Transferee Liability and the Application of Federal versus State Law

We welcome back guest blogger Marilyn Ames.  Marilyn has retired from the Office of Chief Counsel, IRS to the 49th state where she enjoys shoveling snow and other outdoor activities.  She also works with me on the collection chapters of the Saltzman and Book treatise, IRS Practice and Procedure.  Today, she writes about a recent case in which the IRS asserted transferee liability.  Based on the number of transferee cases I am seeing, I believe that the IRS has stepped up activity in this area over the past couple of years.  For those of you interested in transferee liability, Marilyn wrote an earlier post on the subject that you may also want to view.  Keith

In an opinion issued on December 16, 2016, the Seventh Circuit Court of Appeals played Grinch in Eriem Surgical, Inc. v. United States and gifted the Internal Revenue Service and the taxpayer with an opinion calculated to make both unhappy.  The opinion can be found here and at 843 F3d 1160.

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Eriem Surgical purchased the inventory of Micrins Surgical, Inc. when it went out of business in 2009 without paying its taxes.  Eriem also took over Micrins’ office space, hired its employees, used its website and telephone number, and continued Micrins’ business of selling surgical instruments.  Eriem also used the name “Micrins” as a trademark, and Bernard Teiz, the former president of Micrins, continued to play a leading role in Eriem’s business. All of this raised the suspicions of the Internal Revenue Service, although Mr. Teitz attempted to quell those suspicions by having his wife hold the 40% interest in Eriem that he formerly held in Micrins.  But this was not enough, and the Internal Revenue Service concluded that Micrins had simply morphed into Eriem, and levied on Eriem’s bank account and receivables.  Eriem then filed a wrong levy suit under 26 USC §7426(a)(1). The district court applied Illinois state law to determine that Eriem was a successor to Micrins, and as such, was liable for Micrins taxes.  Although Eriem appealed, the United States used this as an opportunity to make an argument that the courts have rejected up to this time.

The courts have long held that whether a third party is liable under some doctrine of transferee liability is dependent on state law. However, for the past few years, the Internal Revenue Service has taken the position that federal common law should govern whether a third party is the alter ego of the taxpayer, arguing that the application of state law leads to different results depending on the law of the applicable state and, consequently, to disparate treatment of taxpayers in essentially the same position. In staking out this position, the IRS has relied in part on United States v. Kimbell Foods, Inc., 440 US 715 (1979) and Drye v. United States, 528 US 49 (1999). The Service’s argument can be found in Chief Counsel Notice 2012-002 (Dec. 2, 2011), which can be located here.  The essence of the Service’s position is that state law should not control in an alter ego dispute, as the question is not one of property rights, but is an issue of the identity of the taxpayer. Since the IRS is ultimately interested in reaching property, not just engaging in identification of the taxpayer, this seems to some extent to be a distinction without a difference – at least without a difference that would matter to the third party/taxpayer.

On appeal, the Seventh Circuit confronted the question of whether state or federal law governed with respect to corporate successorship, and held that since the Internal Revenue Code does not say anything about this issue, “it seems best to apply state law.”  The court held that Kimbell Foods is not dispositive, as the Supreme Court has failed to cite it in later cases for the proposition that federal law controls, and that Drye expressly states that “in tax cases state law determines the taxpayer’s rights in property that the IRS seeks to reach.” Although it is not clear from the opinion if the United States argued that this was really just a case of identity, it’s doubtful that the court would have bought the argument, given that this case was really about the IRS cleaning out Eriem’s bank account.  The Seventh Circuit affirmed the district court’s application of Illinois law, thus ensuring that Mr. Teitz and Eriem were also unhappy with the result.

In an interesting sideshow to the federal/state law question, the Seventh Circuit also rejected Eriem’s argument that the 40% change in ownership had “dispositive significance.” Although Illinois law holds that a complete change of ownership prevents a finding of successorship, the Seventh Circuit affirmed the district court’s conclusion that Mrs. Teitz was serving as a proxy for her husband, and so the purported change in ownership was irrelevant.

Whether the IRS and the Department of Justice will continue to argue that there is a federal common law that should determine when a third party is an alter ego for purposes of tax collection remains to be seen, since it has not been popular with the courts.  In most cases, it doesn’t seem to make a difference to the end result, and may simply be a cut-and-paste argument the government is making to bolster its position.

IRS Master File and Non-Master File Accounts

Today, guest blogger Marilyn Ames provides a brief description of the IRS master file in order to provide context for some of the discussions we have had about taxpayer accounts.  Understanding the way the IRS keeps its books on taxpayer accounts can make a difference.  When an account moves from the master file to non-master file, the transcript, at first glance, can give the impression that the taxpayer owes nothing.  Without an understanding of the different accounts, it is easy to become confused. 

