Refund Claim Time Limits Create an Unwelcome Barrier

Today’s post is from occasional guest blogger Marilyn Ames, a retired Chief Counsel attorney. Marilyn is a Contributing Author who works with me on Saltzman and Book, IRS Practice & Procedure. She and I recently substantially revised the chapter on statute of limitations relating to refund claims, one of the trickiest areas in tax procedure. We also have just completed the last treatise update of the 2020 calendar year, and in that update we came across the sad case of Koopman v United States, which, as Marilyn discusses below, highlights how the rules in Section 6511 can lead to some harsh results. Les

For even the most experienced tax lawyers, one of the most confusing parts of the Internal Revenue Code is Section 6511, which sets out the statute of limitations for refund claims. For most claims, the requirements for filing a timely refund claim are contained in Section 6511(a) and (b), which consists of two parts. First, Section 6511(a) requires the claim for the refund to be filed with a period of three years from the time the return was filed or two years from the time the tax was paid. However, this is only the first hurdle that a taxpayer must successfully cross in order to get a refund. Section 6511(b) then provides that the amount of the refund is limited to the tax paid within the three-year period immediately before the claim is filed if the taxpayer filed the claim within three years from filing the return, as set out in section 6511(a). If the taxpayer had an extension to file the return, that period is added to the three-year period of subsection 6511(b) for determining the amount of the claim allowed. If the claim was filed within subsection (a)’s two-year period, then the refund is limited to the tax paid within the two years immediately prior to the claim. The two-year rule allows taxpayers to file a claim for refund if the taxpayer pays the tax more than three years after filing the return, and then wishes to challenge some aspect of the tax within two years of the payment. The subsection (b) limitations are often referred to as the “look-back” rules. Because of the look-back rules, taxpayers can file a claim for refund that is timely, but still be barred from receiving any part of the refund. The Supreme Court determined in United States v. Clintwood Elkhorn Mining Co. (553 US 1 (2008)) that taxpayers must meet the Section 6511 requirements in order for the court to have jurisdiction to hear a refund suit. (It should be noted that Section 6511 has a long list of exceptions to the Section 6511(a) and (b) requirements that apply in special cases.)

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These two requirements work together in a sometimes-Byzantine way that can create results that seem unfair to taxpayers.  The recent case of Koopman v. United States decided by the Court of Federal Claims in September of this year, illustrates the difficulties a taxpayer can encounter when trying to meet the requirements of both subsections (a) and (b) of Section 6511.  The taxpayer, William Koopman, retired from United Airlines in 2001. When he retired, he was covered by United’s non-qualified deferred compensation plan. Because of the special timing rule for FICA taxes, Mr. Koopman was required to pay the relevant portion of FICA on the present value of his deferred compensation in 2001, the year he retired, although he was to receive his benefits under United’s plan from 2001 through 2006. Unfortunately for Mr. Koopman, United filed a Chapter 11 bankruptcy in 2002, and he only received $248,293 of his deferred compensation instead of the $415,025.91 on which he paid FICA tax.  Instead of cash, he eventually received common stock in partial compensation, with the last distribution of the stock occurring in April of 2007.  

Mr. Koopman, unhappy he had paid FICA taxes on compensation he did not receive, filed a claim for refund in August of 2007 seeking a refund of the FICA taxes paid on the difference between the amount he actually received as deferred compensation and the amount on which he paid the tax. He subsequently filed suit in the Court of Federal Claims, and the United States filed a motion for lack of jurisdiction based on Mr. Koopman’s failure to meet the requirements of section 6511. Although Mr. Koopman was seeking a refund of only $2,416, he was not the only unhappy former United employee; the court notes that he had a co-plaintiff and that there are other cases involving the same issue.  

In ruling on the government’s motion to dismiss for lack of jurisdiction, the court held that under the deemed paid rules of Section 6513(c), United’s quarterly returns for 2001 were deemed filed and the FICA tax included on the returns was deemed paid on April 15, 2002.

Under Section 6511(a), Mr. Koopman only had until April 15, 2005 –three years after the returns were filed—to file a timely refund claim.  He missed that date by over two years.  Additionally, the court determined, under the look-back rules, the taxes were paid no later than April 29, 2004, as United had transferred credits to its FICA taxes for 2001 as late as April 29, 2002. Under Section 6511(b), no amount was paid within either the three-year or two-year periods looking back from the filing of the claim. Accordingly, because neither the three-year or two-year rule of Section 6511(a) was met, the court held it did not have jurisdiction over Mr. Koopman’s refund suit.

Mr. Koopman, pointing out the unfairness of this due to the litigation in the United bankruptcy that had prevented the final distribution being made to him any earlier, raised several arguments to try and overcome the barriers of Section 6511.  The court quickly disposed of his argument that Section 6511 did not apply to FICA taxes, as the statute expressly provides that it applies to any tax imposed by the Internal Revenue Code.  The court then rejected his argument that the statute of limitations should be equitably tolled, as the final determination that United was not going to pay him the full amount of the deferred compensation was made long after the statute of limitations on filing a refund claim expired.  Based on precedent, the court concluded that there is no equitable tolling of the refund statute of limitations as general principles of equity may not override the statutory requirements.  Mr. Koopman also argued that the statute of limitations should not begin running until the taxpayer has an opportunity to learn that the tax has been paid in error.  The court also rejected this argument, based on the precedent of another Supreme Court case, United States v. Dalm (494 US 596 (1990)). Although Mr. Koopman argued that application of Section 6511(a)’s time periods to his situation was unconstitutional under the due process clause, the court concluded that the United States can only be sued in its own courts under the express authorization given by Congress.  

