Does Equity Have a Role in Offers in Compromise?

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Today’s guest blogger is Professor Scott A. Schumacher from the University of Washington School of Law.  In addition to teaching there and directing its graduate tax program, he also directs the federal tax clinic.  Last week the Tax Court issued an opinion in a Collection Due Process (CDP) case on an Effective Tax Administration offer in compromise.  Very few opinions exist on those types of offers and we are excited for Scott to bring us some insight on the case.  The case was presented to the Tax Court on cross motions for summary judgment.  That is also a rarity.  The case itself is worth reading.  If you have a CDP case in Tax Court you have a high chance that the IRS will file a summary judgment seeking to have the Court rule on the basis of the administrative file in the case.  The recent litigation that we have discussed previously in the blog concerning the appellate venue for CDP cases and the absence of a record rule case in the DC Circuit might have some applicability in these types of cases.  The tactic of filing a cross motion for summary judgment is an interesting tactic and perhaps more practitioners will follow Scott’s lead.  Keith 

            Anyone with even a passing familiarity with the Offer in Compromise (OIC) program knows that in submitting an OIC, taxpayers must offer at least the net equity in their assets plus their net future income over a period of months.  So, in answer to the question posed in the title, yes, equity obviously has a role in an OIC.  However, a recent case litigated by the Federal Tax Clinic at the University of Washington School of Law addressed a different type of equity. 

            On March 18, 2014, the United States Tax Court issued its opinion in Bogart v. Commissioner.  Bogart was a Collection Due Process case in which the taxpayers were seeking Court review of the denial of their OIC.  When they filed their OIC, the Bogarts alleged that it would be unfair and inequitable to hold them liable for the tax liability that stemmed from income embezzled by their bookkeeper.  Ruling on cross motions for summary judgment, the Tax Court remanded the case to IRS Appeals because it failed to adequately consider the OIC on public policy and equity grounds. 


             This case is significant because it highlights the all-too common situation of the IRS asking for abuse of discretion review where it has failed to exercise the discretion in the first place.  It is also significant in that it addresses the growing number of cases where taxpayers have been the victim of embezzlement or fraud.  

The Bogarts’ tax liability was the result of unreported income that was embezzled by the bookkeeper of their S Corporation.  The Bogarts did not learn of the embezzlement until an IRS audit two years after the tax year, and the criminal case against their bookkeeper was not resolved for another two years after that.  In the case of embezzlement, the embezzled funds are taxable to the intended recipient (in this case, the S Corporation), even though the corporation never actually received the money.  

The remedy the tax laws provide is a theft loss deduction.  However, in order to claim a theft loss, the investigation, prosecution, and any restitution order must be completed and taken into account before a theft loss may be ascertained and claimed.  For the Bogarts, the case against their former bookkeeper was not resolved until four years after the year of the embezzlement.  Because of the limitations inherent in theft loss and the three-year net operating loss rule, any relief from the harshness of including in income the embezzled funds was not available to them.  

            Their only option was to submit an OIC.  The problem with an OIC, Doubt as to Collectability, is that they had saved too much money in their retirement accounts and could fully pay the liability.  (So much for planning ahead for your retirement!)  They also could not submit an OIC, Doubt as to Liability, because the law is clear that they were taxable on the embezzled funds and were not entitled to a theft loss deduction.  That left an OIC based on “Effective Tax Administration” (ETA).  

Congress expanded the OIC rules in 1998 to allow the IRS to consider ETA Offers.  In implementing the ETA Offer rules, Congress specifically instructed the Service to consider hardship, public policy, and equity.  The IRS rules on public policy and equity are set out in IRM and provide that the taxpayers must show, among other things, that the circumstances of the case are such that other taxpayers would view the compromise as a fair and equitable result.  Representing themselves pro se in their CDP case, the Bogarts filed an ETA Offer that included statements that they were victims of embezzlement by their bookkeeper and that “full payment would cause economic hardship and would be unfair and inequitable.”  Appeals rejected their ETA Offer without addressing the equity argument. 

In the Tax Court, we argued that as victims of embezzlement and fraud, the acceptance of the Bogarts’ offer would not give the appearance of placing them in an unfairly beneficial position. In fact, we submitted that other taxpayers would be shocked to learn that someone could be taxed on income that was stolen before it was ever deposited into their bank account.  In addition, Congress provided a remedy to ameliorate this unfairness – a theft loss.  However, because the investigation and prosecution of embezzler took so long, the Bogarts could not claim a theft loss to reduce their liability.  This is precisely the type of case where equitable relief should be granted – the strict application of the tax laws create a result that Congress and the public would find unfair. 