The National Taxpayer Advocate did a study on the problems created by conversion from master file to non-master file and reported on it in her 2009 annual report.  The issue is further complicated by the timing of when the IRS will or should convert a case from mater file to non-master file and that can depend on the type of case involved.  One trigger causing an account to move to non-master file status  is a request for innocent spouse status. Other triggers include the filing of bankruptcy by one spouse or the filing of an offer in compromise by one spouse.  It should occur whenever the collection on the formerly joint account moves in two directions because the actions of one spouse no longer move in sync with the other.  Consult the IRM on when the split should occur but be aware that the IRS does not always move the account to non-master file status when it should and the failure to do so can cause havoc.  Keith

According to the Internal Revenue Manual, the master file is “the official repository of all taxpayer data extracted from magnetic tape records, paper and electronic tax returns, payments, and related documents….” (IRM 21.2.1.2, Master File (Oct. 1, 2011).  This statement, which appears to include all of a taxpayer’s tax accounts, is not quite correct.  Because of the limitations to the technology behind the master file, the Internal Revenue Service has a Plan B.  That Plan B is known as the non-master file, and as some taxpayers have found to their dismay, it includes liabilities not reflected in the taxpayer’s master file.

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The non-master file system exists for the sole purpose of providing a means to assess and collect liabilities that cannot be handled by the master file. The non-master file was initially a manual system that consisted of index cards maintained in alphabetical order.  Since those not-so-long-ago days, non-master files are now kept electronically, but in a system totally separate from the master file system known as the Automated Non-Master File, or ANMF.  Unfortunately, the ANMF cannot be accessed by the Integrated Data Retrieval System of the IRS, which is how Service employees generally obtain information about taxpayers’ accounts, and from which tax transcripts are usually printed.  If a Service employee does not recognize the existence of a liability on a non-master file, or the taxpayer only receives transcripts printed from the master file system, a taxpayer or an unknowing representative may be left with the impression that there is no outstanding tax liability, while assessments are still lurking on the ANMF.

So what kinds of liabilities are contained on the non-master file?  Generally, cases involving transferor/transferee liability, termination or jeopardy assessments, cases involving lookback interest, and individual returns on which the secondary taxpayer is deceased will be assessed on non-master file.  If the Service is collecting child support obligations, these liabilities will be shown on a non-master file account. Beyond these types of cases, there are other assessments that are also made on the non-master file.  If the Internal Revenue Service needs to make an assessment within a matter of hours, the assessment will be made on non-master file, as it can be posted within 24 to 36 hours, rather than the four to six weeks for an assessment to be made on the master file.  If Congress passes new tax laws that need to be implemented quickly, the returns reflecting those changes will be assessed on non-master file until the master file system can be updated.  Certain other assessments, such as penalty assessments made under IRC §§ 6692, 6652(e), and 6652(d)(1) or (2), are also made on non-master file. A reversal of an erroneous abatement after the statute of limitations on assessment has expired will also occur on non-master file.  And, my personal favorite, some tax liability is simply too big for the master file system and must be assessed on non-master file.  If an individual taxpayer files a return showing a tax liability of $1 billion or more, the record will be maintained on the non-master file.  (Interestingly, the Internal Revenue Service also maintains a spreadsheet of the taxpayers who regularly file such returns, and tracks these returns.  Finally, an IRS list I wouldn’t mind being on.)

Some liabilities may start out on master file, and then be switched to non-master file.  The master file system can only handle a certain number of transactions for any particular tax account.  When the limit is reached, the account is systemically transferred to non-master file.  A transaction code 130 and a freeze will be made on the master file account to warn IRS personnel that this transfer has been made, but the master file account will also have the outstanding liability zeroed out by the addition of an equal credit.  This can make a taxpayer very happy if the Service employee fails to note and tell the taxpayer about the existence of the new non-master file account.  There is also a delay between the movement of a transaction from master file to the new non-master account, and it can be up to 45 days before the new file is posted in the ANMF system.

And if this wasn’t complicated enough, there may also be more than one non-master file account for the same tax period.  If an additional assessment is made for an account on the ANMF system, the additional assessment is not just added to the account as it would be on master file, a new separate non-master file account is established.

The ANMF system also issues different collection notices from those issued by master file.  A taxpayer whose liability is assessed on non-master file will only receive two initial collection notices – those that would be the first and the fourth notices sent for a master file account.  However, the taxpayer will still receive an annual reminder notice for the non-master file account of the outstanding balance, just as a taxpayer does for a liability assessed on master file.

