Reflections on the impact of Nina Olson by Luz Arevalo

As I mentioned in a post on July 8, we are offering reflections on Nina’s impact during the month of July before she retires.  We start off series with a reflection by my fellow Boston clinician, Luz Arevalo.  Luz directs the LITC at Greater Boston Legal Services.  Few clinicians are more passionate advocates than Luz.  So, her comments about Nina’s tone have special meaning.  If you have a reflection and have not sent it in to us yet, I invite you to send it to me at kfogg@law.harvard.edu.  Keith

It was during the 2003 LITC conference that I first heard Nina Olson speak. I remember being struck by her defiant tone. I consider myself educated and yet, it was not until I began to do tax work that I learned there was such a thing as a Taxpayer Advocate. Within the IRS nonetheless. Still, I remember wondering why the feisty tone right there, in a large room full of hundreds of advocates in their own right all of whom were on her side. She gave us lots of data that included taxpayers assisted, types of cases, and ongoing efforts for better customer service. She mentioned the attorneys who worked with her and the topics she planned to address in her annual report. But what always stayed with me was her tone.

Nina came to Boston in 2016 to address the bar. I cannot remember all she said because I was too nervous thinking about what I wanted to say, and making sure she saw my then entire team. By then, I had heard Nina speak, read much of what she wrote, and knew that she demanded perfection. For example, someone had committed the cardinal sin of using the phrase “churning cases” when referring to the work. She was furious and said “I don’t churn cases. I work the cases.” Point taken. So it was important that my team came across as I know it: ready and diligent. I gave her my thanks for supporting a second Boston clinic, for sending Keith Fogg our way, and she said she had big plans for Boston.

Having had a small taste of what is like to build a team and fight for support, one can’t help but admire someone who built an entire national network, some would say with international impact. When my clinic’s private funding was cut because the work needed was not “entirely legal,” I had a WWNS* (*WWNS= What Would Nina Say) moment and asked the funder how many accountants fight for due process?

As I see it, Nina had a vision to get the IRS to do its job, only better. I admire her constancy and zeal in identifying and recruiting key people to share that vision, and make it happen. Her work is not for the faint of heart, but then again, she never struck me as one to faint. And if the skill needed is that of a defiant warrior, so be it. She harnessed it. Or maybe she was born feisty. It suits her, and it left us a legacy worth preserving.

Thank you Nina, for all you did. I think you have touched virtually every taxpayer’s life for the better. Our sky will be a bit less bright without you.

Innocent Spouse Relief and the Administrative Record

Steve Milgrom, an attorney who is the Litigation and Volunteer coordinator for San Diego Legal Aid, brings us today’s guest post. I wrote about Steve’s remarkable presentation at an ABA meeting last December where the audience begged him to finish telling the story of his CDP case about which we had blogged here and here. His CDP case involved an effort to convince the IRS to levy on the client’s retirement account. Today, we are fortunate to have Steve writing about the new additions to the innocent spouse provisions.

Carl Smith discussed his concerns about the proposed innocent spouse legislation in the Taxpayer First Act here and here back in April before it became law. He has some other concerns about it that dovetail with the concerns expressed below by Steve in this post. Carl’s concerns include:

First, what happens if the taxpayer brings suit after 6 months, but before the administrative record is completed and a NOD issued? The record may be minimal (the 8857 and a response by one or both spouses). As I read the statute, there will have been no determination to be reviewed; therefore, the Tax Court creates a de novo record. Thus, it would be best practice always to file a Tax Court petition after 6 months of filing the 8857 — if the IRS determination has not been made yet. This means that all 8857s should be sent certified mail, return receipt requested to establish the exact date of 8857 filing. Section 7502’s mailing rule doesn’t apply, since there is no time deadline to file an 8857.

Second, assuming that there was an NOD issued, how does a non-requesting spouse’s contradiction of a requesting spouse (typically on knowledge or significant benefit) get resolved without the judge being able to hear both spouses in court? Typically, the NRS’s statement is just made part of the administrative record.

Third, note that the prior litigation had only been over the scope of review of (f) cases under (e) proceedings. See, e.g., Porter I and Wilson. But, the new (e)(7) refers to determinations “under this section” (i.e., the complete 6015 — (b), (c), and (f)). This upends all case law under (b) and (c) going back to 2000, when the Tax Court did its first case under (e) and held that the scope of the evidence under (b) and (c) was de novo.

Fourth, this makes it virtually impossible for the NRS to usefully intervene first at the Tax Court stage. If the NRS has something to say, he or she better do it at the administrative level in writing.

After reading the concerns expressed by Steve and Carl, I feel that Congress has created another 6751 type situation in which the court will grapple with the language of the new provision and how it fits into the overall scheme of the innocent spouse provisions. I am also concerned that individuals seeking relief under the innocent spouse provisions will suffer unnecessarily because of these changes.

Keith

My daughter tells me I have a habit of burying the lede. To avoid repeating that mistake, here it is: Congress just stacked the deck against taxpayers trying to overturn a decision by the IRS to deny innocent spouse relief.

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On July 1, 2019 President Trump signed the Taxpayer First Act  (TFA) into law. One provision of the TFA, section 1203, makes procedural amendments to the innocent spouse rules, revisiting 10 year old decisions of the Tax Court in the two Porter cases, which Carl Smith discussed recently here. The new provision defines the scope and standard of review that govern the Tax Court’s review of an IRS determination. Basically, “scope of review” deals with what the court will consider in making its decision, what evidence it will look at. A court’s “standard of review” defines how much deference to give to the decision (determination) made by, in tax cases, the Commissioner.

In Porter I the Tax Court dealt with the scope of review. The government argued that the Court was limited to reviewing the administrative record. The Court rejected this limitation and held that they would hear the case de novo, meaning it would conduct a trial and decide for itself what the facts were. Then in Porter II the Court dealt with the proper standard of review in 6015(f) equitable relief cases. Prior to Porter II the Court had been using an abuse of discretion standard of review for 6015(f) cases and a de novo standard for 6015(b) and (c) cases. In Porter II Court decided that the 2006 amendments to 6015 warranted reconsideration of the standard of review and held that the standard should be de novo in all 6015 cases. Ms. Porter, proceeding pro se, had won very important protections for her fellow taxpayers.

Having lost in the Tax Court, the battlefront moved to Congress. While it took 10 years for Congress to enact legislation on the subject, in my opinion the new law is anything but Taxpayer First. Here is the new 6015(e)(7):

(7) STANDARD AND SCOPE OF REVIEW.—Any review of a determination made under this section shall be reviewed de novo by the Tax Court and shall be based upon—

(A) the administrative record established at the time of the determination, and

(B) any additional newly discovered or previously unavailable evidence.

The first part of the new law provides that the Tax Court is to give no deference (de novo standard of review) to the decision made by the Commissioner. That’s good news and codifies the current practice of the Court.

