Quality Software Case Highlights that There is Still No Written Guidance for Reinstating OICs During CDP

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Carl Smith discusses last week’s important CDP decision in the Quality Software Systems Tax Court case involving the recurring and problematic issue of a defaulted OIC. I agree with Carl that Congress viewed CDP as a mechanism to systemically check IRS collection actions, which prior to CDP were mostly outside judicial review. The case and Carl’s post highlight how the courts (and the Tax Court in particular) continue to play a vital role in ensuring that the IRS balances its legitimate interests in collecting taxes with individual taxpayer rights. That balance necessitates guidance for taxpayers and IRS. Les

Les may correct me on this, but it is my impression that his early view of Collection Due Process (CDP) was that the primary utility of its judicial review feature would be to create a systematic check on the IRS’s collection practices when they were, unintentionally, abusive — rather than as a major aid to individual taxpayers for review of their particular facts. Although most court opinions over the past 18 years since CDP’s enactment have not led to structural changes in IRS collection practices, there are now at least a handful of opinions that have triggered the IRS to rewrite either its regulations or, more often, Internal Revenue Manual provisions to provide for a more reasonable administration of IRS collection. In the post below, to be fair, I will first note a few important changes the IRS made to its written procedures in response to court opinions, but I will also highlight one area where the Tax Court has long hinted to the IRS that written guidance is needed for IRS employees. That one area was illuminated by a June 11 opinion in Quality Software Systems, Inc. v. Commissioner, T.C. Memo. 2015-107, which remanded the case for a supplemental Notice of Determination (NOD) that would, in part, clarify what the currently-unwritten IRS rules are where a taxpayer who has defaulted an Offer in Compromise (OIC) asks, during a CDP hearing, for reinstatement of the OIC as a collection alternative. In the case, at one point, the Settlement Officer (SO) had written that, in light of the minimal failures that triggered the default, it would be “fair” to reinstate the OIC, but in the NOD, he did not do so or explain why he did not do so.

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First, here’s a short, non-comprehensive list of my kudos to the IRS for accepting opinions of the Tax Court — without contesting those opinions for years in appellate courts — and modifying its written collection procedures in various important ways:

  1. When the Tax Court held in Keene v. Commissioner, 121 T.C. 8 (2003), that section 7521 authorized the taxpayer to audio record a CDP hearing, the IRS added a section to the Manual providing procedures for audio recording, currently at § 8.22.5.6.2 (11-8-13)
  1. When the Tax Court held in Montgomery v. Commissioner, 122 T.C. 1 (2004), that a taxpayer could, at a CDP hearing, challenge the correctness of the taxes the taxpayer had reported on his or her return, the IRS amended its regulations to embrace this holding at Reg. §§301.6320-1(e)(1) and 301.6330-1(e)(1).
  1. In light of Tax Court opinions such as Drake v. Commissioner, 125 T.C. 201 (2005), where the Tax Court held that there were ex parte contacts that appeared to have compromised the independence of the SO, the IRS strengthened Rev. Proc. 2000-43, 2000-2 C.B. 404, regarding such contacts, by replacing it, after public notice and comment, with Rev. Proc. 2012-18, 2012-1 C.B. 455.
  1. When the Tax Court held in Vinatieri v. Commissioner, 133 T.C. 392 (2009), that a taxpayer could not be denied currently not collectible status merely because he or she had not filed all prior returns, the IRS modified the Manual to accept such holding. See current Manual § 8.22.7.7(3).

Reinstating Defaulted OICs

Quality Software involves an issue that has come before the Tax Court on several occasions – most famously in two court conference opinions, Robinette v. Commissioner, 123 T.C. 85 (2004), rev’d 439 F.3d 455 (8th Cir. 2006), and Trout v. Commissioner, 131 T.C. 239 (2008). In all three cases, the situation was fairly similar: The taxpayers owed a lot of tax, and they had successfully convinced the IRS to enter into an OIC to settle the past tax debts for comparatively modest amounts. Each OIC contained a provision requiring the taxpayer to stay in filing and payment compliance for five years. In the event of a failure to stay in compliance, the OIC would go into default, and the IRS could immediately begin collection activities with respect to the liabilities before they were compromised. In each case, the taxpayer failed to file at least one tax return on time during the five-year period.