So how does a taxpayer know that the notices being received are for a liability assessed on ANMF?  This is easy – there will be an “N” after the taxpayer identification number.  If there is a reference to a document locator number in a tax transcript, the third digit in the number will be a 6 if the document is on non-master file.  Because the processing involved with non-master file can be extremely specialized, most non-master file accounts are handled at just two Service campuses, Cincinnati and Philadelphia.  If a taxpayer appears to have a non-master file issue, the taxpayer or the representative should send a copy of the notice, letter or other document along with any correspondence discussing the problem so the issue is routed to the right office for handling.

Non-master file assessments are not as common as they were in the past, because one large area of non-master file cases is now handled by the master file system.  In the past, when individual taxpayers filed a joint return and some action occurred that affected only one spouse, the accounts would be split between the two spouses on non-master file.  This could have occurred because of a bankruptcy filing by only one spouse, one spouse being granted innocent spouse relief, or one spouse entering into an offer-in-compromise.  Split assessment accounts can now be created on master file, in what is referred to as MFT 31.  The creation of MFT 31 accounts causes each spouse’s liability and any transactions with respect to that liability to be tracked separately.  The National Taxpayer Advocate has expressed concerns about the MFT 31 accounts.  While report in which these concerns were expressed is now several years old, the issues raised in the report may still have some currency.  Taxpayers and their representatives still need to remain aware, however, because the liability remaining at the time the split assessment accounts are created will still be zeroed out on the original master file account.  As with a transfer to non-master file, if the liability has not been paid off, it may still remain and be lurking in the new MFT 31 account like a monster under the bed.  If the tax transcript shows a transaction code 400, the representative needs to press further to find the transcript for the new split assessment.

What Duty/Ability Does the IRS Have to Notify Clients of Professionals It is Auditing?

We welcome back guest blogger Marilyn Ames who takes a look at a recent complaint filed against the IRS by individuals who may not have received zealous representation from their accountants based on a conflict of interest.  Like me, Marilyn is retired from the Office of Chief Counsel, IRS where she worked for many years as a manager in the Houston office.  She currently assists in updating Saltzman and Book, IRS Practice and Procedure chapters while enjoying her retirement in Alaska.  Keith

In an action that partakes a little of the old fairy tale of spinning gold out of straw, on April 22, 2016, the former CEO and COO of Sprint Corporation, William Esrey and Ronald LeMay, filed suit against the United States seeking damages of $42.5 and $116.8 million, respectively, under the Federal Tort Claims Act.  The basis for their suit is that the Internal Revenue Service did not inform them that their long-time accounting firm, Ernst & Young, was under investigation for its actions in selling tax shelters. Mr. Esrey and Mr. LeMay had not only purchased tax shelters from Ernst & Young, but Ernst & Young was the certified public accounting firm for their employer, Sprint.  The plaintiffs contend the IRS “helped EY to hide information from Plaintiffs knowing that such information would have been critical to Plaintiffs’ evaluation of whether to trust EY and whether to continue to tell Sprint that EY was trustworthy and devoted to helping Plaintiffs resolve their tax audits with the IRS.” The complaint can be viewed here.

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A little background to this convoluted story might be helpful before taking a quick look at the basis for Mr. Esrey’s and Mr. LeMay’s suit and the greater issues the suit raises.  At the time when our story begins unfolding, Mr. Esrey was Sprint’s CEO and the Chairman of its board, and Mr. LeMay was its COO and, according to the complaint, Mr. Esrey’s heir apparent.  Mr. Esrey and Mr. LeMay both employed Ernst & Young as a tax advisor and financial planner, and Ernst & Young was also the certified public accountant for Sprint.  Messrs. Esrey and LeMay both purchased tax shelters from E&Y in each of the years from 1999 through 2001.

The IRS did not take a kindly view of E&Y’s tax shelters, and according to the complaint, began an investigation of these transactions in March of 2002, that at some point included both civil and criminal investigators. The IRS also began auditing those taxpayers who had purchased tax shelters from E&Y, including the plaintiffs. Apparently not recognizing that having the seller of your tax shelter represent you before the IRS might be problematic, Mr. Esrey and Mr. LeMay engaged E&Y to represent them when the IRS began looking at their tax returns.  In the meantime, E&Y negotiated a resolution with the IRS with respect to some of its tax shelter activities, and in June of 2003, paid the IRS $15 million for failing to register the tax shelters they were selling and for failing to maintain lists of those for whom E&Y had acted as a material advisor with respect to the tax shelters.  (Although neither the complaint nor the IRS press release indicate the basis for the payment, presumably these were penalties imposed under IRC §§ 6707 and 6708, which are in a subchapter titled “Assessable Penalties.”) According to the complaint, as part of the settlement the IRS agreed not to use the word “penalty” in its press release in exchange for an additional $1.4 million over the amount previously agreed to.

