with Jack Townsend’s excellent blog  Federal Tax Crimes know that Jack has wondered for quite some time why the IRS has not asserted the civil fraud penalty more frequently against taxpayers who “invested” in tax shelters.  In this particular case, the IRS argued that Hawkins filed a fraudulent return.   So there you go, Jack. They finally claimed that a taxpayer acted fraudulently in claiming losses from a tax shelter on their income tax return, albeit in the context of bankruptcy dischargeability litigation, where the standard of proof for proving fraud is only a preponderance of the evidence.

Judge Carlson, however, explicitly refused to decide whether Hawkins acted with intent to defraud in filing the tax returns in question. Instead, Judge Carlson held that Hawkins had attempted to evade or defeat the taxes in question.  Judge Carlson made it very clear that the basis for his holding  that Hawkins had attempted to evade or defeat the taxes in question was that Hawkins had done nothing more than engage in “unnecessary” expenditures. Here is what Judge Carlson had to say:

The Government has met the required burden with respect to Trip Hawkins by establishing that for more than two and one-half years before filing for bankruptcy protection, he caused Debtors to make unnecessary expenditures in excess of Debtors’     earned income, while he acknowledged that Debtors had a tax liability of $25 million, while he relied upon that tax liability in seeking a reduction of child support payments,    while he knew Debtors were insolvent, while Debtors paid other creditors, and while Debtors planned to file bankruptcy to discharge their tax obligations.

Judge Carlson then commented extensively on Hawkins’ lifestyle, stating as follows:

From the time of their 1996 marriage onward, Debtors maintained a lifestyle that was commensurate with the great wealth they enjoyed at the time they were first married. In 1996, Debtors purchased a home in Atherton, California for $3.5 million. In 2000, Debtors purchased an $11.8 million private jet that they used for family vacations as well as for business trips.  In 2002, Debtors purchased an ocean-view condominium in La Jolla, California for $2.6 million. From the date of their marriage to the date of their bankruptcy petition, Debtors employed various gardeners and household attendants.

Debtors altered this lifestyle very little after it became apparent in late 2003 that they were insolvent. Although they sold the private jet in 2003, they continued to maintain both the Atherton house and the La Jolla condominium until July 2006. In October 2004, Debtors purchased a fourth vehicle costing $70,000.

Debtors’ personal living expenses exceeded their earned income long after Trip had acknowledged that Debtors were insolvent. In the Collection Information Statement accompanying their October 2005 Offer in Compromise, Debtors disclosed annual after-tax earned income of $150,000 and annual living expenses of more than $1.0 million. In the schedules filed in their bankruptcy case in September 2006, Debtors disclosed annual after-tax earned income of $272,000 and annual living expenses of $277,000. The components of Debtors’ living expenses are discussed in more detail below.

* * *

Before examining Hawkins’ expenditures, it is appropriate to examine Hawkins’ earned income. For the purpose of this decision, this court assumes that it should take some account of a debtor’s earned income in determining what expenditures are culpable under section 523(a)(1)(C) as unduly lavish. It may not be appropriate to require a CEO earning hundreds of thousands of dollars per year to live in an apartment suitable for a clerical employee, even if that CEO is insolvent. The effort and skill required to earn such sums require a nuanced approach in determining what living expenses are necessary.  Even the most nuanced approach, however, does not excuse living expenses greatly in excess of earned income over an extended period of time.

Debtors provided two snapshots of their income and expenses between January 2004 and September 2006. In October 2005, Debtors submitted a Collection Information Statement, signed under penalty of perjury, in support of their Office in Compromise. In September 2006, Debtors filed schedules in their chapter 11 case, also signed under penalty of perjury. The October 2005 Collection Information Statement indicated monthly after-tax earned income of $12,500. Bankruptcy Schedule I indicated monthly after-tax earned income of $22,180. All of this income was earned by Trip; Lisa was not employed outside the home at any time during this period.

Against this backdrop, the Debtors’ personal living expenses from January 2004 to September 2006 are truly exceptional. After Trip represented to the family court that he was liable for $25 million in federal and state taxes and that he was insolvent as a result, Debtors spent between $16,750 and $78,000 more than their after-tax earned income each month.

In the Collection Information Statement submitted in October 2005, Debtors stated that their personal living expenses were more than seven times their after-tax earned income, and exceeded that income by more than $78,000 per month.

