TIGTA Report Criticizes TAS’s Approach to Offset Bypass Refunds

Last month TIGTA released a report reviewing the Taxpayer Advocate Service’s role when taxpayers request an offset bypass refund. In the report TIGTA found 1) that TAS offices inconsistently treated taxpayers seeking OBRs, 2) some TAS failures to honor requests as to how taxpayers wished to receive their refunds (paper check, direct deposit to the taxpayer’s account, or direct deposit to a third-party financial institution), 3) some TAS actions that exceeded its delegated authority, especially when a taxpayer seeking an OBR had an open matter with another IRS function, and 4) TAS failed to record fully its processed OBRs. 

In this post I will focus on the first item relating to TIGTA’s findings concerning inconsistencies in the process and standards used to evaluate OBR requests.

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Offset bypass refunds allow taxpayers to receive a refund when the IRS would otherwise apply an overpayment to past due tax liabilities. TAS case advocates are delegated authority to generate an OBR for a taxpayer if the taxpayer has no other debt subject to mandatory offset under Section 6402 and the taxpayer establishes that she is unable to pay reasonable living expenses if the IRS were to offset the overpayment against a past due tax debt.

We have discussed OBRs a few times, including one of our most viewed posts all time, a 2015 post Keith wrote discussing the OBR process. In one of our recent posts on OBRs from this past April, Barbara Heggie discusses challenges that taxpayers face securing the needed documents to prove the financial hardship necessary to get an OBR. In her post, Barbara refers to TAS guidance that allows TAS employees to dispense with third-party documentation: 

Many taxpayers seeking an Offset Bypass Refund will not have access or the ability to secure hardship documentation such as eviction notices, late bills, etc. Determine whether the taxpayer can validate the hardship circumstances through oral testimony or a third-party contact. If so, discuss the case with your LTA to determine if a written statement signed by the LTA confirming that the hardship was validated is appropriate.

The TAS guidance reflects experience that sometimes taxpayers facing hardship have a difficult time providing a full set of documents or record that would prove the hardship.  

In its report, TIGTA found that TAS’s flexibility led to inconsistencies across TAS offices in how TAS case advocates reviewed and decided on OBR requests:

We determined that most OBR cases did not include an analysis of the taxpayer’s income and expenses before an OBR was issued. In addition, we identified cases in which OBRs were provided to taxpayers based on supporting documentation that was not current orreasonable. However, in other cases, TAS case advocatesrequired a full review of the taxpayer’s income and expenses, as well as applied stricter supporting documentation criteria, before determining whether the taxpayer should be issued an OBR. 

The TIGTA report noted specific inconsistencies, including how one office created a detailed processing form to review compliance history and prior OBR requests, while other offices did not consider those factors, and how some offices did not verify supporting documentation. To be sure, TIGTA used only a judgmental sampling approach, which is a non-probability sampling technique, but its auditor’s observations observed a pattern of inconsistencies across offices (the report does not discuss why TIGTA did not do a deeper dive). Despite the limits in auditing technique, in TIGTA’s view, the inconsistencies stemmed from a lack of detailed centralized guidance, which led to inconsistent treatment of similarly situated taxpayers. This leads to an increased “risk of abuse by individuals seeking to avoid payment of their outstanding tax liabilities.” 

The report includes are other specific examples of inconsistencies, some of which reflect a lack of use of financial hardship criteria or processes associated with assessing reasonable collection potential that IRS generally requires when considering alternatives to enforced collection. TIGTA makes a number recommendations, including floating the idea that TAS should create OBR specialists who would have more experience. It also contrasts the TAS OBR process with other more centralized review functions, such as the innocent spouse unit.

TAS’s response to the report reflects a different perspective on its role. In addition to noting that the TIGTA observations only reflected “just a few cases” it noted that centralization could create additional taxpayer burdens. In addition, the lack of detailed process, in TAS view, was by design, and it worried that a too detailed approach in the IRM on OBRs “are unnecessary and that more specific IRM guidance will lead to employees failing to think critically.”

Conclusion

The report reflects very differing perspectives on the OBR process and on tax administration generally.  It reminds me of Gina Ahn’s recent guest post Proving Your Client’s Marital Status, Not as Simple as It Appears but Crucial for EITC where she contrasted Social Security and IRS employees in how they evaluate marital status.  SSA’s perspective is based on ensuring that people receive the maximum benefits they are entitled to receive whereas the IRS perspective is more enforcement based, with a concern that taxpayers may be gaming marital status to generate an improper refund.  TIGTA, consistent with its mission, is primarily concerned with reducing fraud and waste. TAS, consistent with its mission, is attempting to help taxpayers, especially for taxpayers who may be facing financial hardship.

In addition, by design TAS has offices nationwide. Unlike the post RRA 98 IRS, its employees are meant to work with and assist taxpayers who live and work in the same region as TAS employees.  The lack of centralization within TAS is by design. TAS’s decentralized structure helps ensure that its employees are more likely familiar with the circumstances of people it is charged to assist. 

To be sure, finding the right balance between uniformity and flexibility is a challenge.  Providing relief from an offset or collection action is also a challenge, as we generally accept that while IRS should have extraordinary collection powers those powers should not render taxpayers unable to meet life’s necessities. Within this framework, OBRs exist in a shadowy world of tax procedure, and the report highlights that within the shadows it appears that there is a great likelihood of disparate treatment of similarly situated taxpayers. 

What could be done to address the issues TIGTA flagged, while at the same time possibly preserving a role for TAS? In discussing the issue with Keith he raises the important issue as to whether TAS should be the initial point of contact on OBRs. Instead, perhaps IRS could centralize administration of OBRs and local taxpayer advocates could issue a directive if the centralized IRS office failed to 1) take into account the appropriate weighing of a more definitive listing of factors or 2) address unique local circumstances that may create hardships for taxpayers that employees in a centralized location might miss.  Such an approach would take some filing season pressure off of TAS, create standardization, and leave TAS to be creative when needed.  This approach may make additional sense given that during the filing season the IRS typically has additional employees, while TAS typically does not hire up for the filing season and that period creates a lot of extra work for it.

Another District Court Applies The Anti-Injunction Act to Dismiss A Pre-Enforcement Challenge to IRS Notice

Readers of Procedurally Taxing are familiar with the Anti-Injunction Act (AIA) and the CIC Services case that is pending in the Supreme Court. CIC Services raises whether the AIA bars a challenge brought under the Administrative Procedure Act in a pre-enforcement proceeding. It involves the hefty penalties under Section 6707A for failing to comply with information reporting obligations. Last week, in Govig and Associates v US a federal district court in Arizona considered a similar issue. In Govig, the taxpayers claimed that an IRS notice identifying listed transactions violated the APA because it was issued without going through the notice and comment process. In Govig the court concluded that the AIA precluded a pre-enforcement challenge to the IRS notice that triggered the immediately assessable penalty under Section 6707A.

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At issue in Govig is Notice 2007-83. That notice informed taxpayers that tax benefits claimed for a category of trust arrangements were not allowable for federal tax purposes and designated as “listed transactions” trust arrangements that had been “promoted to small businesses and other closely held businesses as a way to provide cash and other property” to owners “on a tax-favored basis.” As the opinion notes, the Notice targeted transactions where businesses used trusts to create welfare benefit funds that included cash-value life insurance policies.