After the settlement in 2003, the criminal investigation of E&Y and its employees continued on, and in May of 2007, four employees were indicted on tax charges in connection with the marketing of tax shelters, and two were eventually convicted.  Newspapers began reporting that E&Y was under investigation for these activities.  Plaintiffs contend that it was at this time they learned of the criminal investigation.

When the employment contracts for Mr. Esrey and Mr. LeMay were renewed in 2001, the plaintiffs disclosed to the Sprint board of directors that they had “entered into the transactions that EY had promoted.”  By 2002, according to the complaint, the Sprint board and audit committee became concerned there would be a conflict of interest between Esrey and LeMay and E&Y because of the audit of the tax shelters.  The complaint does not disclose what caused Sprint to become concerned about this.  The plaintiffs made a presentation to the board in December of 2002 recommending that Sprint dismiss E&Y as its auditor because of the board’s concern regarding a conflict of interest, and E&Y made a presentation that its advice to the plaintiffs “was sound and its actions proper.” The board determined that a potential conflict of interest was great, but that firing its auditor would result in negative publicity and would impact Sprint.  Instead, they asked Mr. Esrey and Mr. LeMay to resign, which they did in 2003.  Although the complaint does not indicate how the amount requested in damages was computed, it was this loss of their employment that has caused the plaintiffs to sue the United States. For those of you who want to know the rest of the story, the complaint also states that Mr. Esrey and Mr. LeMay filed suit in the Tax Court with respect to their tax shelters, the result of which is not disclosed, and they also initiated an arbitration action against E&Y and received a final award in 2014, the amount of which is also unknown.

Ignoring such obvious issues as the statute of limitations problem and the causation issue (after all, the injury complained of occurred in 2003, and was the result of Sprint choosing its auditor over its executives), the larger questions for the tax community are whether a failure to disclose information about a taxpayer’s representative to the taxpayer is actionable under the Federal Tort Claims Act, and whether it should be. By its terms, 28 USC § 2674 provides a remedy for persons injured by governmental negligence in circumstances like those in which a person would be compensated for the negligence of another private person.  Generally, in litigation between private parties, the burden to disclose a conflict of interest in legal representation is on the attorney representing the taxpayer, not on the opposing party or the opposing party’s counsel.  Is it ethical or even desirable to have the IRS reaching out to a taxpayer to question the taxpayer’s choice of representative? If a failure to warn a taxpayer is actionable, when does the duty to warn arise?  Should the IRS issue press releases when it begins investigating return preparers, so the public can avoid those who may prepare questionable returns – at the risk of ruining a potentially innocent person’s business?  An investigation is simply that – an investigation.

The FTCA also permits the United States to assert any defense based on judicial or legislative immunity that would otherwise have been available to the employee whose actions form the basis for the suit.  Any plaintiff arguing that the IRS should have disclosed information to the plaintiff that does not involve the plaintiff’s own tax returns is always going to have to overcome the hurdle of IRC § 6103 – the disclosure statute.  The plaintiffs have ignored this hurdle in their complaint, but it is a sure bet that the United States will not.  It is clear that the IRS believed that Section 6103 applied to the investigation of E&Y; the press release announcing the $15 million paid to the IRS expressly states that the closing agreement between E&Y and the IRS included a disclosure authorization allowing the IRS to issue the press release. If the IRS does have a duty to disclose that a representative is questionable, how does the IRS do that without potentially disclosing the tax return information of other taxpayers?

In support of its allegations that the IRS is liable for the plaintiffs losing their jobs, the complaint asserts that the IRS had a policy at the time of the E&Y audits to seek assurances from taxpayer representatives who were tax shelter promoters that their clients were informed of potential conflicts of interest, citing a then-applicable provision of the IRM and an opinion given by Chief Counsel to an employee of the IRS.  While the plaintiffs are correct that there was such a policy, the policy was to require promoters to inform their clients of a potential conflict of interest, and for the IRS to seek assurances from the representative that it had done so.  While the complaint is silent on whether the IRS asked for and received such an assurance from E&Y, it is not clear that even if the IRS failed to do so that the plaintiffs would have a right to recover.  They would first have to overcome the hurdle of United States v. Caceres, 440 US 741 (1979), in which the Supreme Court held, in a case involving the Internal Revenue Manual, that courts are only required to enforce agency regulations when compliance is mandated by the Constitution or federal law; otherwise, agency directives do not give taxpayers rights not otherwise given.  If the plaintiffs prevail in this suit against the United States, will the IRS be tempted to hide its directions to employees in documents not publicly disclosed, or for IRS attorneys to only give oral advice not made available to the public?

This case raises a number of interesting questions, and its progress will bear watching for the greater impact it may have on both those who enforce the tax laws and those who represent taxpayers.