Manual § 5.8.9.4(3) (4-23-15) (which reflects long-standing earlier Manual provisions) provides that if a taxpayer fails to meet the five-year filing or payment requirements, a Campus OIC Unit should contact the taxpayer and attempt to secure compliance. Only if this doesn’t work will the IRS place the taxpayer’s OIC into default.

In both Robinette and Trout, the IRS sent letters warning the taxpayer of default if the taxpayer did not file an overdue return. In each of those cases, even after receiving the letter, the taxpayer did not file the missing return – even during the CDP hearing – contending instead that the return had been timely filed and sending a copy of an unsigned return as alleged proof (proof the IRS did not accept). Before each taxpayer eventually filed the late returns (which showed small overpayments), the IRS had defaulted each OIC.

In Quality Software, the taxpayer, a corporation, had neglected to timely file Forms 941 employment tax returns and/or make timely required employment tax deposits for several quarters in the five-year period. The IRS believed it sent the taxpayer default warning letters on each occasion, but the taxpayer disputed receiving the last two of the warning letters. To keep the OIC in effect, the taxpayer late-filed each of the returns and paid late-deposit penalties (the last in the amount of $344). But, the IRS defaulted the OIC, anyway, as of the last slip, despite that slip’s correction.

In each of the three court cases, the IRS, after defaulting the OIC, subsequently sent a notice entitling the taxpayer to a CDP hearing, and in the hearing, the taxpayer asked that the OIC not be considered defaulted or, in the alternative, that the OIC be reinstated. In each case, the SO held the OIC had been defaulted and refused reinstatement.

Probably the most interesting thing about these cases from the perspective of tax administration is that the IRS has never promulgated any written guidance to its employees about their ability or inability to reinstate an OIC. And this was the subject of a lot of court language in both the Tax Court and the Eighth Circuit that should have triggered the IRS to realize it needed to promulgate such written guidance. In Robinette, after concluding that the lack of filing was not a material breach of the OIC, the Tax Court found an abuse of discretion in the SO’s not treating the OIC as still in effect or in not reinstating the OIC. Earlier in the opinion, the Tax Court had found:

Mr. Talbott [the SO] believed he had no authority to reinstate petitioner’s offer-in-compromise. He believed only the National Office could reinstate the offer-in-compromise. He stated:  [13]  “The National Office would still have to do the reinstatement by itself” and the “National Office would have the call”. Mr. Talbott reviewed the Internal Revenue Manual. The manual was silent as to whether an Appeals officer has authority to reinstate an offer-in-compromise.

123 T.C. at 91.

In the Eighth Circuit, the court held that compliance with the five-year filing and payment requirement was an express condition of the OIC, so that any lack of materiality of a breach was not relevant. Having concluded that the OIC had been defaulted, the Eighth Circuit held that the SO had not abused his discretion in not reinstating the OIC, writing, in part:

Although it is not at all clear that the IRS’s internal regulations and procedures permit reinstatement of an offer that was properly defaulted, the record reflects that the appeals officer [23]  independently investigated that possibility. He was aware, for example, that if the offer had been defaulted in error, he could approach the IRS national office and request that the offer be reinstated. (Tr. at 110). Although he found that the Internal Revenue Manual was “silent” on whether an offer could be reinstated during a § 6330 collection due process hearing, the appeals officer acknowledged that if he found that the return had been timely filed, he could have called the national office to “say this is what we’ve got. . . . This is what we need to have done.” (Tr. at 110, 111). He also determined through consultation with the national office on March 6, 2001, however, that the original offer-in-compromise could not be reinstated unless there had been an error by the IRS in declaring a default. (Appellant’s App. at 41).

