Equitable Recoupment Applied in Collection Due Process Case

We have alluded to equitable recoupment in a few posts but not written much about it. In EMERY CELLI CUTI BRINCKERHOFF & ABADY, P.C., v. Commissioner, T.C. Memo 2018-55, the issue arises in the collection context. The application of the principle here seems so clearly equitable that I am a bit surprised that the IRS argued against its application. The Court applied equitable recoupment to credit one entity with the employment taxes paid by another. It also relieved the entity of the penalties related to the non-payment of the employment taxes, placing the entity in the same situation it would have been had it made the payments itself.

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Read the opinion for the precise details of how it happened, but a law firm lost a partner and gained a partner. In the process, it moved from one business entity to another. Although the new business began operating at the beginning of 1999 (yes, this case goes back to a quarter of employment taxes payable almost 20 years ago), an existing entity paid employment taxes for the quarter that should have been paid by the new entity. In 2006, the IRS questioned the new entity on the non-payment of the employment taxes for the quarter at issue. The entity tried to explain the overlap in entities and the payment by a related entity of the taxes; however, its explanation failed to stop the IRS from making an assessment.

The taxpayer eventually received a CDP notice and requested a hearing. At the hearing, it explained to the Appeals employee what had happened. The Appeals employee wanted a more detailed explanation of the two entities and how they overlapped. It gave the taxpayer 10 days to provide the explanation. The entity failed to provide it within 10 days and the Appeals employee set up the case for issuance of a determination letter sustaining the IRS decision to levy. A detailed letter arrived at Appeals shortly after the Appeals employee set up the case to have the determination letter issued and 11 days before the determination letter was issued. The Appeals employee did not look at the letter, considering the matter closed from their perspective, and the determination letter issued. The taxpayer filed a petition in Tax Court.

In Court, the IRS argued that the standard of review of the determination letter should be abuse of discretion. The taxpayer argued the review should occur on a de novo basis. The Court side-stepped the issue holding that the outcome would be the same under either type of review. The Court found that the principle of equitable recoupment applied and the payments by the overlapping entity should be applied to the entity before it. In discussing the standard of review before getting to the merits of the argument, the Court chastised Appeals for not looking at and considering the detailed explanation provided by the taxpayer. It stated:

First, we note that the administrative record includes not only material that the settlement officer reviewed but also material that was available for his review. See Thompson v. U.S. Dept. of Labor, 885 F.2d 551, 553-556 (9th Cir. 1989); West v. Commissioner, T.C. Memo. 2010-250, slip op. at 11 n.11. Moreover, at the time of Emery PC’s CDP hearing, the Internal Revenue Manual (IRM) instructed Appeals employees conducting such hearings to “[c]onsider information received after the due date for supplying information but prior to issuance of the Notice of Determination/Decision Letter.” IRM pt. 8.22.2.2.4.11(1)(c) (Oct. 30, 2007); see Shanley v. Commissioner, T.C. Memo. 2009-17, slip op. at 15 (noting the de facto extension of time for submitting information arising from the requirement in IRM pt. 8.22.2.2.4.11(1)(c) that an Appeals employee consider information submitted before the issuance of a notice of determination). It is undisputed that Emery PC submitted substantial information and supporting [*22] documents 11 days before the notice of determination was issued and that the settlement officer did not consider the submission. The submission included two letters with extensive attachments. In view of the fact that these materials were available for the settlement officer’s review, and that IRM guidelines instructed him to review them, we find that the two letters and their attachments are part of the administrative record.

The Court then applied the principles of equitable recoupment to the facts of this case.

Element 1: time-barred overpayment

The Court found that the record established that the related entity overpaid its employment taxes and that, at the time of this case, its ability to obtain a refund for the overpaid taxes was barred by the statute of limitations.

Element 2: same transaction, item, or taxable event

The taxpayer argued that the overpayment by the overlapping entity and its own underpayment arose out of the same transaction. The Court commented on the position of the IRS regarding this argument:

Respondent misconstrues what constitutes a taxable event for this purpose. In our view, the taxable event in the case of employment taxes is not the [*27] Commissioner’s assessment of tax but instead the employer’s payment of wages, which in general triggers the employer’s obligation to withhold and/or to pay Social Security taxes, hospital taxes, and income tax withholdings — the employment taxes at issue in this case. See generally secs. 3102, 3111, 3402, 3403. Thus the taxable event here was the payment of wages to the eight employees of the law firm during the latter 75 days of 1Q 1999 (i.e., wage payments made after the first payment of wages on January 15, 1999). The law firm’s employees received wages biweekly and accordingly there were five such payments to seven and then, after the first two payments, eight employees during this 75-day period. Each of the five payments of wages by Emery PC was a separate taxable event triggering an employment tax liability. Thus, strictly speaking, there were 5 taxable events (or 38, if the seven, then eight, employees are disaggregated) in which Emery PC incurred an employment tax liability that was paid by Emery LLP, and for which respondent both seeks to retain the tax paid by Emery LLP and also to collect it from Emery PC. For each of these 5 (or 38) taxable events, in the absence of equitable recoupment, respondent will have collected employment tax twice on the same payment of wages — albeit with respect to 5, or 38, separate taxable events. All of the wage payments were to the same employees during the same taxable period. Cf. Rothensies v. Elec. Storage Battery [*28] Co., 329 U.S. 296 (declining to treat excise taxes paid on battery sales in different taxable years as arising from the same transaction for purposes of equitable recoupment). Thus, the components of the time-barred overpayment and the employment tax liability that respondent seeks to collect in each instance arose from the same taxable event, albeit 5 or 38 of them. Because the employment taxes that respondent seeks to retain and to collect, respectively, arose from the same payments of wages to the same employees during the same taxable period, we conclude that the requirement that the two taxes arise from the same taxable event has been satisfied.