Before I get to the second part of the change, a little background. Innocent Spouse cases come before the Tax Court in two different postures, with or without a prior determination having been made by the Commissioner. They arrive with a prior determination when a taxpayer files a request for relief on Form 8857 and the Commissioner partially or fully denies the request. The Tax Court also has jurisdiction to hear innocent spouse cases without a prior determination when it is pled as an affirmative defense in a deficiency action or where a stand alone Petition for relief is filed in situations where Form 8857 was filed with the IRS but 6 months has passed without a final determination by the Commissioner.

I suspect the majority of cases arrive via the Form 8857, final determination path. It is in this universe of cases, where the Commissioner has rejected a request for relief, that Congress overturned the Court’s ruling in Porter I and has done great harm to taxpayer rights. In these cases Congress has tied the Court’s hands by limiting what facts it can consider when it engages in de novo review. The new wording requires Court’s decision to be made using the administrative record. Instead of the current Tax Court practice of having a full trial, with examination and cross-examination of witnesses, weighing the credibility of the witnesses testimony, and deciding based solely on the evidence presented to it during the trial, the Court is now to decide the case using the sterile record created during the administrative phase of a request for relief.

According to my research this is the only instance in the Code that the phrase “administrative record” is used. While this is certainly not a new concept in the law, courts are still entertaining arguments over what the administrative record consists of. See In re United States, et al., 138 S. Ct. 371 (2017). Questions that are regularly litigated regarding the administrative record (typically in non-tax cases) include: is the material proffered the full record; who decides what goes into the record; what materials in the agencies possession are relevant; did the agency decision maker consider matters not in the record; and does the record include evidence both supporting and contrary to the agencies decision. This presupposes you know who made the decision. Unlike the recent administrative decision case before the Supreme Court, where the issue was the decision of Commerce Secretary Wilbur Ross to add a citizenship question to the 2020 census, in tax cases I have found that the decision is sometimes made by an unknown manager, not the person that heard the evidence.

Then there is the biggest problem with the record rule as applied to IRS proceedings: little or no record exists of oral statements made by either the IRS or the taxpayer. While some cases can be document heavy, not everything in a person’s life is memorialized in writing. Spousal abuse cases are a serious part of innocent spouse jurisprudence. Sometimes there are police reports or medical records that corroborate allegations of physical abuse. However, the reality is that most abuse, physical and psychological, happens behind closed doors. Evidence of abuse is going to include a heavy component of potentially conflicting testimony. Will this make it into the administrative record in a compelling fashion?

It takes great strength and courage for an abused spouse to talk about the abuse they suffered. Written descriptions of the abuse never, never, convey the true nature of what happened. To get any real understanding of what actually took place you have to hear the parties’ descriptions and observe their body language as they are testifying. This happens at a trial. It is certainly not pretty and isn’t what I thought I would be dealing with when I decided to study tax law instead of family law, but alleviating the financial cost of separating from an abusive spouse is important work that has become a part of tax controversy practice.

How is the record made in these cases? All innocent spouse cases are referred to the IRS specialty unit in Kentucky. Since few taxpayers live in the Covington Kentucky area the opportunity for face-to-face meetings with the IRS is very limited. The record is going to be made by correspondence and phone interviews. The decision maker has no opportunity to observe body language. Advocates have no opportunity to cross examine witnesses. No one is sworn in front of someone wearing a black robe, which at least one Chief Counsel lawyer has explained tends to focus the mind. The IRS has almost complete control over the narrative in the record. You want to record the call so there is an accurate record? Forget it, the IRS prohibits the practice. Are people with a stake in the outcome (the abusive spouse who may end up with sole responsibility for the tax liability) more likely to shade the truth in an unrecorded private phone call with the IRS? In most spousal abuse cases the abusive spouse’s action led to the unpaid taxes in the first place.

The IRS creates a great deal of the administrative record in what are called case notes. Do case notes accurately reflect what happened? Is there the possibility that they present a skewed view? After all, unlike in a court where you have an independent reporter, the IRS personnel creating the record can be the same person making the decision that the Tax Court is then called upon to review. Or even worse, the person creating the record is doing so for the purpose of convincing their Manager that the decision they are recommending is correct. The record is not being made by a neutral party for the purpose of memorializing the evidence, it is made by someone who is advocating a particular outcome.

Then there is the question of what is included in the “administrative record” that the Court is to review. In the Declaratory Judgment Rules the Tax Court has its own definition of “administrative record” (see Rule 210 (b)(12)), which makes no provision for dealing with oral communications. In the CDP regulations, Treasury takes a broader approach:

Q- F4. What is the administrative record for purposes of Tax Court review?
A- F4 . The case file, including the taxpayer’s request for hearing, any other written communications and information from the taxpayer or the taxpayer’s authorized representative submitted in connection with the CDP hearing, notes made by an Appeals officer or employee of any oral communications with the taxpayer or the taxpayer’s authorized representative, memoranda created by the Appeals officer or employee in connection with the CDP hearing, and any other documents or materials relied upon by the Appeals officer or employee in making the determination under section 6330(c)(3), will constitute the record in the Tax Court review of the Notice of Determination issued by Appeals.

26 CFR § 301.6320-1

I’ve had occasion to review IRS case notes of meetings and telephone conversations in which I was a participant. Let’s just say that sometimes it appears that the person making the notes was part of a different conversation.

The adoption of the record rule is going to have a major impact on innocent spouse cases. After a few years of watching it play out in Tax Court it is unlikely anyone will conclude that the effect of the new law was to put taxpayers first. Nina, please come back!

Virtual Currency, FBAR, and the Ripple Effect

We welcome back guest blogger James Creech. In this post James explains some of the current uncertainties surrounding virtual currency, particularly in how future IRS guidance might interact with legal positions taken by other federal agencies. Christine

Recently FinCen informed the AICPA Virtual Currency Task Force that Bitcoin and other Virtual Currencies do not trigger FBAR reporting even when held in an offshore wallet.

This guidance comes as a bit of a surprise for some tax practitioners. Conventional wisdom had been that there was a difference between Virtual Currencies being held in cold storage on a thumb drive in a foreign county, and those being held by a foreign third party who also retained the private keys to the Virtual Currency as a part of their service. It was believed that if the private keys were stored by the wallet service, and the wallet service could convert the Virtual Currency to fiat currency, then the account could be considered similar to an online poker account and reportable under U.S. v Hom, No. 14-16214, 9th Cir., (7/26/16).

While this will be welcome news for many taxpayers who hold foreign wallets, this guidance by FinCen has the potential to be more impactful on the tax consequences of Virtual Currencies than would initially be apparent. The IRS has long relied on other agencies to define key terms, and to more fully develop the legal nature of Virtual Currencies. This FinCen guidance may be the beginning of a deepening rift between agencies.