The taxpayers in Govig are participants in trusts that have been designated as “listed transactions” under the Notice.  The plaintiffs in the case paid the penalties that were assessed in 2019 for violations relating to the 2015 year. They then filed a complaint in federal court, alleging that the IRS failed to comply with the notice and comment regime generally required for legislative rules under the APA and asking the court to set aside the notice as arbitrary and capricious.

In granting the government’s motion to dismiss for lack of jurisdiction, the district court explicitly embraced the reasoning of the DC Circuit in the Florida Bankers case. (For prior posts on Florida Bankers, see my discussion here and Patrick’s Smith’s two part post here and here). As the opinion notes, the challenge was framed as one directed to the “information gathering mandated by the Notice’s disclosure requirement and has nothing to do with the assessment or collection of a tax.”  The court reasoned that this is a “distinction without difference”  and agreed with the conclusion reached by then-Judge Kavanaugh in Florida Bankers, that the AIA applies “even if the plaintiff claims to be targeting the regulatory aspect of the regulatory tax . . . because invalidating the regulation would directly prevent collection of the tax.” 799 F.3d at 1070-71.

It also distinguished the Direct Marketing opinion, emphasizing differences in the text between the Tax Injunction Act (TIA) and the AIA at issue in Govig (and CIC Services):

The pertinent part of the TIA provides that federal district courts “shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under State law.” 28 U.S.C. § 1341 (emphasis added). The AIA in contrast states that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court.” 26 U.S.C. § 7421 (emphasis added).

In reasoning that Direct Marketing should not be read to support pre-enforcement challenges to federal information reporting  requirements backstopped by Title 26 penalties the Govig court leaned in on the differences in wording between the TIA and AIA, noting that those differences mattered in the majority Direct Marketing opinion:

There the Court, applying the cannon against surplusages as well as Noscitur a sociis, found that: the words “enjoin” and “suspend” are terms of art . . . referring to different equitable remedies that restrict or stop official action to varying degrees, strongly suggesting that “restrain” does the same. As used in the TIA . . . “restrain” acts on a carefully selected list of technical terms — “assessment, levy, collection” — not on an all-encompassing term, like “taxation.” To give “restrain” the broad meaning selected by the Court of Appeals would be to defeat the precision of that list, as virtually any court action related to any phase of taxation might be said to “hold back” “collection.” Such a broad construction would thus render “assessment [and] levy” — not to mention “enjoin [and] suspend” — mere surplusage, a result we try to avoid.

In Govig, these differences led the district court to conclude that while the TIA and AIA are similar the differences were enough to justify the AIA’s barring of the pre-enforcement challenge:

The AIA is not so limited by “technical” or “precise” language. Instead, it contains a broader restriction on any suit “for the purpose of” restraining the assessment or collection of taxes. 26 U.S.C. § 7421. The Court can only conclude this different wording is intended to carry a different broader meaning; a conclusion supported by the Supreme Court’s prior applications of the AIA

Finally, the district court in Govig held that the case did not implicate exceptions to the AIA, including the South Carolina v. Regan exception when there is no alternative for posing a legal challenge and the Williams Packingexception when “(1) it is ‘clear that under no circumstances could the government ultimately prevail’ and (2) ‘equity jurisdiction’ otherwise exists, i.e., the taxpayer shows that he would otherwise suffer irreparable injury.”Church of Scientology v. United States, 920 F.2d 1481, 1485 (1990) (citing Commissioner v. Shapiro, 424 U.S. 614, 627 (1976) (quoting Williams Packing, 370 U.S. at 7)).

Conclusion

The Govig case itself breaks no new ground.  While it recognizes that the challenge in Govig is to a reporting regime, rather than the underlying tax, its approach in rejecting the challenge closely follows the reasoning in Florida Bankers.  In the next few months we will see whether this approach is the law of the land, as CIC Services tees this issue up directly.

What is not clear to me from reading the opinion (admittedly I did not dig deeper into the pleadings or underlying briefs) is why the taxpayers did not bring their APA challenge in a refund proceeding. The opinion notes that the plaintiffs fully paid the assessed penalties imposed under Section 6707A. In a refund proceeding, the plaintiffs could have raised the same allegations, i.e., that the alleged IRS notice was issued contrary to the APA. In addition, while the plaintiffs asked the court to take judicial notice that violations of the reporting requirements could lead to criminal penalties, the court declined, noting that Section 6707A merely preserves the possibility for other penalties. The issue of potential criminal liability for violating these notices is also raised in CIC Services, where the plaintiff has alleged that the possibility of criminal liability itself makes the traditional refund process inadequate as a forum for raising alleged violations of the APA. 

Tax Court Finalizes Adoption of New Rules

On April 21, 2020, the Tax Court issues proposed amendments to its rules and solicited comments.  The Court received comments from three sources: 1) the ABA Tax Section; 2) the Office of Chief Counsel and 3) the Tax Clinic at the Legal Services Center of Harvard Law School.  On October 6, 2020, the Tax Court issued a press release putting out the final rules which included some revisions based on the comments.  The final rules are in the body of this post below.

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One of the big changes to the rules is the adoption of limited appearance and special appearance opportunities.  We have written about the limited appearance rule change here, here and here.  The Court has been issuing Administrative Orders concerning limited appearance since 2019 but now puts mention of this opportunity into the rules.  It signals in its comments on the rule changes that it will continue to monitor this practice and we may see more Administrative Orders.

I had the chance last fall to enter a limited appearance on behalf of an individual with whom I had consulted to provide some assistance but who was over the income guidelines set out in IRC 7526 keeping me from taking her as a client because her income slightly exceeded the guideline amount.  The limited appearance I made allowed me to speak for her at calendar call where she moved to dismiss her ex-husband as an intervener in her innocent spouse case for failure to appear at calendar call.  I am sure that she could have explained to the court why it should dismiss her ex-husband but the new rule allowed me to do it for her and that made her much more comfortable.  It may have also allowed the case to move along more efficiently benefiting the government and the Court.

I have not had the chance to make a special appearance but can imagine situations in which that might be useful.  In the remote environment it may be especially useful avoiding the need for a limited appearance in situations in which the appearance is extremely limited.  I would be interested in hearing from anyone out there who has made a special appearance and what make it special.

The Rule changes:

1. Service of papers; cross references corrected

Paragraphs (b)(1) and (4) of Rule 21 are deleted and replaced with the following. [Paragraphs (a), (b)(1)(A) through (D) including the flush language, (b)(2), (b)(3), and (b)(5) remain unchanged and are omitted here.]

