The EITC Ban – Further Thoughts, Part Three

Guest blogger Bob Probasco returns with the third and final post on the ban for recklessly or fraudulently claiming refundable credits. Part Three tackles the ban process.

The first two parts of this series (here and here) addressed judicial review of the EITC ban. The National Taxpayer Advocate’s Special Report on the EITC also made several recommendations about improvements during the Exam stage. The report is very persuasive (go read it if you haven’t already). In Part One, I quoted Nina’s preface to the report, which says that she is “hopeful that it will lead to a serious conversation about how to advance the twin goals of increasing the participation rate of eligible taxpayers and reducing overclaims by ineligible taxpayers.” Part Three is my small contribution to the conversation, concerning the ban determination process.

About that “disregard of rules and regulations” standard

The ban provision refers to a final determination that the taxpayer’s claim of credit was due to “reckless or intentional disregard of rules and regulations.” This standard seems to have been imported from section 6662, although there it covers not only reckless or intentional disregard but also negligent disregard. It seems a strange standard in this context, though.

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The accuracy-related penalty regulations, § 1.6662-3(b)(1), state that disregard of rules and regulations is not negligent, let alone reckless or intentional, if there is a reasonable basis for the return position. But the definition of reasonable basis, § 1.6662-3(b)(3), cross-references the types of authority, § 1.6662-4(d)(3)(iii), applicable to determining whether there was substantial authority for a return position. And those are legal authorities. Arguably, the “disregard of rules and regulations” standard – for the EITC ban as well as the accuracy-related penalty – carries with it an unexamined implication that the facts are known and indisputable; only the application of the law to those facts is at issue.

Such a standard may make a lot of sense with respect to the accuracy-related penalty, at least for sophisticated taxpayers with good records. Those of us who deal a lot with low-income taxpayers and the EITC, however, know that often the credit is disallowed because the taxpayer’s proof is not considered sufficient. It’s a factual dispute, rather than a dispute as to what the law means.

Osteen v. Commissioner, 62 F.3d 356 (11th Cir. 1995) has some interesting discussion of this distinction in the context of the substantial understatement penalty. The very first sentence of the case mentions “certain tax deductions attributable to their farming and horse breeding operations,” so we know that section 183 is going to be the focus. The taxpayers, both of whom were employed full-time, were breeding and raising Percheron horses with the expressed intent to train them, show them, use them to operate a horse-powered farm, and then sell them. The Tax Court opinion, 66 T.C.M. 1237 (1993), determined that the taxpayers did not have “an actual and honest objective of making a profit,” and the Eleventh Circuit concluded that the court’s determination was not clearly erroneous.

The penalty discussion took much longer than the analysis of the profit objective issue. The Tax Court had rejected the petitioners’ penalty defense, which was based on substantial authority, and that puzzled the Eleventh Circuit:

The application of a substantial authority test is confusing in a case of this kind. If the horse breeding enterprise was carried on for profit, all of the deductions claimed by the Osteens would be allowed. There is no authority to the contrary. If the enterprise was not for profit, none of the deductions would be allowed. There is no authority to the contrary. Nobody argues, however, not even the Government, that because the taxpayers lose on the factual issue, they also must lose on what would seem to be a legal issue.

The court reversed on the penalty issue and said that “substantial authority” for a factual issue is met if a decision in the taxpayers’ favor would not have been clearly erroneous:

If the Tax Court was deciding that there was no substantial authority because of the weakness of the taxpayers’ evidence to establish a profit motive, we reverse because a review of the record reveals there was evidence both ways. In our judgment, under the clearly erroneous standard of review, the Tax Court would be due to be affirmed even if it had decided this case for the taxpayers. With that state of the record, there is substantial authority from a factual standpoint for the taxpayer’s position. Only if there was a record upon which the Government could obtain a reversal under the clearly erroneous standard could it be argued that from an evidentiary standpoint, there was not substantial authority for the taxpayer’s position.
 
If the Tax Court was deciding there was not substantial legal authority for the deductions, we reverse because of the plethora of cases in which the Tax Court has found a profit motive in the horse breeding activities of taxpayers that were similar to those at hand.

For those interested in the “factual issue versus legal authority” question, there was also an interesting article by Bryan Skarlatos in the June-July 2012 issue of the Journal of Tax Practice & Procedure: “The Problem With the Substantial Authority Standard as Applied to Factual Issues.”

This is not directly applicable to the EITC ban but a similar approach seems reasonable. A determination in Exam to disallow the EITC often merely means “the taxpayer didn’t prove that she met the requirements,” rather than “the taxpayer didn’t meet the requirements.” But I suspect that some or many of those who make the ban determination proceed with an assumption, implicit if not explicit, that the former is the equivalent of the latter. If the taxpayer doesn’t meet her burden of proof, that may suffice for denying the credit in the conduct year but may not be enough to impose the ban for future years.

For example, one of the three scenarios in IRM 4.19.14.7.1 (7), used as a starting point to help determine whether the ban is appropriate, addresses situations in which the taxpayer provided insufficient documentation but “indicates they clearly feel they are eligible, and is attempting to prove eligibility and it is clear they do not understand.” In those circumstances, the technician is supposed to “[c]onsider the taxpayer’s lack of understanding” before asserting the ban. There is no reference to the relative strength or weakness of the support offered. That formulation strongly supports an assumption by the technician that (understanding the rules + insufficient documentation), rather than (understanding the rules + not meeting the requirements), is sufficient to assert the ban. If so, that’s a problem.

Recommendations for a revised ban recommendation process

The Office of Chief Counsel issued Significant Service Center Advice in 2002 (SCA 200245051), concluding that neither the taxpayer’s failure to respond to the audit nor a response that fails to provide adequate substantiation is enough by itself to be considered reckless or intentional disregard of rules and regulations. That conclusion is also set forth in IRM 4.19.14.7.1 (1): “A variety of facts must be considered by the CET [correspondence examination technician] in determining whether the 2-Year Ban should be imposed. A taxpayer’s failure to respond adequately or not respond at all does not in itself indicate that the taxpayer recklessly or intentionally disregarded the rules and regulations.”

But, as the Special Report points out, the guidance in IRM 4.19.14.7.1 (7) is erroneous and/or woefully inadequate for the CET’s. And research described in the National Taxpayer Advocate’s 2013 Annual Report to Congress showed an incredibly high error rate in the ban determination. The Special Report recommends that the IRS develop a ban examination process independent from the audit process, modeled on other means-tested programs, to improve accuracy and provide adequate due process protections. The report also mentions several recommendations from earlier annual reports. For example, in the 2014 Annual Report to Congress, the NTA recommended (again) that a single IRS employee be assigned to work any EITC audit in which the taxpayer calls or writes to respond.

The Special Report didn’t, and couldn’t, define the appropriate process in depth. That is something that the IRS, in consultation with TAS, will have to develop, and it may take a significant amount of time. But while we’re waiting for that, here are suggestions for some specific parts of a revised process that would be on my wish list.

First, the ban determination process should incorporate the concept of the strength of evidence for and against eligibility. The ban should be asserted only when the evidence against eligibility is significantly stronger than evidence for eligibility. The inability to provide evidence for eligibility is not equivalent to deemed evidence against eligibility. And some types of evidence against eligibility will be stronger or weaker than other types.

Second, the process for determining eligibility for the credit should expand the types of evidence that can be submitted and considered, which in turn will affect the relative strength of evidence to be considered during the ban determination phase. The standard audit request and the IRM 4.19.14-1 list focus on third-party documents. Third-party documents are strong evidence but they’re not the only evidence; they’re just the only evidence Exam seems to accept. The IRS experimented with allowing third-party affidavits in test cases from 2010-2013. Starting with tax year 2018, taxpayers can submit third-party affidavits (signed by both the taxpayer and the third party) to verify the residency of qualifying children (IRM 4.19.14.8.3). Why not for other aspects of the eligibility determination? Why not talk directly with the taxpayer and assess credibility?

This is a pet peeve of mine. It’s frustrating to receive a notice of deficiency (because the technician did not accept other types of evidence) and then get a full concession by the government in Tax Court (because the IRS attorney understands the validity of testimony as evidence). I like getting the right result but would prefer to avoid the need to go to Tax Court, delaying the resolution. As the Special Report points out, the IRS cannot properly determine whether to assert the ban without talking to the taxpayer. If a technician/examiner is talking to the taxpayer for that, and assessing their understanding of the rules and regulations, why not also accept verbal testimony (or statements by neighbors and relatives) and evaluate credibility, to accurately evaluate the strength of the evidence for eligibility and therefore the propriety of imposing the ban?

Conclusion

The Special Report would, if its recommendations were implemented, transform a critically important benefit to low-income taxpayers. Nina, Les, and the rest of the team did a fantastic job. It will be a long, hard fight to achieve that transformation but it will be worth it.

The EITC Ban – Further Thoughts, Part Two

Guest blogger Bob Probasco returns with the second of a three-part post on the ban for recklessly or fraudulently claiming refundable credits. In today’s post Bob looks at legislative solutions to the issue of Tax Court jurisdiction.

My last post summarized previous arguments by Les and Carl Smith that the Tax Court lacks jurisdiction to review the proposed imposition of the EITC ban and then examined what the Tax Court is actually doing.  Some cases have ruled on the ban, but some cases have expressed uneasiness about this area and have declined to rule at all.  Congress has clearly stated its intent that judicial review would be available, but it’s appropriate to clarify that by an explicit grant of jurisdiction – preferably in a deficiency proceeding for the year in which the alleged conduct – the taxpayer intentionally or recklessly disregarded rules and regulations – occurred.  The National Taxpayer Advocate’s Special Report on the EITC recommended that Congress provide an explicit grant of jurisdiction to the Tax Court to review the ban determination.  This post offers suggestions – some sparked by Tax Court decisions and/or previous posts here on PT – about exactly how that should be implemented.  The point at which recommendations turn into legislation is a danger zone where flawed solutions can create problems that take years to fix.