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It is expected that the IRS will be releasing new Virtual Currency guidance shortly that will address some of the technological developments in the industry. One of the areas that could be addressed by this guidance is whether Virtual Currency held in foreign wallets is reportable on Form 8938. If the IRS decides that the Hom rational is correct and that foreign wallets are reportable this will create another significant distinction between the FBAR and Form 8938. For taxpayers this creates a higher likelihood of unfilled Form 8938’s due to taxpayer error and greater confusion between FBAR and Form 8938 requirements. I expect that this increased error rate will be higher than normal due to the fact that the Virtual Currency community relies heavily on industry blogs that many times are more interested in promoting virtual currency purchases rather than informing readers about compliance requirements.

For tax practitioners this split also raises questions of how much weight to put on the guidance of other administrative agencies. Because the IRS has issued so little guidance on Virtual Currency there are very few absolutes. We know that Virtual Currency is property because Notice 2014-21 clearly says so. What we don’t know is how far that definition goes, or if it can be treated like other specialized types of property. In the non-IRS context, the SEC has defined certain types of Virtual Currency as securities, and the CFTC has said that it is a commodity. It logically follows that if the IRS says a certain Virtual Currency is property, and the SEC says this Virtual Currency is a security, that a dealer in that particular Virtual Currency should be able to use a mark to market election under IRC 475. Given that Virtual Currencies as a whole suffered a bear market in 2018, a mark to market treatment might provide a desirable tax loss for many in the industry.

If there is a split in the FBAR and Form 8938 definitions, then assumptions that the IRS will allow taxpayers to import definitions from other agencies in order to tackle unaddressed issues lose some of their logic. It is impossible to overstate how important prior FinCen definitions are for IRS Virtual Currency guidance. The root definition of what is a Virtual Currency for IRS purposes is based in a 2013 FinCen definition of “convertible virtual currencies”. If the IRS does not see eye to eye with FinCen then there is a diminished likelihood that the IRS would adopt a CFTC definition and allow Virtual Currencies the same type of preferential tax treatments that they would allow for an established commodity. Of course the opposite reaction might also be true. If the IRS is the first agency to state that foreign wallets are reportable, we might see FinCen respond by adjusting their guidance to require FBAR disclosure as well. Either way, the pending IRS guidance will tell us a lot about how the IRS is thinking about Virtual Currencies and how it intends to incorporate guidance from other administrative agencies.

The Sixth Circuit Sustains the IRS on Another MidCoast Transferee Liability Case

We welcome back occasional guest blogger Marilyn Ames. As I have mentioned before Marilyn and I worked together at Chief Counsel’s office for many years though I mostly worked in Richmond and she in Houston. In retirement she calls upon her deep knowledge of collection and tax procedure issues to assist in updating the treatise edited by Les, “IRS Practice and Procedure.” More specifically, one of the chapters she assists in updating is Chapter 17 involving transferee liability. The case she discusses in this post will soon make its way into the treatise as do many of the cases we write about in PT. By reading the post you receive a little more depth that usually goes into the treatise and you receive the information a little earlier but if you do not look at the treatise you can lose some of the context provided by the expanded discussion of the issue in general. Enjoy the post and remember that the treatise can assist you in obtaining a greater understanding of the issue. Keith

Prior to the creation of the intermediary transaction, Section 6901 of the Internal Revenue Code was a sleepy little backwater whose appearance in litigation was mainly in cases involving tax protesters trying to keep from paying taxes by transferring their property to various trusts and family members. Section 6901 is a procedural mechanism that permits the United States to collect unpaid tax liability from insolvent taxpayers by reaching transferees who have received property belonging to the taxpayer in a fraudulent conveyance. Because Section 6901 is solely a procedural statute, the government must show the transferee is liable by using some other federal statute, such as the Federal Debt Collection Procedures Act, or the relevant state fraudulent conveyance statute. Currently, the vast majority of states have fraudulent conveyance statutes based on the Uniform Fraudulent Transfer Act, which was approved as a uniform law in 1984. Prior to that time, most states passed fraudulent conveyance statutes based on the 1918 Uniform Fraudulent Conveyance Act.

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In the last years of the last century and the first years of this one, a company called MidCoast caused the government to take a second look at the use of Section 6901 when MidCoast began marketing a tax transaction to help shareholders that sold privately held corporations to save on the income taxes that would otherwise be owed on the sale. To do this, MidCoast, in what the Internal Revenue Service named an intermediary transaction, combined an asset and a stock sale of the privately held corporation. The corporation would sell its assets to an unrelated third party, thus triggering a tax on the corporation for any gain realized on the assets. The shareholders would then sell their shares to MidCoast, which would resell the stock to another not so unrelated third party. Although MidCoast claimed to borrow the funds from the purchaser of the shares to pay the shareholders, in actually it would use the cash held by the corporation from its asset sale, leaving the corporation insolvent with no way to pay its tax liability. MidCoast would set the price of the shares at the amount of the cash held by the corporation, less a percentage of the estimated tax liability triggered by the asset sale. MidCoast marketed at least sixty of these transactions.

In 2001, the Internal Revenue Service issued Notice 2001-16 (2001-1 CB 730), designating the “intermediary transaction” tax shelter as a listed transaction. Litigation began as to whether the government could collect the corporations’ tax liability from the former shareholders who had walked away with cash for their shares as transferees under Section 6901. Initially, the Tax Court was not sympathetic to the government’s arguments, and held in favor of the shareholders under various arguments. Some of these cases can be found in the Tax Court’s opinion in Julia R. Swords Trust v. Comm’r, 142 TC 317 (2014), the citations for which are replete with little red flags as the various circuit courts reversed and remanded many of these cases to the Tax Court. After the initial flood of reversals, the Tax Court got the hint and began finding transferee liability existed in most of these cases, based on the relevant state law, with the courts of appeal affirming the later decisions entered in the Service’s favor. (The Julia Swords case is an exception, notable as it was decided under Virginia law, which is one of the few states that has not passed a version of the Uniform Fraudulent Transfer Act).

The latest opinion in the Section 6901 litigation is that of Hawk v. Commissioner, 924 F3d 821 (6th Cir. 2019), and with this opinion the Sixth Circuit drives another nail in the intermediary transaction coffin for those cases decided in states with law based on the Uniform Fraudulent Transfer Act. The former shareholders in Hawk argued that they should not be held liable as transferees under Tennessee law as they did not know that MidCoast’s scheme was fraudulent, and without such knowledge, there was no fraudulent conveyance. The Sixth Circuit rejected this argument, noting that the Uniform Fraudulent Transfer Act, upon which the Tennessee act is based, replaced the language that an exchange of property was made for fair consideration if it was made in good faith, with the language that the transfer had to be for “reasonably equivalent value.” The “good faith” language had been part of the Uniform Fraudulent Conveyance Act, and the court held that the drafters of the Uniform Fraudulent Transfer Act had made the change to “reasonable equivalent value” to eliminate any inquiry into the transferee’s intent when determining whether a transfer is constructively fraudulent. The bottom line, the court holds is that the transferees’ “ ‘extensive emphasis on their due diligence and lack of knowledge of illegality’ doesn’t shield them from the sham nature of the transaction and absolve them of transferee liability.”