Element 3: inconsistently subjected to two taxes

The Court found that the taxation of the employment tax had occurred twice under inconsistent theories in a manner that satisfied this element.

Because the Court found that all of the elements of equitable recoupment applied, it granted the taxpayer relief on this basis.

After doing so, the Court went on to address the penalties applied and determined that the taxpayer should not be subjected to penalties for failure to pay the employment taxes since the overlapping entity had made those payments. Because the Court was unsure if an exact match existed between the payments made by the overlapping entity and the payments due from the taxpayer, it did not completely rule for the taxpayer. It reserved the possibility that the IRS could show some of the employment taxes remained unpaid.

The application of equitable recoupment to these facts seems logical and prevents an injustice to the taxpayer who otherwise would have had to pay these taxes twice. The objection of the IRS to this outcome is not immediately clear to me but I have not read its briefs. I would have hoped that under these circumstances the IRS would have looked for a way to assist the taxpayer rather than to tax it twice.

 

 

 

Mr. Smith Continues to Suffer from His Failure to File and Other Updates on Late Filed Returns

I have not written about the one day late rule in bankruptcy cases for some time. The litigation has cooled off, but the final fate of the issue remains unresolved. See prior posts on the issue here, here, here, here, and here if you need a reminder of the problems taxpayers suffer in bankruptcy when they fail to timely file their returns. While the tide seems to have turned against the one day rule which set up an absolute bar to discharge, taxpayers in circuits other than the 1st, 5th, and 10th still suffer the consequences of filing late as well. Mr. Smith is one.

Mr. Smith brought the case that is currently the leading opinion regarding the discharge of taxes on a late filed return in the 9th Circuit. Though the 9th Circuit declined to adopt the one day rule, it still found that Mr. Smith did not discharge his tax liability in a case in which the IRS had filed a substitute for return before he filed Form 1040 for the year at issue. In a case decided on March 7, 2018, the District Court for the Northern District of California turned back Mr. Smith’s latest effort to rid himself of the liability stemming from failing to timely filing his 2001 return and having the IRS do it for him.

In addition to recounting Mr. Smith’s latest travail, I discuss two recent lower court opinions on the failure to timely file issue.

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Mr. Smith failed to timely file his 2001 return, eventually leading to the IRS preparing a substitute for return. Seven years after his return was due and three years after the IRS assessed a liability based on the SFR, he filed a Form 1040 reporting about $40,000 more than the IRS assessed. After submitting the Form 1040, he waited more than two years before filing his bankruptcy petition. The IRS agreed with Mr. Smith that the $40,000 liability shown on the late filed Form 1040 was discharged but argued that the liability shown on the SFR was not. The 9th Circuit agreed with the IRS.

Having taken his case to the Circuit Court and lost, Mr. Smith now returns to the bankruptcy court with new arguments in an attempt to rid himself of the tax assessment created by the SFR. First, he argues that since the 9th Circuit found his Form 1040 was a nullity he is entitled to “an abatement of taxes since the IRS lacked authority to assess the additional tax amount of $40,095 based on the Form 1040” he filed seven years late. Second, he argues that because he is forever barred from filing a 2001 return, he should receive declaratory judgment relief that he need not comply with I.R.C. 6012. Third, he moves for a class action seeking a declaratory judgment for all taxpayers who failed to timely file a return resulting in an SFR who lacked reasonable cause and another class action for those taxpayers who filed Form 1040 that did not constitute a return.

The bankruptcy court found that Mr. Smith lacked standing to bring this action. It also found there is no actual controversy with respect to the $40,095 assessment. Additionally, the court pointed out that even if he had standing to sue, I.R.C. 6404(b) states that “no claim for abatement shall be filed by the taxpayer in respect of any assessment of any tax imposed under Subsection A.” Further, the court found that the Anti-Injunction Act also bars the relief he sought and no waiver of sovereign immunity exists. The arguments put forth by Mr. Smith basically allowed the bankruptcy court to touch almost all procedural bases for dismissing a case.

The bankruptcy court shows no sympathy for Mr. Smith since he created his own problem, he moves to almost tax protestor like arguments, and he provides the court with no legal basis for granting the relief he sought. The case demonstrates the frustration of owing a non-dischargeable tax especially when it would have been relatively easy for the taxpayer to avoid the problem. The case also shows the limitations of trying alternative arguments to the straightforward discharge argument under B.C. 523(a)(1)(B) as well as the limitations of seeking to bring a class action to stop the IRS by seeking a declaratory judgment.

Smith shows the limitations of continuing to fight about the discharge when taxpayer files a late return. Two cases on this issue were recently decided, Word v. IRS and IRS v. Davis, in which taxpayers filing late returns did not receive a discharge. These cases deserve brief mention in the continuing saga of the two decade old issue.

In Wood, the taxpayers filed a chapter 7 petition on May 29, 2015. The issue turned on whether their 2010 return was filed. Mr. Wood passed away before the trial occurred. Mrs. Wood testified that they routinely prepared and filed their returns over a 20 year period and that Mr. Wood, a CPA, would prepare it, discuss it with her, and then file it. She presented a filed extension and a copy of the return signed by her and her husband on September 19, 2011; however, the IRS denied ever receiving the return. The IRS put on testimony of a bankruptcy specialist who searched the IRS records and found no evidence of a return. The Court found that Mrs. Word’s testimony about what happened could not overcome the IRS records regarding lack of receipt. Mrs. Wood was hampered in presenting her case because her husband had handled the mailing of the return. The Court expressed sympathy but could not get past the absence of evidence to overcome the presumption of regularity in the IRS records.