 

 

 

Transferee Liability When Selling a Corporation

We welcome back guest blogger Marilyn Ames who writes about an important recent 9th Circuit opinion reversing and remanding a Tax Court decision regarding the proper standard to apply in transferee liability cases.  Marilyn, a Chief Counsel retiree and current resident of Alaska, is working with me to revise and update Chapter 17 of Saltzman and Book on transferee, trust fund and other derivative tax liability issues.  Keith

In its second opinion on the issue of transferee liability issued within a year, the Ninth Circuit recently took the Tax Court to task in the case of Slone v. Commissioner, 2015 WL 5061315 (August 28, 2015), and remanded the case, instructing the Tax Court to use the correct legal standard in applying Section 6901 of the Internal Revenue Code to the transaction in question.  In doing so, the Ninth Circuit expanded the analysis to be used in determining when a person is liable as a transferee, which it first set out as a two-prong test a year earlier in Salus Mundi Foundation v. Commissioner, 776 F.3d 1010 (9th Cir. 2014). In the Slone case, the Ninth Circuit recognized it was breaking new ground, holding: “Although we have not previously considered how a court should analyze a transaction for purposes of transferee liability under § 6901, both the Supreme Court cases, and our own precedent, require us to look through the form of a transaction to consider its substance.”

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In order to understand the breadth of the Ninth Circuit’s holding, a review of the facts in the Slone case is necessary. The facts in Slone are not simple.  Slone Broadcasting Co. sold all its assets to Citadel Broadcasting Co. for $45 million. Before this transaction closed, Fortrend International, LLC approached the shareholders of Slone and suggested a merger with Slone Broadcasting, with an alleged eye to restructuring the resulting company to engage in asset recovery. The shareholders agreed, and after the asset sale, sold their shares of Slone to Berlinetta, Inc., an affliate of Fortrend, for $35.8 million.   At this point, Slone no longer had its radio broadcasting network, but did have a lot of cash and a tax liability of about $15 million from the sale of its assets. Berlinetta agreed to assume Slone’s income tax liability, and the Slone shareholders received cash payments for their stock totaling $33.6 million.

Slone then merged with Berlinetta, and the remaining company changed its name to Arizona Media Holdings Inc. Within days of the sale of the stock, an unnamed shareholder of the new Arizona Media contributed Treasury bills with a basis of $38.1 million to the new company.  Arizona Media then sold the bills for $108,731.  When Arizona Media filed its tax return for this fiscal year, it reported a $37.9 million gain from the sale of Slone’s assets, claimed a loss of $38 million from the Treasury bill sale, and no tax liability.  It then requested a refund of the $3.1 million tax payment previously made by Slone, which the IRS granted.

Once the IRS took a closer look at Arizona Media’s return, it was not so agreeable.  Eventually, the Service assessed a deficiency against Arizona Media in the amount of $13.5 million, along with interest and penalties.  Arizona Media paid nothing towards this liability, and the next year the state of Arizona dissolved Arizona Media for failing to file its annual report.  Once again, the IRS was not happy and looked around for another party to tap for the unpaid bill.  Using Section 6901, the IRS determined that the shareholders were liable as “transferees” of Slone, taking the position that the substance of the transactions was that Slone dissolved when it sold its assets to Citadel, and the remaining assets – consisting of the cash from the asset sale – were then distributed to the shareholders through the transaction put together by Fortrend. According to the Commissioner, the Slone shareholders were transferees as they received the assets of a taxpayer who owes income tax. The Tax Court disagreed with the Commissioner, holding that it would respect the form of the transactions, so the shareholders were not the transferees of Slone.  The Service was again unhappy, and appealed to the Ninth Circuit.

It was here that the Commissioner got some limited satisfaction.  The Ninth Circuit found that the Tax Court had applied an incorrect legal standard in characterizing the transaction for tax purposes. The Court, at length, instructs the Tax Court on the standard it should have applied, holding that determining whether a person is a transferee requires a two-prong inquiry.  The first prong requires an analysis of federal law to determine if the person is a transferee under Section 6901 and federal tax law.  The second prong of the test requires an analysis of whether the person is substantively liable for the transferor’s unpaid taxes under applicable state law because of the receipt of the transferor’s property, using the state’s fraudulent conveyance law.  The two prongs are separate and independent inquiries, according to the Ninth Circuit.

The Ninth Circuit’s focus in Slone is on the first prong, with a new emphasis on looking at what a transaction actually is.  Citing Frank Lyon Co. v. United States, 435 U.S. 561 (1978), and Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir. 1990), the Ninth Court outlines another two-part test for determining whether a transaction is a sham: was there a business purpose for the transaction, and has the taxpayer shown the transaction had economic substance beyond the creation of tax benefits? Although the Ninth Circuit outlines a two-step test, which should consider both subjective and objective factors, the Court suggests a “holistic” analysis rather than a rigid application of the two steps.  In other words “If a common sense review of the transaction leads to the conclusion that a particular transaction does not have a non-tax business purpose or ‘any economic substance other than creation of tax benefits,’ the form of that transaction may be disregarded, and the Commissioner may rely on its underlying economic substance for tax purposes” (citing Reddam v. Commissioner, 755 F.3d 1051 (9th Cir. 2014)).