Apparently tiring of intermediary transactions and Section 6901 litigation, the court goes further and asks “Was there a way to make this tax-reduction strategy work?” The court’s answer is “ ‘maybe’ in the abstract and ‘not likely’ here.”

With the Hawk opinion, it appears that the litigation involving intermediary transactions may be on the wane, and that Section 6901 may be on its way back to the quiet little backwater where it previously spent its days.

Some Facts About the Walquist Case, Along with Some Nuance

Frequent guest blogger Bob Kamman put his formidable investigative skills to work to bring us an in-depth look behind the Walquist opinion. Christine

“Everyone is entitled to his own opinion, but not to his own facts.”
–Daniel Patrick Moynihan

“Facts, sir, are nothing without their nuance.”
–Norman Mailer

The Tax Court is certainly entitled to its opinion in Walquist v. Commissioner, 152 T.C. No. 3, which Keith Fogg blogged here. But a review of the record and other public documents yields facts that may contradict those cited in the opinion, or at least provide some meaningful nuances. Serious questions are therefore raised about its precedential value.

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 Here are what the Tax Court found to be some of the facts:

R through his Automated Correspondence Exam system determined, for Ps’ 2014 tax year, a deficiency in tax and a penalty for an underpayment attributable to a substantial understatement of income tax. R’s computer program generated a 30-day letter inviting Ps to reply and submit relevant information. When Ps declined to respond, the program generated and issued to them a notice of deficiency in the form of a Letter 3219. This letter again invited Ps to contact R, but they did not do so.

Here is what actually happened:

Petitioners filed their 2014 Form 1040 with a paper return that was received by the Fresno Service Center on April 2, 2015. It must have been placed in the “Funny Box” (see Internal Revenue Manual 3.10.73.3.4) because it was stamped “Frivolous Return Program – Internal Revenue Service – Fresno CA” on that day. The next stop in its processing was April 13, 2015, when it was stamped “Received – FRP 306.”

The taxpayers had added to the jurat (declaration under penalty of perjury, just above their signatures), “This return is in accordance with 12 USC 411, 12 USC 95(a)(2), [illegible].” Those sections are used by tax protesters who claim income is not taxable unless paid or measured by Federal Reserve notes, or something like that.

They also wrote “Demand for Lawful Money Reduction” on Line 21, with a bracketed amount of $87,647.96 to indicate a loss. The pretrial memorandum correctly transcribes the first word as “Demand” but a later pleading erroneously changed it to “Remand.”

The next we see of the return is an internal IRS Form 8278, “Assessment and Abatement of Miscellaneous Civil Penalties,” dated July 27, 2015 and signed by “Ms. Bluemel” as originator and Krista Decaria as manager and reviewer. (They work not in Fresno, but at the IRS Ogden Service Center.) It assesses a $5,000 penalty for a frivolous tax return. Assessment of this penalty is not subject to deficiency procedures. In its “Remarks” section, the Form 8278 states “Argument 29.” IRM 25.25.10.2 explains this as “Any other position deemed frivolous.”

The Walquists filed a joint return. Both spouses had W-2 income. Craig Walquist earned $20,113 from two employers, with $624 federal income tax withheld. Maria Walquist earned $59,840 from one employer, with $5,105 withheld. The total withholding from W-2 forms was $5,729 but their return claimed $5,730.69. In August 2015, IRS grabbed the $5,000 penalty from this amount. That left $730.69, which was applied to taxes they owed for 2008. Then IRS allowed $54.12 interest from April 15 on the “overpayment.” That amount went to 2008, also.

All of these facts come from IRS pleadings in the Tax Court case. To find out what happened between August 2015 and August 2017, when the Notice of Deficiency was issued, we must look elsewhere. Did IRS just throw the fishy 1040 back in the sea of returns, only to have the audit commence again because of some unreported income? Fortunately, the taxpayer attached some IRS correspondence to the lawsuit he filed in the District Court for Minnesota. But first, let’s look at some more facts from the Tax Court opinion.

Alerted to petitioners’ underreporting by computer document matching, the IRS processed the examination of their return through its Automated Correspondence Exam (ACE) system, employing its Correspondence Examination Automated Support (CEAS) software program. This software is designed to process cases ‘with minimal to no tax examiner involvement until a taxpayer reply is received.’ Internal Revenue Manual (IRM) pt. 4.19.20.1.1 (Dec. 18, 2017).

On July 26, 2017, the CEAS program generated and issued to petitioners a Letter 525, General 30-Day Letter. In cases such as this–where the understatement of income tax calculated by the program exceeds the greater of $5,000 or 10% of the tax required to be shown on the return–the program systematically includes in the letter a substantial understatement penalty. See sec. 6662(b)(2), (d)(1)(A). The program accordingly calculated a penalty of $2,766.40, or 20% of the proposed deficiency of $13,832. See sec. 6662(a).

What Walquist attached to his District Court complaint, though, is a Letter 525 dated June 30, 2017. It says, “We’re auditing your 2014 Form 1040, and need a response from you.” Attached to the letter is a computation showing a balance due of $18,003. This included $13,832 tax; $2,766 Section 6662 penalty; and $1,405 interest. In a box on the Letter 525 for “Examiner’s Signature,” there is printed “Tax Examiner”; and in the box for “Employee ID,” the number 1000099771.

The Letter 525 adds, “let us know by July 30, 2017 if you agree or disagree with our proposed changes.” The Walquists both signed a two-page, single-spaced letter dated July 26, 2017, asserting tax-protester arguments based on Federal Reserve notes. (There is no proof it was mailed, but no reason to believe it was not. It would not have accomplished anything, anyway). IRS responded with the August 30, 2017 Notice of Deficiency.

In addition to his $20,113 of W-2 income, Walquist received $14,159 in “non-employee compensation” reported on Forms 1099-MISC, which IRS determined was subject to $2,001 self-employment tax. He also received $1,215 in unemployment compensation.

As IRS stated in a November 26, 2018 filing, “respondent’s determinations are chiefly based on a misclassification of income rather than underreporting of income by petitioners.” In other words, the $14,159 of self-employment income should not have been reported as wages, but instead shown on Schedules C and SE.

The Notice of Deficiency shows the same employee identification number as the Letter 525. It is attributed to Christine L. Davis, from Ogden’s “Return Integrity and Compliance Services, Integrity and Verification Operation.” That IRS office “detects, evaluates and prevents improper refunds.”

As it turned out, the software that IRS relied on to figure the tax did not produce an accurate result. It was only after the Tax Court petition was filed that IRS Counsel reduced the $13,832 amount to $12,220, and the $2,766 Section 6662 penalty to $2,444. A $60 filing fee saved the taxpayers $1,934 plus interest. They should have quit while they were ahead. The Tax Court also corrected its error in ordering them to pay the filing fee, before it found that it had already been received. Perhaps it was paid in Federal Reserve notes which caused some accounting problems.