The Tax Court agreed that the case should be remanded.  Even though the rejection of an OIC is reviewed for abuse of discretion, the Court has repeatedly held that the IRS abuses its discretion when it fails to adequately consider a proposed collection alternative.  Here, the appeals officer never explicitly addressed the equity argument, and remand was therefore required. 

The failure of the IRS to specifically address issues raised by the taxpayer is not unique to the Bogarts’ case, nor is this problem confined to collection cases.  Indeed, perhaps the most common area where this occurred is in innocent spouse cases.  While it appears to be getting better, the IRS would almost routinely deny a claim for innocent spouse relief without providing any reasoning.  

The Bogarts’ case is also not an isolated incident of the IRS refusing to apply equitable grounds in ETA Offers.  Indeed, Nina Olson, in her 2012 Annual Report to Congress, listed as a Most Serious Problem the Service’s refusal to approve ETA Offers in cases involving embezzlement or theft of tax payments by payroll service providers (PSP).  The NTA decried the ambiguous policies and procedures that limit the use of ETA OICs as a viable collec­tion alternative for victims by third parties in failing to remit payroll taxes to the IRS: “Victims of PSP failures are employers who tried to (and to their mind, did) comply with the tax laws. The IRS’s failure to acknowledge this reality demonstrates a lack of concern for the victim’s economic harm and increases the risk of future noncompliance and business failure.”   

The Tax Court’s decision in Bogart will hopefully encourage the IRS to expand its use of ETA Offers to relieve victims of fraud from unfair and burdensome tax liabilities. 




  1. Eric Rasmusen says

    The Bogart opinion says:

    “Respondent argues that embezzlement does not constitute exceptional circumstances because petitioners can claim a theft loss [11*] deduction. See sec. 165; sec. 1.165-8(d), Income Tax Regs. But at the administrative level repondent did not consider whether the theft loss constituted exceptional circumstances–even though petitioners requested relief on public policy and equity grounds. The administrative record indicates that respondent did not consider those grounds but focused solely on economic hardship grounds.”

    So, “respondent [IRS] did not consider whether the theft loss constituted exceptional circumstances”. How appalling! The only special feature of the case, after all, is that the taxpayer can’t claim the theft loss because the loss recognition rule and the loss expiration period accidentally combine to defeat the uncontroversial purpose of the statute.

    I haven’t looked at the statutes and regulations. I bet the problem is in the regulations, not the statute. If it is, then the Bogarts should argue that the regulations fail Chevron, in their case at least, by creating a recognition rule that defeats the unambiguous purpose of the regulation given the existence of a 3-year loss period. Probably the IRS failed to go through proper notice-and-comment in making the regulation, since it’s pre-Mayo, in which case the regulation shouldn’t even get Chevron deference. By arguing this, the Bogarts should be able to get out of even the $10,000 they’ve offered in the past (better withdraw that offer quick!).

    • I do not know the issue well enough to have an opinion on the likelihood of success in attacking the regulations if the problem is in the regulations. I am responding just to point out that paying $10,000 might be a cheap price compared to the cost of litigation attacking the regulations. Even if a low income tax clinic agreed to handle the attack, the toll of waiting for several years and the effort necessary to succeed might not equal the benefit of a quick resolution. For low income taxpayers who have high success rates with offers in compromise, the equation in representing them often includes a balancing of the benefits of prolonged fighting about the underlying liability versus the possibility of a relatively quick and easy resolution through the offer process. Here, the amount offer is worth taking a hard look and the fact that it is an ETA offer means than a normal offer on doubt as collectibility is unavailable. The clinic working the case and the client may have looked at the prospect of fighting the merits and decided that even if they might succeed, the cost would be much higher.

  2. A J Decaria EA says

    Under the constructive receipt doctrine, a taxpayer is presumed to have received funds even when there is a theft. With respect to IRC Sec 165(e), a theft loss is deductible in the year of discovery. However the regs at 1.165-8 and with reference to the regs at 1.165-1(d) state that the loss cannot be claimed if there is a prospect of recovery, until that prospect of recovery is determined as to amount. The Bogarts had to pursue legal remedies, however long they took, before they were entitled to the loss. They were trapped by an inequity in the law.
    The Effective Tax Administration,Exceptional Circumstances OIC may have been their only choice. But the court put it back in the hands of Appeals, and appears to left Appeals free to specifically address the issue and say no. While that may not have happened, it is uncertain that this type of OIC will work in the future, as an Appeals Settlement Officer could still address the inequity and say no. A taxpayer may still need to pursue the matter in the tax court.
    It would seen prudent for a tax advisor in this circumstance to suggest claiming the loss in the year of discovery anyway, asserting that, even though recovery is being pursued, there is little actual prospect of recovery. An audit could find against the taxpayer, but the same equity arguments raised in Bogart could be raised up front, potentially precluding the need for the OIC. Bogart may even be useful as precedent.
    As a

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