Grant Tax Court jurisdiction in a deficiency proceeding for the “conduct year,” not the “ban years”

Les explained the benefits of this approach in his “Problematic Penalty” blog post.  Ballard saw the “attractiveness,” as do I.  It’s even more attractive today.  Although challenging the ban in a proceeding with respect to the conduct year is a better solution, back in 2014 taxpayers at least would have the opportunity to challenge the ban in a proceeding with respect to the ban year. (The “conduct year” is the year for which the taxpayer recklessly or intentionally disregarded rules or regulations to improperly claim the EITC and the “ban year” is a subsequent year for which the taxpayer cannot claim the EITC.)  As Les pointed out, and the Office of Chief Counsel explained in 2002 guidance (SCA 200228021), summary assessment procedures were available for post-ban years (for failure to re-certify) but the IRS would have to issue a notice of deficiency to disallow EITC in a ban year.  But since then, summary assessment authority for the ban years was added by the PATH Act of 2015, in section 6213(g)(2)(K), and the IRS is using it.  There is still an opportunity for judicial review after a summary assessment, but that opportunity has a lot of problems, as described in the Special Report.

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The Special Report, Part IV, also recommends changes in summary assessment authority, under which some adjustments are not subject to the deficiency procedures, for an initial determination in the conduct year that the taxpayer is not entitled to the EITC.  Although I’m not entirely sure, I think the report is not recommending any change to the summary assessment authority under section 6213(g)(2)(K) for automatic disallowances in the ban year.  That’s understandable, as normally the correct application of the ban will be straight-forward and not require a separate examination in the ban year.  But there may some instances where the ban shouldn’t be applied automatically.  I’ll return to that below in the discussion of the application of the determination in the ban year.

Require that the proposed ban be set forth in a notice of deficiency for the conduct year

Of course, judicial review will be difficult if not impossible unless imposition of the ban is explicitly asserted and at issue in a case for the conduct year.  In all seven of the Tax Court cases discussed in my last post, the ban was explicitly asserted in an amended answer (Taylor) or the NOD itself (the other cases).  But that doesn’t always happen.

Carl Smith mentioned, in comments to the “Ballard” blog post, seeing a lot of cases where the ban was imposed by letter (presumably Notice CP79) rather than NOD.  I’ll quote his final sentence:

I wonder why some 32(k) sanctions are imposed by a simple letter and others (though apparently very few) are imposed in notices of deficiency.

My answer might be along the lines of: “Because the IRS thinks it can do that, unless Congress explicitly says otherwise, and it’s easier.”  My experiences with the EITC ban have made me more cynical.

My experience is consistent with Carl’s.  In just the past couple of years, my clinic has had four cases in which the IRS imposed the ban and issued Notice CP79.  Only one of the NOD’s explicitly stated the intent to impose the EITC ban.  In the other three cases, there was no indication whatsoever. 

In fact, in one case, there was an indication that an examiner had decided not to impose the ban.  After the NOD was issued, the taxpayer provided additional information and received a response from the IRS declining to change the proposed tax increase.  The letter included Form 886-A Explanation of Items that, again, did not propose the ban.  It also included a separate attachment, explaining why the additional information provided was insufficient.  That attachment stated at one point (emphasis added):

For future reference on the EITC BAN (Earned Income Tax Credit Ban) – The ban was considered.  If you continue to claim XXXXXXX for the credit and disallowed for no relationship, you could be subject to a 2-year earned income tax ban if you are found reckless and intentionally disregard the tax laws, rules and regulations.  You must meet the relationship test, residency test, age test and support test to be eligible for the credits.

That certainly sounds as though the determination required for the ban had not been made when the NOD was issued.  Nevertheless, when the taxpayer failed to file a petition timely, the IRS imposed the ban.

Given all the evidence that the IRS is asserting the ban without ever mentioning it in a notice of deficiency, the grant of jurisdiction to the Tax Court should be carefully crafted.  It should include not just jurisdiction to review the determination but also incorporate safeguards like those found in Section 6213(a) for tax assessments:

  • The determination required by section 32(k) is not a final determination until: (a) a notice of deficiency setting forth the determination has been properly mailed to the taxpayer; and (b) the expiration of the 90-day or 150-day period or, if a petition is filed in Tax Court, the decision of the Tax Court has become final.
  • Any disallowance of the credit in subsequent years based on the ban, before the determination is final, can be enjoined by a court proceeding, including in the Tax Court, despite the Anti-Injunction Act.

Applying the ban in the ban year

The cases I discussed in the last post suggested some specific issues that may need to be addressed when legislation is drafted to grant Tax Court jurisdiction to review the ban.  The first is obvious and fairly straight-forward.  Congress may need to modify section 7463(b) to specify that the determination in a small case with respect to the ban will be treated as binding for a proceeding in a future ban year.

How do we address the problem (discussed in Ballard and Griffin) that the court may not know yet whether the ban even had an effect in the ban years, because (for example) the taxpayer may not yet have filed returns claiming the credit for those years?  I don’t consider this concern an insurmountable obstacle.  Consider an analogy to the TEFRA partnership rules.  Under those rules, the court makes a redetermination of proposed adjustments on one return (the partnership’s).  The effect of that adjustment on other returns (the partners’) is authorized by provisions for computational adjustments.  The redetermination might turn out to have no effect on the partners’ returns, but the court doesn’t have to consider that in making its ruling in the partnership proceeding.

Currently, any credit claimed in the ban years can be disallowed automatically through the summary assessment authority in section 6213(g)(2)(K).  I don’t like that solution and think that instead Congress and/or the IRS should consider an approach similar to that in TEFRA: providing for some assessments without requiring a notice of deficiency in the ban year, but in other circumstances requiring a notice of deficiency because new fact determinations are needed.

Why might new fact determinations be needed?  Primarily because some exceptions or limitations should be carved out.  An all-or-nothing approach simply doesn’t make sense all the time.  What if:

A. The credit was reduced, but not disallowed, because some of the taxpayer’s earned income was disallowed.

B. The credit was claimed for 3 children and was only disallowed with respect to one.

C. The credit was disallowed because Husband’s earned income could not be verified.  Husband later married Wife, who has earned income and children from a previous marriage, and filed a joint return.  (See page 48 of the Special Report.)

Should we consider for future years, in situations like those: (A) allowing the credit but solely with respect to the taxpayer’s earned income from a Form W-2; (B) allowing the credit solely with respect to the children who qualified in the conduct year; or (C) allowing the credit but solely with respect to Wife’s earned income and qualifying children?

Lopez (situation A) suggested that there might be an exception for a partial disallowance:

It would appear that our findings will result in the reduction of petitioner’s claimed earned income tax credit for each year, but we expect that the credit will not be entirely disallowed for either year.  Consequently, we make no comment in this proceeding regarding the application of section 32(k).

A recent CCA (situation B) mentioned in Les’s blog post, however, concluded that partial disallowance was enough to trigger the ban.  The CCA’s reasoning was that section 32(k) doesn’t prohibit imposition of the ban for partial disallowances; thus, any disallowance is enough to trigger the ban.  “Disallowance” is not explicitly restricted to “total disallowance.”

Fair enough, but that doesn’t seem to be how Lopez interpreted the statute.  I don’t think it is entirely clear under current law.  Section 32(k) doesn’t refer to a disallowance (without explicitly specifying “total”) in the conduct year; it refers to the taxpayer’s “claim of credit” due to disregard of rules and regulations.  If the taxpayer could not legitimately claim any credit at all, that could meet the requirement (if done intentionally or recklessly).  In Lopez, was the “claim of credit” contrary to rules and regulations?  Or was the “claim of [at least some amount of] credit” consistent with rules and regulations but the amount excessive?  Lopez suggests the latter.  Does the answer depend on the reason for the excessive amount?  These questions deserve more thought.  The conclusion in the CCA may not be the best answer.

Another wrinkle came up in Griffin.  The court found the taxpayer was not entitled to EITC at all for 2013 because the taxpayer did not establish that any of the claimed dependents met the necessary tests.  However, the court found the taxpayer might be entitled to EITC for 2014, subject to applicable AGI limitations and thresholds after adjustments, because one of the two dependents claimed as qualifying children did meet all of the tests.  Should the ban be imposed if the taxpayer is not entitled to the EITC at all for one year but is entitled to at least some EITC in another year included in the same NOD, particularly if it’s the latest year included in the NOD?

Even if the CCA above is correct, current law is not immutable.  Congress should consider carving out exceptions or limitations to the ban.  If it doesn’t, we can try to change the law by persuading a court concerning the proper interpretation of the statute.  If the law changes, either through Congress or a court decision, we may want to use a more nuanced approach, like that in TEFRA, rather than blanket summary assessment authority.

Conclusion

This finishes my discussion of judicial review.  Establishing robust judicial review with all the flourishes will provide significant protection to low-income taxpayers who claim the EITC.

Some protection but, given current IRS practices, not enough.  Not all cases even go to Tax Court, so our primary goal should be to reduce the need for judicial review by improving the ban determination process in Exam.  The Special Report offered several suggestions along those lines.  I have some additional thoughts, coming up in Part Three of this series.

The EITC Ban – Further Thoughts, Part One

Guest blogger Bob Probasco returns with the first of a three-part post on the ban for recklessly or fraudulently claiming refundable credits. In today’s post Bob looks at how the Tax Court has addressed the ban. Part Two will suggest legislative solutions to the issue of Tax Court jurisdiction. Part Three tackles the ban process.

As Bob mentions, in the recent Special Report to Congress on the EITC that I helped write, we flagged the ban as an issue that potentially jeopardizes taxpayer rights. The Senate Appropriations Committee in a committee report accompanying the IRS funding for FY 2020 directs the IRS to “make the elimination of improper payments an utmost priority.” S. Rep. No. 116-111, at 26-27. At the recent Refundable Credits Summit at the IRS National Office that I attended IRS executives explored ways to reduce overpayments (in addition to increasing participation and improving administration more generally). The ban is part of the IRS toolkit. As Bob highlights today, there are fundamental questions concerning the path that taxpayers can employ to get independent review of an IRS determination. Les

One of Nina Olson’s last acts as National Taxpayer Advocate was the release of the Fiscal Year 2020 Objectives Report to Congress.  Volume 3 was a Special Report on the EITC; Les discussed it in a recent post.  If you are interested in issues affecting low-income taxpayers, you’ve probably already read it.  It’s definitely worth your time.  Kudos to Nina and to Les and the rest of the team that worked on the Special Report.  There are a lot of innovative, creative suggestions, backed up by thorough research, that would not just improve but transform how the IRS administers this program.