Using this newly articulated standard, the Ninth Circuit concludes that the factors the Tax Court looked at in reaching its decision were not relevant to determining whether the transactions in question had a “business purpose . . .other than tax avoidance, or whether the stock purchase transaction had economic substance other than shielding the Slone Broadcasting shareholders from tax liability.” The Tax Court’s findings were, the Court opined, factors that related to the question of whether the shareholders had knowledge that would make the transaction fraudulent under state law.  And so the Ninth Circuit sent the Slone cases back to the Tax Court to apply the correct legal standard.

Whether the IRS will be happy at the end of the day remains to be seen.  Although the Tax Court may not have applied the correct factors in reaching a conclusion as to the first prong, the Tax Court did make factual findings that would support a negative conclusion that the Slone shareholders had acted fraudulently under state law, the second prong of the test to impose transferee liability under Section 6901.  Since both prongs must be met to impose liability, the Commissioner may simply have won one battle, the overall impact of which remains to be seen.

NorCal Tea Party Patriots v. IRS: Change in the Restrictions on Disclosure of Third Party Information?

Today, we welcome back guest blogger Marilyn Ames writing from the 49th state where she lives following her retirement from the Office of Chief Counsel.  Keith

On April 1, 2015, the court in the NorCal Tea Party Patriots case issued an order requiring the government to turn over information identifying the other organizations allegedly targeted by the Internal Revenue Service for intensive scrutiny when the organizations applied for tax-exempt status.  This order is at odds with a decision by the Court of Appeals for the Federal Circuit, and, if allowed to stand, may signal a sea change in the ability of taxpayers to get information regarding the tax returns and return information of third parties.

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For those not familiar with the case, here’s a little background. In May of 2013, ten organizations filed suit against the United States, the Internal Revenue Service and various individual employees of the Internal Revenue Service, alleging that their rights under the Privacy Act, the First and Fifth Amendments and the non-disclosure provisions of IRC § 6103 were violated when they applied for tax exempt status and were then subjected to intensive scrutiny because of their dissent from the policies of the Obama administration.  The plaintiffs also sought to certify a class consisting of all other organizations subjected to the same intensive scrutiny for their “dissenting” beliefs. After some preliminary procedural skirmishing, the Privacy Act count was dismissed, as were the individual IRS employees, leaving the remaining counts to go forward against the United States and the Internal Revenue Service.  The request for class certification also remained to be decided.

In their efforts to certify a class, the plaintiffs served discovery on the government. They requested, among other items, that the government turn over any lists or spreadsheets the IRS used to track groups flagged for heightened review, the list of 298 applicants that the IRS compiled and provided to the Treasury Inspector General for Tax Administration (“TIGTA”) for its use in reviewing the conduct of the IRS, and an additional tracking sheet of applicants also sent to TIGTA.  This information was to form the basis for the plaintiffs’ efforts to certify a class. The government refused, claiming that the disclosure would violate the provisions of the disclosure statute, IRC § 6103.  It is this discovery request that triggered the court’s order of April 1.

Section 6103(a) of the Internal Revenue Code states that “returns and return information” are confidential, and cannot be disclosed except as permitted by the Internal Revenue Code.  Section 6103 then proceeds, in the longest section in the Internal Revenue Code, to detail exactly when a taxpayer’s return or return information can be disclosed.  Fortunately for us, we can skip most of section 6103 and go directly to the subsection at issue – IRC § 6103(h)(4)(B), which deals with when returns or return information can be disclosed in a judicial or tax administration proceeding.  Both parties agreed that the list in question constituted return information as defined in section 6103(b)(2). (Basically, return information is all information regarding a taxpayer’s return received by, recorded by, prepared by, furnished to, or collected by the Internal Revenue Service in its determination of the possible existence or a liability of any person for a tax, penalty, interest, fine, forfeiture or offense.  That covers pretty much everything if taxes are involved.)

The plaintiffs argued that the information they requested meets the exception to disclosure contained in section 6103(h)(4)(B), which provides that disclosure can be made in a judicial proceeding “if the treatment of an item reflected on such return is directly related to the resolution of an issue in the proceeding,” sometimes referred to as the item test. Citing past cases, the court noted that the issue to which the return information relates is not limited to matters concerning the taxpayer’s tax liability.  Quoting Chief Counsel Advisory, IRC CCA 201250020, the court stated: “The item must ‘affect the resolution or be germane to an element of the claim,’ but it need not be dispositive of the issue.” The court concluded that the spreadsheets and lists were directly related to the issue of class certification, denied the government’s motion for a protective order and granted the plaintiffs’ motion to discover the information.