* * *

Several aspects of this Statement are worthy of note. The $33,600 housing expense included expenses for a 5-bedroom, 5.5 bath house in Atherton (later sold for $10.5 million), and a 4-bedroom, 3.5 bath condominium in La Jolla (later sold for $3.5 million). The transportation expense covers four vehicles for a family with only two drivers, and includes a $70,000 Cadillac SUV purchased ten months after Trip Hawkins had acknowledged Debtors’ tax liability and insolvency in the family court proceeding.

* * *

The schedules filed in Debtors’ bankruptcy case indicate that Debtors’ personal living expenses greatly exceeded their after-tax earned income until just before they filed their bankruptcy petition in September 2006. Debtors sold the Atherton house just before the bankruptcy petition was filed. Debtors sold the La Jolla condominium after the bankruptcy petition was filed. If one adds the minimum amount they could have been spending for housing before the July 2006 sale of the Atherton house, together with the income and living expenses that Debtors reported in their bankruptcy schedules, Debtors’ living expenses greatly exceeded their after-tax earned income through July 2006.

* * *

Debtors made expenditures in excess of earned income for more than two-and-one-half years after Trip Hawkins acknowledged in January 2004 that Debtors were insolvent and would not pay their tax debt in full. Debtors did not sell the Atherton home until July 2006. They did not sell the La Jolla condominium until after filing for bankruptcy protection in September 2006. 24 They reported in their bankruptcy schedules that on the petition date they were still making the expenditures for the Cadillac SUV, child care, and recreation noted above. Debtors’ high level of expenditure also continued well after they consented to assessment of tax by the IRS in the amount of $21 million in December of 2004, and well after the assessments were recorded in March 2005. The Collection Information Statement indicates that Debtors’ monthly living expenses were seven times their earned income ten months after they consented to assessment and seven months after the IRS formally assessed the additional tax. This is not a case where the taxpayers acted appropriately once the tax was formally assessed, perhaps suggesting that their earlier failure to pay was based on some innocent misconception of their duty.

There is one point not focused on by Judge Carlson but of potential relevance to the resolution of the case under the standard relied on by him.  The IRS taxes were not assessed until March of 2005, some 18 months after the family court hearing. Assuming that Hawkins did not knowingly sign  fraudulent tax returns when he claimed the tax shelter losses on those returns, his duty to pay the audit deficiency assessments did not arise until after the taxes were assessed and notice and demand for payment was sent in 2005. See, e.g., §6651(a)(3) of the Internal Revenue Code, which imposes a penalty for the taxpayer’s failure to pay a deficiency in income taxes only after the taxpayer has received notice and demand for payment after the tax deficiency has been assessed.

Based on the premise that Hawkins had no duty to pay the additional taxes until they were properly assessed, I have difficulty with Judge Carlson’s reliance on the pre-assessment conduct of Hawkins to determine that he attempted to evade or defeat the taxes in question.   Pre-assessment conduct of a taxpayer is certainly relevant for purposes of determining whether a taxpayer engaged in Spies-type evasion of taxes under section 7201.  See, e.g., United States v. Voorhies, 658 F.2d 710 (9th Cir. 1981).  But I am unaware of any case in which the IRS has ever charged or convicted a taxpayer for a failure to pay a tax under section 7203 based on the taxpayer’s conduct prior to the tax being assessed and billed to the taxpayer.

When Can Taxpayers Challenge the Merits of the Underlying Liability in CDP Appeals: Why the Tax Court Was Wrong in Lewis v. Commissioner and Its Progeny

Introduction: Today’s guest post is provided by A. Lavar Taylor. Lavar is the founding partner in the firm of  A. Lavar Taylor and Associates. Lavar has extensive experience in both the private and public sector as his firm bio highlghts. He is a thoughtful commentator and creative advocate, and  I have learned much from his prior writing, especially in the collection area. This post considers a fundamental question in the CDP statute, namely, when should the Tax Court be entitled to consider the merits of a tax liability in CDP cases. It may seem odd that some fifteen years into the statute we still have some fundamental ambiguous issues. As this post points out, that is largely attributable to an unclear statute and at times earlier court opinions that stemmed from pro se taxpayers who may not have made their cases in the best possible way. In this post Lavar makes a forceful argument that the Tax Court should reconsider earlier precedent on the issue.  Les