Nina’s preface to the report says that she is “hopeful that it will lead to a serious conversation about how to advance the twin goals of increasing the participation rate of eligible taxpayers and reducing overclaims by ineligible taxpayers.”  In that spirt, I’d like to offer my small contribution to the conversation, with additional thoughts about some of their suggestions.  The entire Special Report is important, but after a client’s recent “close encounter of the worst kind” with the EITC ban of section 32(k)(1), I have a particular interest in Part V.  This post will address the need for judicial review and what the Tax Court is actually doing.  Part Two will provide some further thoughts about how the Tax Court’s jurisdiction (when clarified by Congress) should be structured.  Part Three will address suggested changes to the ban determination process.

Does the Tax Court have jurisdiction to review the imposition of the ban?

Congress clearly envisioned the opportunity for pre-payment judicial review.  According to the legislative history for the Taxpayer Relief Act of 1997, “[t]he determination of fraud or of reckless or intentional disregard of rules or regulations are (sic) made in a deficiency proceeding (which provides for judicial review).”  H. Conf. Rpt. 105-220, at 545.  But there is no jurisdictional statute that clearly and unequivocally covers this, at least not until the ban is actually imposed in a future year.

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The question of Tax Court jurisdiction has been discussed here on Procedurally Taxing several times: 

I will follow Les’s terminology and refer to the year in which the taxpayer recklessly or intentionally disregarded rules and regulations by claiming the EITC as the “conduct year,” and to the subsequent years in which the taxpayer is not allowed to claim the credit because of the ban as the “ban years.”

Les and Carl Smith advanced arguments, in the “Problematic Penalty” and “Ballard” blog posts, that the Tax Court does not have jurisdiction to review an EITC ban in a deficiency proceeding for the conduct year.  The Tax Court has jurisdiction to redetermine the amount of a deficiency stated in a notice of deficiency as well as accuracy-related penalties applicable to the understatement, but explicitly does not have jurisdiction to determine any overpayment or underpayment for other years.  Although the EITC ban looks somewhat like a “penalty,” it does not fall within the scope of penalties that are treated like taxes, which are limited to Chapter 68.  Ruling on whether the ban was valid, in a deficiency proceeding for the conduct year, would therefore be a declaratory judgement for which the court has no jurisdiction.  The ban years will only be subject to the court’s deficiency jurisdiction if/when a notice of deficiency is issued with respect to them.

What has the Tax Court actually been doing?

I’m persuaded by Les’s and Carl’s arguments.  The Tax Court may not be, though.  It has addressed the issue of the ban in seven cases to date: Campbell v. Commissioner (2011 decision concerning 2007-2009 tax years), Garcia v. Commissioner (2013 decision concerning 2008 tax year), Baker v. Commissioner (2014 decision concerning 2011 tax year), Ballard v. Commissioner (2016 decision concerning 2013 tax year), Lopez v. Commissioner (2017 decision concerning 2012-2013 tax years), Griffin v. Commissioner (2017 decision concerning 2013-2014 tax years), and Taylor v. Commissioner (2018 decision concerning 2013 tax year).  All were either summary opinions, bench opinions, or orders granting a decision for the government when the taxpayer did not participate.

I’m not going to go into a lot of detail here concerning the cases.  The PT blog posts above have already discussed Campbell (in the blog comments only),Garcia, Baker, Ballard, and Taylor – only Lopez and Griffin appear to be new here.  (The Lopez case was actually discussed here, but that was with respect to an earlier order dealing with a different issue.)  But I do want to summarize how the Tax Court responded to the issue, with a couple of additional observations.

Campbell and Taylor imposed the ban, when the taxpayers did not respond to a Motion to Dismiss for Lack of Prosecution and a Motion for Default Judgment respectively, without any discussion of jurisdiction to do so.  In addition to the jurisdictional issue, it’s noteworthy that there was – or could have been – evidence supporting a determination of intentional or reckless disregard of regulations.  In Taylor, as previously noted in William Schmidt’s blog post, the court granted a motion to deem Respondent’s allegations, including those relevant to civil fraud and the ban, as admitted when the Petitioners did not respond to the amended answer.  (Because the ban was apparently not proposed in the notice of deficiency but was instead asserted in the notice of deficiency, the government would have the burden of proof.)  In Campbell, Respondent filed a motion to show cause why statements in a proposed stipulation of facts should not be deemed admitted.  The court granted the motion, Petitioners did not respond, and the court could have deemed those statements (which presumably would have covered the ban) as admitted.  Instead, the court simply granted the motion to dismiss for lack of prosecution.

These decisions to impose the ban demonstrate an interesting quirk.  The Office of Chief Counsel issued Significant Service Center Advice in 2002 (SCA 200245051), concluding that neither the taxpayer’s failure to respond to the audit nor a response that fails to provide adequate substantiation is enough by itself to be considered reckless or intentional disregard of rules and regulations.  That conclusion is also set forth in IRM 4.19.14.7.1 (1): “A variety of facts must be considered by the CET [correspondence examination technician] in determining whether the 2-Year Ban should be imposed. A taxpayer’s failure to respond adequately or not respond at all does not in itself indicate that the taxpayer recklessly or intentionally disregarded the rules and regulations.”  In these cases, and assuming the taxpayers were equally uncooperative during the audit, arguably the IRS should never have asserted the ban.  But that’s during the audit.  If the IRS does assert the ban, challenging that in Tax Court (if the taxpayer remains uncooperative) opens the door for deemed admissions supporting the ban.  It’s better to cooperate.

Garcia and Baker disallowed the EITC but concluded that claiming the credit was not due to a reckless or intentional disregard of rules and regulations and therefore that the taxpayers were not subject to the ban for following years.  Reliance on a paid return preparer was significant for both decisions.  Neither case discussed the court’s jurisdiction to rule on the validity of the proposed ban.

Ballard and Griffin declined to rule on the ban.  Both made the same argument: there was no information in the record as to whether returns had been filed, and whether the EITC had even been claimed, for the ban years.  Further, both pointed out that any ruling in an S-case is not precedential in any other case.  It was questionable whether a ruling in a proceeding with respect to the conduct year would have any effect at all in the ban years.  Ballard seemed to suggest that this factor was the most critical:

Respondent made that determination for the year in dispute here, but the determination obviously has no consequence to the deficiency determined in the notice – the consequences of the determination take effect in years other than the year before us.  Normally, in a deficiency case the Court is reluctant to make findings or rulings that have no tax consequences in the period or periods presently before us.  Nevertheless, we can see the attractiveness in making the determination in the same year that the earned income credit is disallowed albeit on other grounds and we have addressed the issue in other non-precedential opinions, see
Section 7463(b).
 
In this case not only does the application of section 32(k) have no tax consequence to Petitioner’s Federal income tax liability for the year before us, the record does not reveal whether a finding or ruling on the point would have any Federal tax consequence in either 2014 or 2015.

The court “is reluctant,” rather than “has no jurisdiction,” and even that is qualified as “normally.”  The court’s concern may have been jurisdiction but the language in the opinion suggests that the court might have been willing to rule if the record included appropriate information about the future years.  As far as I know, though, Campbell, Taylor, Garcia, and Baker also did not have such information in the record.

Ballard did, however, rule that the petitioner (who relied on a paid return preparer) was not liable for an accuracy-related penalty for negligence.  That strongly suggested that the ban should not apply; if the taxpayer was not negligent with respect to erroneously claiming the EITC, how would the IRS demonstrate the higher culpability of “reckless or intentional”?

Lopez also declined to rule on the ban, for a slightly different stated reason.  The IRS had disallowed the total gross receipts reported on Schedule C, eliminating the earned income required for claiming EITC.  The court allowed gross receipts in an amount less than the taxpayer had claimed.  With respect to the ban, it said:  “It would appear that our findings will result in the reduction of petitioner’s claimed earned income tax credit for each year, but we expect that the credit will not be entirely disallowed for either year.  Consequently, we make no comment in this proceeding regarding the application of section 32(k).”

Thus, in four cases the court ruled on the ban – two upholding it and two rejecting it – apparently without considering the jurisdictional issue.  Although Ballard, Griffin, and Lopez all declined to rule on the ban, none of them simply stated that the court had no jurisdiction with respect to the proposed ban.  Ballard and Griffin pointed out that a decision would not be precedential in an S-case.  The court, however, explained the primary justification not as lack of jurisdiction but what appears to be more like a concern about ripeness.  Lopez, on the other hand, did not mention that a summary opinion has no precedential effect for any other case.  Although far from clear, that decision sounds as though it assumed an implicit requirement for the ban – that it applies only when the credit was improperly claimed, not when it was properly claimed but in an excessive amount.  (I’ll return to that point in my next post.)

Despite the court (sometimes) being willing to rule on the issue, it would be better if the court’s jurisdiction to do so were firmly established.  The lack of explicit jurisdiction creates a serious problem.  What happens if the IRS asserts the ban in a notice of deficiency, the court disallows at least a portion of the EITC, but the court does not rule on the ban?  I suspect that the IRS will impose the ban in the future years.  It would be interesting to know what happened to Mr. Ballard, after the strong hint in the bench opinion. 

The taxpayer could still contest the validity of the ban in a deficiency proceeding for a ban year; that clearly would come within the scope of section 6214.  But the “Problematic Penalty” blog post pointed out pragmatic problems with that solution, which lead Les to conclude that it wouldn’t make sense from a policy perspective.  Since that blog post, an additional problem has arisen, making that solution even worse.  Summary assessment authority for the ban years was added by the PATH Act of 2015, in section 6213(g)(2)(K), and the IRS is using it.  Although the taxpayer still has an opportunity for judicial review after a summary assessment, the opportunity is less obvious than with a notice of deficiency and may be missed by unrepresented taxpayers.  It also comes with a shorter time to respond.