It is in footnote 4 of the court’s order that things get really interesting, because it is here that the court rejects the government’s arguments based on the reasoning of the case of In re United States, 669 F.3d 1333 (Fed. Cir. 2012).  The government relied on the United States case for two propositions.  First, an item reflected on a return can only be information provided by the taxpayer and filed with the IRS. In other words, only returns can be disclosed using the item test, because only returns are filed.  Return information, including return information prepared by the government, cannot be disclosed.  Second, the government argued, the item test did not permit disclosure because the return information in question did not “directly relate” to an issue in the case.  The court in the United States case expressly held an item is never directly related when the only link between the taxpayer and the third party is the same tax treatment.  (It should be noted there is a split in the circuits as to how strictly the “directly related” part of the item test should be applied. The NorCal court mentions several of these cases.) When these two propositions are taken together, a taxpayer seeking information regarding a third party’s tax treatment can almost never get it.

The NorCal court felt that the item test should be more broadly interpreted on both these points, and looked to an unexpected source for support in its decision.  In October of 2012, after the opinion in the United States case was issued, the IRS Chief Counsel issued an advisory opinion that contradicted the United States case on both these points in the results reached.  (While the court recognized the advisory opinion contained in IRS CCA 201250020 is by its own terms not to be used or cited as precedent, the court said it was not citing it as precedent but “for its well-reasoned analysis.”) The issue presented in the advisory opinion was whether third party return information could be used in the cases of other taxpayers involved in similar captive insurance programs all set up by the same individual.  The opinion concluded that third party return information could be disclosed under the item test if it showed a pattern that directly related to the resolution of an issue in the case.  In the situation in the opinion, if return information of a third party showed that the arrangement sold to the taxpayer did not have sufficient individualized risk transfer and distribution to qualify as insurance, the third party information could be disclosed.  It could not be disclosed simply to show that the taxpayer had entered into an invalid transaction similar to that of the third party.

If the government does not seek to block the discovery order, the court in NorCal may have opened a door for a broader reading of section 6103(h)(4)(B).  If so, this would allow taxpayers to obtain information on how the IRS treats those taxpayers who are similarly situated, provided the taxpayer can show a pattern that would bear on the resolution of an issue in the case. It would also allow the IRS to use this information in the same way.  Overall, this can only work towards tax administration that treats similar taxpayers consistently.

 

“Do Overs” – The Binding Effect of an Offer in Compromise

Today we welcome first time guest blogger Marilyn Ames. Marilyn and I worked together at IRS Chief Counsel’s office for many years separated by about 1,500 miles.  She is retired now and living in Alaska but assisting me in rewriting the Saltzman and Book collection chapters.  We are working on the offer in compromise section of the book and by chance I received a question from another clinic about what to do when the IRS begins auditing your client for a period covered by the offer.  This past summer I had drawn a question from another clinic about what to do when your client discovers they should have received a large refund for a period covered by the offer.  As we looked at those situations, we decided that the effect of the offer was clear under the law but perhaps not clear to those entering into the offer.  That discussion led to this post and I thank Marilyn for her efforts.  Keith  

The IRS has had the authority to compromise with taxpayers since the first income tax code, and taxpayers and the IRS have been litigating over the effect of an accepted compromise almost as long.  Usually it has been the taxpayer who has requested what my children used to call a “do over” when they played games; as in “I don’t like what happened in the move I just completed and now I want to take that move back.”  Recently, however, it appears that the IRS has begun to ask for do overs in the area of offers in compromise.

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Section 7122 and its predecessors give the IRS the authority to compromise any civil or criminal case arising under the internal revenue laws. In the first reported do over case involving an accepted offer in compromise, Ely & Walker Dry Goods Co. v. United States, 34 F.2d 429 (8th Cir. 1929), the taxpayer discovered after it entered into a compromise involving its income tax liability and the fraud penalty for its fiscal year ending in 1918, that its inventory was incorrectly computed.  The parties agreed that absent the compromise, the taxpayer would be entitled to a refund.  The taxpayer argued that the compromise was only of the fraud penalty, not the tax, so the compromise was not precluded by the acceptance of the offer in compromise.  The court rejected the taxpayer’s argument, holding that the income tax liability “constituted an entire, single liability, that this single liability, treated as such by the parties, was duly compromised, and that such compromise is a bar to this action.” 34 F.2d at 432. 