Although situations such as Mr. Koopman’s seem to cry out for a remedy, Mr. Koopman could have acted earlier to protect his rights.  United filed bankruptcy in 2002, which should have been a red flag to Mr. Koopman that he was not going to receive all his deferred compensation.  He could have filed a protective claim for refund any time before April 15, 2005 that would have been timely, and then waited for the result of the bankruptcy litigation that was delaying a final determination as to his treatment.  The Internal Revenue Service is not only familiar with protective refund claims, but in some cases, reminds taxpayers who may be affected by ongoing litigation to file such a claim.  Earlier this year, the IRS issued a notice that the due date for filing a protective claim for the 2016 tax year for individual tax payments had been postponed until July 15, 2020, with an emphasis that this included claims involving the Affordable Care Act litigation.  The protective claim procedure allows tax practitioners to protect taxpayers whose rights may be affected by current litigation or expected changes in the law from being caught up in the Draconian maze of Section 6511 without a right to recourse if they wait for a final outcome.

Tax Refunds and the Disposable Income Test

We welcome back occasional guest blogger Marilyn Ames, who like me is retired from the Office of Chief Counsel, IRS and who did a lot of bankruptcy work when she worked for the government.  She discusses today a recent 5th Circuit case allowing the debtor to keep an earned income tax credit despite some local rules in Texas requiring her to turn a part of it over.  Although the 5th Circuit does not base its decision on the fact that the refund resulted from the earned income tax credit, that fact plays an important role.  Keith

As illustrated by the Covid-19 payments recently dispersed by the Internal Revenue Service and the use of the IRS to carry out portions of Obamacare, Congress frequently uses the IRS and the Internal Revenue Code as a means of administering social programs that have little or nothing to do with taxes. One of the problems of using the IRS to execute these types of programs is that courts assume that all provisions in the Internal Revenue Code are tax-related, which can, at worst, result in decisions at odds with the purposes of these programs, and at best, create precedent that fails to acknowledge Congressional intent.

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The Fifth Circuit’s recent decision in the bankruptcy case of Matter of Diaz (found here or at 2020 WL 5035800) illustrates this issue. While the Fifth Circuit reached what is clearly the right conclusion under the Bankruptcy Code, it did so without recognizing why its decision was correct as a matter of policy. The Diaz case involves the amount of a tax refund that must be turned over as part of a Chapter 13 plan as disposable income, to be paid to general unsecured creditors. The bankruptcy court, the district court and the Fifth Circuit all failed to state why the debtor had a refund, but the Fifth Circuit does provide enough facts for an educated guess to be made that Ms. Diaz’s refund for 2017 resulted from the earned income credit. During 2017, Ms. Diaz worked as a medical assistant, and earned $2,644.16 per month, or a total of $29,791 for the year. During this year, she was a single parent with two children.  She filed bankruptcy on December 1, 2017, but her bankruptcy schedules filed later included her refund for 2017 in the amount of $3,261. Assuming that Ms. Diaz filed a return showing three exemptions and claiming the standard deduction for a head of household of $9,350, her return for 2017 would have showed a taxable income of $8,291 and a tax liability of $828. Making another assumption that she qualified for the earned income credit, the EITC for 2017 would have been $3,208, or about the amount of the refund she claimed on her return. (The tax liability on her return could have been offset by the child tax credit, resulting in a refund of any withholding, and she could also have been entitled to the additional child tax credit, but close enough given the facts available.)

Ms. Diaz filed bankruptcy in the Western District of Texas, which uses a standard form for Chapter 13 plans. Section 4.1 of the standard form provides that the debtor must turn over any tax refunds in excess of $2,000 to be disbursed to creditors pursuant to the plan by the Chapter 13 trustee. The only exception to turning over these funds is if the debtor’s plan provides for payment of 100% of the general unsecured claims, the debtor files a notice requesting that she be permitted to keep the excess refund amount, and the trustee does not object. Ms. Diaz could not make such a request, as her plan provided for only 12% of the general unsecured claims to be paid. Rather than filing a plan providing for the excess amount of $1,261 from her 2017 refund to be turned over to the Chapter 13 trustee, Ms. Diaz filed a plan that divided the total amount of her refund by 12 months, and then included that portion in her monthly income.  Provision 4.1 of the standard form was then stricken through. When the refund was included as part of her monthly income, the plan was adequate to meet the requirements of the Bankruptcy Code.

This gerrymandering did not sit well with the Chapter 13 trustee, who objected to the plan as it did not meet the provisions of Section 4.1 of the standard plan.  Ms. Diaz argued that the plan violated both the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure. The bankruptcy court and the district court for the Western District of Texas disagreed, holding that the district court had authority to require that a standard Chapter 13 plan be used pursuant to the provisions of Federal Rule of Bankruptcy Procedure 3015.1, and that tax refunds are disposable income under Bankruptcy Code § 1325(b)(2) that must be included in the plan. The bankruptcy court rejected the debtor’s argument that her tax refund was similar to payments received for dependent adult children that are excludable from a debtor’s disposable income, apparently not recognizing that all or part of the debtor’s refund was probably attributable to the EITC, which is computed based on the number of dependents a taxpayer has. The district court affirmed the ruling of the bankruptcy court with even less consideration of why the debtor was entitled to a refund.  The bankruptcy court opinion can be found here (586 BR 588) and the district court opinion can be found here (2019 WL 4545613).