Thus, we are left with two alternatives for Tax Court review of the assertion of the ban.  Doing so in a deficiency proceeding for the conduct year is by far the best alternative and is consistent with Congress granting summary assessment authority for the ban years.  I suspect that is what Congress had in mind, but if so, it forgot to clearly grant jurisdiction.  Reviewing the assertion of the ban in a deficiency proceeding for a ban year has the advantage of fitting within the Tax Court’s existing jurisdiction but is a horrible solution for a number of reasons. 

Even if the court were willing to rely on the legislative history as implicit jurisdiction to address the ban in a deficiency proceeding for the conduct year, it would still be worthwhile to establish appropriate guidelines.  There are some obvious questions about exactly how the entire process should work.  Setting those guidelines proactively in legislation or regulation would also be helpful for the vast majority of these cases that never make it to Tax Court. 

The Special Report recommends a ban determination process independent of the audit process.  That is a great idea that would go a long way in solving some of the problems the report points out.  But for simplicity, and in case the IRS is reluctant to implement the Special Report’s recommendation, Part Two will discuss how Tax Court jurisdiction could be structured within the framework of a deficiency proceeding for the conduct year.

Another Court Rules on Jurisdiction for Overpayment Interest Suits – Part Two

Today Bob Probasco continues his update on overpayment interest suits. Part One can be found here Christine

And now Bank of America

Bank of America filed its case in the Western District of North Carolina (WDNC). As noted above, Pfizer chose its forum to take advantage of a favorable Second Circuit precedent; Bank of America likely chose the WDNC to avoid an unfavorable precedent. Approximately $141 million of the $163 million at issue involves interest netting and, as the government pointed out, Bank of America currently has another interest netting case pending in the CFC. 

The case in the WDNC likely raises the “same taxpayer” issue (see discussion here and here). It involved overpayments and underpayments for tax years ranging from 1987 to 2009, for six different entities that ultimately merged into a seventh, the plaintiff. Federal Circuit precedent, from Wells Fargo & Co. v. United States, 827 F.3d 1026 (Fed. Cir. 2016), allows separate companies that merge to be considered the “same taxpayer.” But it also applies a “temporal requirement” that the two entities must be the “same” for the entire period of overlap between the overpayment and the underpayment. Effectively, this means that the latest of the two tax years with balances to be netted must be after the date of the merger. Based on information in the complaint, most of the amount at issue appears to be precluded by the holding in Wells Fargo. Bank of America’s case in the CFC, on the other hand, did not have a Wells Fargo problem. Settlement negotiations began almost immediately and are ongoing.

Bank of America had a strong incentive to file the current case in the WDNC. As I stated before, in my second post on interest netting, I think Wells Fargo was an overly narrow construction of the statute. But the CFC is bound by that precedent, while the WDNC might reach a different conclusion. Unfortunately, the amounts at issue exceeded the limitation on Tucker Act jurisdiction by a district court. Thus, Bank of America had to argue that the case fell under “tax refund jurisdiction” and the government promptly filed a motion to dismiss for lack of jurisdiction, arguing that claims for additional overpayment interest are only cognizable under Tucker Act jurisdiction. A magistrate judge reviewed the motion to dismiss and concluded that “tax refund jurisdiction” encompasses claims for additional overpayment interest. In Bank of America Corp. v. United States, 2019 U.S. Dist. LEXIS 109238, the district court judge agreed and adopted the magistrate judge’s Memorandum and Recommendation.

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The court found the interpretation of § 1346(a)(1) in E.W. Scripps Co. v. United States, 420 F.3d 589 (6th Cir. 2005) persuasive. The statute provides concurrent jurisdiction for district courts and the CFC over actions for the recovery of “any sum alleged to have been excessive . . . under the internal-revenue laws.” The Scripps court concluded that a claim for overpayment interest fit that part of the statute. The “sum” at issue is not the amount of overpayment interest at issue; it is the total balance the United States retained, the net of tax liability, penalties, underpayment interest, and overpayment interest.

That’s a bit abstract; here’s a simple illustration. Say that the taxpayer originally paid $5,000,000 but the IRS eventually determined that the correct tax liability was only $4,500,000 and refunded $500,000. The sum retained by the government is $4,500,000; it received $5,000,000 but then refunded $500,000. But if the government should have paid (but did not) $80,000 of overpayment interest, it should have only retained $4,420,000, the net of $5,000,000 originally received and $580,000 (tax refund plus overpayment interest) paid back to the taxpayer. The sum actually retained ($4,500,000) is “excessive,” more than the proper amount of $4,420,000. I think this is a somewhat strained reading of the statute, but it persuaded the Scripps court and the district court in Bank of America.

The opinion also noted that most courts that have considered the issue have held that claims of additional overpayment interest fall within “tax refund jurisdiction.” Strictly speaking, that may be true, but it fails to address a couple of limitations on that statement. First, only one Circuit Court (the Sixth), and few district courts outside the Sixth Circuit, have directly addressed the issue. Historically, most claims for overpayment interest have been filed in the CFC rather than district court. It’s not at all clear that other Circuit Courts would reach the same conclusion. For example, although technically dicta, in Sunoco, Inc. v. Commissioner, 663 F.3d 181, 190 (3d Cir. 2011) the Third Circuit stated that actions for overpayment interest in district court fall under § 1346(a)(2) rather than § 1346(a)(1).

Second, the CFC (which handles most interest cases) generally won’t have disputes as to which jurisdictional statute applies, for structural reasons. District court jurisdiction is split between § 1346(a)(1), for tax refund actions, and § 1346(a)(2), for Tucker Act claims, because there is a dollar limitation for the latter. The CFC has no such dollar limitation and only has one relevant jurisdictional statute, § 1491(a)(1), which is similar to the language of § 1346(a)(2). When a case includes both underpayment interest and overpayment interest (most interest netting cases do), some practitioners may specify both § 1346(a)(1) – under Chapter 85 of Title 28, governing district court jurisdiction, but referencing the CFC – and § 1491 for jurisdiction, just in case. But the CFC may not address the jurisdictional statute at all in those cases. When it does, it often refers to jurisdiction for both tax refunds and overpayment interest as arising under the Tucker Act, i.e., § 1491; only the underlying cause of action and statute of limitations are different. That was the only jurisdictional basis that Paresky mentioned and there are many other examples.

The government also relied on similar language in § 1346(a)(1) and Code section 7422(a). Here’s § 1346(a)(1), with the relevant language italicized:

Any civil action against the United States for the recovery of any internal-revenue tax alleged to have been erroneously or illegally assessed or collected, or any penalty claimed to have been collected without authority or any sum alleged to have been excessive or in any manner wrongfully collected under the internal-revenue laws

And here’s Code section 7422(a), which states requirements for refund suits, also with the relevant language italicized:

No suit or proceeding shall be maintained in any court for the recovery of any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, until a claim for refund or credit has been duly filed with the Secretary, according to the provisions of law in that regard, and the regulations of the Secretary established in pursuance thereof.

The government argued that: (a) it is well-established actions for overpayment interest are not refund suits; (b) § 1346(a)(1)’s language is virtually identical to that in section 7422; (c) therefore, § 1346(a)(1) is limited to refund suits, just as section 7422 is; and (d) therefore, district courts only have jurisdiction over actions for overpayment interest under § 1346(a)(2), which is limited to $10,000.

Bank of America circumvented this conclusion by arguing that § 1346(a)(1) includes both refund suits and “non-refund” suits, such as those for overpayment interest. There are very minor differences in the language of the two statutes, but the court identified one significant difference that convinced it to agree with Bank of America’s argument. Section 7422(a) includes a qualifying header: “No suit prior to filing claim for refund.” And § 1346(a)(1) has no header. I’m not sure how much should be read into that; Chapter 85 of Title 28 appears to have no headers or titles at the paragraph level, and few at the subsection level, as opposed to the section level.

These issues might be reviewed by the Fourth Circuit on appeal at some point, but not soon. The WDNC’s opinion just denied the motion to dismiss; now the parties will need to proceed to the merits of the case. The case has more complex facts and legal issues (including the “same taxpayer” issue) than Bank of America’s CFC case, so a final determination might take a long time.

Conclusion

Now we have three recent cases that addressed the issue but with somewhat inconsistent results. Pfizer and Bank of America concluded that district courts’ “tax refund jurisdiction” encompasses claims for overpayment interest. Paresky did not address the jurisdictional statute, because the case was originally filed in the CFC, but may now with the post-transfer motion before the SDF. The CFC and Federal Circuit might view the issue differently than Pfizer and Bank of America did, but their jurisdictional statute doesn’t differentiate as the district court jurisdictional statute does and they will never rule on the district court statute.

Pfizer concluded that the Code statute of limitations applies. Paresky concluded that the general federal 6-year statute of limitations applies, but that may change in the SDF. Bank of America didn’t directly address the statute of limitations, as the government did not assert untimely filing as a basis for the motion to dismiss, but the court certainly suggested that it would not apply the Code statute of limitations.

These issues potentially could be addressed on appeal by three different Circuits – the Second (Pfizer), the Eleventh (Paresky), and the Fourth (Bank of America). So far, only the Sixth Circuit has ruled on whether district court jurisdiction for these cases fits under § 1346(a)(1). It will be interesting to see if a circuit split develops that would give the government an opportunity to overturn Scripps. And we might even see a decision in Bank of America that would create a circuit split on the “same taxpayer” issue and allow taxpayers an opportunity to overturn that part of the Wells Fargo result.

Another Court Rules on Jurisdiction for Overpayment Interest Suits – Part One

We welcome back guest blogger Bob Probasco of Texas A&M University School of Law for an update on taxpayer suits to recover overpayment interest. Today, Part One sets the stage and recaps the status of the ongoing Pfizer and Paresky cases. Christine

Last year, I wrote about the Pfizer and Paresky cases, which involved questions about jurisdiction and statutes of limitations for taxpayer suits seeking interest payable to them by the government for overpayments. Recently, the District Court for the Western District of North Carolina issued its opinion in Bank of America Corp. v. United States, 2019 U.S. Dist. LEXIS 109238 (W.D.N.C. June 30, 2019) addressing the issue.