Some more facts from the Tax Court:

Whether an accuracy-related penalty determined by an IRS computer program is a ‘penalty automatically calculated through electronic means’ does not appear to have been decided in any published Opinion of this Court. . . .The penalty at issue was calculated and instantiated in letter form by a computer software program. Because the computer did this without human intervention, no ‘individual making such determination’ appears to exist.

Yes, “instantiated” is a word. But that part about human intervention?

In its pretrial motion dated October 5, 2018, the IRS attorney informed the Court:

Respondent determined that petitioners were liable for an I.R.C. §6662 accuracy-related penalty for their 2014 tax year. I.R.C. § 6662 (a). Respondent is able to satisfy its burden of production with respect to this penalty. I.R.C. § 6751 requires respondent to furnish evidence of managerial approval of the accuracy-related penalty prior to the issuance of the notice. As an exhibit to respondent’s September 5, 2018 motion to dismiss, respondent submitted a signed Declaration and Case History demonstrating managerial approval of the accuracy-related penalty in this case prior to issuance of the notice. As such, respondent is able to meet its burden of production.

In other words, in a case where the Tax Court saw no human intervention in a tax-protester audit, the IRS itself saw the need for managerial approval of a Section 6662 penalty, and confirmed it was done.

But maybe that is not the precedent the Court intended to establish with this case. Maybe the message is the $12,500 penalty it assessed under Section 6673, for taking a position in Tax Court that was frivolous or groundless.

The maximum penalty that could have been assessed is $25,000. It might not be coincidence that $12,500 nearly matches the amount of tax, $12,220, that should have been shown on the Walquists’ frivolous return. That does not include the $5,000 penalty they had already paid to IRS.

The Tax Court penalty can now be collected from either spouse. In 2014, Mrs. Walquist was the primary breadwinner, responsible for 63% of the income. Filing separately, she still would have owed more than $3,000 tax. But there is little evidence that she is the primary tax protester. She was not a plaintiff in the District Court case. An IRS notice attached to that complaint indicates that for 2016 her husband filed separately, and was again penalized $5,000. It is the husband who has self-published a book that asks such questions as, “Have American Christians erred in assuming our country is Biblically on the side of good?”

I searched Tax Court opinions from 2017 to date for cases involving joint returns where the Section 6673 penalty was considered. Most such cases during this period involved taxpayers who are unmarried or filing separately.

I found two cases involving joint returns. In one of them, Henry and Kathy Jagos, TCM 2017-202, the taxpayers had income of $544,167 in 2012. They denied owing tax because they “are private-sector citizens (non-federal employee) employed by a private-sector company (non-federal entity) as defined in 3401(c)(d).”

From the Court’s opinion:

At trial the Court encouraged the Jagoses to abandon their frivolous arguments and cited specific authorities for them to consider. The arguments raised in their 70-page brief were a rehash of the very same arguments that were dispatched in those cases. And the Jagoses have raised frivolous arguments at every stage of this process from their 2012 income tax return to their closing brief. For disregarding the cases cited to them and wasting the Court’s resources with their frivolous arguments, we impose a sanction under section 6673 . . .

The Court found that they owed $155,149 in tax – but assessed only a $1,000 penalty under Section 6673.

In the other case, Michael Wells and Lynn Kirchner-Wells, TCM 2018-188, the Court noted:

Petitioners also attached Forms 4852, Substitute for Form W-2, Wage and Tax Statement, to each of the returns indicating zero wages and the same amounts of tax withheld as was shown on each Form W-2. The Forms 4852 included the following tax protester statements: I am a private-sector worker, not an ‘employee’ as defined in IRC 3401(c) and IRC 3121. I worked with a private-sector company, not a federal employer as defined in IRC 3401(d). I did not engage in a ‘trade or business’ as defined in USC Section 7701(a)(26).

The tax deficiency was $52,051, but no Section 6673 penalty was assessed. “The Court may on its own determine whether to impose a penalty not to exceed $25,000 when it appears to the Court that a taxpayer’s position is frivolous or groundless. Sec. 6673,” Judge Gerber wrote. “We did not find in the record that petitioners have made these or similar frivolous claims in the Court before or that they have been previously forewarned. Thus we will not impose one here, nor does respondent seek a section 6673 penalty in this case.”

Has the Tax Court now announced an end to leniency for tax protesters? At least the Walquist case suggests that those with frivolous arguments (and their spouses) should stick to the facts, and keep their opinions to themselves.

IRS Can File a Proof of Claim in Bankruptcy Court for the Full Amount of Tax Liability Even After an Accepted Offer in Compromise

Guest blogger Ted Afield today discusses the intersection of offers in compromise with bankruptcy. Professor Afield (with co-author Nancy Ryan) will be creating a chapter on Offers in Compromise for the next edition of Effectively Representing Your Client Before the IRS. Christine

In our clinic at GSU, we do a lot of collections work and routinely submit offers in compromise, which the IRS often accepts, on behalf of our clients. While our hope is always that the accepted offer will be a critical step that allows the taxpayer to get back in compliance with his or her tax obligations and get out from under the weight of a detrimental financial liability, unfortunately the accepted offer is sometimes not enough to prevent a taxpayer from continuing to be overwhelmed by other financial obligations. In situations like these, the taxpayer may in fact file bankruptcy during the 5-year compliance window for the offer in compromise. If this happens, the IRS potentially has a claim in the bankruptcy proceeding because the offer in compromise may have already been defaulted or may be defaulted in the future if the taxpayer fails to file tax returns and timely pay taxes. Accordingly, the IRS will file a proof of claim in the bankruptcy proceeding, which raises the question of should this proof of claim be for the full amount of the tax liability or for the compromised amount of the tax liability.

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This was the question recently taken up in a memorandum opinion by the Bankruptcy Court for the Southern District of Texas, Houston Division, in In Re: Curtis Cole, No: 18-35182 (May 29, 2019). In this case, Mr. Cole and the IRS had entered into a compromise of tax liabilities for 2003-2014 totaling over $100,000 for the much more manageable sum of $1,000. During the five-year monitoring period, Mr. Cole started off well and timely filed and paid his 2016 income tax. For 2017, however, Mr. Cole recognized that he would not be able to timely file a return, and he accordingly requested and was granted an extension. Mr. Cole did then file his 2017 return and pay his 2017 tax bill on October 15, 2018.

PT readers who do a lot of OIC work will immediately recognize the potential problem that Mr. Cole created for his offer because an extension of time to file is not an extension of the time to pay taxes, raising the possibility that the IRS would default Mr. Cole’s offer for failing to pay his 2017 taxes in a timely manner. Compounding the problem was that Mr. Cole had filed for Chapter 13 bankruptcy one month earlier, on September 15, 2018. As a result, the IRS filed a proof of claim in the bankruptcy proceeding for the full amount of the original tax liability that was compromised under exactly that theory (i.e., that Mr. Cole’s late payment of 2017 taxes caused his offer to default and thus caused the amount of the IRS’s claim to be the full amount of the tax liability).