Since 1929, taxpayers have unsuccessfully attempted to get a do over by distinguishing the holding in Ely & Walker Dry Goods that a compromise of a tax liability closes that tax year, and the liability cannot be reopened.  The Internal Revenue Service has agreed with that holding, both in its litigation positions and in its publicly stated policy. Treas. Reg. § 301.7122-1(e)(5) expressly states that acceptance of an offer in compromise conclusively settles the liability of the taxpayer specified in the offer, and that neither the taxpayer nor the Government will be permitted to reopen the case after an offer has been accepted unless the taxpayer has committed fraud by supplying false information or documents, or by concealing assets or the ability to pay. The regulations further allow the liability included in an offer in compromise to be reopened in the event of a mutual mistake of material fact.  The court in Rosenberg v. United States, 313 F. Supp. 28 (N.D. 1970)upheld this regulation, stating that it had the force and effect of law as it was not clearly unreasonable.

Absent fraud or mutual mistake of fact, the courts have not allowed taxpayers the requested do over. One of the more recent attempts to avoid the binding effect of an offer in compromise was made by the taxpayer in Dutton v. Commissioner, 122 T.C. 133 (2004), in which the taxpayer tried persuade the Tax Court that his claim for innocent spouse relief should be granted and he should receive a refund. The Tax Court rejected his argument that there was a mutual mistake sufficient to have had a material effect on the agreed exchange of performances.

In Revenue Procedure 2003-71, written for the purpose of describing the process for submitting and resolving an offer in compromise, the IRS emphasizes in section 8.02 that “Acceptance of an offer in compromise will conclusively settle the liability of the taxpayer specified in the offer.”  In PLR 5807022300A, the IRS stated “So long as an offer in compromise is in effect, all rights to further adjustments for the year or periods involved are waived.  For a compromise is a binding contract, conclusive against both the Government and the taxpayer.”

Despite the long-settled legal position that an accepted offer in compromise closes out all tax periods and years included in the offer, the recent case arising in one clinic suggests that the IRS seeks to give itself a de facto do over. It contacted a taxpayer with an accepted offer seeking to audit years included in the compromise.  The contact came in the form of a CP 2000 notice.  These notices are issued by the Automated Under Reporter (AUR) Function when the information returns filed with the Service do not match the information reported on the taxpayer’s return.  Presumably this is not a compromise where the IRS has discovered that there was fraud or a mutual mistake of fact, as the taxpayer has not received the letter required for a rescission IRM 5.8.9.2.1, Rescission Procedures (September 23, 2008) of an accepted offer in compromise. Absent fraud, it is doubtful that the existence of this potential additional liability would constitute a mutual mistake of fact that would have kept the IRS from accepting the offer in compromise, and that the compromise could be rescinded.

Apparently this is a case of the right hand and the left hand of the IRS not knowing what the other is doing, although if the IRS computer systems can match income information with returns, it would seem that the system could also be programmed to recognize the existence of an accepted offer in compromise for this tax period. The possibility exists that the AUR Function did not pick up the computer code entered in the offer case or the timing of the underreporter case came just before the offer code appeared on the account.  Since these cases are worked basically by computers rather than individuals, the timing of the offer and the AUR notices may have been ships passing in the night that no one at the IRS observed.

The Internal Revenue Manual IRM 5.8.4.17, Pending Assessments (May 10, 2013)  contains clear instructions on how to handle audits that are open when an offer in compromise is submitted for the same year, but doesn’t appear to recognize that an audit could be opened after the offer is accepted.  While a taxpayer with an accepted offer who receives a CP 2000 notice may find someone at the IRS who understands the tax year is closed, or may have competent counsel who can make the argument, the possibility exists that many taxpayers in this situation would simply pay the additional liability.  Because this has happened in only one known case, it is unclear if a systemic issue is at play or an anomaly.

One final aspect of later discovered issues in offers bears mentioning.  If the IRS discovers a tax period that should have been included in an offer in compromise but was not, and both parties are in agreement, the procedure is simply to add the additional tax periods to the original offer.  The additional liability must have been assessed before the original offer in compromise was accepted.  IRM 5.8.9.5, Overlooked Periods (April 15, 2011).  While you want to put every period in which the taxpayer has an assessed liability into an offer and you want to resolve all periods for which the taxpayer is under audit at the time of the offer, sometimes a period gets overlooked.  This procedure can fix the problem if the assessment occurred before the offer acceptance.  This procedure cannot fix the problem if the audit did not result in an assessment.  It also cannot help the taxpayer who later “discovers” they were due a refund for a period covered by the offer.  Because of the binding nature of the offer, a complete review of taxpayer’s circumstances for all open years should take place in conjunction with the submission of the offer to avoid problems of the failure to cover periods or the failure to seek a refund before it’s too late.