Setting the stage

There are two district court jurisdictional statutes at issue in these cases. This first is 28 U.S.C. § 1346(a)(1). It has no dollar limitation. That’s the statute we rely on when filing tax refund suits, so I will refer to it as “tax refund jurisdiction.” But I will keep that term in quotes; taxpayers sometimes argue successfully that this covers suits for overpayment interest, although technically those are not refund suits.

The second is § 1346(a)(2), which provides jurisdiction for any claim against the United States “founded either upon the Constitution, or any Act of Congress, or any regulation of an executive department . . . .” This is commonly referred to as “Tucker Act jurisdiction” and for district courts is limited to claims of $10,000 or less. The comparable jurisdictional statute for the Court of Federal Claims, § 1491(a)(1), has no such limitation.

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There are also two different statutes of limitation potentially applicable. The general federal statute of limitations, § 2401 (for district courts or § 2501 for the Court of Federal Claims), requires that complaints be filed within six years after the right of action first accrues. In the Code, section 6532(a)(1) requires the taxpayer to file a refund suit no later than two years after the claim is disallowed.

As a result of all this, not to mention different precedents in different circuits, taxpayers who file suits for overpayment interest may sometimes want to file in district court and other times prefer the Court of Federal Claims. The government’s position is that these claims fit under Tucker Act jurisdiction only, not “tax refund jurisdiction.” And the government may disagree about whether the taxpayer’s preferred venue is available. There may also be a secondary dispute, concerning which statute of limitations applies and whether the suit was filed timely.

Brief recap and current status of Pfizer

The underlying issue in the Pfizer case was straightforward: whether overpayment interest is due when the IRS mails a refund check within the 45-day safe harbor of section 6611(e) but the check is not received by the taxpayer and must be replaced. Pfizer filed suit in the Southern District of New York (SDNY), asserting “tax refund jurisdiction,” to take advantage of a favorable precedent in the Second Circuit. Tucker Act jurisdiction would be available in the SDNY, but is limited to $10,000, and therefore inadequate for this case. The government filed a motion to dismiss for lack of jurisdiction, asserting that standalone suits for overpayment interest do not fall within the scope of “tax refund jurisdiction.” The court agreed with Pfizer and denied that motion to dismiss.

But the government filed a second motion to dismiss for lack of jurisdiction, arguing that the refund statute of limitations in the Code had expired and the suit was not filed timely. Pfizer argued that the general six-year statute of limitations in § 2401 applied even though Pfizer was relying on “tax refund jurisdiction” rather than Tucker Act jurisdiction. The court disagreed with Pfizer, applied the two-year statute of limitations from the Code, and granted the government’s motion to dismiss the case.

The case is currently on appeal. Pfizer asked the court, if it affirms the decision below, to transfer the case to the Court of Federal Claims (CFC). That would allow the case to proceed, as suit was filed within the six-year general statute of limitations for Tucker Act claims, although the Second Circuit precedent Pfizer wanted to rely on would not be binding in the CFC. Keith and Carl filed an amicus brief arguing that even if the filing deadline in section 6532(a) applies, it is not jurisdictional and is subject to estoppel or equitable tolling arguments. At oral arguments on February 13, 2018, the Second Circuit panel asked the parties whether it could assume without deciding that claims for overpayment interest fell within the terms of § 1346(a)(1) and proceed to the statute of limitations issue. Roughly 18 months later, we’re still waiting for an answer.

Brief recap and current status of Paresky

The Pareskys have been trying to resolve these tax issues since 2009, first to claim substantial losses that generated refunds and then to get interest on the refunded amounts. It has been a very long, complicated struggle and makes you wonder what would have happened if they hadn’t been represented by very competent tax advisors. In the course of the attempted resolution, the IRS advised them to file a refund claim and, when the claim was denied in 2015, advised that they had two years to file suit. Relying on those statements, the Pareskys filed suit in 2017 in the CFC. The government filed a motion to dismiss, arguing that the six-year statute of limitations applied and had expired in 2016. The plaintiffs argued that the two-year statute of limitations applied; alternatively, they argued that that the six-year statute of limitations didn’t start in 2010, as the government asserted, or was suspended due to government misconduct.

The first step in the court’s decision was relatively easy, because there are numerous precedents in the Federal Circuit that the six-year statute of limitations applies to claims for overpayment interest. It took more effort to analyze when the claims accrued. The normal documentary evidence was not available because it had been destroyed in the normal course of business, during the very long period this dispute had lasted. The court was left with “complicated factual issues” that it resolved in the government’s favor. Finally, the court concluded that the taxpayers had not met the burden of proof to apply the accrual suspension rule. But the CFC denied as moot the government’s motion to dismiss because it granted the taxpayers’ motion to transfer the case to the District Court for the Southern District of Florida (SDF). That would allow the Pareskys to try to persuade the SDF that “tax refund jurisdiction” covers claims for overpayment interest and that the Code statute of limitations applies.

In Pfizer, the taxpayer appealed to the Second Circuit and the question of whether to transfer to another jurisdiction if that was unsuccessful was deferred. In Paresky, the case was transferred immediately rather than giving the plaintiffs an opportunity to convince the appellate court to rule in their favor on the jurisdictional issue. I don’t know if the plaintiffs’ desires were a deciding factor in that difference between the two cases. But Pfizer clearly wanted to remain in the SDNY if possible, while the Pareskys seemed caught by surprise at the jurisdictional challenge, given the advice they received from the IRS, and were open to immediate transfer. They filed a motion to transfer very soon after the government’s motion to dismiss.

In the SDF case, the Pareskys filed an amended complaint, asserting jurisdiction under §§ 1346 and 1491. (This phrasing provides for alternative theories, as “§ 1346” does not distinguish between “tax refund jurisdiction,” § 1346(a)(1), and Tucker Act jurisdiction, § 1346(a)(2). But § 1491 does not apply in district court.) The government quickly filed a motion to dismiss for lack of jurisdiction, and the parties repeated their arguments over which statute of limitations applied. The parties’ submissions on the motion to dismiss were completed on February 26, 2019. We’re still waiting for the district court’s decision, and possibly an appeal to the Eleventh Circuit.

Reflections on the Impact of Nina Olson by Bob Probasco

We welcome regular guest blogger Bob Probasco. Bob is the director of the Low Income tax Clinic at Texas A&M University School of Law. Prior to starting the clinic at Texas A&M, Bob had a long a varied career in different tax positions. Before law school, he spent more than twenty years in various accounting and business positions, including with one of the “Big Four” CPA firms and Mobil Oil Corporation. After law school and a year clerking with Judge Lindsay of the Northern District of Texas, he practiced tax law with the Dallas office of Thompson & Knight. He left T&K in 2014 and started a solo practice before switching to full time academia. Keith

I’ve been working in tax controversy for eighteen years now, but most of that was with a large law firm in Dallas. The tax system works fairly well for people like our clients. If they have a dispute with the IRS, they know exactly where to find (and can afford to hire) the right people to solve it. So I’ve known of Nina for a long time but I didn’t begin to really understand the full extent of her impact until I joined the LITC community in late 2016. For what it’s worth, here are some aspects of Nina’s work that stand out to this “new kid.”

Relentless warrior: I think someone else referred to Nina as a fierce warrior, which she is. But “relentless” is more impressive to me. The IRS is a huge, unwieldy bureaucracy and therefore incredibly difficult to change. It takes time and coming back, year after year after year, to achieve change. Most of us who beat our heads against a brick wall will lose our enthusiasm at some point. Nina absolutely will not stop. (Yes, she’s retiring – but that just means changing where she sits; her battles on behalf of taxpayers won’t stop.)

Educator: More than almost anyone I can think of, Nina has incorporated into her efforts the insight that to make the tax system work better, education (in a broad sense and of a lot of different groups) is critical. Her annual report is about not just identifying necessary reforms but also giving Congress a better understanding of how the system currently works and how problems arise. Her “Roadmap of a Tax Controversy” videos were originally designed for TAS employees. As she put it, no matter what they do in TAS, they have to understand the larger context in order to do their best. We’ve just seen the “subway map,” which will help taxpayers understand not only how complex the system is but how to navigate through it. And of course she’s directed a lot of research and advocacy into the specific topic of how the IRS needs to better educate taxpayers in notices and correspondence.

As the director of an academic LITC, this aspect of Nina’s work particularly impresses me. I will always point my students to the videos, the map, and the annual reports to Congress.

General: I had this thought initially when Nina spoke at the first Annual Grantee conference I attended, in December 2016. She was talking to her “troops” – the LITCs as much as TAS staff – in a different manner than I see with other audiences. She’s not just talking about issues, she’s giving us our orders. Nina loves her troops but demands a lot from us as well; she makes clear the need for our best efforts and explains things we need to do better. (Why are you doing so many CNCs instead of OICs? Can you find opportunities in litigation to give real teeth to the TBOR?) The mission is too important for us to give anything less.

Working in an LITC can be frustrating. We’re dealing with a huge bureaucracy with over-worked and under-trained employees while representing clients who may struggle to give us what we need to help them. We can’t always get the results we think our clients deserve. I suspect I’m far from the only one who walks out of Nina’s speeches not only with a lot of new ideas and clearer direction but also feeling re-energized. And I thought: exhausted from our efforts, perhaps feeling stressed and out-numbered and not confident in success, but now ready to charge up the hill? What a minute – that’s the movie scene with the general rallying her troops right before the big battle! Henry V at Agincourt, Aragorn before the Black Gate of Mordor, or Teddy Roosevelt at Kettle Hill are dramatic examples; add Nina to the list.

Builder: I confess that, before reading Keith’s article “History of Low-Income Taxpayer Clinics,” I wasn’t aware that Nina built from scratch the first non-academic LITC. Starting a new LITC isn’t easy, even with a strongly established tradition, support from an academic institution, and the help of the TAS LITC Program Office. What Nina faced was a far more daunting challenge but she succeeded. Of course, she has also built a strong Taxpayer Advocate Service; despite losing a great NTA, TAS will thrive – or they’ll have to answer to her.