Based on the fact that the issue arises in the bankruptcy context, I presume that the taxpayers filed the return, or planned to file the return, without remittance or with only partial remittance; however, I would have liked some discussion about that fact. It seems that she should have known about the remittance aspect of the case and that would have made her story more convincing. The couple also owed for 2009 and may have filed the 2009 return without remittance as well since no mention is made in the opinion of audits. Almost no returns have prior credits exactly equal to the liability shown on the return. Taxpayers generally talk about the monetary consequences of filing a return and anticipate results based on those consequences, e.g., anticipating a refund check or anticipating an immediate bill. The discussions surrounding the money may have provided her with more detail about the mailing of the return with which she could have persuaded the bankruptcy court or the absence of those discussions may have been persuasive.

The Wood case does not present the same issue as Smith and the line of cases involving late filed returns. Rather, it presents the straightforward issue of whether the taxpayers filed a return. Although a slightly different issue, the issue of whether the taxpayer filed a return in the first place regularly presents itself in these cases.

In Davis, the IRS brings an appeal of a bankruptcy court decision and the district court reverses based on the Third Circuit’s recent decision regarding late filed returns. Mr. Davis failed to timely file his 2005 and 2006 returns. The IRS prepared SFRs and made assessments based on the SFRs. Subsequently, he filed Forms 1040 for the two years, waited more than two years, and filed his chapter 7 bankruptcy petition on July 12, 2012. After receiving his chapter 7 discharge, he filed a chapter 13 petition on August 11, 2014. The fight over the impact of the chapter 7 discharge arose in the chapter 13 case when the IRS filed a proof of claim asserting a tax due on 2005 and 2006. The bankruptcy court held that filing the Forms 1040 and waiting two years before filing bankruptcy allowed him to discharge the taxes. Subsequent to the bankruptcy court’s decision discharging the tax debt for the late filed returns, the Third Circuit issued its opinion in Giacchi v. United States, 856 F.3d 244 (3d Cir. 2017). In that opinion, blogged here, the Court found that filing a Form 1040 after the IRS made an assessment based on an SFR did not meet the part of the Beard test requiring “an honest and reasonable attempt to comply with tax law.” The Third Circuit did not say that a debtor in these circumstances could never satisfy the fourth prong of the Beard test, but it provided no guidance on how a debtor might do so.

The IRS argued in the Davis appeal that his case did not involve close facts and the district court agreed. The most interesting aspect of the case may not involve the application of Giacchi, but how the IRS was able to take the appeal. I have not gone back to read the motions filed but it appears that the debtor may have kept open the time for the IRS to bring an appeal of the bankruptcy court decision by seeking to directly appeal to the Third Circuit in the original case and then failing to follow through, but in the process keeping the door sufficiently open to allow the IRS to appeal the adverse bankruptcy decision to the district court. The short shrift the district court gives to the arguments of Mr. Davis suggests that in the Third Circuit the fact pattern of an SFR assessment prior to the filing of the Forms 1040 may be fatal to the attempt to discharge the liability.

 

Son of Boss Case Shows Limitations of Reliance on Tax Advisors to Avoid Penalty

Son of Boss cases seem to go on forever. In Palm Canyon X Investments, LLC, AH Investment Holdings, LLC, Tax Matters Partner v. Commissioner, No. 16-1334 (D.C. Cir. Feb. 16, 2018), the D.C. Circuit affirmed with a per curiam opinion the decision of the Tax Court to sustain the 40% penalty imposed under IRC 6662 for a 400% misstatement of basis. The case does not break new ground but does serve as a reminder of the limitation of the defense of reliance on counsel.

The taxpayer raised as a defense the existence of reasonable cause citing IRC 6664(c)(1). The basis asserted for the reasonable cause grounded in reasonable reliance on the advice of a “competent and independent professional advisor.” We have written recently, here and here, on the perils of using an expert witness who did not have sufficient independence from the transaction. Today’s case demonstrates the same problem when relying on a professional to avoid an otherwise applicable penalty. In the Palm Canyon case, the taxpayer not only relied on professionals who lacked independence but failed to rely on professionals who did. The existence of the case points to the high dollars at stake in the penalty and the wealth of the taxpayer to push the fight this far.

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The Son of Boss tax shelter came into existence over two decades ago. It involved artificially inflating basis in a partnership interest in order to get a tax write-off for artificial losses created upon dissolution. The D.C. Circuit cited to a 20 year old decision invalidating a transaction based on this scheme. So many people invested in the scheme that the IRS issued Notice 2000-44 specifically warning taxpayers that the use of this scheme could result in the imposition of the type of heavy penalty at issue here. By the time it issued this Notice, several cases already existed sustaining the legal position of the IRS.

The taxpayer here went looking for a tax shelter in 2001. The taxpayer had an accountant and a lawyer. These individuals looked at the Son of Boss tax shelter offered to their client and advised him that the generic tax opinion provided by the shelter promoter was “aggressive.” The D.C. Circuit’s opinion does not say whether they provided the taxpayer with a copy of the IRS Notice or copies of the cases that had already determined this type of shelter would not work. The taxpayer decided to purchase the shelter and paid a $325,000 fee for doing so. He claimed a $5,000,000 loss reducing his tax liability from $1,500,000 to nothing which would have been a great bargain had the IRS not disallowed the loss in full and imposed the 40% penalty.

At the circuit court level, the taxpayer did not dispute the unlawful nature of the transaction but argued only that the reliance on the lawyers and the tax advisors who prepared their advice for those selling the scheme provided a basis for removing the penalty for reasonable cause. The court quickly went through five reasons why the taxpayer could not succeed with a reasonable cause argument.

First, the Notice issued by the IRS expressly warned against doing what he did and did so over a year before he bought into the scheme. The existence of the notice “makes proof of reasonableness in this case an especially steep uphill battle.”