Shortly after the passage of RRA98 I had the privilege of taking a step away from my position as District Counsel for Virginia/West Virginia and coming into Washington to temporarily head the division of Chief Counsel’s office in charge of collection issues – then known as the General Litigation Division.  Many of the changes to the code in RRA98 fell under the jurisdiction of the General Litigation Division and we set about to write the regulations on those new code sections.  At the top of the list was collection due process.  I met daily with the attorney who was drafting the regulation and regularly with the Associate Chief Counsel and the Chief Counsel on the progress and shape of the CDP regulations.   I do not remember considering the particular issue that Lavar writes about when we were writing the initial CDP regulations.  We had a lot of things to cover in those regs and we were trying to get them out (and did) before CDP went into effect six months after enactment of the statute.  I agree with Lavar’s position and think that if we had thought about it and discussed it at the time that we might have addressed it. Keith

If taxes are the life blood of the government, then tax procedure necessarily defines the process by which the government extracts that life blood from taxpayers. Ideally, the extraction process should not involve any gratuitous pain or discomfort and should not land the taxpayer in the poorhouse. But sometimes, whether due to a lack of cooperation by taxpayers or due to a poor job done by the government in extracting  life blood from  taxpayers, the extraction process can create discomfort, hardship, and financial difficulty.  This leads to the topic of this blog post, namely, the Collection Due Process (“CDP”) procedures and when they allow a taxpayer to challenge the merits of the underlying tax liability under section 6330(c)(2)(B).

read more...

In 1998 Congress revolutionized the collection process by enacting sections 6230 and 6330 of the Internal Revenue Code.   Since these provisions took effect in early 1999, taxpayers have had the opportunity to challenge (either prospectively or retrospectively) collection action by the IRS, both administratively and in court.  Taxpayers have also had the opportunity to challenge the merits of the underlying tax liability under certain circumstances, thus creating a new “prepayment” forum in which taxpayers may litigate a tax liability.

Section 6330(c)(2)(B) states that a taxpayer “may also raise at the hearing challenges to the existence or amount of the underlying tax liability for any tax period if the person did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.”

This provision, like many of the provisions in section 6320 and 6330, has  spawned litigation regarding  the meaning of the statute.  In Lewis v. Commissioner, 128 T.C. 48 (2007), the Tax Court upheld the validity of Treas. Reg. §301-6330-1(e)(3), Q&A-E2, which purports to interpret section 6330(c)(2)(B) of the Code.  That regulation provides in relevant part:

Q-E2.             When is a taxpayer entitled to challenge the existence or amount of the tax liability specified in the CDP Notice?

A-E2. A taxpayer is entitled to challenge the existence or amount of the underlying liability for any tax period specified on the CDP Notice if the taxpayer did not receive a statutory notice of deficiency for such liability or did not otherwise have an opportunity to dispute such liability. Receipt of a statutory notice of deficiency for this purpose means receipt in time to petition the Tax Court for a redetermination of the deficiency determined in the notice of deficiency. An opportunity to dispute the underlying liability includes a prior opportunity for a conference with Appeals that was offered either before or after the assessment of the liability. An opportunity for a conference with Appeals prior to the assessment of a tax subject to deficiency procedures is not a prior opportunity for this purpose.

In Lewis, the taxpayer, a plumber, filed his 2002 Form 2010 late.  He paid the tax shown due with the return at the time he filed the return. The IRS assessed late filing and late payment penalties.    Lewis then submitted a request for abatement of these penalties. Ultimately, the Office of Appeals denied the request for abatement.

The IRS then issued a section 6630 Notice of Intent to Levy. Lewis timely requested a hearing with the Office of Appeals and in that appeal sought to challenge the late filing and late payment penalties.  Appeals refused to address the merits of the penalties, claiming  that Lewis had received a “prior opportunity” to challenge the penalties as the result of the prior administrative hearing before the Office of Appeals.  Lewis challenged that refusal in a petition to the Tax Court and sought to litigate the merits of these penalties in the Tax Court case.

Judge Goeke held that Lewis could not challenge the merits of the late filing and late payment penalties in the CDP administrative proceeding or in the Tax Court case because Lewis had a “prior opportunity” to dispute these penalties in the prior administrative hearing with the Office of Appeals.  Judge Goeke believed that the language of section 6330(c)(2)(B) was susceptible to more than one interpretation, stating as follows:

On the one hand, it can be read to mean an opportunity to challenge the underlying liability in a forum ultimately subject to judicial review. On the other hand, it can be read to include challenges subject to judicial review as well as challenges heard by respondent’s Appeals Office in circumstances where no subsequent prepayment judicial review of the determination is available.

With all due respect to Judge Goeke, I would rephrase the choice faced by the Court in that case. And I submit that the choice is not a difficult one at all once a more complete analysis is performed. Simply put, the Court reached the wrong conclusion in Lewis.