In addition to organizations and institutions, Nina recruits people, to build the general community of those who want to help low-income taxpayers. Ted Afield’s post mentioned her making time to talk with all of the students at the 25th anniversary celebration for his LITC, in part so “she could influence them to always be thinking of how the tax system could be inadvertently hurting the most vulnerable among us.” I saw the same thing when she spoke at the 2017 annual meeting of the State Bar of Texas Tax Section. This was in June, when most students are busy with summer jobs or summer relaxing, but three of my former students from another law school attended the conference; Nina’s speech was the big draw. And when she spoke with them, at length, afterward? They will remember that for a long time.

In my brief time in the LITC community, I still haven’t fully realized Nina’s impact on the tax world. But that’s true (to a lesser degree) even for the veterans such as Keith, Les, Christine and all those who sent in their reflections. If Nina never did anything more, we would continue for many years to see changes that trace back to her tenure as NTA.

Interest Computation and Something Else

Guest blogger Bob Probasco returns with a lesson on tax overpayments, taking us through a helpful comparison between overpayment rules and those applicable to wrongful liens and levies. It isn’t always simple to properly characterize a claim. Christine

At the end of June, the IRS released CCA 201926001, addressing a question regarding computation of overpayment interest. The fact pattern was a bit out of the ordinary, so I understand why a field attorney might want clarification. The answer that the interest specialist reached seems reasonable as a practical matter. However, there are some complications and issues that the CCA didn’t address or even acknowledge. The interest computation discussion in the CCA was fairly straightforward and might not warrant discussion here by itself; I found the other questions more intriguing.

The interest computations

The issue was stated as: “Whether interest is allowable on the refund of a remittance made by a non-liable spouse that the Service incorrectly applied to the liable spouse’s tax liability?” You can probably anticipate the fact pattern.

  • Husband and Wife 1, who divorced in Year 7, had joint tax liabilities for multiple earlier years.
  • Husband married Wife 2 in Year 9, when the joint tax liabilities of Husband and Wife 1 were still outstanding.
  • Husband and Wife 2 bought real property in Year 11.
  • The Service filed a Notice of Federal Tax Lien with respect to Husband’s joint tax liability, which attached to the real property that Husband and Wife 2 had purchased.
  • Husband and Wife 2 wanted to sell the property, so they sought a certificate of discharge of the lien, in return for payment equal to the value of the government’s interest in the property. They sold the property in Year 13.

So far, so good. But the IRS’s Conditional Commitment to Discharge (Letter 403) overstated the amount to be paid, as almost the full amount of the sales proceeds rather than only Husband’s half-interest. Alas, no one noticed and corrected the error in time, so the title company sent the full amount of the sale proceeds to the IRS. The IRS received and applied the proceeds against the joint tax liabilities for Years 1 and 2 of Husband and Wife 1, sometime after April 15th of Year 13.

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Later in Year 13, Wife 2 realized that her half-interest in the sale proceeds had been applied to tax balances for which she was not liable, and she filed a claim for refund. On the same date she filed the refund claim, she also filed a request for assistance with the Taxpayer Advocate Service.

The IRS agreed that Wife 2 was entitled to get the money back and prepared to issue a refund in Year 14. But before the IRS issued the refund, it determined that Husband and Wife 2 also had unpaid joint tax liabilities, for Years 12 and 13. So the IRS credited some of Wife 2’s money to those balances. As we all know, when a taxpayer makes an overpayment of her tax liability, the IRS has the authority under Section 6402(a) to offset it against any other outstanding tax liability, e.g., for another year, and only refund the amount (if any) left over. There apparently was still a remaining amount to be repaid to Wife 2, which had not yet been refunded.

Now we get to the advice provided in the CCA: how much overpayment interest should the IRS pay to Wife 2 on that money applied to Years 12 and 13, or refunded? That was a fairly straight-forward analysis. Because Wife 2 had no liability for Years 1 and 2, to which the sales proceeds were applied, she had an overpayment. Interest on an overpayment is allowable under Section 6611. Interest begins on the date of the overpayment, regardless of whether the overpayment is credited to another liability or refunded. Here, that was the date that the proceeds from the sale of the real property were received and applied to Husband and Wife 1’s tax liabilities, sometime after April 15th of Year 13.

For the portion of the overpayment that was credited to Husband and Wife 2’s liability for Year 12, interest stops on the due date of that return, or April 15th of Year 13. Because the date of the overpayment was after that date, there would be no overpayment interest on the amount applied to the liability for Year 12. But there would be overpayment interest on the amount applied to the liability for Year 13, for the period from the date of the overpayment to April 15th of Year 14. For the remainder of the overpayment, to be refunded to Wife 2, interest runs from the date of the overpayment to a date no more than 30 days before the date of the refund check.

Pretty straight-forward and you may be wondering why a CCA was needed. Or you may have noticed that the issue as stated wasn’t how to determine the amount of allowable interest, but whether interest was allowable. And perhaps you raised the same question I did:

Did Wife 2’s share of the sale proceeds, improperly applied to Husband and Wife 1’s joint tax liabilities, really result in an “overpayment”?

Overpayment or something else?

First things first. Why might it be important to know whether the amount at issue is classified as an overpayment? Three important Code sections that apply to overpayments come to mind. The person making the overpayment can bring suit to compel the IRS to refund it, with a particular statute of limitations and a requirement to first exhaust administrative remedies. The IRS can, instead of refunding the overpayment, credit all or a portion against outstanding tax liabilities for other periods by the same person. With certain exceptions, the government pays interest to the person who made the overpayment when refunding or crediting it.

The Code doesn’t expressly define what an overpayment is. Generally, it’s considered to arise when a taxpayer pays more than the correct amount of the tax liability. But Wife 2 falls into a category that is sometimes referred to as “persons other than taxpayers” or “third parties” – that is, persons who make payments (voluntarily or involuntarily) of other persons’ tax liabilities. In at least some circumstances, those payments are not treated the same way as overpayments for purposes of judicial review, offset, or interest.

If the IRS had levied against the sales proceeds, that would be a wrongful levy. Judicial review is available, either before or after property has been surrendered or sold and without the requirement to exhaust administrative remedies, through a suit in district court (Section 7426(a)(1)). Wrongful levy suits have to be brought within two years of the levy, but if the third party makes an administrative claim under Section 6343(b), the period is extended to the earlier of 12 months after the administrative claim was filed or six months from the date of disallowance. A wrongful levy suit, rather than a refund suit, is the exclusive judicial remedy. Sections 6343 and 7426 refer to the return of property or payment of a judgment, rather than refund of an overpayment. Sections 6343(c) and 7426(g) are specific interest provisions, separate from Section 6611 but applying the overpayment rate from Section 6621.

Of course, the IRS had not levied Wife 2’s property. The IRS merely required payment in return for a discharge of the lien, allowing Husband and Wife 2 to sell the real property. The situation was very similar to that in United States v. Williams, 514 U.S. 527 (1995), where the plaintiff was coerced to authorize payment from the sale proceeds in order to convey clear title. She later submitted a refund claim and, when it was denied, filed a refund suit. The Court concluded that the amount the plaintiff sought to recover was an overpayment and that she could do so by a refund suit. This holding was based largely on the fact that there was no other feasible judicial remedy.

But in the Internal Revenue Service Restructuring & Reform Act of 1998, Congress enacted Sections 6325(b)(4) and 7426(a)(4) to address the problem noted in Williams. The owner of the property can deposit money equal to the amount determined by the IRS as the value of the government’s interest in the property (or furnish an acceptable bond) and the IRS “shall” – instead of “may” as in Section 6325(b)(3) – discharge the lien. The IRS “shall” refund the deposit, with interest at the overpayment rate of Section 6621, to the extent that it determines either that the value of the government’s interest was lower than previously determined or that it can satisfy the outstanding liability from other property. And just in case the IRS doesn’t agree or is slow to respond, the owner of the property can file suit in district court, to re-determine the amount of the government’s interest in the property, within 120 days after the certificate of discharge is issued. The IRS has concluded that this is the judicial remedy for an allegedly wrongful lien; a refund suit, as in Williams, is no longer an option. Most courts that have considered the issue have agreed with the IRS; Munaco v. United States, 522 F.3d 651 (6th Cir. 2008) is a good example and cites others.

How do the above provisions related to wrongful levies and wrongful liens line up against the three key aspects of how the Code treats overpayments?

Judicial review

There is a much shorter period of time to file suit for wrongful levy or wrongful lien, than the statute of limitations for a refund suit, which arguably can stay open indefinitely if the refund claim is never disallowed. A refund suit is not available for wrongful levies and liens. It certainly makes sense to require action by the third party promptly. Once the IRS collects from the third party, collection actions against the person who is actually liable for the tax may cease. A challenge by the third party does not toll the statute of limitations for collection and if the collection from the third party is held invalid, the IRS will want to go back to the liable party.

However, in the fact pattern of the CCA, the shorter statute of limitations for a wrongful lien suit might not have been a constraint. Wife 2 did file Form 911, Request for Taxpayer Advocate Service Assistance. In addition to the salutary effect on IRS personnel of the possibility of a Taxpayer Assistance Order, under Section 7811(d) the request itself suspends any relevant statute of limitations pending any relief that TAS might order. This was recently addressed in a wrongful levy case, Rothkamm v. United States, 802 F.3d 699 (5th Cir. 2015). (Note, however, that tolling under section 7811(d) is not automatically tracked by the IRS, and the National Taxpayer Advocate has recommended repealing the provision.)

Offset against other tax liabilities

For wrongful levies, Section 6343 refers to the return of property, rather than refund of an overpayment, and does not mention offset against other tax liabilities. For wrongful liens, Section 6325(b)(4) refers to the refund of a “deposit” and again does not mention offset against other tax liabilities. (The term “deposit” is explicitly distinguished from the term “payment” in other contexts; the former must be returned, regardless of the statute of limitations for refunds, on request without requiring proof of an overpayment.) And Section 7426 refers to payment of judgements, again without any mention of crediting the judgement amount against other tax liabilities. None of these provisions references Section 6402(a). A definitive court ruling would be nice but even without it I think the best interpretation of the statutory framework is that there is no right to unilaterally offset recoveries from a wrongful levy or lien against other liabilities the taxpayer may have.