RULE 21. SERVICE OF PAPERS

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(b) Manner of Service: (1) General: All petitions shall be served by the Clerk. Unless otherwise provided in these Rules or directed by the Court, all other papers required to be served on a party shall be served by the party filing the paper, and the original paper shall be filed with a certificate by a party or a party’s counsel that service of that paper has been made on the party to be served or such party’s counsel. For the form of such certificate of service, see the Appendix, Form 9. Such service may be made by:

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(4) Change of Address: The Court shall be promptly notified, by a notice of change of address filed with the Court, of the change of mailing address of any party, any party’s counsel, or any party’s duly authorized representative in the case of a party other than an individual (see Rule 24(e)). A separate notice of change of address shall be filed for each docket number. For the form of such notice of change of address, see the Appendix, Form 10.

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Explanation

Rule 21(b)(1) and (4) is amended to remove references to Appendix I and replace them with references to the Appendix. Rule 21(b)(4) is amended to revise the reference to Rule 24 to account for changes to that Rule.

2. Appearance and Representation

Rule 24 is deleted and replaced with the following.

RULE 24. APPEARANCE AND REPRESENTATION

(a) Appearance:

(1) General: Counsel may enter an appearance by signing and filing:

(A) the petition or other initial pleading or document;

(B) an entry of appearance; or

(C) a substitution of counsel in accordance with paragraph (d).

See Rules 22, 23, and 26 relating to signing and filing papers with the Court.

(2) Required Information: Any paper that counsel may use to enter an appearance must include:

(A) the case name and docket number (if any); and

(B) counsel’s name, mailing address, email address (if any), telephone number, and Tax Court bar number.

(3) Counsel Not Admitted to Practice: An entry of appearance filed by counsel not admitted to practice before the Court is not effective until counsel is admitted. Where it appears that counsel who is not admitted to practice can and will be promptly admitted to practice, the Court may recognize that counsel in a pending case. See Rule 200 regarding the procedure for admission to practice before the Court and Rule 201(a) regarding conduct of practice before the Court.

(4) Limited Appearance and Special Recognition:

(A) Limited Appearance: Counsel may file a limited entry of appearance to the extent permitted by the Court.

(B) Special Recognition: The Court may, in its discretion, temporarily recognize an individual as the party’s representative, and no entry of appearance is necessary.

(5) Law Student Assistance: A law student may assist counsel with drafting a pleading or other document to be filed with the Court. In addition, with the permission of the presiding Judge or Special Trial Judge, and under counsel’s direct supervision, a law student may present all or any part of the party’s case at a hearing or trial. A law student may not, however, enter an appearance in any case, be recognized as counsel in a case, or sign a pleading or other document filed with the Court.

(b) Representation Without Counsel:

(1) General: A party that is not represented by counsel may proceed as follows:

(A) an individual may represent himself or herself;

(B) an authorized officer may represent a corporation;

(C) an authorized individual may represent an unincorporated association; and

(D) a fiduciary may represent an estate or trust.

See Rule 60 regarding proper parties and capacity.

(2) Required Information:

(A) The initial pleading or other paper filed by a party must include the party’s name, mailing address, email address (if any), and telephone number.

(B) If the initial pleading or other paper is filed by an authorized officer, authorized individual, or fiduciary, it must also include that person’s name, mailing address, email address (if any), telephone number, and capacity in which that person is appearing.

(c) Withdrawal of Counsel:

(1) Notice of Withdrawal as Counsel: Counsel desiring to withdraw as counsel for a party may file a notice of withdrawal as counsel if:

(A) more than one counsel entered appearances for that party and at least one counsel will continue to serve as counsel for that party;

(B) the notice of withdrawal is filed no later than 30 days before the first day of the Court’s session at which the case is calendared for trial; and

(C) there is no objection to the withdrawal.

(2) Motion To Withdraw as Counsel: Counsel desiring to withdraw as counsel for a party but who is ineligible to do so under paragraph (c)(1) must file a motion to withdraw as counsel.

(3) Motion To Withdraw Counsel by Party: A party desiring to withdraw the appearance of that party’s counsel must file a motion to withdraw counsel by party.

(4) General Requirements:

(A) Any notice or motion under this paragraph must include a statement that counsel or the party provided prior notice of the notice or motion to the counsel’s client or the party’s counsel and to each of the other parties to the case or their counsel and whether there is any objection to the motion.

(B) Any motion to withdraw as counsel or to withdraw counsel must also include the party’s then-current mailing address, email address (if any), and telephone number.

(d) Substitution of Counsel:

(1) No later than 30 days before the first day of the Court’s session at which the case is calendared for trial, counsel who has not previously appeared for a party in that case may enter an appearance by filing a substitution of counsel substantially in the form set forth in the Appendix, Form 8.

(2) The substitution of counsel must state that:

(A) substituted counsel enters an appearance for the party;

(B) current counsel’s appearance is withdrawn for the party;

(C) current counsel provided prior notice of the substitution to the counsel’s client and to each other party or their counsel; and

(D) there is no objection to the substitution.

(3) The substitution of counsel must be signed by current counsel and by substituted counsel, contain the information required by paragraph (a)(2), and be filed by the substituted counsel.

(4) Counsel entering an appearance as substituted counsel within 30 days of the first day of the Court’s session at which the case is calendared for trial must file an entry of appearance under paragraph (a), and any related withdrawal of counsel must be undertaken in accordance with paragraph (c).

(e) Change in Required Information: A party or counsel must promptly notify the Clerk in writing of any change in the information required under this Rule, or of the death of counsel, for each docket number involving that party or in which counsel has entered an appearance.

(f) Change in Party or Authorized Representative or Fiduciary: Where (1) a party other than an individual participates in a case through an authorized representative (such as an officer of a corporation or a member of an association) or through a fiduciary, and there is a change in the representative or fiduciary, or

(2) there is a substitution of parties in a pending case, counsel signing the motion resulting in the Court’s approval of the change or substitution will thereafter be deemed first counsel of record for the representative, fiduciary, or party. Counsel of record for the former representative, fiduciary, or party desiring to withdraw as counsel must file a motion in accordance with paragraph (c)(2).

(g) Limitations on Representation:

(1) Conflict of Interest: If any counsel of record (A) was involved in planning or promoting a transaction or operating an entity that is connected to any issue in a case, or (B) represents more than one person with differing interests with respect to any issue in a case, then that counsel must either secure the client’s informed written consent; withdraw from the case; or take whatever other steps are necessary to obviate a conflict of interest or other violation of the ABA Model Rules of Professional Conduct. See Rules 1.7 and 1.8, ABA Model Rules of Professional Conduct. The Court may inquire into the circumstances of counsel’s employment in order to deter such violations. See Rule 201.

(2) Counsel as Witness:

(A) Counsel may not represent a party at trial if the counsel is likely to be a necessary witness within the meaning of the ABA Model Rules of Professional Conduct unless: (i) the testimony relates to an uncontested issue; (ii) the testimony relates to the nature and value of legal services rendered in the case; or (iii) disqualification of counsel would work substantial hardship on the client. See Rule 3.7, ABA Model Rules of Professional Conduct.

(B) Counsel may represent a party at trial in which another professional in the counsel’s firm is likely to be called as a witness unless precluded from doing so under the ABA Model Rules of Professional Conduct. See Rules 1.7 and 1.9, ABA Model Rules of Professional Conduct.