Mr. Cole was not happy with this development and attempted to raise a couple of equitable arguments that did not have much of a leg to stand on. Mr. Cole’s first hope was that he would be simply forgiven his confusion over whether a filing extension also constituted a payment extension. This did not have much resonance in light of the fact that it is well established that filing extensions are not in fact payment extensions. Mr. Cole also attempted to argue that he effectively had rights under the Internal Revenue Manual by asserting that the IRS violated its own procedures when it did not offer him any opportunity to cure his late payment before declaring the offer to be in default. See I.R.M. 5.19.7.2.20, which states that in the event of a breach of the offer’s terms, the IRS should send the taxpayer a notice letter and provide an opportunity to cure before defaulting the offer. Again, this argument could not carry much weight in light of the well-established principle that the IRM does not give taxpayers any rights, and thus the IRS was not obligated to provide an opportunity to cure the default. Ghandour v. United States, 37 Fed. Cl. 121, 126 n.14 (1997).

Mr. Cole’s strongest argument was based on his reliance on a bankruptcy court opinion from the Eastern District of North Carolina that had ruled on a similar issue and had concluded that the proof of claim should be for the compromised amount rather than the full amount of the tax liability. In re Mead, No. 12-01222-8-JRL, 2013 WL 64758 (Bankr. E.D.N.C. Jan. 4, 2013). The Mead court found that the contractual language in Form 656 stating that the IRS may file a “tax claim” for the full amount of the tax liability if a taxpayer files for bankruptcy before the offer’s terms expire is ambiguous in regards to whether the “tax claim” refers to the full liability or the compromise amount. Accordingly, the Mead court held that the IRS violated the nondiscrimination rule of 11 U.S.C. § 525(a), on the grounds that it appeared that the IRS was trying to collect the full amount of the tax liability, rather than the compromised amount, solely because the taxpayer was in bankruptcy.

The Cole court, however, was not persuaded by its sister court in North Carolina and held that Mead was both distinguishable and simply incorrect.  Mead was distinguishable because, unlike in Cole, there was not an issue of whether the offer had been defaulted. However, even without that distinguishing characteristic, the Cole court noted that the outcome would be the same. In other words, regardless of whether the offer was in default, if the terms of the offer had not yet expired, the IRS would still need to file a proof of claim for the full amount of the tax liability in order to preserve its rights in case the taxpayer did subsequently default the offer. This is why the terms of the offer explicitly state in Section 7: “If I file for bankruptcy before the terms and conditions of the offer are met, I agree that the IRS may file a claim for the full amount of the tax liability, accrued penalties and interest, and that any claim the IRS files in the bankruptcy proceeding will be a tax claim.” I do not agree with the Mead court’s assertion that this language is ambiguous.

It’s not that the issue of whether the offer has been defaulted is irrelevant. Rather, that issue is simply premature at the moment when the IRS files its proof of claim. Even if the offer has unequivocally not yet been defaulted, the IRS must file a proof of claim for the full amount of the liability to protect its right to recover the full amount, should a default occur. So when can Mr. Cole attempt to make his likely to be very uphill arguments that he has not defaulted the offer? As the court notes, he does this when he submits his Chapter 13 plan, in which he will propose how to treat the IRS’s claim. If he believes he has not defaulted his offer, he can propose that the IRS only receive what it is owed if the offer is still in force. The IRS can then object if it believes that the offer is in default, and the issue can then be decided.

In comparing Cole and Mead, I think the Cole court likely has the better argument. The contractual language in Form 656 pretty unambiguously gives the IRS the right to file a claim for the full amount of the tax liability in a bankruptcy proceeding during the five-year monitoring period. That does not mean that the IRS will recover the full amount if the offer is not in default, but taxpayers should certainly expect such a claim to be filed and that they will have to litigate whether the offer is defaulted when they propose their bankruptcy plan.

Five Things to Know About FedEx and the Tax Court

Today Bob Kamman explores FedEx issues in Tax Court and brings us several interesting findings. The bottom line for practitioners (as always) is to be aware of the jurisdictional perils that await those who cut it close without carefully checking the list of designated private delivery services. Christine

Inspired by Keith Fogg’s post about the Tax Court petition that could not be delivered by FedEx during the January 2019 government shutdown, I searched recent Tax Court orders for similar cases. Here are five things I learned.

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1) You can’t always trust word searches on the Tax Court website.

I searched for orders with the word “FedEx” from October 1, 2018 through May 28, 2019.  The search returned three hits.  Then I searched for “FedEx” from April 30, 2019 through May 28, 2019.  That search returned ten hits.  So I searched for “FedEx” from only November 1 through December 31, 2018.  That search returned five hits, none of which were in my first search.

My conclusion, or at least hypothesis, is that the search “times out” after a certain number of orders are searched.  Results will be more accurate if done by month, rather than for longer periods. 

2) The case described in Keith’s post is not unique.

In the Awad case, in response to an earlier order the Court writes

The petition, filed January 30, 2019, arrived at the Court in an envelope with a FedEx ship date of January 29, 2019. . . . petitioners indicated that the petition was originally mailed to the Tax Court on January 16, 2019, (2) petitioners provided respondent a copy of the envelope in which the petition was originally sent to the Tax Court on January 16, 2019, a copy of which was attached to the Response, and (3) petitioners also provided respondent a copy of the envelope in which the petition was returned to them, a copy of which was attached to the Response.

It is not clear whether the first attempt was through the U.S. Postal Service, or through FedEx.

And then there is the unfortunate petitioner in Chicas, whose deadline for filing was December 31, 2018 – a date the government was closed.  He used UPS Ground to send his petition on January 3, 2019.  It was returned by UPS, and he sent it again by UPS Ground on February 22, 2019.  He was late the first time, and UPS Ground is not an acceptable service anyway. 

3) IRS does not always question jurisdiction.  Sometimes it needs help from the Tax Court.

That is what happened in Powerhouse Mortgage Corporation.  In dismissing the case on November 29, 2018,  Judge Foley explained,

Attached to the petition was a notice of determination concerning collection action dated July 17, 2018 . . .The petition had been received by the Court in an envelope sent by FedEx Express Standard Overnight and bearing a ship date of August 17, 2018. An answer to the petition followed on October 9, 2018, but did not address jurisdictional matters. Nonetheless, because review of the record suggested a fundamental jurisdictional defect, the Court by Order dated October 12, 2018, directed the parties, on or before November 2, 2018, to show cause in writing why this case should not be dismissed for lack of jurisdiction, . . .Shortly thereafter and in lieu of a response, respondent on October 17, 2018, filed a Motion To Dismiss for Lack of Jurisdiction on the identical ground of an untimely petition.. . .petitioner was afforded additional time, until November 9, 2018, to object to respondent’s motion as well. 

The petitioner did not respond, and the motion to dismiss was granted.