Not allowing the IRS to offset these remedies for wrongful levies or liens against a third party also makes sense. The existence of an overpayment by the party liable for the tax does not imply any error or wrongful action by the IRS; a wrongful levy or lien does. Further, offset could be abused by the IRS to avoid the consequences of such error or wrongful action as well as procedural safeguards for collection actions in those other years.

An example, albeit extreme, of such abuse in a different context is described in Kabbaby v. Richardson, 520 F.2d 334 (5th Cir. 1975). Local police arrested the plaintiff and found cocaine, a substantial amount of cash, and assorted weapons and pieces of jewelry in his car. The police notified the IRS, which issued a termination assessment and seized the property. The IRS later abated the assessment, presumably because of previous court decisions invaliding such assessments when the IRS did not issue a subsequent notice of deficiency. But the IRS refused to return the property because it was an “overpayment” and could be credited to the plaintiff’s unsatisfied tax liabilities for other years. The court rejected that argument. The termination assessment without appropriate factual foundation was an abuse of authority. Allowing the IRS to keep the property would give the IRS an advantage and defeat procedural safeguards. Some other courts have disagreed; these are not always sympathetic plaintiffs.

Interest

Interest is payable on recovery of a wrongful levy or deposit to challenge a wrongful lien, as well as on a judgement resulting from judicial review in district court. However, Sections 6325, 6343, and 7426 contain separate interest provisions – with references to the overpayment interest rate in Section 6621 – rather than simply stating that Section 6611 applies. The amounts may be the same but other interest provisions, such as “restricted interest” and interest netting, may not apply to interest paid pursuant to Sections 6325, 6343, and 7426.

Based on these differences in judicial review, authority to offset, and interest, I think there’s a very strong case that Wife 2’s share of the sale proceeds, paid by mutual mistake in order to discharge the lien, was not an overpayment.

If this was not an overpayment, what effect does that have?

Obviously, the fair result is that Wife 2 can recover her share of the sale proceeds. But if the IRS had resisted, it’s not entirely clear whether Wife 2 was legally entitled to any relief at all. She apparently didn’t use the process set forth in Section 6343(b)(4). When she and Husband sought a certificate of discharge, she didn’t request a substitution of value as a deposit to be held by the IRS pending a determination whether the value of the government’s interest in the property included her half-share. If she had noticed the error in time, she might have done that or even obtained a revised Letter 403. It appears that she and Husband instead made a payment under Section 6343(b)(2), with a later refund claim. If Sections 6343(b)(4) and 7426(a)(4) really are the exclusive remedies for a wrongful lien, the IRS might have been able to push back successfully. Perhaps a court would decide that a refund claim and suit under Williams should still be available, but it seems unlikely.

Assuming that the IRS did the right thing and agreed that she should get her share of the sale proceeds back, though, could the IRS unilaterally offset part of that against her and Husband’s tax liabilities Year 12 and 13? I’m not aware of any case law specifically on point but for the reasons described above I think Section 6402(a) doesn’t apply to such amounts and the IRS has no authority to make such offsets unilaterally. Husband and Wife 2 may have consented to that offset, because they wanted to resolve the liabilities or didn’t want to force the IRS to jump through the procedural hoops for a levy, but the CCA doesn’t mention anything about that. Other taxpayers might not want to give up the cash.

What about interest computation with respect to the credits to Husband and Wife 2’s tax liabilities for Years 12 and 13? The CCA’s answer is reasonable but how can you evaluate whether it’s legally correct? Section 6325(b)(4)(B) doesn’t provide the answer because it also doesn’t provide for offset against other tax liabilities.

Conclusion

Tax law is not always clear – as Bayless Manning ponders in Hyperlexis and the Law of Conservation of Ambiguity: Thoughts on Section 385, 36 Tax Law. 9 (1982):

Consider the United States Constitution. The Constitution is open-ended, generalized and telescopic in character. What has it spawned? Pervasive ambiguity and unending litigation.

Contrast the extreme counter-model of law, the Internal Revenue Code and its festooned vines of regulations. The Code and regulations are particularized, elaborated and microscopic in character. What have they spawned? Pervasive ambiguity and unending litigation.

I might have reached the same answer as in the CCA. Sometimes a reasonable answer based on analogy is the best that can be achieved. The final result seems fair.

A Question of Identity – Interest Netting, Part 2

Today, guest blogger Bob Probasco brings us the second part of his post on interest netting. At the end of this part he refers to an article in the most recent edition of The Tax Lawyer. If you are a member of the ABA Tax Section you can link through to the article after signing in as a member. If you are not a member but have access to Heinonline, Westlaw or Lexis you can also get to articles of The Tax Lawyer. As the editor of that law review, I invite you to look at the articles there which explore issues in much more depth than we are able to do on the blog. I hope you would agree with me that after 70 years it continues to be a premier tax law review. If you have a law review article on tax you want to publish, consider sending it to The Tax Lawyer. Keith

We’re continuing to explore the “same taxpayer” issue for interest netting under Section 6621(d), for which the Federal Circuit issued an important decision in November. In Part 1 of this two-part series, I discussed other approaches to netting, the background of Section 6621(d), early IRS guidance, and the first of four major cases that have addressed this question. In Part 2, I’ll wrap up with the remaining cases plus some thoughts about the future.

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The evolution of “same taxpayer”

Section 6621(d) allows netting only of equivalent overpayments and underpayments “by the same taxpayer.” Part 1 covered what I consider one of the more interesting attempts at IRS guidance on this issue, Field Service Advice 2002-12028,. It concluded that to qualify for this benefit, one must “both be liable for the underpayment of tax, and entitled to the overpayment of tax.” This kept the restrictive adjective “same” while creating exceptions for mergers and consolidated returns by attributing overpayments or underpayments of one corporation to another. As taxpayers starting filing cases for expansive interpretations of “same taxpayer,” the DOJ retreated from the IRS guidance to very narrow interpretations that would, in practice, make interest netting virtually impossible for the large corporations that most need it.

Balances that arose prior to consolidation: Energy East Corp. v. United States, 645 F.3d 1358 (Fed. Cir. 2011), aff’g 92 Fed. Cl. 29 (2010). This case involved acquisitions in which the subsidiaries survived as members of an affiliated group and tried to net overpayments and underpayments for pre-acquisition tax years. The taxpayers lost. That was probably the right result, although I still have some reservations. The case was decided by a “temporal requirement” that later cases borrowed. Read Part I for the gory details.

And now on to the other three cases.

Attribution of an overpayment on a consolidated return to its members: Magma Power Co. v. United States, 101 Fed. Cl. 562 (2011). Magma Power had an underpayment for its 1993 tax return; it was acquired by CalEnergy on February 24, 1995; it was included thereafter on consolidated tax returns with CalEnergy and other subsidiaries; and the consolidated group overpaid its taxes for 1995-1998. The question was whether Magma’s 1993 underpayment could be netted against the consolidated group’s overpayments. If the situation were reversed – a 1993 overpayment by Magma and consolidated group underpayments for 1995-1998 – it would be an easier decision because all group members are severally liable for group underpayments. But this fact pattern is the one that FSA 200212028 answered as “theoretically possible.”

Magma provided an affidavit to the effect that a substantial portion of the overpayments by the consolidated group were attributable to Magma. How substantial? More than 100% of the reduction of consolidated taxable income resulting in the 1995 and 1997 overpayments; 92% of the reduction of consolidated taxable income resulting in the 1996 overpayment; and 79% of the reduction of consolidated taxable income resulting in the 1998 overpayment. The government disputed the plaintiff’s methodology and amounts but conceded that some portion of the overpayments were attributable to Magma.

The Court of Federal Claims’ opinion is one of the best and most comprehensive analyses of this issue I’ve read – kudos to the court and the litigants. I think it’s also potentially the most important for future developments in interpretation of Section 6621(d). The court interpreted “same taxpayer” as “same TIN.” In that respect it accepted the government’s argument. But the court also concluded that overpayments could be attributed to individual members of a consolidated group, not just underpayments (for which all members are severally liable per regulation); the government appeared to concede neither. The court also rejected the “complete identity” or “exact DNA identity” argument of the government. Key to the decision was the court’s observation that the group is not itself a taxpayer, merely a method of combining all the members for computing tax liability; the members of the group are the taxpayers. Further, the tax liability of the consolidated group must be allocated to individual members as part of tracking E&P for each member pursuant to Section 1552. Either individual members pay their allocated share of the tax liability or the amount they don’t pay would be treated as a contribution from the other member who did pay, Treas. Reg. section 1.1502-33(d)(1). Because the tax liability is allocated and payments by the group are allocated, that should be enough to allocate overpayments to individual members as well, shouldn’t it?

After a careful consideration of legislative history, previous IRS guidance, and the remedial nature of the legislation, the court held that pre-merger Magma Power and post-merger Magma Power “should be properly considered the same taxpayer to the extent the consolidated group’s overpayment can be traced to the company” (emphasis added). Because there had not yet been an agreement by the parties or determination by the court of how much of the overpayments could be attributed, the court ordered the parties to propose further proceedings to resolve the case.

The parties entered a stipulation as to the amount owed about eleven months later – interest computations can be difficult and securing the required government approvals for settlement can drag out – and the court entered judgment. The government filed a notice of appeal on November 20, 2012, and then filed a motion in the Federal Circuit to dismiss the appeal on December 12, 2012. We have no assurance of how the Federal Circuit would rule on this issue but apparently, DOJ was not confident or at least wanted to avoid the risk of an adverse precedent.

This analysis seems to follow the “attribution to a single entity” framing of FSA 200212028 rather than a “two entities are treated as the same taxpayer” framing.

Statutory mergers, various scenarios: Wells Fargo & Co. v. United States, 827 F.3d 1026 (Fed. Cir. 2016), aff’g in part and rev’g in part 119 Fed. Cl. 27 (2014). Stephen Olsen posted here a few years ago when the Court of Federal Claims and Federal Circuit opinions came out.