The type of “opportunity” specifically referred to by Congress which, if not pursued by the taxpayer, precludes the taxpayer from challenging the merits of the liability in a Collection Due Process proceeding is a judicial opportunity (the opportunity to seek Tax Court review of a notice of deficiency), not an administrative opportunity. Thus, in interpreting the statute, the proper inquiry is whether Congress intended to limit the ability of taxpayers to challenge the merits of the underlying liability in CDP cases only where they previously had a judicialopportunity to challenge the underlying liability,  or instead intended to also limit the ability of taxpayers to challenge to challenge the merits of the underlying liability in CDP cases where taxpayers have had  a prior non-judicial, or merely an administrative , opportunity to challenge the merits of the underlying liability, even where there was no judicial opportunity to challenge an adverse administrative ruling by the IRS.

A challenge to a tax liability heard by the IRS’s Office of Appeals is merely one form of administrative challenge available to taxpayers. Taxpayers have multiple administrative opportunities to challenge a tax liability, including (but not limited to) the following:  1) offer in compromise based on doubt as to liability at the Examination level, 2) offer in compromise based on doubt as to liability at the Office of Appeals level, 3) audit reconsideration at the Examination level, 4)  audit reconsideration at the Office of Appeals level, 5) penalty abatement request at the Examination level, 6) penalty abatement request at the Office of Appeals level, 7) amended return at the Examination level, and 8) amended return at the Appeals level.  Each of these is a distinct administrative “opportunity” available to taxpayers whose tax liability has not previously been adjudicated by a court and whose liability is not currently being litigated. But they are all administrative opportunities, as opposed to judicial opportunities, and none of these administrative opportunities carry with them a right of the taxpayer to seek judicial review of an adverse administrative ruling.

Thus, the dichotomy set up by the Court in Lewis (administrative opportunities where there is a right of judicial review  versus  administrative opportunity  where there is no right of judicial review) was not proper. The proper dichotomy is whether Congress intended the concept of a “prior opportunity” in section 6330(c)(2)(B) to include both a “judicial opportunity” and a purely  “administrative opportunity” (i.e., an administrative without a right of judicial review) to challenge the underlying tax liability or intended to only include a  “judicial opportunity” to challenge the underlying tax liability.

Under the principle of ejusdem generis, the “ prior opportunity” referred to by section 6330(c)(2)(b) would necessarily be a judicial opportunity. See, e.g., Canton Police Benevolent Association of Canton, Ohio v. United States, 844 F.2d 1231 (6th Cir. 1988), Host Marriott Corp. v. United States, 133 F.Supp.2d 790, 793 (D.Md. 2000). That principle derives from the Latin term which means of the same kind, which when it comes to statutory interpretation generally provides the principle that when a statute lists something specific and then refers to the general, the general must refer to the same kind of things previously listed.

It seems to me that the application of ejusdem generis appropriate in this situation.  If the concept of  “prior opportunity” includes a purely  administrative opportunity to challenge the liability where there is no right of judicial review of an adverse administrative ruling, then there could never be any circumstances under which a taxpayer could  challenge the merits of an assessment under section 6332(c)(2)(B).  Such a result  would render meaningless the statutory right under section 6330(c)(2)(B) to challenge the merits of the liability in a CDP case and would violate the rule of statutory construction that says that statutes should not be interpreted in a way that renders them ineffective or futile. Matut v. Commissioner, 86 T.C. 686, 690 (1986).

Virtually every taxpayer who has received a bill from the IRS for unpaid taxes has an  “opportunity” to challenge the liability administratively, provided that the liability has not been previously adjudicated by a court and is not the subject of pending litigation.  Depending on the circumstances which preceded the assessment, the challenge to the liability can be done by submitting an offer in compromise based on doubt as to liability, a request for audit reconsideration, a request for penalty abatement and/or an amended returns, none of which carry with them the right of judicial review of an adverse ruling.

For example, taxpayers who for some reason do not actually receive a valid notice of deficiency have the ability to seek administrative audit reconsideration of the assessed deficiency.  See Baltic v. Commissioner, 129 T.C. 178 (2007), Internal Revenue Manual §4.13.3.   Because virtually every taxpayer who owes assessed taxes which have not been previously adjudicated by a court has an administrative opportunity to dispute the liability, it makes sense to construe the “opportunity” in section 6330(c)(2)(B) only as a judicial opportunity, not an administrative opportunity where there is no right of judicial review of an adverse administrative ruling. Otherwise the right to challenge the underlying liability in CDP proceedings is meaningless.