Explanation

Rule 24 is amended stylistically to enhance its readability; to simplify the procedures governing the appearance, substitution, and withdrawal of counsel representing a party; and to clarify certain limitations on counsel’s ability to represent a party.

Rule 24(a)(1)-(3) and (5) reorganizes portions of former paragraph (a) and lists the methods by which counsel may enter an appearance for a party, identifies the information that counsel must provide the Court, and describes the procedures applicable to counsel not admitted to practice before the Court and law student assistance. This reorganization is largely stylistic. Rule 23(a)(3) requires counsel to provide contact information, including an email address, on any paper filed with the Court. Consistent with that requirement, Rule 24(a)(2) is amended to require counsel entering an appearance in a case to provide an email address. Rule 24(a)(4) is new and recognizes the Court’s practice of permitting limited appearances and specially recognizing counsel or other individuals. In May 2019, the Court adopted procedures governing limited entries of appearance and revised those procedures in May and June 2020. See Administrative Order 2020-03, issued May 29, 2020, and revised June 19, 2020, superseding Administrative Order 2019-01, issued May 10, 2019. The Court intends to maintain flexibility regarding the procedures governing limited entries of appearance and will continue to provide guidance through administrative channels. The Rule is further amended to recognize that judges have the discretion to specially recognize counsel or other individuals in appropriate circumstances. For example, a judge may specially recognize counsel at a trial or hearing solely to receive an oral status report or for the submission of documents related to the disposition of the case.

Rule 24(b)(1) and (2) reorganizes former paragraph (b) and describes scenarios in which a party may proceed without counsel and the information that a representative of a party must provide the Court. The Rule includes a new cross reference to Rule 60, which provides a comprehensive discussion of proper parties and capacity to represent a party. This reorganization is largely stylistic, and no substantive change is intended.

Rule 24(c) is amended to provide a simplified procedure for withdrawal of counsel for a party when more than one counsel entered an appearance for that party and at least one counsel will continue to serve in that capacity. In that circumstance, and if there is no objection, counsel may file a notice of withdrawal no later than 30 days before the first day of the trial session at which the case is set for trial. The notice of withdrawal will be effective when it is entered on the docket record for the case.

Rule 24(d) is reorganized and amended to provide for substitution of counsel, if there is no objection, no later than 30 days before the first day of the trial session at which the case is set for trial. The amendment clarifies that the substitution of counsel must be filed by the substituted counsel and must include the signatures of both the current counsel and the substituted counsel. The Rule further provides procedures to be followed if substituted counsel enters an appearance within 30 days of the first day of the trial session at which the case is set for trial.

Rule 24(e) is reorganized and amended to provide that a party or counsel must promptly notify the Court of any change in the information required by the Rule, including notification of the death of counsel.

Rule 24(g)(1) and (2) reorganizes former paragraph (g). Although the amendment is largely stylistic, new paragraph (g)(2) clarifies the restrictions on counsel’s representation of a party where counsel may be called as a witness in a case in which counsel has entered an appearance.

3. Proceeding to enforce overpayment determination; cross references corrected

Paragraph (e) of Rule 260 is deleted and replaced with the following. [Paragraphs (a), (b), (c), (d), and (f) remain unchanged and are omitted here.]

RULE 260. PROCEEDING TO ENFORCE OVERPAYMENT DETERMINATION

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(e) Recognition of Counsel: Counsel recognized by the Court in the action in which the Court determined the overpayment which the petitioner now seeks to enforce will be recognized in a proceeding commenced under this Rule. Counsel not so recognized must file an entry of appearance pursuant to Rule 24(a) or a substitution of counsel pursuant to Rule 24(d).

Explanation

Rule 260(e) is amended to revise the reference to Rule 24 to account for changes to that Rule.

4. Proceeding to redetermine interest; cross references corrected

Paragraph (e) of Rule 261 is deleted and replaced with the following. [Paragraphs (a), (b), (c), and (d) remain unchanged and are omitted here.]

RULE 261. PROCEEDING TO REDETERMINE INTEREST

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(e) Recognition of Counsel: Counsel recognized by the Court in the action in which the Court redetermined the deficiency or determined the overpayment the interest in respect of which the petitioner now seeks a redetermination will be recognized in a proceeding commenced under this Rule. Counsel not so recognized must file an entry of appearance pursuant to Rule 24(a) or a substitution of counsel pursuant to Rule 24(d).

Explanation

Rule 261(e) is amended to revise the reference to Rule 24 to account for changes to that Rule.

5. Proceeding to modify decisions in estate tax case involving section 6166 election; cross references corrected

Paragraph (e) of Rule 262 is deleted and replaced with the following. [Paragraphs (a), (b), (c), (d), and (f) remain unchanged and are omitted here.]

RULE 262. PROCEEDING TO MODIFY DECISION IN ESTATE TAX CASE INVOLVING SECTION 6166 ELECTION

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(e) Recognition of Counsel: Counsel recognized by the Court in the action in which the Court entered the decision which the petitioner now seeks to modify will be recognized in a proceeding commenced under this Rule. Counsel not so recognized must file an entry of appearance pursuant to Rule 24(a) or a substitution of counsel pursuant to Rule 24(d).

* * * * * * *

Explanation

Rule 262(e) is amended to revise the reference to Rule 24 to account for changes to that Rule.

Summary Judgment Victory for Incarcerated Individuals

Two more victories have come in for incarcerated individuals in the short time since our last post on this subject.  Rarely does a case move so fast and so favorably.  It helps that the IRS took a position unsupported by the statute and that it inexplicably reached this position after reversing itself.  Still, it’s been a swift road to justice, up to this point, for incarcerated individuals.  You can access our prior posts on this case here and here.  You can access our initial post on this issue expressing incredulity at the flipped position of the IRS regarding the ability of incarcerated individuals to receive the EIP here.

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Yesterday, the district court for the Northern District of California granted summary judgment in Scholl v. Mnuchin and made the preliminary injunction permanent.  For a case initially filed on August 1, 2020, getting summary judgment in 75 days can make your head spin if you are primarily a Tax Court practitioner but even if you regularly practice in district court.  You can access the decision here.

On Friday the 9th Circuit ruled in an emergency appeal brought by the IRS that the IRS needed to follow an earlier order from the district court and send out notice to the incarcerated individuals.  You can find that opinion here.

Yesterday’s district court opinion follows the path set out by the order granting the preliminary injunction.  First, it addressed standing and ripeness.

In both their stay motion and opposition to plaintiffs’ motion for summary judgment, defendants explain at length why the court’s analysis of title 26 U.S.C. § 6428 was in error and incarcerated individuals are not entitled to an advance refund. See Mtn. at 3–7; Dkt. 70 at 8–11. From that premise, defendants argue that if their interpretation of section 6428 is correct, so too are their arguments regarding ripeness and standing. Mtn. at 7. In other words, if plaintiffs’ interpretation of the CARES Act is correct, then standing would exist. If, however, defendants’ interpretation of the CARES Act is correct, then standing would not exist because if no advance refund is presently owed, then any harm was not actual or imminent.