See also Jones, dismissed by Judge Foley on December 3, 2018.  IRS didn’t notice that the petitioners not only were late, but used the wrong FedEx service.  However, the Court did:

The petition in the above-docketed proceeding was filed on September 4, 2018. Therein, petitioners alleged dispute with a notice of deficiency dated June 1, 2018, issued with respect to the 2015 and 2016 taxable years. The petition had been received by the Court in an envelope sent by FedEx Express Saver and bearing a ship date of September 1, 2018. Unexpectedly, respondent thereafter on September 21, 2018, filed an answer to the petition, not addressing the matter of timeliness.

Nonetheless, because review of the record continued to suggest a fundamental jurisdictional defect, the Court at that juncture issued an Order To Show Cause dated October 24, 2018, directing the parties to show cause in writing why this case should not be dismissed for lack of jurisdiction, on the ground that the petition was not filed within the time prescribed by section 6213(a) or 7502. . . . In particular, the Order To Show Cause noted, first, that the date of the notice of deficiency underlying this proceeding indicated a statutory deadline for filing a petition pursuant to section 6213(a) . . .that expired on August 30, 2018, and, second, that FedEx Express Saver is not a designated private delivery service for purposes of the section 7502 . . . timely mailing provisions.

Substantially the same facts have also led Judge Foley to request both parties in Rodriguez to explain by June 11 why the case should not be dismissed when FedEx Express Saver was used and the petition was not received by the required date.  This May 22, 2019 order is somewhat confusing because it states the FedEx envelope “reflects a ship date of August 25, 2019.

I am sure that will be cleared up in later proceedings.  Maybe it was just another FedEx mistake, as happened in Muramota.  In that case, the petition was “in an envelope indicating that the petition was received and processed by FedEx on May 15, 2018, for delivery by FedEx 2-day mail.”  But when Judge Thornton questioned jurisdiction, because the last date to petition was May 14, 2018, “the parties are in agreement that the petition was delivered to FedEx on May 14, 2018, as evidenced by a receipt provided by petitioners’ counsel, and the petition was therefore timely mailed.”  A stipulated decision was entered the same day.

4) Petitioners continue to use FedEx services that do not qualify for “timely mailed” recognition.

Judge Foley’s four-page order of February 25, 2019,  dismissing the Thompson case explains why FedEx Express Saver service is not a qualified “private delivery service.”  The petitioners had noted that they followed the instructions on the second page of their Notice of Deficiency, which apparently did not explain “private delivery service” limitations.  I looked at a couple Notices of Deficiency from 2018 and did not find a reference to private delivery services on them. 

Similar language was used by Judge Foley in his four-page order of February 4, 2019, dismissing Griffiths.

5) The Tax Court uses FedEx also.

When it absolutely positively has to get there faster than the Postal Service can deliver, or when there may be other benefits, the Tax Court uses FedEx to contact Petitioners.  (It probably gets a discounted government rate.)  

For example, in McPhee,  “On May 7, 2019, the Court was informed of an unsuccessful delivery attempt by FedEx of the Notice of Change of Beginning Date of Session, served on petitioners on May 1, 2019. Petitioners subsequently advised the Court that their address has changed. . . .”

Breland, Jr. v. Commissioner: Another Bankruptcy-Tax Trap for the Unwary Practitioner

Today we welcome first-time guest blogger Brad D. Jones. With editorial assistance from returning guest Ken Weil, in this post Brad evaluates the implications for bankruptcy debtors and practitioners of the Tax Court’s recent Breland decision. For a bankruptcy primer written for tax practitioners, see the bankruptcy chapter of Effectively Representing Your Client Before the IRS. Ken and Brad will be updating this chapter for the 8th edition of the book, expected to be published in December 2020. Several of Keith’s past PT posts also address the intersection of tax procedure and bankruptcy. Christine

If a tax is non-dischargeable, an understated IRS claim for that tax can have a devastating impact on an individual debtor’s financial well-being post-bankruptcy. This is because 11 U.S.C. § 523(a)(1)(A) of the Bankruptcy Code provides that non-dischargeable IRS claims can be collected by the IRS post-petition “whether or not a claim for such tax was filed or allowed.” If the IRS’s claim is understated, a person’s unpaid tax liabilities will generally be collectible by the IRS even if all of the individual’s available assets were used in the bankruptcy to pay other, lower-priority debts. As a result, an unfiled or undervalued IRS claim can lead the IRS to continue to pursue an individual for unpaid tax debt post-bankruptcy, even if the IRS did not pursue its claims in the bankruptcy case or allowed funds that should have gone to its claims to be paid to other creditors. The issue of how to fix a debtor’s tax liability and what needs to occur in the bankruptcy court to do so was at issue in Breland, Jr. v. Commissioner, 152 T.C. No. 9 (2019).

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Bankruptcy debtors generally have two main avenues to fix the amount of their tax liability for a given year: (1) file a motion for the bankruptcy court to determine the amount of their tax debt pursuant to 11 U.S.C. § 505; or (2) object to the IRS’s proof of claim. See Internal Revenue Service v. Taylor, (In re Taylor), 132 F.3d 256, 262 (5th Cir. 1998). In Breland,the Tax Court considered the effect of a resolved proof-of-claim objection on the ability of the IRS to pursue post-petition claims “regardless of whether a claim for the tax was filed or allowed,” as contemplated in § 523(a)(1)(A).

Breland involved a commercial-real-estate investor who allegedly owed a substantial sum to the IRS post-bankruptcy. The issue was whether the IRS could agree in the bankruptcy to a consent order setting the amount of its priority claim, allowing the debtor to pay a substantial sum to creditors subordinate to the IRS, and then later issue a notice of deficiency seeking up to $45 million more for the same tax years that it had compromised. The Tax Court held that it could, narrowly interpreting the bankruptcy court’s order as not addressing the total amount of the debtor’s federal tax liability. The Tax Court reached that result even though its interpretation conflicted with the interpretation of the bankruptcy court that entered the order. The Tax Court’s holding is surprising given that proof of claim objections are generally res judicata on the IRS and final orders resolving contested matters in bankruptcy are typically given broad preclusive effect. The Breland ruling forces bankruptcy practitioners to be particularly vigilant in addressing tax issues in the bankruptcy context.

Breland undercuts the ability of individual debtors to rely on proof of claim objections to fix the amount of their tax liabilities. In Breland, the debtor filed a Chapter 11 bankruptcy case and the IRS filed a proof of claim stating it was owed over $2 million in income tax for the years 2004 to 2008. The debtor filed an objection, stating in its entirety, that the “Debtor objects to the penalties assessed against him on the grounds that the Debtor had reasonable cause for not paying the taxes on time.” The parties entered into a consent order in which the IRS agreed to settle the debtor’s objection by agreeing to specific amounts for its priority tax debts with both sides agreeing that the disputed penalty portion was a general unsecured claim to be resolved after bankruptcy plan confirmation. After conducting discovery related to the disputed penalty portion, the IRS filed an amended proof of claim and asserted additional tax was due. The debtor objected on the grounds that the consent order fixed the debtor’s tax obligation. The bankruptcy court granted the objection and the IRS appealed. The district court remanded to the bankruptcy court for clarification as to the preclusive effect of the consent order. In response to the remand from the district court, the bankruptcy court ruled:

[T]he Court finds that the Consent Order . . . is the controlling document as to the extent of the Debtor’s tax obligation to the IRS. The Consent Order contains a clear statement of the total IRS claim amount and divides that amount into priority and general unsecured values. . . Moreover, by its terms, the Consent Order appears binding and complete. No specific limitation on the Consent Order’s effect is indicated in its terms. The IRS did not reserve the right to assert additional claims. Indeed, the Consent Order did not reserve any rights to the IRS, only to the Debtor. The purpose of the Consent Order is unclear if it was not meant to bind the IRS to its terms.