The statutory language refers only to the existence of an “opportunity,” not to an effort to take advantage of that “opportunity.”  Logically, under section 6330(c)(2)(B), that “opportunity” must necessarily  refer to an opportunity not taken advantage of.  Indeed, the fact that a failure to file a Tax Court petition in response to the issuance of a notice of deficiency precludes a taxpayer from challenging the merits of the liability shown on the notice of deficiency during a CDP appeal indicates that “opportunities” not taken advantage of are the opportunities which matter for purposes of section 6330.

The statute likewise does not limit the definition of an “opportunity” to an “opportunity” to take a matter to the Office of Appeals.  The statute on its face applies to all “opportunities.”  This is another reason why it makes sense to limit the definition of “opportunities” to judicial opportunities.

Thus, the distinction drawn by Treas. Reg. §301-6330-1(e)(3), Q&A-E2 between cases where there has been a prior hearing with the Office of Appeals and cases where there has been no prior hearing with the Office of Appeals has no support in the statutory language.  If the “opportunity” referred to in section 6330(c)(2)(B) includes all administrative opportunities, it should not matter whether or not the taxpayer has taken advantage of the administrative opportunity to go to the Office of Appeals. The mere existence of the administrative “opportunity” would theoretically prohibit the taxpayer from challenging the merits of the tax liability during a CDP appeal.

While it is possible to construe the term “opportunity” to include only those administrative opportunities (with no right of judicial review of an adverse administrative ruling)  which the taxpayer actually invokes, such a result makes no sense from a standpoint of tax administration. Such a rule would discourage knowledgeable taxpayers from attempting to resolve liability disputes as early as possible. Instead, knowledgeable taxpayers would sit back and wait for the IRS to issue a notice of intent to levy under section 6330, or to file a notice of federal tax lien, before they challenged the liability. And taxpayers who are not knowledgeable and who attempt to resolve liability disputes early in the collection process will be unknowingly penalized if they are unsuccessful in their initial administrative challenge and then seek to challenge the liability later in the context of a CDP hearing.

The regulation’s “carve out” for pre-assessment hearings with the Office of Appeals in cases subject to the deficiency procedures from the rule that prohibits raising the merits of the liability where there has been a prior hearing with the Office of Appeals  is nonsensical. For example, if a taxpayer had a hearing with the Office of Appeals following an income tax examination but prior to the issuance of the notice of deficiency to the taxpayer’s last known address, and the taxpayer did not actually receive the notice of deficiency, the taxpayer would currently be able to raise the merits of the tax liability in a CDP appeal. See, e.g.,  Kuykendall v. Commissioner, 129 T.C.  77 (2007), and cases cited therein.   Yet taxpayers who have pre-assessment hearings with the Office of Appeals regarding proposed Trust Fund Recovery Penalties are not able to raise the merits of the tax liability in a CDP appeal. See, e.g., Mason v. Commissioner, 132 T.C.  301 (2009).

Because interpreting the phrase “opportunity to dispute such tax liability” to include pure administrative opportunities would render nugatory the language in section 6330(c)(2)(B) which allows the taxpayer to challenge the underlying tax liability in a CDP appeal under certain circumstances, the Court’s holding in Lewis is not consistent with the statutory language of section 6330.

In addition, the Court in Lewis erred in deferring   to the Secretary’s interpretation of section 6330(c)(2)(B).   Section 6330(c)(2)(B) defines the scope of the Tax Court’s jurisdiction to review the merits of the tax liability which is subject of the collection action being reviewed by the Court pursuant to Section 6330.  In deferring to the Secretary’s interpretation of section 6330(c)(2)(B) as set forth in the Treasury Regulations, the Court effectively deferred to the Executive Branch in defining the scope of the Tax Court’s jurisdiction.

Courts have repeatedly stated that the courts, not the Executive Branch,  define the scope of their own jurisdiction.   See, e.g.,  Marbury v. Madison, 5 U.S. (1 Cranch) 137 (1803).    Courts have also repeatedly held that agency regulations which purport to define the scope of the jurisdiction of the courts are not entitled to any judicial deference. See, e.g.,  Schweika v. Department of Homeland Security,  723 F.3d 710 (6th Cir. 2013). Thus, the Court in Lewis should not have deferred to the interpretation of section 6330(c)(2)(B) set forth in the Treasury Regulations.

Because the taxpayer in Lewis was unrepresented, the concepts and arguments discussed in the blog post were not presented to, or considered by, the Court. That is most unfortunate, because we are now stuck with a result in Lewis that is in my view incorrect, barring a change of heart by the Tax Court, with or without a prompting by a Circuit Court of Appeals.