The court finds again that the failure to disburse the advance refund to the incarcerated individuals created an actual economic injury to them.  While it says that the incarcerated individuals did not need to establish that they were in fact entitled to the injury on the merits to move forward on the standing issue it determines that “they have established a legally cognizable right in the payments that defendants issued and then either intercepted or required to be repaid.”

With respect to ripeness the IRS again argued that the FAQ stating that the incarcerated individuals were not entitled to advance credit in 2020 did not create a reviewable agency act, because the plaintiffs can file their 2020 returns in 2021 seeking the credit.  The IRS also argued that the FAQs were not sufficiently formal administrative action, even though high level officials had stated that these would be the only pronunciations on the CARES Act.  Because the IRS has “already taken concrete action applying their determination to incarcerated individuals,” the court found ripeness satisfied.

It again finds a waiver of sovereign immunity in the APA, that the IRS had taken final agency action regarding the incarcerated individuals, and that no adequate alternative remedy exists, because filing the 2020 return, having the credit denied and suing for refund is quite different than getting a quick injection of cash during an economic crisis.  The court finds staying the action would create irreparable harm.  Because it is granting the motion for summary judgment, the court finds it appropriate to make the injunction permanent.

The court denied the first basis for summary judgment which plaintiffs requested under section 706(1) of the APA.  It did so because it finds that the IRS acted on the CARES Act as a whole.  Based on case law, even if it acted arbitrarily and incorrectly the fact that it acted is sufficient to satisfy the requirements of this provision:

Here, the IRS carried out its statutory responsibility by issuing advance refund payments to millions of Americans. It also acted with regard to incarcerated individuals; the agency initially issued EIPs to incarcerated individuals then changed its decision. Purposefully excluding incarcerated individuals from receiving advance refund payments is akin to drawing a boundary. That boundary might be arbitrary and capricious or contrary to law, but at the very least the agency acted.  

The second APA claim involves section 706(2)(A) and whether the IRS acted contrary to the law and in excess of statutory authority.  Here, the plaintiffs win.  The court addresses the “novel” statutory argument advanced by the IRS.  In doing so it looks back to litigation under the stimulus payment enacted by Congress during the great recession upon which the current stimulus legislation is based.  It finds that the advance refund is a special payment requiring the IRS to send it out as quickly as possible.  It rejects several arguments advanced by the IRS regarding the interpretation of the CARES Act legislation and the timing of the payments.  Then it rejects any argument the IRS may have regarding coverage of the CARES Act and incarcerated individuals.  It finds the action of the IRS to be arbitrary and capricious and reaffirms it prior holding.  It also reaffirms the class certification.  It orders the following:

For the foregoing reasons, defendants’ motion for stay pending appeal is DENIED. Plaintiffs’ motion for summary judgment of their first claim is DENIED and their motion for summary judgment of their second claim is GRANTED. As discussed herein, the court finds and declares that defendants’ policy violated the APA and is hereby VACATED. The Court also vacates the provisional certification of the class and certifies a litigation class for all purposes. Finally, the court enters the following permanent injunction.

PERMANENT INJUNCTION

Defendants Steven Mnuchin, in his official capacity as the Secretary of the U.S. Department of Treasury; Charles Rettig, in his official capacity as U.S. Commissioner of Internal Revenue; the U.S. Department of the Treasury; the U.S. Internal Revenue Service; and the United States of America, are hereby enjoined from withholding benefits pursuant to 26 U.S.C. § 6428 from plaintiffs or any class member on the sole basis of their incarcerated status. Within 30 days of the court’s September 24, 2020 order, defendants shall reconsider advance refund payments to those who are entitled to such payment based on information available in the IRS’s records (i.e., 2018 or 2019 tax returns), but from whom benefits have thus far been withheld, intercepted, or returned on the sole basis of their incarcerated status. Within 30 days of the court’s September 24, 2020 order, defendants shall reconsider any claim filed through the “non-filer” online portal or otherwise that was previously denied solely on the basis of the claimant’s incarcerated status. Defendants shall take all necessary steps to effectuate these reconsiderations, including updates to the IRS website and communicating to federal and state correctional facilities. Within 45 days of the court’s September 24, 2020 order, defendants shall file a declaration confirming these steps have been implemented, including data regarding the number and amount of benefits that have been disbursed.

A number of organizations have geared up over the past week to assist incarcerated individuals in filing to get their request for the EIP in before the portal closes.  The IRS has not stated what it will do with these requests as they arrive.  For a number of reasons, it would be best for the incarcerated individuals to submit their requests this year but they will face significant hurdles in doing so, not taking into account the hurdle of having the IRS approve the payment.  This issue is not over yet both for practical and legal reasons.  Kudos to the district court for acting so quickly that it is possible for many of the incarcerated individuals to make the requests for the EIP.  With over two million incarcerated individuals in the United States, there are a lot of forms to prepare in a short time.

DAWSON is Coming

On October 7 the Tax Court issued a press release announcing that it is about to install and implement its new case management system.  The Tax Court has been talking about its new system for a while now, but the announcement puts a new wrinkle in the situation because of the things the Court and the parties will need to do during the period of installation.  So, even if you do not particularly care that the Tax Court is implementing a new case management system, it’s time to sit up and pay attention so you know what’s happening during the installation process.

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DAWSON is an acronym for Docket Access Within a Secure Online Network and is also a nice tribute to the longest serving judge in Tax Court history, Judge Howard Dawson.  I had my only appearance before Judge Dawson in 1979 in Boise, Idaho.  He was highly regarded then and went on to become a legend at the court.  You can read about him here and here.

The press release informs that public that because of the installation of the new case management system:

To facilitate the transition to DAWSON, beginning at 5:00 PM Eastern Time on November 20, 2020, the current e-filing system will become inaccessible and all electronic files will become read-only. Consistent with current practices, cases will remain electronically viewable. No documents may be e-filed in the current system after that time. The Court does not anticipate issuing any orders or opinions during the time e-filing is inaccessible.

The press release notes that the Chief Judge issued Administrative Order 2020-04 extending the time for the IRS to file answers in all petitions filed between September 21, 202 and October 28, 2020.  It goes on to say that all other documents required to be filed between 5:00 PM ET on November 20, 2020 and whenever DAWSON becomes active must be filed in paper.  The normal rule required leave to file documents in paper is waived during this period.  The Court notes that timely mailing will apply to documents mailed during this period. 

It also acknowledges that going through another period of petitions being filed with the Court without acknowledgement of the filing going to the IRS will trigger another round of premature assessments.  In the notice it cites to the email address created by Chief Counsel, IRS to alert the IRS to a Tax Court filing and the need to abate a premature assessment.  That address is Taxcourt.Petitioner.Premature.Assessment@irs.gov.  It’s nice to see the Court be proactive on this issue and great that Chief Counsel’s office has just set up an address to help in fixing the problem.  Because pro se individuals will struggle to find this address, everyone should keep it in mind when working with a petitioner who files during this period.

Finally, a smaller point to note comes from Judge Buch and Deputy Clerk Jessica Marine, who gave a preview of DAWSON at the Court Procedure and Practice Committee session of the ABA Tax Section Fall Meeting on September 30. They reported that all links (URLs) to Tax Court opinions and orders will be broken after the new system comes in, meaning that existing opinions and orders will have different URLs, and the current URLs will not redirect. So, if you have saved any links to orders or opinions, you may want to download them before the new system goes live at the end of December, or be prepared to run a fresh search when you want to reference the document.