Whether or not the appeals officer believed that he personally could reinstate an offer-in-compromise, he clearly was aware that reinstatement was permitted in certain circumstances, and he was prepared to recommend reinstatement to the national office if he thought it was warranted. The record shows, however, that the appeals officer found that reinstatement [24]  was not appropriate in this case, given that Robinette’s return was not timely filed and there was no error in defaulting the original agreement. This exercise of judgment was not an abuse of discretion.

439 F.3d at 463.

In Trout, the Tax Court changed position and accepted the Eighth Circuit’s Robinette analysis that the compliance provisions were actually express conditions of OICs. However, the Tax Court distinguished its opinion in Robinette on the issue of whether the OIC should have been reinstated, as follows:

The Appeals officer understood even then [– i.e., during the CDP hearing –] that he had the discretion to excuse the breach of the express condition and reinstate the OIC. He chose not to. This is understandable — Trout’s only consideration for the potential forgiveness of almost 95 percent of his tax debt was his promise to timely file and pay his taxes for five years after the OIC. In Robinette, the consideration given by the taxpayer for the OIC was not only a timely-filing-and-paying promise but also an agreement to pay substantial portions of his income exceeding $100,000. Not so here: All the IRS was getting other than the small $ 6,000 in upfront money was Trout’s promise to comply with the law. This focused the Appeals officer’s concentration on Trout’s compliance history (both before and after the OIC) — which featured multiple requests for extensions of his filing deadlines, followed by returns that he filed late or not at all. Trout also offered no other collection alternatives, such as an installment agreement, even though he was doing fairly well.

131 T.C. 235 (footnote omitted).

In finding no abuse of discretion in Trout, it is not clear why the Tax Court, in the above quote, said that the SO understood that he had the discretion to reinstate a defaulted OIC.

In Quality Software, the IRS did not argue that all of the slips justified the defaulting of the OIC – just the late filing of one Form 941 (on which no tax was due) and the payment of a $344 penalty for late deposit for another quarter, both of which were done after the taxpayer requested a CDP hearing, but before the hearing was held. During the consideration of the matter at Appeal, the SO wrote in his case activity record that he “agree[d] that a reinstatement of the TP’s offer is a viable resolution, technically, all proper procedures were followed in defaulting the offer.” He then consulted a person in the COIC Unit who told him that there was no procedural basis for reinstatement.

The SO then wrote in his case activity record:

At this point although the TP has technically defaulted I need to consider the hazards of litigation since the TP’s CDP request was filed in a timely manner. My concern is whether or not the US Tax Court may find that an abuse of discretion has occurred by not reinstating the TP’s offer since the actions which caused the default were de-minimus (sic) and were rectified. Essentially, would it be fair to reinstate the TP’s offer? In this instance I believe it would be.

The SO then consulted an Appeals “analyst” (whoever that is), who told him “that reinstatement of the TP’s offer should be denied as there was a genuine default of the TP’s offer.” In an NOD, the taxpayer was told only: “Your request for the reinstatement of your offer in compromise has been denied. It was determined that you did not comply with the compliance terms and provisions of Form 656, Offer in Compromise.”

Judge Halpern’s Rulings In Quality Software

Before Judge Halpern, the IRS argued that under, contract principles that apply to interpreting OICs, an injured party to a contract may bring the contract back into existence. In the context of OICs, the IRS argued that it had complete, unreviewable discretion to reinstate an OIC and: “[B]oth respondent and its Appeals Office have consistently maintained a policy that they will not reinstate an OIC that was properly defaulted after a taxpayer breached its terms and conditions.” The IRS argued that there was no abuse of discretion in applying to the taxpayer this blanket rule denying OIC reinstatements. The IRS also argued that it was irrelevant whether the IRS had mailed letters warning of default, as the letter are not necessary to have a default – a point that the judge agreed with.