The IRS appealed, losing in the district court and stipulating to dismissal of its appeal to the 11th Circuit. In the midst of the proceedings in the bankruptcy and district courts, the IRS issued its notice of deficiency, triggering the filing of the debtor’s petition before the Tax Court.

Outside of bankruptcy, a consent order would normally be res judicata on the IRS’s attempt to collect additional amounts for the tax years set forth in the consent order. See United States v. Int’l Bldg. Co., 345 U.S. 502, 506 (1953) (consent order not binding on the United States for tax years subsequent to those years covered in the consent order). The consent order would also be binding if the tax in question were dischargeable. And Breland agreed that the consent order would be res judicata on the IRS if the “order had fixed petitioner’s total Federal tax liability for the subject tax years.”

Even though on remand the bankruptcy court had directly addressed the issue before the Tax Court and found its own order to be “the controlling document as to the extent of the Debtor’s tax obligation to the IRS,” the Tax Court interpreted the consent order narrowly. In the Tax Court’s view, the bankruptcy court’s order did not control for two reasons: First, the Tax Court believed res judicata did not apply because it believed that the consent order establishing the amount of the IRS’s claim and resolving an objection to plan confirmation is an inherently different proceeding than a proceeding to determine whether a particular liability is owed. The Tax Court noted that debtor’s proof of claim objection only challenged the penalties assessed, which the Court found undercut his argument that the consent order determined the total pre-petition tax liability. Second, in the Tax Court’s view, reading the consent order as a final determination of the debtor’s tax liabilities would have the effect of discharging otherwise non-dischargeable debts and contradict § 523(a)(1)(A). The Tax Court did not think res judicata applied because in its view the consent order was not “a final judgment on the merits of [the debtor’s] entire Federal tax debt for any given year.”

The Tax Court’s statement that a determination of an individual’s tax debt in bankruptcy is not the same cause of action as determining the tax debt generally is puzzling. The Court did not cite to any cases in its res judicata analysis that arose in the context of a settled or litigated proof of claim objection. The Tax Court’s view that the consent order was a different cause of action than a determination of tax liability is a more restrictive interpretation than is typically applied in a res judicata analysis. Generally, causes of action are the same for res judicata purposes if they arise “out of the same nucleus of operative fact.” In re Piper Aircraft Corp., 244 F.3d 1289 (11th Cir. 2001). In the context of a contested proof of claim, it is difficult to see how a dispute over the amount of the same tax, for the same years, and involving the same individual, can possibly not arise out of a common factual nucleus, which is precisely the reason that proof of claim objections generally are res judicata. See Hambrick v. Commissioner, 118 T.C. 348, 353 (2002) (recognizing that unlike proof of claim objections or a tax liability determination by the bankruptcy court, the mere confirmation of a Chapter 11 plan generally does not require a determination of the amount of a debtor’s non-dischargeable tax liability).

Similarly, the Tax Court’s consideration of the non-dischargeable nature of the debt also does not make much sense in the context of interpreting the scope of the bankruptcy court’s order regarding a proof of claim settlement. While unpaid non-dischargeable debts will generally survive whether the plan is confirmed or not, the purpose of a proof of claim objection is different. A claim objection is generally filed to determine the total amount owed, which does not turn on dischargeability (though a claim objection often establishes the facts from which dischargeability can easily be determined). In this case, the debtor conceded the non-dischargeability of the tax at issue. So in compromising the amount of the priority claim under the consent order, the IRS knew it was establishing the amount of the non-dischargeable portion of its claim. The bankruptcy court clearly understood this difference, which is why it interpreted its order as controlling for the amount of tax at issue.

Moreover, the Tax Court did not give any consideration to the way proofs of claims fit within the bankruptcy scheme as a whole. A basic underpinning of bankruptcy law is the absolute priority rule: the concept that higher priority claims (such as priority tax claims) must be paid in full before estate assets are used to pay lower priority claims. See Czyzewski v. Jevic Holding Corp., 137 S. Ct. 973, 983 (2017) (recognizing that the “priority system has long been considered fundamental to the Bankruptcy Code’s operation”). Establishing the amount of priority tax claims and paying those claims before funds are lost paying lower priority debts is central to both the bankruptcy priority scheme and claims filing process – so much so that the Bankruptcy Code permits debtors to file a proof of claim on behalf of the IRS when doing so is necessary to determine the amount of the tax debt. 11 U.S.C. § 501(c); Taylor, 132 F.2d at 262 (suggesting the option of filing a claim for the IRS to fix the amount of the tax debt). The Tax Court’s decision to apply a restrictive reading of the consent order, at odds with the bankruptcy court’s own interpretation, frustrates these objectives of the Bankruptcy Code. It is also incompatible with the deference courts typically exercise in favor of orders entered by another court. See Colonial Auto Center v. Tomlin (In re Tomlin), 105 F.3d 933, 941 (4th Cir. 1997) (recognizing that the bankruptcy court is in the best position to interpret its own order and its interpretation warrants customary deference).

On May 7, 2019, the debtor filed a Motion to certify the Tax Court’s order to permit an immediate appeal and the Tax Court issued an order requiring the IRS to respond by June 10, 2019. Regardless of the outcome of any appeal, Breland is instructive for practitioners with bankruptcy clients facing tax debts. The Tax Court made much of the fact that neither the plan nor the consent order referenced the bankruptcy court’s authority under 11 U.S.C. § 505 to determine the amount of a debtor’s tax liability. It would be advisable for practitioners to seek to include language either in the Chapter 11, 12, or 13 plan or in orders resolving the IRS claims that specifically reference Bankruptcy Code § 505 and state that the plan or the order constitutes a determination of the amount of the total tax due for the years at issue. Similarly, the Tax Court in Breland also appeared troubled that the debtor’s proof of claim objection only stated that the objection was to the amount of the penalties. If a debtor is going to file an objection to the IRS’s proof of claim anyway, it may be helpful to include an objection to any amounts in excess of those asserted in the IRS proof of claim with a reference to 11 U.S.C. § 505.

Update: coincidentally, on the date this post was published the Tax Court issued a memorandum opinion holding that the Brelands had overstated their long-term capital loss by nearly a million dollars. Christine