Well, why not do this during 2020.  It’s already a year like no other.  Shutting down the clerk’s office again may be more normal than abnormal in a year like this.  Although the Court does not anticipate issuing opinions or orders during the DAWSON installation period, I can foresee the need for an occasional order.  If you need an order, you should certainly request it.  I do not read the press release as a prohibition against the Court issuing orders. 

Revoking the Release of Federal Tax Lien

In Webb v. IRS, No. 1:17-cv-00058 (S.D. Ind. 2020) taxpayers get a sad lesson in the ability of the federal tax lien both to survive bankruptcy and to come back to life after release.  This is not a story of foreclosure, though that chapter may still be written, but rather a story first of what bankruptcy can and cannot do with respect to tax liens (and liens in general) and second of the power of federal tax lien revocation.  When the dust settles, the taxpayers come out of bankruptcy with their discharge, including a discharge of the federal taxes at issue, but with a home (and any other assets they have) still encumbered by the federal tax lien.

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In 2010 the IRS filed notices of federal tax lien (NFTLs) against the Webbs in the jurisdiction where they lived and owned a home.  In 2013 the Webbs jointly filed what must have been a chapter 7 bankruptcy petition.  On their schedules they listed all of their assets and liabilities including their home.  They must have claimed a homestead exemption for all or part of the equity in their home based on Indiana laws.  The exemption varies from state to state, and I did not go and look up the available exemption in Indiana.  On November 4, 2013, the bankruptcy court granted the Webbs a discharge.  The court doesn’t lay out the facts in a way that makes it easy for me to state the years for which the Webbs owed taxes when they filed their petition, but it seems that they owed for several years and that the years were fairly old making them susceptible to discharge.

After the bankruptcy discharge, on February 10, 2014, the IRS abated the tax liabilities and released the tax liens.  The discharge requires the IRS to not seek to collect from the taxpayers any discharged liabilities; however, it does not prevent the IRS from collecting liabilities from property to which its lien attaches.  Apparently, the IRS acted first to avoid violating the discharge injunction and they, two years later, came to the realization that the Webbs retained property after the discharge to which the federal tax liens attached.  After coming to that realization, the IRS needed to reverse the abatement of the taxes and revoke the release of the federal tax lien.  It reversed the abatement in 2016 and revoked the releases in 2017 to 2019.

People filing chapter 7 bankruptcy may spend little time with a lawyer discussing what precise debts will survive bankruptcy.  If they do have this discussion, it often does not include the distinction between discharging the personal liability on the underlying tax and the survival of the lien.  So, many debtors in the Webbs position would expect their tax liabilities to go away and when the IRS wipes away the liabilities immediately after bankruptcy, the action reinforces their expectations.

It is not surprising that the Webbs would react with shock and dismay as the IRS reverses the abatement of their tax liability and reinstates its liens.  Unfortunately, the IRS can do this and their arguments failed.

Discharge of Liens

The Webbs first argue that the IRS cannot reinstate the liens because the tax liabilities were discharged.  This argument fails and it should.  This argument does not make a distinction between the effect of the discharge on their personal liability for the tax debt versus the effect on the lien encumbering their property.  A bankruptcy discharge can wipe out a personal liability but does not affect a lien interest.  The court establishes that the IRS validly established the liens prior to bankruptcy and then describes the law regarding the survival of liens including tax liens.

Reversal of Abatement

The Webbs next argue that the IRS could not reverse the abatement of the assessments because the tax liabilities were discharged.  This argument also fails because the lien interest allows the assessment to survive (or to be reinstated.)  According to the court the IRS did not cite to cases that established this exact point, but it did find other cases regarding reversal of abatement that supported the IRS position.

Revoking the Lien Release

The IRS regularly releases liens it later regrets releasing.  The Webbs continue to argue that the IRS cannot revoke the release because of the effect of the discharge.  IRC 6325(f)(2) allows the IRS to revoke a release if it releases a lien “erroneously or improvidently.  Here, the IRS stated that it acted erroneously or improvidently in releasing the lien initially.  The court finds that the IRS followed the appropriate procedures in reinstating the lien.  Therefore, the court finds the refiling of the liens after the revocation of the release to properly reestablish the liens.

Limitations on Scope of Liens

When the IRS filed its claim in the chapter 7 case it claimed a secured amount of $12,357.00 and a general unsecured amount of $383,527.99.  I cannot say exactly why the IRS filed its claim with those amounts but it normally calculates the equity of its liens based on the statements in the debtor’s schedules.  The IRS does not perform a separate analysis of the value of the debtor’s property in filing its claim form.  Here, the Webbs’ argument is that if the court allows the IRS to reverse the abatement and reinstate its liens, the IRS can only assert a lien interest in the amount listed on its claim.

The court discusses the cases cited by the Webbs but not any cases the IRS might have cited.  It concludes that the IRS can pursue its lien claim in the amount of $395,884.99 the full amount of the lien.  This does not mean that the IRS will collect that amount.  The case does not provide enough information to allow speculation on the amount the IRS will ultimately collect on its lien claim but it could be much closer to $12K than $395K.  The IRS can only collect from assets in existence at the time of the bankruptcy filing.  It cannot collect from the Webbs personally.  Its lien claim does not come ahead of the first mortgage on the Webbs’ home. 

The lien claim probably matches the amount of the Indiana homestead exemptions plus whatever increases in value have occurred with respect to the assets the Webbs protected using their homestead exemption.  Not only does the discharge limit the IRS in the assets from which it can pursue to satisfy the debt but the discharge makes it difficult for the IRS in other ways.  It must make sure that in reinstating the assessment its computer does not offset subsequent refunds due to the Webbs.  In cases of this type the primary available asset of any value may be the Webbs home.  The IRS must now navigate the issues regarding administrative seizure and sale of a home or bring a suit to foreclose its lien on the home.  The IRS does not go after people’s homes that often though certainly it can do so.

The Webbs were right to want to prevent the reassessment of the liability and reattachment of liens but had little defense to this action, which can cruelly come after the victory party they may have held upon receipt of the discharge.  I expect that having gone this far the IRS will pursue collection from their home but that brings another case.  This case simply reestablished the liens.  It did not enforce them.

Latest Update on Providing Stimulus Payments to Incarcerated Individuals

A couple weeks ago I blogged about the significant victory achieved on behalf of prisoners with the grant of a preliminary injunction ordering the IRS to stop denying stimulus payments to incarcerated individuals.  As discussed previously, the denial of refunds to incarcerated individuals makes little sense when the statutory language provides no basis for excluding them.  The behavior of the IRS here allowing the payments and then deciding about six weeks after the passage of the CARES Act to exclude them also makes for a puzzling situation.  As discussed in the prior post, the judge swatted away all of the arguments made by DOJ in granting a complete victory for the incarcerated individuals.

The government appealed the case on October 1.

