Two Notices of Deficiency, One Abatement, One Lien Release – Taxpayer Still Owes

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The recent bankruptcy case of Lewis v. IRS  caught my eye for the number of procedural gears in motion.  The focus of the case is on the impact of the release of the federal tax lien, but much more happens in the case and following the action plus, wondering why the IRS chose a certain path makes for an interesting discussion of what happens when the IRS makes a mistake and how it goes about correcting that mistake.

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Mr. Lewis had a business installing water lines for the city of Haynesville, Alabama. Apparently, the city did not have its own public works department with the capacity to do this and it contracted with Mr. Lewis to get this done.  In 2004, he installed enough water lines to earn $429,251.50.  Unfortunately, Mr. Lewis did not have time to file a federal tax return for that year.  The IRS prepared a substitute for return for him and issued a notice of deficiency.  He defaulted on the notice of deficiency, allowing the IRS to assess.  Based on the assessed liability, the IRS filed a notice of federal tax lien in 2010.  This fact pattern repeats itself all too often and presents nothing unusual.  Mr. Lewis has a case much like that of several clients of the Harvard Tax Clinic.

At almost the same time the IRS decided to file the notice of federal tax lien, Mr. Lewis “got religion” and decided to file his 2004 tax return. He did not get a whole lot of religion, however, because the Form 1040 that he sent to the IRS did not include the $429,251.50 he received for installing water lines and reported no income tax due.  When I first read that he filed the Form 1040 after the SFR assessment, I thought that perhaps he was trying to set the year up for a discharge in bankruptcy; however, he would not leave off the income from the installation of water lines if bankruptcy drove the filing of this return.  So, I cannot speculate why he filed this very late return and why he reported no tax liability on it.  Nonetheless, the IRS processed the return and abated the liability assessed as a result of the SFR.  The IRS routinely processes returns filed after SFRs and abates the SFR assessments down to the amount on the late filed return; however, the IRS usually gives some thought to the information reported on the SFR.  Here, the IRS appears to have given no thought to the late return before abating the assessment based on the SFR.

The abatement of the assessment created a zero balance on the account which triggered the release of the notice of federal tax lien as well as the refund of some of the money the IRS has collected to that point. The following year, the IRS awoke from its slumber on this case and began an audit of the 2004 return that failed to report any of the money on the Form 1099 issued by the city.  Not surprisingly, the IRS determined that he should have reported that amount and issued him a new notice of deficiency offering him what must have been at least his third chance to go to the Tax Court (the filing of the notice of federal tax lien would have given him a chance as well as the first notice of deficiency and I do not know if he also received a CDP notice for intent to levy though I would expect that he did.)  Mr. Lewis again chose not to go to Tax Court and the IRS again assessed the tax.  On January 23, 2015, the IRS filed a second notice of federal tax lien for 2004 and, I assume, gave him another CDP notice since this was a separate assessment.

Mr. Lewis filed a Chapter 13 petition on March 18, 2015 and eventually objected to the large proof of claim filed by the IRS. Mr. Lewis argued that the release of the federal tax lien had the effect of “extinguish[ing] any and all tax liability stemming from the tax period 2004.”  Mr. Lewis is not the first person against whom the IRS has improvidently released the federal tax lien.  A long list of cases exists deciding essentially the same argument he makes in this case – that the statute absolves him from all future liability for the period.  Unfortunately for taxpayers making this argument, that is not exactly what the statute says.  Section 6325(a)(1)(A) says that

“If a certificate is issued pursuant to this section by the Secretary and is filed in the same office as the notice of lien to which it relates… such certificate shall have the following effect:

(A)  In the case of a certificate of release, such certificate shall be conclusive that the lien referred to in such certificate is extinguished.”

Having the lien extinguished and having the liability extinguished are obviously not the same thing, and the Court walked through several cases making that point. I did not read all of those cases but suspect that few of them involved the fact pattern here in which the IRS actually went to the trouble to reassess the liability and file a new notice of federal tax lien.  A footnote in the opinion states that the IRS briefed the issue of whether the lien release barred the IRS from issuing a second notice of deficiency but the Court found it did not need to reach that issue.

Because the IRS not only released the first lien but abated the assessment, I think the court reached the right result using the wrong analysis. The first lien no longer mattered by the time Mr. Lewis filed bankruptcy.  The IRS might have tried to reverse the abatement – something it can do under the right circumstances – and revoke the release of the first lien but it did not.  Instead, it used its authority to issue another notice of deficiency.  The lien on which the IRS based its claim in the bankruptcy case had never been released.  Unless the court found that the release of the first lien barred the IRS from taking any further action with respect to the tax year 2004, which is the argument advanced by Mr. Lewis, the court did not need to cite to the line of cases holding that the release of the tax lien only extinguishes the lien but not the underlying liability.

Sometimes, a mistake by the IRS prevents it from collecting the tax at issue. Here, it had several avenues to use to continue pursuing collection of the tax.  It lost the priority position it held based on the original lien.  Several years passed before it filed the second lien.  The case does not provide enough facts to allow me to determine if other creditors benefited from the loss of the lien position.  The case also does not provide enough details to make it clear whether the IRS will collect on the outstanding liability, but it is clear that the claim filed by the IRS will withstand a challenge simply trying to argue that a mistaken release bars the IRS from further collection for the year at issue.

 

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