Second, the taxpayer’s reliance on the advice of individuals connected with the promotion of the scheme is “objectively unreasonable.”

Third, the taxpayer could not rely on the advice of his accountant whose role here was to investigate the bona fides of the promoter and not to provide tax advice. Additionally, to the extent that the taxpayer’s accountant did provide tax advice it was that the claimed benefits of the scheme were “too good to be true.”

Fourth, the taxpayer could not rely on the advice of his own lawyer as a shield from the penalty because his lawyer was skeptical of the transaction. Like the accountant, the taxpayer’s lawyer limited his due diligence to the scheme’s players and not to the substance of the transaction.

Fifth, the tax opinions provided by the promoters did not pass muster. The opinions were not based on “all pertinent facts and circumstances” relating to the taxpayer, and the parties giving the opinions were part of the promotion team.

Perhaps the only surprises in this opinion are that the taxpayer bought the shelter in the first place, given the information about the scheme available at the time of purchase, and that 17 years later he is still fighting about the penalty when the denial of penalty relief here follows consistent patterns of prior opinions on this subject. While it’s easy to be dismissive of the case, this is a sophisticated taxpayer. The case not only provides guidance on when a taxpayer cannot rely on professional advice to avoid a penalty but insight on the power of pull of the tax shelter scheme that it would motivate someone to fight this long after the conclusion of the transaction and in the face of high odds.

 

IRS Claims in Bankruptcy

A pair of recently decided cases address the validity and the amount of the claim of the IRS in bankruptcy.  Each case offers a small lesson on such claims.  In In re Yuska, No. 14-01504 (N.D. Iowa April 6, 2018), the debtor attacked the IRS claim because the bankruptcy specialist checked the wrong box on the claim form.  In United States v. Austin, No. 17-6024 (B.A.P. 8th Cir. April 9, 2018), the court determined the value of the IRS secured claim, secured by virtue of a chose in action held by the debtor.  Neither case reaches a surprising result, though the bankruptcy court’s decision in Austin, overturned by the Bankruptcy Appellate Panel in the case discussed here, did produce a surprising result and one which the IRS appealed on a valuation matter because of the legal issue involved.

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In Yuska, the debtor owed the IRS over $1 million, which the court had previously determined in an adversary proceeding.  From the court’s description of Mr. Yuska’s arguments, I believe he qualifies as a tax protestor.  In this follow-up matter, he attacks not the validity of the underlying liability but the validity of the claim of the IRS filed in the proceeding.  He argues that in preparing the claim, the IRS bankruptcy specialist checked the box on the claim indicating that she was the creditor rather than checking the box that she was filing the claim as an agent of the creditor.

The first argument of the IRS in the case sought a decision based on res judicata due to the prior adversary proceeding determining Mr. Yuska’s liability.  The court did not base its decision on its prior determination regarding the amount of the liability but looked instead to the basis for objecting to a claim.  It held that the following bases for objecting to a claim exist:

1) The claim is unenforceable against the debtor and property of the debtor;
2) The claim is for unmatured interest;
3) The claim is for a tax assessed against property of the estate and exceeds the value of the interest of the estate in such property;
4) The claim is for services of an insider or attorney of the debtor and exceeds the reasonable value of such services;
5) The claim is for a debt that is unmatured on the date of the filing of the petition and that is excepted from discharge under section 523(a)(5) of this title;
6) The claim is the claim of a lessor for damages resulting from the termination of a lease of real property and meets other criteria;
7) The claim is the claim of an employee for damages resulting from the termination of an employment contract and meets other criteria;
8) The claim results from a reduction due to late payment in the amount of an otherwise applicable credit available to the debtor in connection with an employment tax on wages, salaries, or commissions earned from the debtor; or
9) The proof of such claim is not timely filed…

The court found that unless the objecting party meets one of these objections, the court shall determine the amount of the claim and shall allow such claim in that amount.  Here, the complaint of the debtor raises a technical issue related to the preparation of the claim form.  The IRS agrees that the employee checked the wrong box but argues that this technical deficiency does not invalidate the claim.  The court pointed out that Bankruptcy Rule 3001(a) requires that a claim conform substantially with the official form published by the rules.  The court finds that the form filed by the IRS substantially complies with the rules, that common sense should not disallow a claim based on a small technical failure, and that the debtor himself recognized in his pleadings that the IRS employee was not the true claimant against the estate.  So, it determines that the IRS has a valid and binding claim.

In Austin, the debtor had a workman’s comp lawsuit pending at the time of filing the bankruptcy petition.  Prior to the filing of the petition, the IRS had filed a notice of federal tax lien.  So, the IRS would have a secured claim in the value of the lawsuit (minus the attorney’s fees for bringing the suit.)  The issue presented is the value of the suit.  The issue can regularly arise in bankruptcy cases; however, cases attacking the value are not commonly reported.

In their schedules, the debtors listed the suits as contingent and unliquidated exempt property and valued the claims at $0.00.  Debtors objected to the secured claim of the IRS assigning value to the lawsuits and argued initially that the value of the IRS lien in these suits was $0.00.  The bankruptcy court determined that the suits had some value and overruled the objection.  While that litigation was pending, the debtor negotiated a settlement netting $15,661.00 after attorney’s fees.  The IRS learned of the settlement and amended its claim to reflect that amount as the value of its secured claim.

The debtors’ objected to the amended secured claim of the IRS, arguing that the value of the claim was not equal to the amount of the settlement.  They attached an affidavit of their attorney who “opined that the worker’s compensation claims had a nuisance value of $3,000 on the petition date.”  The IRS responded that this affidavit was not substantial evidence contradicting their claim and that under B.C. 502 the claim is presumed correct unless an objection to the claim is filed and supported by substantial evidence.