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On October 7, 2020, the Court issued its next ruling.  This time it focused on relief.  In its initial ruling the court asked the parties to confer and, if possible, propose agreed upon relief measures.  The parties did not reach agreement but proposed separate plans.  Once again the court did not find the DOJ argument availing. 

Website

The first issue concerned the information on the IRS website about incarcerated individuals.  The FAQ first published by the IRS in early May told incarcerated individuals they were ineligible for the stimulus payment.  The parties were not far apart on how to fix this but the IRS had not gone far enough so:

the court ORDERS defendants to update the IRS.gov website (and any other related page) to state that incarcerated individuals who have not received the advanced refund payment may provide information to the IRS to allow the IRS to consider the individual’s eligibility for the refund. The website shall indicate that individuals may file using the online non-filers tool or by mailing a simplified paper tax return to the IRS. Defendants shall update all FAQs and any other pages that discuss the eligibility of incarcerated individuals for an EIP to reflect the court’s order.

The court gave the IRS until October 8, 2020 to update its website and additionally provided:

Defendants shall also communicate to IRS employees or other federal employees who interact with the public to answer questions regarding EIP in accordance with the guidance posted on the IRS.gov website and the court’s orders.

I know the word is getting out, because we have received calls to the tax clinic from individuals seeking help for their incarcerated family or friends.  Similar messages have appeared elsewhere in LITC information site.

Communication with Prison Officials

Before the litigation the IRS had affirmatively gone out to prison officials to make it clear that incarcerated individuals should not receive the stimulus payments and to solicit their support in intercepting any stimulus payments headed to incarcerated individuals.  Reversing this message is needed not only to allow the incarcerated individuals to receive the checks but also to keep them from any disciplinary measures that might result from requesting the stimulus payment in the face of the IRS position regarding their entitlement prior to the litigation.  The parties again were not miles apart in their request, but the request made by the attorneys representing the incarcerated individuals contained significantly more detail, much of which the court adopted:

the court ORDERS defendants to distribute the following documents to all state and federal correctional facilities for which it maintains any communication channel: (1) a cover letter that includes2 the four main points addressed by plaintiffs in the proposed plan; (2) an electronic version of the simplified paper return (Form 1040/1040-SR) referred to in Rev. Proc. 2020-28 with instructions on how to complete the simplified form; and (3) legal notice, as described below.

The court did not order a specific date by which the this had to occur but ordered the parties to work together expeditiously.

Mailed Notice to Class Members

Here the parties had significant differences of opinion.  Plaintiffs’ lawyers pointed out that the IRS has a database of incarcerated individuals updated at least to October, 2019.  The IRS argued that it did not have current or last known addresses for individuals incarcerated earlier this year but how have been released.  The IRS also said:

in their opposition to plaintiffs’ motion for notice to class, defendants detailed significant obstacles to providing effective individualized notice including outdated addresses, unformatted and invalidated data, and incomplete data. Dkt. 56 at 7. Ordering the IRS to provide individualized notice would force the IRS to reallocate resources from its other commitments to disbursing advance refund payments for eligible individuals. Id. Finally, any mailed notice will not arrive in time to postmark a simplified paper return by October 15, 2020.

The Court accepted the IRS position that it did not have good addresses for everyone but ordered it to send individualized notices to everyone for whom it did have a good address by October 15, 2020.  That puts a lot of pressure on the IRS.  Of course, there is also a fair amount of pressure on the incarcerated individuals if they want to receive the stimulus payment in 2019.

Deadline to Submit Simplified Paper Returns

The IRS had already moved the deadline for seeking the stimulus payment through its portal from October 15 to November 21 but the deadline for paper returns remains at October 15.  Because of their location, incarcerated individuals will struggle to get to an online portal.  Plaintiff’s attorneys sought an ability to submit the request for the stimulus payments by paper at a later date.

The Court pointed to an IRS publication to community organizations extending the time to file by paper to October 30.  Here is a copy of that publication:

Based on the IRS granting to community organizations the deadline of October 30, the court granted to incarcerated individuals that deadline as well.  This is still a tight deadline but is feasible for many.  Of course, missing the deadline does not preclude individuals from obtaining the credit on their 2020 returns filed next year.  Since a high percentage of the incarcerated individuals do not have a return filing obligation, getting the stimulus payment through the submission of a form now provides greater relief.

As with the first order, the judge not only acted quickly but provided almost full relief for the incarcerated individuals.

Acting on the momentum of the earlier decisions, plaintiff’s attorneys filed a motion for summary judgment on September 29.  The government filed its response on October 7.  Plaintiffs filed a reply on October 9 and the Tax Clinic at the Legal Services Center of Harvard Law School filed an amicus brief on behalf of the Center for Taxpayer Rights in support of plaintiffs on that date.  Because the court has acted quickly in its prior decisions, this decision could occur very soon.

The government has not explained why it flip flopped regarding incarcerated individuals last spring (and regarding decedents).  In testimony last week, the Commissioner suggested to the House Committee before whom he was testifying that this was a question best asked of the Treasury Department.  Perhaps the IRS determination of the CARES Act was overruled by Treasury or some higher authority.  So far, this mystery remains unexplained.  Whoever in the government made the decision to flip flop on this issue in the face of very plain language in the statute is learning that at least the district court in the Northern District of California is not buying their interpretation.

Consistency and the Validity of Regulations

Guest contributor Monte Jackel discusses guaranteed payments and how differing regulations inconsistently approach whether such guaranteed payments are indebtedness. While the post highlights substantive technical issues it also flags a procedural issue: the difficulty in challenging tax regulations outside normal tax enforcement procedures. That procedural issue, present in the current teed up Supreme Court case CIC v Commissioner which is now set for oral argument on December 1, as Monte suggests and as I discussed last year in Is It Time To Reconsider When IRS Guidance Is Subject to Court Review?, may call for a legislative fix. Les

How can a guaranteed payment on capital under section 707(c) of the Internal Revenue Code be both an actual item of “indebtedness” if, but only if, there is a tax avoidance motive for purposes of section 163(j)’s limitation on business interest expense but only be “equivalent to” but not actually be indebtedness for purposes of the foreign tax credit? Well, if you are the IRS with the “pen in hand”, anything is possible.

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Section 163(j)(5) defines “business interest” for purposes of section 163(j) as “any interest paid or accrued on indebtedness properly allocable to a trade or business.” Thus, the key term here is “indebtedness”. More on that later. 

Similarly, income equivalent to interest is referenced in section 954(c)(1)(E) and in regulation §§1.861-9(b)(1) and 1.954-2(h)(2) and specifically refers to guaranteed payments on capital as equivalent to interest expense at regulation §1.861-9(b)(8). On the other hand, the very same guaranteed payment on capital is treated as actual interest expense under regulation §§1.469-2(e)(2)(iii) and 1.263A-9(c)(2)(iii). 