The Fifth Circuit disagreed that the debtor was required to turn over the refund, relying on Bankruptcy Code § 1325. If a plan does not provide for an allowed unsecured claim pursuant to § 1325(a), the plan cannot be confirmed unless the debtor includes all projected disposable income to be paid out to general unsecured creditors. Ms. Diaz’s plan did not provide for her unsecured creditors pursuant to § 1325(a), so she could only have a plan confirmed that included all projected disposable income. Noting that district courts may not adopt local rules or create standard plans that abridge, enlarge or modify any substantive right, the Fifth Circuit focused on whether the tax refund in excess of $2,000 was part of the debtor’s projected disposable income that had to be turned over to the Chapter 13 trustee.

Although the Bankruptcy Code does not define projected disposable income, § 1325(b)(1)(B) does state how it is to be calculated. Disposable income is the current monthly income received by the debtor, less “amounts reasonably necessary to be expended” for the debtor’s maintenance and support, plus any qualifying charitable contributions and business expenditures. Current monthly income is calculated by averaging the debtor’s monthly income in the six full months preceding the bankruptcy petition. The definition of “amounts reasonably necessary to be expended” is included in §1325(b)(3), and is different depending on whether the debtor has monthly income, when calculated for a year, greater than the median family income of the applicable state.  This amount can vary depending on the number of individuals in the household. If the debtor has current monthly income, when calculated over 12 months, greater than the applicable state median family income, only those expenses included in Bankruptcy Code § 707(b)(2) are included as amounts reasonably necessary.  If the debtor has less than the applicable median amount, all amounts for the maintenance or support of the debtor or the debtor’s dependents are included.

In the Diaz case, Ms. Diaz’s current monthly income, projected over 12 months, was less than $59,570, the median income for a family of her size in Texas in 2017. The expenses she claimed on her bankruptcy schedules totaled far less than the IRS National Standards for a family of the same size.  The Fifth Circuit concluded that “[W]e find it entirely plausible that Debtor will use her ‘excess’ tax refund of $1,261 for expenses that are reasonably necessary for her family’s maintenance and support.” Because the standard form required Ms. Diaz to turn over the tax refund in excess of $2,000 without determining whether the excess was an amount reasonably necessary to be expended, it violated her substantive right as a below-median income debtor to retain any refund reasonably necessary to be expended for her family’s support.

Although reaching the correct decision under the Bankruptcy Code, the Fifth Circuit failed to consider whether the refund was generated by the EITC and, if so, whether that fact should be considered in determining whether a debtor should be required to include these funds. The earned income tax credit was enacted in part to provide relief for low-income families. Hopefully, the provisions of Bankruptcy Code § 1325(b)(1)(B) expanding the amounts that can be considered to be amounts reasonably necessary to be expended for the maintenance and support of families with incomes below the median income of the state will be sufficient to continue to protect the relief Congress granted to low-income families through the EITC provisions. However, the fact that Ms. Diaz was required to appeal her case to the Fifth Circuit in order to protect her rights argues for an opinion that more explicitly recognizes the purposes of the EITC.

Trying to Find Order in the Anti-Injunction Act and the Tax Injunction Act

We welcome back Marilyn Ames who has blogged for us several times in the past.  She graciously agreed to write about some recent litigation that highlights the confusion currently surrounding these provisions.  Keith

In the past few weeks, I have been revising the subchapter in Saltzman and Book, IRS Tax Practice and Procedure on the Anti-Injunction Act.  It has been an exercise in frustration, as, although the Supreme Court says it likes “rule[s] favoring clear boundaries in the interpretation of jurisdiction statutes,” it doesn’t necessary mean what it says.  That’s a quote from Direct Marketing Association v. Brohl, 135 S. Ct. 1124, 1131 (2015), discussing the lesser known sibling of the AIA, the Tax Injunction Act, which is aimed at preventing federal courts from hearing suits intended to restrain the assessment, levy, and collection of state taxes.  And in the midst of this attempt to make some sort of order out of something which does not have any, two district courts have added their opinions to the fray.

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In State of New York, et al. v. Mnuchin, which can be found here, the Southern District of New York takes on the issue of whether the Anti-Injunction Act prevents four states from bringing suit to litigate the constitutionality of the $10,000 ceiling placed on the deduction of state and local taxes (SALT) by the 2017 Tax Cuts and Jobs Act. The federal government raised three challenges to the Court’s subject matter jurisdiction, including the limitation imposed by the Anti-Injunction Act (AIA). The AIA, located at 26 USC § 7421(a) provides, with numerous exceptions, that “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed.”  (For those of you interested in historical/legal trivia, the initial iteration of the AIA was passed in 1867.) In addition to the exceptions to the AIA actually contained in the statute, the Supreme Court created a judicial exception to the AIA in Enochs v. Williams Packing & Navigation Co.,370 U.S. 1 (1962), requiring the plaintiff to meet a two-part test to overcome the bar of the AIA: (1) it is clear at the time the suit is filed that under no circumstances could the government prevail on the merits; and (2) the action at issue will cause the plaintiff irreparable injury. And with this opinion, the race began to explore the boundaries of this court-made exception. 