The court found that “substantial evidence means ‘more than a mere scintilla.  It means such relevant evidence as a reasonable mind might accept as adequate to support a conclusion.’  Substantial evidence requires financial information and factual arguments.  Here the Smallwood Affidavit does not contain the financial or factual information necessary to support Mr. Smallwood’s opinion of value.”  Debtor’s attorney basically argued that they did not have much of a case and only by his skill did he obtain a settlement of over $20,000.  The court points out that no matter how wonderful Mr. Smallwood was it was the debtors’ claim that formed the basis for the recovery.  It also found that presenting evidence by way of affidavit prevented the IRS from its opportunity to cross examine.  It stated that “allowing a valuation of a tort claim without a reasonable factual basis encourages abuse.”

So, the court found the debtors failed to present substantial evidence sufficient to overcome the presumption of validity in the claim.  The court did not discuss the fact that a secured claim is not static in value.  Even if the value of the tort claim was $3,000 at the outset of the case, the value of the claim could rise if the property to which the lien attach rises in value.  The case provides an interesting glimpse at the amount of proof needed to win an objection regarding the value of property but I wanted it to also discuss the ability of a secured claim to rise or fall in value.  That ability is why creditors seek to lock in value through cash collateral proceedings at the outset of a bankruptcy case.

Where Not to Leave the Joint Return

The case of Plato v. Commissioner, T.C. Memo 2018-7 involves whether petitioner is liable for penalties for filing his return late. The petition says that the IRS determined a deficiency in Mr. Plato’s taxes for the year in issue of $165,133.80. You can see that with a liability of that size filing late could be quite costly. Although the defense was novel, it is not successful or well thought out.

Mr. Plato separated from his wife in December 2007 and they have lived apart since the time of the separation. He prepared a joint return for 2007 and took it to his wife’s separate residence to get her to sign it on April 15, 2008. Perhaps the case would have turned out better had he visited her a little bit earlier. According to Mr. Plato, he left the return and a check for $46,073 (the amount of the liability reported on the return) “under the mat at the front door” of her residence. He left it there for her to sign and mail the return to the IRS; however, there is no evidence that she did so. The opinion does not say whether Mr. Plato expected his wife to be home when he went by with the return or whether he regularly left material for her under the door mat. Since the Court found that no one ever tendered the check, someone may want to look under that mat now.

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The opinion states that Mr. Plato did not request an extension to file but he “asked his wife to request an extension.” It did not say whether this request was made in writing with the package under the mat or was through a separate means of communication. You would think that he might have followed up with her and followed up with his bank account which would not have had $46,073 withdrawn to pay the check, but the opinion is silent on what he did after dropping off the return under her mat.

Eventually, the IRS grew tired of waiting for the former Mrs. Plato to look under her doormat and it prepared a substitute for return for him for 2007. (It is silent about what happened with respect to his wife and that is appropriate though it leaves details about his case unstated.) After the IRS issued its notice of deficiency with respect to the 2007 year, Mr. Plato submitted a return with the filing status of married filing separate and he tendered a check of $43,490. He also filed a Tax Court petition because the notice of deficiency would have contained penalties and perhaps additional taxes. The parties reached agreement on the tax liability with the IRS apparently accepting the late filed return; however, Mr. Plato sought removal of the late filing penalty.

He argued that leaving the signed joint return under the doormat of his estranged’s wife’s residence together with a check for full payment together with his long history of filing compliance should satisfy the reasonable cause exception to the penalty. We have posted before about the IRS administrative rule regarding first time abatement. The opinion does not address this administrative rule since it is a rule that the IRS can apply but one that does not save a taxpayer in a judicial proceeding. If Mr. Plato would have qualified for first time abatement, he should have worked that out with the IRS during the examination phase of his case. The fact that he did not file a return until after the notice of deficiency was issued suggests that he was not working with the IRS during the examination phase.

Mr. Plato found a case on which he relied for his argument that his prior timeliness coupled with his trip to the doormat should excuse him from the penalty; however, the case on which he relied, Willis v. Commissioner, 736 F.2d 134 (4th Cir. 1984), in which the 4th Circuit overturned a decision of the Tax Court, was itself effectively overruled a year later by the case of Boyle v. Commissioner, 469 U.S. 241 (1985). Additionally, the Tax Court pointed to its own non-precedential opinion, Sutherland v. Commissioner, T.C. Memo 1991-619, holding that failing to obtain an estranged spouse’s signature on a joint return does not necessarily constitute an acceptable excuse for failing to timely file. A taxpayer who is separated from their spouse faces a difficult situation with respect to the filing of a joint return. The joint return may significantly reduce the tax liability; however, the other spouse may have many concerns about signing the joint return and signing on to joint and several liability with a person in whom their trust has dissipated. It is understandable to have discussions seeking to persuade an estranged spouse to sign a joint return. Leaving the joint return under the doormat on the last date to timely file does not evoke the kind of sympathy necessary to avoid a penalty. The decision provides no surprises but an interesting fact pattern and a cautionary tale.

Despite losing the failure to file penalty and despite going pro se against three government attorneys, all was not lost for Mr. Plato. The IRS also asserted an estimated tax penalty against him. The Court found that the IRS did not carry its burden of production with respect to his prior year’s liability and the application of exceptions to this penalty in his circumstances. So, it did not sustain the estimated tax penalty. The Court makes no mention of the Graev issue. I cannot tell if the failure to mention Graev results from a failure of Mr. Plato to raise the issue (not all Tax Court judges seem to affirmatively require the IRS to prove the necessary approvals were secured) or a showing of proof that the Court felt unnecessary to discuss.