It is very hard to either see or to justify treating guaranteed payments on capital under section 707(c) as both actual interest expense or as equivalent to interest expense for purposes of different provisions of the Internal Revenue Code. Either a guaranteed payment represents interest on indebtedness under all provisions of the Internal Revenue Code or it does not, unless a specific provision of the Code expressly treats guaranteed payments on capital a certain way. Merely because a statute or implementing regulation treats a guaranteed payment on capital as equivalent to interest does not mean that it can be both actual indebtedness for some but not all provisions of the Code and as equivalent to but not actual interest on indebtedness for purposes of other provisions of the Code. 

The recently finalized foreign tax credit regulations, T.D. 9922, had this to say about the issue:

The Treasury Department and the IRS have determined that guaranteed payments for the use of capital share many of the characteristics of interest payments that a partnership would make to a lender and, therefore, should be treated as interest equivalents for purposes of allocating and apportioning deductions under §§1.861-8 through 1.861-14 and as income equivalent to interest under section 954(c)(1)(E). This treatment is consistent with other sections of the Code in which guaranteed payments for the use of capital are treated similarly to interest. See, for example, §§1.469-2(e)(2)(ii) and 1.263A-9(c)(2)(iii). In addition, the fact that a guaranteed payment for the use of capital may be treated as a payment attributable to equity under section 707(c), or that a guaranteed payment for the use of capital is not explicitly included in the definition of interest in §1.163(j)-1(b)(22), does not preclude applying the same allocation and apportionment rules that apply to interest expense attributable to debt, nor does it preclude treating such payments as “equivalent” to interest under section 954(c)(1)(E). Instead, the relevant statutory provisions under sections 861 and 864, and section 954(c)(1)(E), are clear that the rules can apply to amounts that are similar to interest.

OK, so the IRS is saying here that a guaranteed payment on capital is not and does not have to “indebtedness” for the item to be treated the same as interest expense under the enumerated statutory provisions. This is so without regard to there being a tax avoidance reason for the taxpayer to have used a guaranteed payment on capital instead of actual indebtedness. Technically true in the case of the enumerated provisions but does it make good policy sense or is it merely “talking out of both sides of your mouth” and, thus ultra vires? 

Take a look at how guaranteed payments on capital recently fared under the final section 163(j) regulations (T.D. 9905). The final regulation preamble had this to say about the issue:

Proposed §1.163(j)-1(b)(20)(iii)(I) provides that any guaranteed payments for the use of capital under section 707(c) are treated as interest. Some commenters stated that a guaranteed payment for the use of capital should not be treated as interest for purposes of section 163(j) unless the guaranteed payment was structured with a principal purpose of circumventing section 163(j). Other commenters stated that section 163(j) never should apply to guaranteed payments for the use of capital….In response to comments, the final regulations do not explicitly include guaranteed payments for the use of capital under section 707(c) in the definition of interest. However, consistent with the recommendations of some commenters, the anti-avoidance rules in §1.163(j)-1(b)(22)(iv)…include an example of a situation in which a guaranteed payment for the use of capital is treated as interest expense and interest income for purposes of section163(j).

Without getting into the merits of the example the IRS added to the anti-avoidance rule, suffice it to say that acting “with a principal purpose” of tax avoidance in preferring a guaranteed payment on capital to actual interest on indebtedness is a very low barrier for the IRS to meet. After all, “a principal purpose”, based on existing authority is merely an important purpose but need not be the predominant purpose and the test can be met even if there is a bona fide business purpose for using the guaranteed payment in lieu of actual indebtedness and even though the transaction has economic substance. 

But what about how the U.S. Supreme Court and the IRS itself treated a short sale for purposes of interest deductibility and the unrelated business income tax, respectively? In Rev. Rul. 95-8, 1995-1 C.B. 107, the issue was whether a short sale of property created “acquisition indebtedness” for purposes of the unrelated business income tax under section 514. The IRS concluded, in a revenue ruling that is still outstanding, that the answer was no:

Income attributable to a short sale can be income derived from debt-financed property only if the short seller incurs acquisition indebtedness within the meaning of section 514 with respect to the property on which the short seller realizes that income. In Deputy v. du Pont, 308 U.S. 488, 497-98 (1940), 1940-1 C.B. 118, 122, the Supreme Court held that although a short sale created an obligation, it did not create indebtedness for purposes of the predecessor of section 163.

In turn, the U.S. Supreme Court had this to say about what is “indebtedness” under the Internal Revenue Code (Deputy v. du Pont, 308 U.S. 488 (1940)): 

There remains respondent’s contention that these payments are deductible under § 23 (b) as “interest paid or accrued . . . on indebtedness.” Clearly [the taxpayer] owed an obligation….But although an indebtedness is an obligation, an obligation is not necessarily an “indebtedness” within the meaning of § 23 (b)…. It is not enough….that “interest” or “indebtedness” in their original classical context may have permitted this broader meaning.  We are dealing with the context of a revenue act and words which have today a well-known meaning. In the business world “interest on indebtedness” means compensation for the use or forbearance of money. In [the] absence of clear evidence to the contrary, we assume that Congress has used these words in that sense. (footnotes omitted). 

And so, the U.S. Supreme Court says that “interest on indebtedness” means “compensation for the use or forbearance of money”. A guaranteed payment on capital is a return on equity and cannot be transformed into interest on indebtedness based on some general regulatory authority under section 7805(a), no matter how abusive the IRS views a transaction. And effectively treating a guaranteed payment on capital as “equivalent to interest” but not actually indebtedness for purposes of certain enumerated provisions (such as section 901) seems to be overreaching given the mandate of the U.S. Supreme Court on an economic equivalent to interest on indebtedness at that time, a short sale. 

Can the IRS write a regulation that circumvents the dictates of the U.S. Supreme Court using a general grant of regulatory authority under section 7805(a)? I would think that the answer is clearly and obviously no. But what is the price that the IRS will ultimately pay if the results enumerated here are overruled by a court several years down the road? Other than spending taxpayer dollars unnecessarily, it does not appear that there is any downside in doing so. 

Note that this bifurcated treatment of a guaranteed payment on capital “infects” other recent regulations because in one case (T.D. 9866, the GILTI final regulations) there is an explicit cross reference to the definition of interest income and expense under section 163(j) (which presumably includes the application of the interest expense anti-abuse rule in those final regulations), and in another case (T.D. 9896, the section 267A final regulations) the substance of the definition of interest expense and the anti-avoidance rule exception were incorporated into those regulations.

How can this practice be effectively stopped? Will it require court litigation and years of uncertainty or is there a mechanism for, in effect, penalizing the IRS for taking positions that, if the IRS were a tax advisor to a client other than itself, it could not have concluded the way it does without disclosure on the equivalent of form 8275? 

Could section 7805(a) be amended to curtail this IRS practice? For example, could a sentence or two be added there to say that “the IRS cannot issue regulations or other guidance inconsistent with the literal words of a provision of the Internal Revenue Code unless Congress expressly grants that power”? 

Now, some will say that doing such a thing contravenes the ability of the courts to adjudicate tax disputes and so is perhaps unconstitutional but clearly inadvisable. Others will say that the regulatory guidance process would grind to a halt because of the forceful taking by the Congress of administrative discretion and expertise. 

I don’t think the status quo is acceptable. On the other hand, I do recognize the implementation problems. Is there any solution other than to throw up your hands in disgust and move on to something else?