This case included many different factual circumstances, resulting from a series of seven mergers and 64 separate refund claims. The government and Wells Fargo identified three “test claims”; the principles would govern all of the claims. Wells Fargo (represented by the same firm that represented Magma Power) argued that merged corporations are always treated as the “same taxpayer,” regardless of the timing of the payments. The government argued that taxpayers are only the “same taxpayer” if they have the same TIN at the time of the payments.

Scenario One: Wachovia had an overpayment for 1993; First Union had an underpayment for 1999. The two merged in a statutory merger in 2001, and First Union survived. The government argued that the netting was not available because the two corporations had different TINs and were unaffiliated at the time of both the overpayment and the underpayment.

Scenario Two: First Union had an overpayment for 1993, underwent four statutory mergers between 1993 and 1999 (in each of which it was the surviving corporation), and First Union had an underpayment for 1999. The government conceded the availability of netting in this situation; “the underpaying and overpaying company retained the same TIN because it was the surviving corporation in the mergers.”

Scenario Three: CoreStates had an overpayment for 1992 and merged with First Union in 1998 with First Union surviving. Then First Union had an underpayment for 1999. The government argued that netting was not available because the two corporations had different TINs.

The Federal Circuit mentioned the “same taxpayer = same TIN” rule from Magma Power, without explicitly adopting the rule. But it mischaracterized the Court of Federal Claim’s application of the rule as that “the consolidated group or corporations met the ‘same taxpayer’ requirement because they shared a single TIN.” As discussed above, that is not what the CFC did in Magma Power. The court focused on the TIN of the subsidiary, Magma Power, rather than the consolidated group. It allowed netting, but only if the consolidated return’s overpayment could be traced or attributed to the company.

Based on merger law, the Federal Circuit concluded that two merging corporations are the “same” regardless of which survives. The Court of Federal Claims declined to apply the temporal requirement from Energy East because joining an affiliated group (when both corporations maintain their separate identity) differs from a statutory merger (in which only once corporation survives). But the Federal Circuit disagreed, applied the temporal requirement, and allowed netting in Scenario Three but not in Scenario One.

In Energy East, the Federal Circuit seemed to say that the taxpayer must be the same before both the underpayment and the overpayment. Of course, that was the situation being decided; the court wasn’t dealing with a situation with an overpayment made prior to the acquisition. But in Wells Fargo, the court allowed netting in Scenario Three, when the overpayment was made prior to the merger. Apparently, the requirement is that the taxpayer must be the same when the overpayments or underpayments are made. That seems plausible; there are no overlapping balances to be netted until the second balance comes into existence.

I don’t find the temporal requirement imposed in Energy East and Wells Fargo completely persuasive. The court interpreted an overpayment or underpayment as being associated with a particular date rather than a period. That’s understandable, given the language in Sections 6601(a) and 6611(b). But I think the antiquated language of the Code has effectively been superseded by Avon Products Co. v. United States, 588 F.2d 342 (2d Cir. 1978), and the realities of tax administration. In Avon Products, the Second Circuit concluded that individual transactions must be netted into a single balance before computing interest. The IRS has acquiesced in not only the result of that case but also the reasoning. Over a period of time, the single balance required by Avon Products may change from underpayment to overpayment back to underpayment, and the traditional determinations of the “date” of an overpayment and underpayment no longer fit well. They are better considered in terms of a period rather than a particular date when they arise. Admittedly, no court has yet reached the same conclusion.

Further, the “last antecedent rule” is simply an interpretative standard, not an ironclad rule any more than other canons of statutory construction. Given the remedial nature of netting, it would have been possible to interpret the provision more broadly. Even if both the underpayments and overpayments began before the merger or joining into an affiliated group, netting might be permissible if both are still outstanding afterward. At that point, once the two corporations become the “same taxpayer,” the harm that Section 6621(d) is intended to remedy exists. Netting might be allowed from that point. This argument is likely stronger for mergers than for affiliated groups that file consolidated returns.

But that’s not what the court ruled.

Not part of the parent’s consolidated return: In Ford Motor Company v. United States, 908 F.3d 805 (Fed. Cir. 2018), aff’g 132 Fed. Cl. 104 (2017), the court concluded that Ford Motor Company (“Ford”) and a wholly-owned subsidiary were not the “same taxpayer” for purposes of interest netting. Against the backdrop of the earlier cases, Ford seems an even harder case for the taxpayer to win. Ford formed Ford Export Services B.V. (“Export”), its wholly-owned subsidiary, in 1984 as a foreign sales corporation. Because FSCs must be foreign rather than domestic corporations and a consolidated group cannot include foreign corporations, Ford and Export filed separate U.S. income tax returns between 1990 and 1998. Ford had an overpayment for the 1992 tax year and Export underpaid its taxes for 1990-1993 and 1995-1998. Ford claimed that Ford and Export were the same taxpayer because Ford “exercised near complete control over Export’s operations” and “Export never performed any activity that Ford did not direct.”

Instead of relying on a dictionary, the Federal Circuit concluded that the meaning of “same taxpayer” depended on “background legal principles” at the time Congress enacted Section 6621(d). One of those background legal principles was that a parent corporation and its subsidiaries are separate taxable entities. (Cases cited in the opinion concluded that even if the parent and subsidiaries join to file a consolidated return, the group is not as a single entity and individual members retain their identity.) The court identified “the unique legal effects of a merger” as an exception to that general rule, citing Wells Fargo. Ford argued that the FSC statute was another relevant background legal principle that would constitute an exception to the general rule, but the court disagreed. There was no statutory provision for FSCs comparable to the continuation of the identity of the acquired corporation in the successor corporation after a merger.

The plaintiff’s arguments here were based on control and direction because of the factual situation: Export was not a member of the affiliated group that filed a consolidated return. That suggests that the decision may be relatively narrow in scope and may also help explain why the court reached this decision. This level of “control and direction” will most often occur with a subsidiary that meets the 80% voting and value test for an includible corporation in an affiliated group (even if not includible for other reasons such as being a foreign corporation). Consider three categories such subsidiaries might fall into: (a) included in the affiliated group; (b) not included in the affiliated group but a foreign corporation with no US income; and (c) not included in the affiliated group but a corporation that files a US tax return. If the Federal Circuit eventually blesses netting involving attribution from consolidated returns, similar to FSA 2001-12028 and Magma Power, the effect of the decision in Ford may be limited to category (c). Further, allowing netting based on control and direction, rather than attribution from a consolidated return, would impose more of an administrative burden on the IRS because the factual determination is more difficult. It’s not well suited for a general background legal principle to apply as an interpretation of “same taxpayer.” On the other hand, netting with subsidiaries who meet the 80% test but are not includible for other reasons, might be a viable test.

What does the future hold?

The boundaries of “same taxpayer” are still not entirely clear. Because most netting claims include a request for additional overpayment interest, these cases will usually be brought in the Court of Federal Claims rather than district court. Review by the Supreme Court and legislative action both seem unlikely in the extreme. So the Federal Circuit’s decisions carry a lot of weight. But there are some possibilities the Federal Circuit has not yet ruled on.

In a statutory merger, the Federal Circuit will allow netting of a pre-merger balance against a post-merger balance but not if both balances are from pre-merger years. If a taxpayer or the government wants to change that, it will be difficult to do just through litigation.

The Federal Circuit has never directly ruled on netting in the context of consolidated returns. Energy East and Wells Fargo involved mergers; a Magma Power appeal was dismissed on the government’s request; and Ford involved a subsidiary that was not consolidated. The opinion in Ford seems to suggest that these situations are not an exception to the general rule that a parent and its subsidiaries are separate entities and therefore are not the same taxpayer. I don’t think that necessarily precludes netting, though.

First, I suspect that as a practical matter the IRS has been allowing netting administratively, and thus there have been no lawsuits, in circumstances where one member has an overpayment based on a separate tax return and the consolidated return has an underpayment. We haven’t seen such a case in the Federal Circuit and I would expect to by now if the IRS were disallowing the claims. If that’s correct, I’m not sure that the opinion in Ford will be enough for the IRS to change its administrative practice.

Second, treating a parent and its subsidiaries as separate entities does not preclude netting if you allow attribution of underpayment and overpayments to individual members of the affiliated group. Then, as in Magma Power, you are dealing with a single taxpayer; the attribution results in one taxpayer having equivalent overpayments and underpayments outstanding at the same time. The Federal Circuit has not addressed the attribution theory and, based on its mischaracterization of Magma Power in Wells Fargo, may not have considered it yet.

Netting in the context of consolidated returns, under an attribution theory, will still create administrative issues. Even in simple netting claims, the taxpayer cannot use balances if it has previously used them for netting. For example, if Corporation A nets a 2001 underpayment against a 2004 overpayment, Corporation A cannot later net the same 2001 underpayment against a 2006 overpayment. This would apply for netting under an attribution theory in the context of consolidated returns. Further, the netting claim would have to provide documentation to support the attribution. But such administrative issues should not be an impediment. Revenue Procedure 2000-26 simply shifts the burden to the taxpayer requesting netting. A more significant problem with netting in the context of consolidated returns might arise with respect to disputes between members of the group about the attribution – particularly after a member has left the group but still wants to net past balances as part of the group against post-departure balances.

Are there situations other than mergers and consolidated returns that might supply “background legal principles” to justify netting? Contractual assignments of tax liabilities and the right to refunds of overpayments might be a possibility, although courts are often reluctant to be bound by those when deciding tax issues. There may be others.

Even if the Federal Circuit is unlikely to approve netting in the consolidated return context or other situations, it’s worth still contesting issues on which the Federal Circuit has not yet ruled. Interest disputes for the largest corporations can involve significant amounts, which alone justifies taking a shot. Ford, as an example, involved a $20 million claim while Wells Fargo involved a $350 million claim (although that included items other than netting).

Postscript

As I was finishing this post up, I received the latest volume of The Tax Lawyer, which includes an article “More of the ‘Same’: Section 6621(d) in the Federal Circuit” by David Berke, an associate at Skadden, Arps. He and I are not in complete agreement, but for those with an interest in a different perspective on this topic, it’s worth perusing.