It’s now been over a decade since Mr. Plato left the check under the doormat. I hope he knows what happened to it. The opinion leaves it as an unsolved mystery.

 

Revisiting Craft

It has been almost four years since I wrote a post on United States v. Craft, 535 U.S. 274 (2002). At the time I wrote the last post, a circuit split existed on how to value the interest of the spouses in a tenancy by the entirety. The IRS argues for a 50/50 valuation whereas some taxpayers argue for a valuation based on the actuarial interest of each of the spouses. The issue has been quiet recently, perhaps because of the lack of IRS activity in the area based on its diminished capacity or perhaps because the cases that have moved forward have all involved situations in which the 50/50 split favors the spouse who does not owe the tax. In United States v. Gerard, 121 AFTR 2d 2018-640 (N.D. Ind. April 9, 2018), another court voiced an opinion on how to split the proceeds.

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Robert and Cynthia Gerard bought a home in Indiana in 1990 as tenants by the entirety. Over 90% of the purchase of the property has been paid by Robert. From 2003 to 2008, Cynthia owned a business treated as a sole proprietorship and incurred employment taxes which remain unpaid. In 2012, following in the footsteps of the Crafts, Robert and Cynthia conveyed, by gift, the property to Robert individually. I am guessing they had not read the Supreme Court’s opinion at the time they decided to make this transfer and they may have thought that it would magically remove the federal tax lien from the property.

They argue that at the time of the transfer her interest was worth much less than his because he had contributed the lion’s share toward the purchase of the property and her business had been a net drain on the family finances. They further claim that the property was transferred due to her health and the need for Robert to manage her affairs.

The case involves a fight about the amount owed as well as the extent of the federal tax lien on the property. With respect to the amount owed, the Court found that Cynthia owed $60,969.04 plus statutory accruals, resolving that aspect of the case and then turned to the lien.

The Gerards argued that Robert was a purchaser when the property was transferred to him from joint ownership. That argument flies in the face of the statute. IRC 6323(h)(6) defines a purchaser as:

“a person who, for adequate and full consideration in money or monies worth, acquires an interest (other than a lien or security interest) in property which is a valid under local law against a subsequent purchaser without actual notice.”

Despite the deed of gift, the Gerards argue that Cynthia’s use of joint marital assets in connection with her business formed the basis for meeting the full and adequate consideration test. The IRS argued that the deed itself stated it was transferred “without any consideration other than love and affection.” It further argued that even if the language of the deed prepared by the Gerards does not control the transfer, the consideration they offer is past consideration which is insufficient to meet the test of adequate consideration. The Court agreed with the IRS on the issue of past consideration and determined that Robert was not a purchaser.

Having determined Robert did not purchase the property from the joint tenancy, the remaining dispute centered on the extent to which the liens attached to the property. The Gerards contend that Cynthia’s interest in the property was something less than half of the property and the federal tax lien only attached to her smaller interest. The arguments regarding who has what interest in the property usually stem from an application of the actuarial tables and usually occur when the husband owes the money and the actuarial tables show that the wife has the greater life expectancy. Here, the argument builds around the husband’s contribution toward the purchase of the property. The IRS argues that they each have a 50% interest and that’s what the court found that Indiana law supports. The court cites Indiana case law in support of the position that husband and wife each become owner of half of the property.

In addition to the several cases involving Indiana law, the court cited the earlier Craft decisions from the Third and Sixth Circuits, supporting a 50/50 split of the value of the property.  So, the court concludes that the lien against Cynthia attaches to her 50% interest in the property.  I was curious that I had not seen the Craft issue in some time and felt there must be cases decided since my last post.  My research assistant found the following cases which may benefit someone concerned with this issue: United States v. Tannenbaum, 2016 WL 4261755 (E.D.N.Y. 2016)United States v. Bogart, 715 Fed. Appx. 161 (3d Cir. 2017); United States v. Cardaci, 856 F.3d 267 (3d Cir. 2017); In re Conrad, 544 B.R. 568 (Bankr. D. Md. 2016); and United States v. Born, 2016 WL 1239219 (D. Alaska 2016).

The third issue in the case involves whether the court should allow the IRS to foreclose its lien and sell the property giving Robert a monetary amount equal to his interest in the property based on the sale. Although it initially sought summary judgment on this issue, the IRS backed away from that request and argued that the decision to foreclose required the gathering of facts. Such facts would be necessary in order to make a United States v. Rogers, 461 U.S. 677 (1983) determination that foreclosure properly serves the interests of all parties in this situation. So, the amount of the liability is now known, the extent of the lien in the property is known, and all that remains to learn is whether the court should order foreclosure or defer it based on the Rogers factors.

 

 

Innocent Spouse Status versus the Federal Tax Lien

The case of United States v. Kraus, No. 3:16-cv-5449 (W.D. Wash. April 3, 2018) demonstrates the problems that can occur when your spouse engages in tax protestor action even if you were “innocent.” The result here for the wife is the loss of her home, even though she has no personal liability for the unpaid tax. She argues that such a result renders her innocent spouse status somewhat meaningless; however, the court points out that innocent spouse status relieves the individual of personal liability but does not destroy the federal tax lien or the remedies available in connection with the lien.

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Ms. Lao married Mr. Kraus in 1988. At the time of the decision, they had three children ages 16, 24, and 27. During almost all of the marriage, Mr. Kraus earned the money used by the couple and she took care of the family. He handled all of the family finances, including tax filing, and gave her an allowance for household expenses. He stopped filing taxes in 1999, claiming that only federal employees need file tax returns. He ran a jewelry business with his brother. When the IRS audited the business and him individually, he did not engage in the audit, causing the agent to determine taxable income without the benefit of his assistance. As a result, the agent determined a huge liability because of the lack of expenses to offset the income. In addition to owing taxes for the years of non-filing, Mr. Kraus had numerous frivolous filing penalties for his tax protestor submissions to the IRS in response to its correspondence.