One of these cases, and the one relied on by the court in State of New York v. Mnuchin, is South Carolina v. Regan,465 US 367 (1984).  In Regan, South Carolina invoked the Supreme Court’s original jurisdiction and asked leave to file a complaint against Donald Regan, the Secretary of the Treasury at the time to litigate whether a provision of TEFRA was unconstitutional. The provision in question required state obligations to be issued in registered rather than bearer form in order to qualify as tax exempt under IRC § 103.  The government raised the AIA in its objection to South Carolina’s motion, arguing that the state did not fall within any of the specific exceptions or within the judicial exception created in Williams Packing.  The Supreme Court then created an exception to its exception, holding that the AIA was not intended to bar a suit when Congress has not provided the plaintiff with an alternative legal way to challenge the validity of a tax.  Because South Carolina was not liable for a tax which it could then pay and use as the basis for a refund suit, it had no other way to litigate the constitutionality of the TEFRA provision.  In this situation, the Supreme Court said “a careful reading of Williams Packing and its progeny supports our conclusion that the [AIA] was not intended to apply in the absence of such a remedy.”

In State of New York v. Mnuchin, four states that impose lots of state and local taxes sued to have the $10,000 ceiling on the deduction of SALT declared unconstitutional.  The federal government argued that the suit was barred by the AIA and that the Williams Packing exception did not apply.  This is not like South Carolina v. Regan, the federal government argued, because the taxpayers affected in these four states have a motivation to file refund actions to challenge the law.  (It’s not clear from the opinion why the federal government felt that the bond holders in Regan who bought bonds that no longer qualified as tax exempt would not have a similar motivation.) The district court rejected the federal government’s argument, and noted that in both Regan and the suit before the court, the plaintiff-states were seeking to protect their own interests, rather than those of their taxpayers. In this situation, the court in State of New York v. Mnuchin held, a state has no other legal remedy to assert its sovereign interests. When a plaintiff has no other legal remedy to litigate the issue, then the AIA does not apply even if the plaintiff cannot meet the Williams Packing test.  Having won the jurisdictional battle, the states in New York v. Mnuchin then lost the war when the district court held that the ceiling on SALT deductions is constitutional.  Lots for everyone to argue about on appeal.

The second opinion of American Trucking Associations, Inc. v. Alviti, 377 F.Supp.3d 125 (D.R.I. 2019)involves the Tax Injunction Act, 28 USC § 1341, which provides “the district courts shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under State law where a plain, speedy and efficient remedy may be had in the courts of such State.” As the Supreme Court recognized in Williams Packing, the TIA “throws light on the proper construction to be given” to the AIA.  In other words, these statutes have similar language and purpose. In the Alviti case, which can be found here, the plaintiffs are long distance trucking companies and associations that filed suit against the state of Rhode Island challenging the constitutionality of a bridge toll scheme.  The statute, known as the “Rhodeworks” Act, expressly prohibits the imposition of the bridge toll on any vehicles other than large commercial trucks. Under the Rhodeworks Act, the toll is set by state agencies in terms of the amount and the locations where it will be collected, and the funds go into a special account to be used only for the replacement, rehabilitation, and maintenance of bridges. The scheme instituted sets maximum daily amounts that can be collected based on the routes traveled, which the plaintiffs argue falls more heavily on trucks involved in interstate rather than intrastate travel.

The state of Rhode Island raised the TIA as a defense to the suit, arguing that although the fees were labelled as tolls, they were actually taxes subject to the TIA.  Although the Supreme Court has indicated it prefers clear boundaries, the district court framed the issue as one “which pits the actual language of the TIA and the context surrounding its enactment in the 1930s against several more modern decisions of the First Circuit that attempt to distinguish between fees and taxes.” In other words, let’s make this more confusing. The district court then cited a number of cases decided prior to enactment of the TIA, including one decided by the Supreme Court in 1887, that a toll is not a tax and that they are distinct and serve different purposes. Despite these decisions, the court then discussed whether the exaction in question fell within the three-pronged test of San Juan Cellular Telephone Co. v. Pub. Serv. Comm’n of P.R., 967 F.2d 683 (1st Cir. 1992), the purpose of which is to decide if a challenged assessment is more like a tax or a regulatory fee.  Despite finding that two of the three prongs were more in the nature of a fee, the court relied on the final prong of the test to decide the bridge tolls were actually taxes, and the suit was thus barred by the TIA. The case has been appealed to the First Circuit, and as the trucking company plaintiffs note in the brief to the circuit, this is the first case involving an exaction labelled a toll that has been found to be a tax.

It seems that while the mirage of clear boundaries for the AIA and the TIA is out there, the courts have difficulties in making their way to it.  I am reminded of a scene from Monty Python and the Holy Grail – “Bring me a shrubbery.” “Not THAT shrubbery.”

And we go on trying to make sense of what the courts really want.

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

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

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

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

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

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

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

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

When Does Interest Start Running on a Transferee Liability

We welcome back guest blogger Marilyn Ames. Marilyn is retired from Chief Counsel’s office but works with us on IRS Practice and Procedure assisting with many chapters because of the breadth of her knowledge. She has done a lot of writing on transferee liability and provides insight on a recent case in that area. Keith

When a taxpayer has an unpaid income tax liability, the Internal Revenue Code is clear that interest on the unpaid tax accrues from the original due date of the return. However, when the Internal Revenue Service attempts to collect liability under Internal Revenue Code § 6901, the transferee liability section, questions arise as to the ability of the IRS to collect interest on the unpaid tax debt.  Because Section 6901 is merely a procedural law, the Internal Revenue Service must look to state law or other federal law for the substantive provisions that allow collection of taxes from a person who receives property from the taxpayer. The Internal Revenue Code provides that a transferee is liable for interest on the unpaid tax debt after the Internal Revenue Service issues a notice of transferee liability, but does state law govern the collection of interest before this date? The Ninth Circuit addressed this in the recent case of Tricarichi v. Comm’r, 122 AFTR2d 2018-6634 (9th Cir. Nov. 13, 2018). 