In deciding to remand the case to Appeals, however, Judge Halpern wrote:

While there may be good reason for Appeals’ blanket rejection of the reinstatement of OIC agreements in cases of breach, we cannot tell that from the record or from respondent’s argument. It is not even clear such a policy exists despite [the SO’s] determination and respondent’s contentions on brief. Cf. Trout v. Commissioner, 131 T.C. at 255 (“The Appeals officer understood * * * that he had the discretion to excuse the breach of the express condition and reinstate the OIC. He chose not to.”).

If such a policy does exist, it is not readily apparent what reasons or principles justify the lack of an exception to reinstatement in all circumstances of breach, especially given the individualized analysis afforded the initial termination decisions of breached OIC agreements. See, e.g., IRM pt. 5.8.9.3 (Jan. 1, 2015) (procedures for handling breached but not yet terminated OIC agreements, referred to as “Potential Default Cases”); supra pp. 4-5 (petitioner breached several times yet respondent did not terminate the agreement). And if there are no reasons or principles justifying the policy, we point out that one definition of “arbitrary” is, “determined by chance, whim, or impulse, and not by necessity, reason, or principle”. The American Heritage Dictionary of the English Language 91 (5th ed. 2011). By having discretion to reinstate OIC agreements, but choosing never to exercise that discretion, without providing any sort of justification, Appeals may be abusing its discretion. In this instance, Appeals has excused itself from stating facts and reasons that respond to the evidence and arguments of petitioner and has deprived us of the opportunity for thoughtful judicial review. Cf. Estate of Roskiv. Commissioner, 128 T.C. 113, 128-131 (2007) (“By adopting a bright-line rule in every case, the Commissioner has shirked his administrative duty to state findings of fact and reasons to support his decisions that are sufficient to reflect a considered response to the evidence and contentions of the losing party and to allow for thoughtful judicial review.”); see also Harborlite Corp. v. Interstate Commerce Comm’n, 613 F.2d 1088, 1092 (D.C. Cir. 1979) (on which we relied in Estate of Roski).

In conclusion, Judge Halpern wrote:

[I]f Appeals, on further consideration, determines not to reinstate the agreement, it can include in its determination a full explanation of its reasons, whether those reasons are particular to the facts of this case or whether those reasons amount to a policy not to reinstate OIC agreements that have been terminated without regard to the facts of a particular case. Our remand will also give the parties the opportunity to consider whether [the SO’s] communications with the COIC Unit constituted prohibited ex parte communications between Appeals and other IRS employees.

Final Observation

For over a decade, Tax Court opinions have highlighted this problem of lack of written guidance.

Regardless of whether the Quality Software case ever comes back to the Tax Court, it is more than time for the IRS to issue written procedures on reinstating (or not reinstating) OICs, so that its employees, taxpayers, and the courts, will all know how to approach these situations.

About Carlton Smith

Carlton M. Smith worked (as an associate and partner) at Roberts & Holland LLP in Manhattan from 1983-1999. From 2003 to 2013, he was the Director of the Cardozo School of Law tax clinic. In his retirement, he volunteers with the tax clinic at Harvard, where he was Acting Director from January to June 2019.

Comments

  1. Anonymous says

    5.19.7.3.20.4 (01-08-2014)
    Reopening Defaulted Offers

    • Carl Smith says

      That Manual provision provides instructions to Collection personnel, not Appeals Officers in CDP. And, it provides little guidance even to Collection personnel. First, it states what everyone agrees can lead to reinstatement: “A situation may arise where an offer in compromise is defaulted and we later discover that the termination was an IRS error.” More relevant, but without any guidance, the provision also states: “In rare situations a defaulted offer may be reopened based upon a taxpayer’s exceptional circumstance.” It may be, however, that this last sentence contradicts what Counsel argued in the Tax Court in Quality Software — that there is a uniform policy never to reinstate an OIC for any reason.

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