The couple sold their prior residence in 2003 and purchased a new home. At the time of the suit to foreclose, they had almost completely paid off the home. Mr. Kraus had also “transferred” the home to a trust though the couple and their children continued to live in the home, make all decisions related to the home, and pay all of the bills. Mr. Kraus told Ms. Lao that the transfer to the trust was for estate planning purposes and to protect the property from frivolous suits.

The couple was divorced in 2010 and she began working at a retail store. Mr. Kraus continued to live in the marital home and they split the bills. When the tax situation arose, she applied for and received innocent spouse status under IRC 66, since Washington is a community property state. Despite her innocent spouse status, the IRS sought to foreclose its lien on the property owned by the couple. The court quickly brushed aside the fraudulent transfer and determined that the lien attached to the property. Ms. Lao argued that allowing the IRS to foreclose on the house would render her IRC 66 relief “an empty shell of false security.” The court responded that IRC 66 relief does not entitle her to prevent foreclosure. “While innocent spouse relief prevents the assessment of a tax against Lao individually in any separate property she may possess, it does not affect the ability of the Government to pursue collection remedies against Lao’s interest in community property.” Under Washington law, “all debts of each spouse that are acquired during the marriage attach to the marital community as a whole and one spouse’s tax liabilities are presumed to be community debts if they are incurred during the marriage.”

Even if she obtained a separate property interest after the divorce, she took that interest subject to the preexisting liens or mortgages. “Any separate interest that Lao possesses in the subject property must lie in the equity that exceeds the preexisting mortgage and liens.”

The court finds an open question of whether the lien could continue to grow after her interest in the property separated from the marital community. The court said that interest accruing after the divorce may only attach to his separate property and requested additional briefing on this point. It appears that the IRS will obtain permission to foreclose on the entire property and sell it, leaving her with money from the sale but no home where she and the children, one of whom is a minor, have lived for 15 years. I was surprised that the court did not apply the equitable factors in United States v. Rogers, 461 U.S. 677 (1983) to decide whether selling the home under these circumstances was appropriate. Applying the factors in that case might cause the court to pause in making the decision to sell the property at this time – at least until the youngest child reaches the age of majority.

The case demonstrates the limits of innocent spouse status. Being an innocent spouse does not stop the IRS from taking collection action that can have a negative impact on the innocent spouse where property interests of the non-liable spouse remain intertwined with the liable spouse. While she will receive some equity from the sale of the home, this situation causes her to lose her home despite being innocent of the actions causing the liability.

For those interested in the power of the federal tax lien, the Pro Bono & Tax Clinics committee of the ABA Tax Section will host a panel discussing Kraus and other lien cases at the May Meeting in D.C. next week. Christine

 

Chief Counsel Guidance on Passport Denials and Recent Legislative Change

On April 5, 2018, the IRS issued CC-2018-005 providing guidance to Chief Counsel attorneys regarding how to handle IRC 7345 cases brought in Tax Court. We reported in a prior post that Deputy Chief Counsel Drita Tunuzi stated at the last ABA Tax Section meeting that the IRS would probably start issuing the notices by the end of February. The timing of this guidance syncs with the timing of the earliest Tax Court cases Chief Counsel’s office might expect based on the issuance of the revocation notices. We are unaware of any pending cases on this issue and welcome comments directing us to filings under this new provision of the code. In addition to discussing the recent guidance, I have copied below, thanks to an alert from Carl Smith, the language of a small amendment to jurisdiction of these cases.

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Legislative Change

Congress made a minor change to the provisions on the Tax Court and district court review of passport revocation decisions, taken from the Joint Committee print description of the bill:

Amendments relating to the Fixing America’s Surface Transportation Act (2015)

Revocation or denial of passport in case of certain unpaid taxes (Act sec. 32101). – The Act provides for judicial review of the Secretary’s certification that an individual has a seriously delinquent tax debt, either in a U.S. district court or in the Tax Court. The provision clarifies that the party against whom a Tax Court petition is filed is the Commissioner of the Internal Revenue Service. The provision also provides a tie-breaker rule clarifying that the court first acquiring jurisdiction over the action has sole jurisdiction, and corrects a cross reference.

Here’s the text of the changes, which can be found at pages 2804-2805 of the bill:

21 SEC. 103. AMENDMENTS RELATING TO FIXING AMERICA’S

22 SURFACE TRANSPORTATION ACT.

23 (a) AMENDMENTS RELATING TO SECTION 32101.—

24 (1) Section 7345(e)(1) is amended—

1 (A) by striking ‘‘or the Tax Court’’ and in-

2 serting ‘‘, or against the Commissioner in the

3 Tax Court,’’, and

4 (B) by adding at the end the following:

5 ‘‘For purposes of the preceding sentence, the

6 court first acquiring jurisdiction over such an

7 action shall have sole jurisdiction.’’.

8 (2) Section 7345(f) is amended by striking

9 ‘‘subsection (a)’’ and inserting ‘‘subsection

10 (b)(1)(B)’’.

11 (b) EFFECTIVE DATE.—The amendments made by

12 this section shall take effect as if included in section

13 32101 of the Fixing America’s Surface Transportation

14 Act.

New Chief Counsel Guidance

The guidance starts by describing the statute and the IRM provisions that we discussed in our prior post. It provides that the IRS will rely on automated systems to identify

“every module on an individual’s account with an unpaid assessed tax liability that is not statutorily excepted from the definition of seriously delinquent tax debt or otherwise in a category excluded from certification. Once all eligible modules have been identified, the systems will aggregate the amount of unpaid liabilities. If the total is more than the statutory threshold, the taxpayer will be identified as having a seriously delinquent tax debt, and a Transaction Code (TC) 971 Action Code (AC) 641 will post to each module.