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The transferee in this case, Michael Tricarichi, was the sole shareholder of West Side Cellular, Inc., which received a $65 million settlement in 2003. Before its return for 2003 was due, Mr. Tricarichi, who was then a resident of Ohio, sold his West Side stock in a “Midco” tax-shelter transaction, leaving West Side Cellular with insufficient assets to pay its corporate income taxes for 2003. Mr. Tricarichi received about $35.2 million in the transaction, and then moved to Nevada to enjoy the fruits of his labors. (The workings of the Midco transaction, which have been the subject of frequent litigation in the recent past, are outlined in Diebold Foundation, Inc. v. Comm’r, 736 F3d 172 (2d Cir. 2013)).

In 2012, the Internal Revenue Service issued a notice of transferee liability to Mr. Tricarichi, which was duly litigated in the Tax Court, the result being that the Tax Court determined that Mr. Tricarichi was liable for the full amount of West Side’s tax deficiency and the associated penalties and interest in the tidy total sum of about $35.1 million. In a separate opinion, the Ninth Circuit affirmed the Tax Court’s conclusion that Mr. Tricarchi was liable as a transferee under Internal Revenue Code § 6901 and the Ohio Uniform Fraudulent Transfer Act, leaving the question of when and whether a transferee is liable for the amount of interest due on the transferor’s tax liability before the notice of transferee liability is issued to this opinion.

Mr. Tricarichi, the transferee, argued that Ohio law determined his liability for any interest before the notice of transferee liability was interested. Under Ohio law, Mr. Tricarichi would have owed nothing instead of the nearly $13.9 million that accrued between the due date for the 2003 return and the issuance of the notice of transferee liability in 2012. He cited the Supreme Court’s decision in Commissioner v. Stern, 357 US 39 (1958), for the proposition that state law should determine the existence and extent of transferee liability, including the amount of the interest that can be collected on the underlying claim – which in Mr. Tricarichi’s view would be the tax and penalties owed by the taxpayer, but not the interest that accrued between the due date of the taxpayer’s 2003 return and June of 2012 when the IRS issued the notice of transferee liability.

The Ninth Circuit disagreed, holding that Internal Revenue Service’s claim is computed under the Internal Revenue Code, and will include statutory interest. The extent of the liability to be determined under state law is actually a question of the amount of the claim that can be recovered from the assets transferred. When the taxpayer transfers sufficient assets to pay the underlying claim, including the interest that has been accruing under the Internal Revenue Code for the unpaid tax liability, it is unnecessary to look to state law for the creation of a right to interest. It is only necessary to look to state law for interest when the assets transferred are insufficient to satisfy the total claim for the liability of the transferor/taxpayer. In that case, the relevant state law determines whether the Internal Revenue Service may recover any prejudgment interest beyond the value of the assets transferred. The Ninth Circuit adopted the “simple rule” formulated by the First Circuit in Schussel v. Werfel, 758 F3d 82 (1st Cir. 2014) that “the IRS may recover from [the transferee] all amounts [the transferor] owes to the IRS (including section 6601 interest accruing on [the transferor’s] tax debt), up to the limit of the amount transferred to [the transferee], with any recovery of prejudgment interest above the amount transferred to be determined in accord with [state] law.”

Under this relatively simple rule, because West Side’s tax deficiency, including interest and penalties was $35.1 million, and Mr. Tricarichi received $35.2 million in assets from West Side, an amount in excess of West Side’s tax liability, Mr. Tricarichi was liable for the full amount of the $35.1 million. The fact that Mr. Tricarichi will also be liable for interest as a transferee from the issuance of the notice of transferee liability in 2012 is irrelevant to the determination that he received more from West Side in assets than the tax claim against West Side. As a resident of Nevada, Mr. Tricarichi should understand that his attempt to break the bank in his litigation with the IRS has left him busted.

 

 

 

 

Does IRS Bear the Responsibility to Affirmatively Obtain a Ruling from the Bankruptcy Court before Pursuing Collection after Discharge?

We welcome back guest blogger Marilyn Ames. Marilyn is retired from Chief Counsel’s office and works with Les, Steve and me on updates to the treatise “IRS Practice and Procedure” which Les edits. Since her last guest post, she has moved from Alaska back to Texas where she lives much nearer to her grandchildren. She writes today about a recent First Circuit opinion that imposes a liability on the IRS for failing to prove that a debt was excepted from discharge. The failure of proof resulted from an unusual situation; however, the important issue in the case focuses on the responsibility of the IRS at the conclusion of a bankruptcy case. I have written about the fraud exception to discharge on several occasions. Here is a sample post on the topic if you want background on the underlying discharge issue. Keith

Both the Internal Revenue Code and the Bankruptcy Code are statutory schemes of almost mind-numbing complexity, and when the two collide, the results are generally ugly. Such was the case in Internal Revenue Service v. Murphy, a case of first impression from the First Circuit issued on June 7, 2018, which can be found here. The majority opinion, as noted by the dissent, has the result of “hiding an elephant in a mouse hole” and could significantly change the ability of the Internal Revenue Service to collect debts that are otherwise not discharged in a bankruptcy case.