The SBSE Commissioner will certify that the identified individuals each have a seriously delinquent tax debt. The Service, under section 7508(a)(3), will postpone the certification of taxpayer serving in a combat zone or contingency operation. The Service will send a list of all certified individuals to the State Department. Once it has received notice from the Service, the State Department will not issue a new or renewed passport to a certified individual and it may revoke a previously issued passport, except for return travel to the United States…. Contemporaneously with the certification, the Service will notify individuals of their certification by sending them a CP508C notice by regular mail. The CP508C notice will list the tax liabilities giving rise to the certification by taxpayer identification number, tax period, and type and will inform the individual of the right to seek judicial review in a federal district court or the Tax Court.”

The Notice anticipates that taxpayers will raise challenges to the underlying liabilities, the period of limitations, and the scope and standard of review. It lays out the responses the Chief Counsel attorneys should make to those arguments.

Judicial Review of the Underlying Liability

The Notice takes the position that IRC 7345 does not provide for judicial review of the liability through this process. This statute does not waive sovereign immunity. A suit seeking to challenge the liability would effectively seek to restrain collection of an assessed tax and that would be prohibited by the Anti-Injunction Act. Section 7345 is not a provision providing an exception to that act.

Time for Seeking Review

IRC 7345 does not provide a period of limitations for bringing a certification action. While many people may rush to Court to avoid having their travel restricted, others may not even receive the notice sent by regular mail or may not appreciate its meaning immediately. The Notice takes the position that the general statute of limitations provided in 28 USC 2401(a) applies. This is a six year period. So, the IRS will not argue that the court lacks jurisdiction if the taxpayer brings a suit contesting certification within six years of issuance of the certification notice. The Notice also provides that taxpayers will have six years from the date grounds for reversal existed to bring an action challenging whether the IRS failed to reverse certification.

Scope of Review

IRC 7345 does not specify the scope or standard of review applicable to certification actions. The IRS takes the position that, in the absence of a statutory standard of review, the review is “confined to the administrative record, and ‘no de novo proceeding may be held. United States v. Carlo Bianchi & Co., 373 U.S. 709, 715 (1963).’” Because the IRS bases its decisions on its computer records of taxpayer accounts, it takes the position in the Notice that review is limited to the computerized records of those modules. The standard the IRS tells its attorneys that the Court should apply is whether the IRS action was “arbitrary, capricious, an abuse of discretion or otherwise not in accordance with law.”

Answers

The Notice tells IRS attorneys that the title of the response to the action brought by a taxpayer under IRC 7345 should be “Answer.” The Notice directs attorneys to attach the certification letter to the answer if the taxpayer fails to attach it to the petition. Once the attorney answers the case, it will not be referred to Appeals because of the ”automated nature of the Service’s process for identifying modules and certifying individuals with seriously delinquent tax debts and because the determinations will have been verified by the assigned attorneys in answering the cases.”

This guidance together with the other guidance provided above tells you what the IRS thinks of the scope of judicial review here. The IRS expects the courts to have little to say. I expect the courts may have something to say about that even if they generally agree with the scope of review. It will be interesting to see if someone brings a Facebook-type action seeking to get to Appeals to discuss their passport certification case. The Notice begins to bring into focus the areas where the initial fights over procedure will occur.

Motions

The Notices walks the attorneys through five types of motions – Motion to Dismiss for Lack of Jurisdiction, Motion to Change Caption, Motion to Dismiss for Failure to State a Claim or Motion for Judgment on the Pleadings, Motion for Summary Judgment, and Motion to Dismiss on the Grounds of Mootness. I suspect that the IRS will crank out a Motion for Summary Judgment on almost every one of these cases given its view of the standard of review and the issues the taxpayer can raise. The other motions will be used depending on the circumstances of the case. The Notice also talks about what the attorneys should put in a stipulated decision document. It contemplates that the IRS will enter into a stipulated decision if the IRS erroneously certifies a taxpayer, a valid basis for reversing the certification exists or the taxpayer concedes the case.

Who Represents the IRS

The Notice provides the normal breakdown of representation with the Tax Division of the DOJ representing the IRS in cases brought in District Court and Chief Counsel attorneys providing representation in Tax Court. If the case is brought in District Court, Chief Counsel would provide a defense letter and the information the DOJ attorneys would need in order to properly defend the case. The Notice instructs attorneys to always use the settlement classification of “Standard.” The Standard classification in a defense letter means that the DOJ should coordinate with Chief Counsel prior to settling the case. The other classification provided in a defense letter is Settlement Option Procedure which signals to DOJ that it can settle the case without coming back to Chief Counsel. Even in cases classified as Standard, the DOJ has ultimate settlement authority. So, it must contact Chief Counsel if it wants to settle a case but it need not listen to what they say. Because this is a new basis for jurisdiction, the IRS naturally wants to know about and have a voice in any decisions made on these cases. After five or ten years, it will probably revert the process to the normal process in which the issues in the case cause the settlement classification rather than having a blanket Standard classification apply.

Coordination with the National Office

As with the Standard classification, the norm when a new statute is rolling out is to have every case coordinated through the National Office and that is what the Notice provides here. This means that if you have one of these cases it will take longer to get a settled resolution since the local attorney will need to coordinate with their counterpart in the National Office. Coordination is not a bad thing. It will provide uniformity while slightly slowing down the process.

Conclusion

The Notice provides clarity on how Chief Counsel’s office will handle these case. I expect that after a year or so of working with these cases, another Notice might get issued further clarifying the procedures and dealing with the situations that have arisen which no one anticipated or dealing with adverse decisional law.