The hiding of the elephant began in 2005, when Mr. Murphy filed a Chapter 7 bankruptcy, listing debts of $601,861.61. Of that amount, $546,161.61 was owed to the Internal Revenue Service for unpaid taxes for a number of years, and to the State of Maine for one year. The bankruptcy court entered Mr. Murphy’s discharge in February of 2006, which provided that the “discharge prohibits any attempt to collect from the debtor a debt that has been discharged.” For those without either personal or professional experience with a Chapter 7 discharge order, it does not list the specific debts that are or are not discharged. The Internal Revenue Service was given notice of the entry of the discharge.

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For three years after the entry of the discharge, the Internal Revenue Service informed Mr. Murphy that it believed his tax debts were not discharged under the provisions of Bankruptcy Code § 523(a)(1)(C), as Mr. Murphy had either filed fraudulent returns or had made some other “attempt to evade or defeat [these] taxes in any manner.” In 2009, the Internal Revenue Service levied on property belonging to Mr. Murphy, which caused him to file suit against the Internal Revenue Service in the bankruptcy court, seeking a declaration that the tax liability had been discharged. Although the IRS continued to take the position that the taxes were nondischargeable as they were due to Mr. Murphy’s fraudulent actions, the AUSA did little to present evidence to show this when Mr. Murphy filed a motion for summary judgment, and the bankruptcy court granted the summary judgment motion, holding that the taxes were discharged. The government did not appeal. The AUSA was subsequently diagnosed with a form of dementia, and had probably been experiencing it when he defended the Internal Revenue Service in the dischargeability case.

Mr. Murphy then filed a complaint under Internal Revenue Code § 7433(e), seeking damages for willful violation of the injunction created by the discharge in the bankruptcy case. After some initial procedural skirmishing over the effects of the earlier discharge litigation and the AUSA’s illness, the Internal Revenue Service agreed that the summary judgment ruling determined that the taxes were discharged, and to the amount of the damages Mr. Murphy had suffered. The only issue remaining was the question of whether the Internal Revenue Service had willfully violated the discharge injunction such that Mr. Murphy was entitled to monetary damages under Section 7433(e).

The bankruptcy court held that Mr. Murphy was entitled to damages, as the term “willfully violates” means that “when, with knowledge of the discharge, [a creditor] intends to take an action, and that action is determined to be an attempt to collect a discharged debt.” The bankruptcy court’s decision was affirmed by the district court, and the Court of Appeals also found in favor of Mr. Murphy, agreeing that the Internal Revenue Service only had to intend to take the actions resulting in collection of the discharged taxes. A good faith belief that the taxes were not dischargeable was not a defense. The Court of Appeals also rejected the IRS argument that because Section 7433(e) is a waiver of sovereign immunity, it must be construed narrowly by permitting a good faith defense. The end result of the Court of Appeals’ opinion is that, for all practical purposes, the Internal Revenue Service must litigate dischargeability before it begins collection of taxes it reasonably believes have not been discharged, or risk having monetary damages imposed against it. This requirement of pre-collection litigation, not contained in the Bankruptcy Code, is the elephant the dissent believes the majority is hiding in a mouse hole.

As noted by Judge Lynch in the dissenting opinion, the majority got this one wrong. In reaching its decision, the majority opinion creates a standard of near strict liability by stripping the government of a reasonable good faith defense, rather than reading this waiver of sovereign immunity narrowly and construing ambiguities in favor of the sovereign, as generally required. Judge Lynch notes that the majority picks and chooses among circuit and lower court opinions in reaching its definition of willful violation, ignoring a Supreme Court opinion issued in Kawaauha v. Geiger, 523 US 57 (1998), a case decided just months before Section 7433(e) was passed. (This is an interesting omission by the majority, given that retired Supreme Court Justice David Souter was one of the two judges signing on the majority opinion.) In Kawaauhau, which interpreted the phrase “willful injury” in connection with another provision of Bankruptcy Code § 523, the Supreme Court held that the word “willful” modified “injury” and required a deliberate or intentional injury, rather than merely a deliberate or intentional act that leads to injury. The same rationale would appear to apply to Internal Revenue Code § 7433(e), leading to the dissent’s conclusion that a “willful violation” requires a deliberate or intentional violation, not just a deliberate or intentional act. If the IRS acts reasonably and in good faith, the violation cannot be willful. Judge Lynch notes that this conclusion is consistent with other Supreme Court decisions construing the phrase “willful violation.”

But Judge Lynch’s most convincing argument is that the majority’s opinion changes the tax collection scheme without an express mandate from Congress. Under the majority’s opinion, the Internal Revenue Service must first go to court and prove the taxes are still owed before instituting any collection action after a discharge, even though not expressly required by Bankruptcy Code § 523. The treatment of tax liabilities under Section 523(a)(1)(C) should be compared to the debts listed in Bankruptcy Code § 523(c)(1). For these types of debts, Congress has provided that they are automatically deemed to be included in the discharge injunction unless the creditor obtains a judicial determination that the debt is not discharged. When Congress wanted a creditor to sue first, then collect, it knew how to provide for it. It did not hide the requirement in a statute allowing for damages that is not even in the Bankruptcy Code, but in a provision of the Internal Revenue Code. An elephant in a mouse hole, indeed.

 

 

Transferee Liability and the Application of Federal versus State Law

We welcome back guest blogger Marilyn Ames.  Marilyn has retired from the Office of Chief Counsel, IRS to the 49th state where she enjoys shoveling snow and other outdoor activities.  She also works with me on the collection chapters of the Saltzman and Book treatise, IRS Practice and Procedure.  Today, she writes about a recent case in which the IRS asserted transferee liability.  Based on the number of transferee cases I am seeing, I believe that the IRS has stepped up activity in this area over the past couple of years.  For those of you interested in transferee liability, Marilyn wrote an earlier post on the subject that you may also want to view.  Keith

In an opinion issued on December 16, 2016, the Seventh Circuit Court of Appeals played Grinch in Eriem Surgical, Inc. v. United States and gifted the Internal Revenue Service and the taxpayer with an opinion calculated to make both unhappy.  The opinion can be found here and at 843 F3d 1160.

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Eriem Surgical purchased the inventory of Micrins Surgical, Inc. when it went out of business in 2009 without paying its taxes.  Eriem also took over Micrins’ office space, hired its employees, used its website and telephone number, and continued Micrins’ business of selling surgical instruments.  Eriem also used the name “Micrins” as a trademark, and Bernard Teiz, the former president of Micrins, continued to play a leading role in Eriem’s business. All of this raised the suspicions of the Internal Revenue Service, although Mr. Teitz attempted to quell those suspicions by having his wife hold the 40% interest in Eriem that he formerly held in Micrins.  But this was not enough, and the Internal Revenue Service concluded that Micrins had simply morphed into Eriem, and levied on Eriem’s bank account and receivables.  Eriem then filed a wrong levy suit under 26 USC §7426(a)(1). The district court applied Illinois state law to determine that Eriem was a successor to Micrins, and as such, was liable for Micrins taxes.  Although Eriem appealed, the United States used this as an opportunity to make an argument that the courts have rejected up to this time.

The courts have long held that whether a third party is liable under some doctrine of transferee liability is dependent on state law. However, for the past few years, the Internal Revenue Service has taken the position that federal common law should govern whether a third party is the alter ego of the taxpayer, arguing that the application of state law leads to different results depending on the law of the applicable state and, consequently, to disparate treatment of taxpayers in essentially the same position. In staking out this position, the IRS has relied in part on United States v. Kimbell Foods, Inc., 440 US 715 (1979) and Drye v. United States, 528 US 49 (1999). The Service’s argument can be found in Chief Counsel Notice 2012-002 (Dec. 2, 2011), which can be located here.  The essence of the Service’s position is that state law should not control in an alter ego dispute, as the question is not one of property rights, but is an issue of the identity of the taxpayer. Since the IRS is ultimately interested in reaching property, not just engaging in identification of the taxpayer, this seems to some extent to be a distinction without a difference – at least without a difference that would matter to the third party/taxpayer.

On appeal, the Seventh Circuit confronted the question of whether state or federal law governed with respect to corporate successorship, and held that since the Internal Revenue Code does not say anything about this issue, “it seems best to apply state law.”  The court held that Kimbell Foods is not dispositive, as the Supreme Court has failed to cite it in later cases for the proposition that federal law controls, and that Drye expressly states that “in tax cases state law determines the taxpayer’s rights in property that the IRS seeks to reach.” Although it is not clear from the opinion if the United States argued that this was really just a case of identity, it’s doubtful that the court would have bought the argument, given that this case was really about the IRS cleaning out Eriem’s bank account.  The Seventh Circuit affirmed the district court’s application of Illinois law, thus ensuring that Mr. Teitz and Eriem were also unhappy with the result.

In an interesting sideshow to the federal/state law question, the Seventh Circuit also rejected Eriem’s argument that the 40% change in ownership had “dispositive significance.” Although Illinois law holds that a complete change of ownership prevents a finding of successorship, the Seventh Circuit affirmed the district court’s conclusion that Mrs. Teitz was serving as a proxy for her husband, and so the purported change in ownership was irrelevant.

Whether the IRS and the Department of Justice will continue to argue that there is a federal common law that should determine when a third party is an alter ego for purposes of tax collection remains to be seen, since it has not been popular with the courts.  In most cases, it doesn’t seem to make a difference to the end result, and may simply be a cut-and-paste argument the government is making to bolster its position.

IRS Master File and Non-Master File Accounts

Today, guest blogger Marilyn Ames provides a brief description of the IRS master file in order to provide context for some of the discussions we have had about taxpayer accounts.  Understanding the way the IRS keeps its books on taxpayer accounts can make a difference.  When an account moves from the master file to non-master file, the transcript, at first glance, can give the impression that the taxpayer owes nothing.  Without an understanding of the different accounts, it is easy to become confused. 

The National Taxpayer Advocate did a study on the problems created by conversion from master file to non-master file and reported on it in her 2009 annual report.  The issue is further complicated by the timing of when the IRS will or should convert a case from mater file to non-master file and that can depend on the type of case involved.  One trigger causing an account to move to non-master file status  is a request for innocent spouse status. Other triggers include the filing of bankruptcy by one spouse or the filing of an offer in compromise by one spouse.  It should occur whenever the collection on the formerly joint account moves in two directions because the actions of one spouse no longer move in sync with the other.  Consult the IRM on when the split should occur but be aware that the IRS does not always move the account to non-master file status when it should and the failure to do so can cause havoc.  Keith

According to the Internal Revenue Manual, the master file is “the official repository of all taxpayer data extracted from magnetic tape records, paper and electronic tax returns, payments, and related documents….” (IRM 21.2.1.2, Master File (Oct. 1, 2011).  This statement, which appears to include all of a taxpayer’s tax accounts, is not quite correct.  Because of the limitations to the technology behind the master file, the Internal Revenue Service has a Plan B.  That Plan B is known as the non-master file, and as some taxpayers have found to their dismay, it includes liabilities not reflected in the taxpayer’s master file.

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The non-master file system exists for the sole purpose of providing a means to assess and collect liabilities that cannot be handled by the master file. The non-master file was initially a manual system that consisted of index cards maintained in alphabetical order.  Since those not-so-long-ago days, non-master files are now kept electronically, but in a system totally separate from the master file system known as the Automated Non-Master File, or ANMF.  Unfortunately, the ANMF cannot be accessed by the Integrated Data Retrieval System of the IRS, which is how Service employees generally obtain information about taxpayers’ accounts, and from which tax transcripts are usually printed.  If a Service employee does not recognize the existence of a liability on a non-master file, or the taxpayer only receives transcripts printed from the master file system, a taxpayer or an unknowing representative may be left with the impression that there is no outstanding tax liability, while assessments are still lurking on the ANMF.

So what kinds of liabilities are contained on the non-master file?  Generally, cases involving transferor/transferee liability, termination or jeopardy assessments, cases involving lookback interest, and individual returns on which the secondary taxpayer is deceased will be assessed on non-master file.  If the Service is collecting child support obligations, these liabilities will be shown on a non-master file account. Beyond these types of cases, there are other assessments that are also made on the non-master file.  If the Internal Revenue Service needs to make an assessment within a matter of hours, the assessment will be made on non-master file, as it can be posted within 24 to 36 hours, rather than the four to six weeks for an assessment to be made on the master file.  If Congress passes new tax laws that need to be implemented quickly, the returns reflecting those changes will be assessed on non-master file until the master file system can be updated.  Certain other assessments, such as penalty assessments made under IRC §§ 6692, 6652(e), and 6652(d)(1) or (2), are also made on non-master file. A reversal of an erroneous abatement after the statute of limitations on assessment has expired will also occur on non-master file.  And, my personal favorite, some tax liability is simply too big for the master file system and must be assessed on non-master file.  If an individual taxpayer files a return showing a tax liability of $1 billion or more, the record will be maintained on the non-master file.  (Interestingly, the Internal Revenue Service also maintains a spreadsheet of the taxpayers who regularly file such returns, and tracks these returns.  Finally, an IRS list I wouldn’t mind being on.)

Some liabilities may start out on master file, and then be switched to non-master file.  The master file system can only handle a certain number of transactions for any particular tax account.  When the limit is reached, the account is systemically transferred to non-master file.  A transaction code 130 and a freeze will be made on the master file account to warn IRS personnel that this transfer has been made, but the master file account will also have the outstanding liability zeroed out by the addition of an equal credit.  This can make a taxpayer very happy if the Service employee fails to note and tell the taxpayer about the existence of the new non-master file account.  There is also a delay between the movement of a transaction from master file to the new non-master account, and it can be up to 45 days before the new file is posted in the ANMF system.

And if this wasn’t complicated enough, there may also be more than one non-master file account for the same tax period.  If an additional assessment is made for an account on the ANMF system, the additional assessment is not just added to the account as it would be on master file, a new separate non-master file account is established.

The ANMF system also issues different collection notices from those issued by master file.  A taxpayer whose liability is assessed on non-master file will only receive two initial collection notices – those that would be the first and the fourth notices sent for a master file account.  However, the taxpayer will still receive an annual reminder notice for the non-master file account of the outstanding balance, just as a taxpayer does for a liability assessed on master file.

So how does a taxpayer know that the notices being received are for a liability assessed on ANMF?  This is easy – there will be an “N” after the taxpayer identification number.  If there is a reference to a document locator number in a tax transcript, the third digit in the number will be a 6 if the document is on non-master file.  Because the processing involved with non-master file can be extremely specialized, most non-master file accounts are handled at just two Service campuses, Cincinnati and Philadelphia.  If a taxpayer appears to have a non-master file issue, the taxpayer or the representative should send a copy of the notice, letter or other document along with any correspondence discussing the problem so the issue is routed to the right office for handling.

Non-master file assessments are not as common as they were in the past, because one large area of non-master file cases is now handled by the master file system.  In the past, when individual taxpayers filed a joint return and some action occurred that affected only one spouse, the accounts would be split between the two spouses on non-master file.  This could have occurred because of a bankruptcy filing by only one spouse, one spouse being granted innocent spouse relief, or one spouse entering into an offer-in-compromise.  Split assessment accounts can now be created on master file, in what is referred to as MFT 31.  The creation of MFT 31 accounts causes each spouse’s liability and any transactions with respect to that liability to be tracked separately.  The National Taxpayer Advocate has expressed concerns about the MFT 31 accounts.  While report in which these concerns were expressed is now several years old, the issues raised in the report may still have some currency.  Taxpayers and their representatives still need to remain aware, however, because the liability remaining at the time the split assessment accounts are created will still be zeroed out on the original master file account.  As with a transfer to non-master file, if the liability has not been paid off, it may still remain and be lurking in the new MFT 31 account like a monster under the bed.  If the tax transcript shows a transaction code 400, the representative needs to press further to find the transcript for the new split assessment.