Review of Stephanie Hunter McMahon’s “The Perfect Process is the Enemy of the Good: Tax’s Exceptional Regulatory Process”

August 7, 2018 by Leave a Comment

We welcome guest blogger Sonya Watson who teaches at UNLV law school where she is an assistant professor in residence and the director of the Rosenblum Family Foundation Tax Clinic. In the last few weeks, with decisions in Altera and Good Fortune, we have seen major circuit courts of appeal opinions considering whether Treasury’s regulations withstand challenge. Professor Watson returns to provide us with another review of a tax procedure article that directly considers the relationship of Tax regulations and broader administrative law concepts. Keith

Earlier this year I reviewed Professor Kristin Hickman’s article, “Restoring the Lost Anti-Injunction Act,” in which she argued that that a narrow interpretation of the Anti-Injunction Act (“AIA”) is warranted to protect taxpayers’ presumptive right to pre-enforcement judicial review of agency rules and regulations under the Administrative Procedure Act (“APA”).  While the AIA prevents pre-enforcement review of tax laws, the APA allows pre-enforcement review. Hickman argues that it is especially important that taxpayers are able to invoke the APA and hold the IRS to the APA’s standards because of Treasury’s and IRS’ belief than in many instances, the APA does not apply to them. Today I review Professor Stephanie McMahon’s “The Perfect Process is the Enemy of the Good: Tax’s Exceptional Regulatory Process” in which McMahon plays devil’s advocate. McMahon argues that tax is exceptional and as such, Treasury and IRS shouldn’t be bound to the letter of the APA. Rather, Treasury and IRS should follow the spirit of the APA. She argues that this is especially true considering that the APA is not without flaws and that other agencies may not properly adhere to the APA either.

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Because the procedures set out in the APA don’t always accomplish the APA’s goals, rather than focusing on whether agencies strictly adhere to the procedures set out in the APA, we should focus on whether the procedures that the agency does employ are in line with the goals underlying the procedures provided in the APA. The goals underlying the APA’s procedures include: the promotion of public deliberation; reasoned agency decision-making with few errors; and agency accountability to the public and Congress. McMahon argues strict adherence to the APA can thwart accomplishment of these goals. In particular, she takes issue with the APA’s notice and comment process.

The notice and comment process, along with the hard look doctrine, which requires agencies to “consider all comments and to explain why it was not persuaded by all but frivolous comments,” may cause agencies to delay or defer issuing guidance because doing so is too burdensome in terms of resources. Producing guidance costs money:

When not excepted from notice and comment procedures, agencies face significant costs associated with compliance. Although it is impossible to calculate all of the costs of rulemaking because data is unavailable or immeasurable, Professor David Franklin notes, “Congress, the President, and the courts have all taken steps that have made the notice-and-comment rulemaking process increasingly cumbersome and unwieldy. Even critics of tax exceptionalism note that the “procedures are quite burdensome.” Many federal agencies have responded by foregoing notice and comment and issuing interpretative tools, policy statements, and informal guidance. “[B]usy staffs, tight budgets, and a variety of competing priorities” may affect how agencies weight the choice of rulemaking tools.

Further, there is always the risk that that courts may invalidate a rule to which Treasury and IRS have devoted its scare resources.

Aside from being a drain on resources, the notice and comment process creates the potential for agency capture. Agency capture occurs when an interested party influences an agency by dominating it “in ways that are detrimental to the public purpose for which it was created.” There are several ways to capture an agency, one of which is with information. In the context of the IRS, the notice and comment process may lead to information capture if an interested taxpayer inundates the IRS with large amounts of information—evidence and arguments pertaining to a rule—which then may have the effect of drowning out other voices or overcomplicating the issues, making it more difficult for less sophisticated taxpayers to participate. Because the APA’s notice and comment process does not provide a way to effectively filter information so that agencies aren’t overwhelmed by the information received, the process may not achieve its goal of increased public participation in rulemaking. Further, the notice and comment process may be unnecessary considering that “[i]nformal meetings, roundtables, speeches and leaks, advisory committees, and negotiated rulemaking are ways to really get information from the public.”

To the extent that Treasury can promote the goals underlying the APA without following the APA, McMahon believes it makes sense for Treasury to do so. To this end she states that Treasury is justified in availing itself of the good cause exemption to the APA. The good cause exemption allows agencies to issue binding guidance without notice and comment by explaining why notice and comment would be “impracticable, unnecessary, or contrary to the public interest.” Regarding Treasury’s use of the good cause exemption, McMahon writes:

Good arguments can be made for the good cause exemption to apply widely in the tax context. Currently tax provisions are tied to the federal government’s budget and there are restrictions on both deficit spending and the national debt. As a part of the federal fiscal planning, tax provisions are almost always estimated to have immediate effect, and that estimation is necessary in order to accomplish other goals of federal budgeting. In other words, if tax provisions were given delayed effective dates to permit time for notice and comment, this delay would alter the cost calculation of the federal budget.

The foregoing is in addition to the consideration that taxpayers and tax practitioners need Treasury to create guidance quickly in order to be able to better ensure compliance with the ever evolving tax laws.

Courts’ deference to agency rules is another important consideration in the debate over whether Treasury should be required to adhere to the APA. The more likely it is that courts will defer to an agency, the more important it is to make sure that the agency follows proper procedure in creating a rule. Final, legislative regulations enjoy significant deference but interpretative, proposed and, temporary regulations, as well as other types of guidance (revenue rulings, etc.) may enjoy less deference. This is because although agencies theoretically have broad discretion under Chevron, courts often apply tax-specific standards when deciding the extent to which they should defer to tax guidance, making deference harder to secure in the tax arena. Therefore, the idea that courts’ deference to agency rules make it vitally important that agencies follow proper procedure should be tempered with the knowledge that courts often don’t defer to agencies and that this is especially true in the case of Treasury and IRS.

Finally, adherence to the APA might inhibit the use of heuristics. The notice and comment process is meant to provide a means for an agency to receive information it should consider when creating guidance. However, it is unlikely that an agency will receive information regarding all the considerations it should make in creating guidance. So rather than relying on the notice and comment process to receive the information it needs to create good guidance, Treasury should create and rely on heuristics whenever possible. Heuristics are rules of thumb that aid decision making. Using heuristics in the administration of the Internal Revenue Code would allow non-experts to participate by giving them rules that are easier to apply. It also allows Treasury to keep up with changes in the law—because the Code continuously evolves, it is impossible to create guidance that will cover all possible scenarios. Heuristics don’t provide the specificity that regulations do, so using heuristics helps ensure compliance by those who might otherwise plan around the rules. Anyway, taxpayers and practitioners already use heuristics to understand and apply the code:

Developed through common law and now incorporated into practice by the IRS, tax lawyers know that gross income is interpreted broadly while deductions are construed narrowly as a matter of legislative grace, income is to be taxed to earners, substance prevails over form, and (although possibly threatened by codification) transactions need economic substance. These ideas, among others, guide the practice of law and the choices taxpayers make when they report the tax consequences of their activities. Without such guideposts, every new tax provision must be fully and singularly explicated, and any ambiguity litigated from scratch.

McMahon does acknowledge, however, that more detailed guidance may be necessary when heuristics are insufficient.

 

 

Filed Under: Administrative Procedure Act (APA) Tagged With:

Article Review: How Can Tax Collection Be Structured to Observe and Preserve Taxpayer Rights: A Discussion of Practices and Possibilities

March 6, 2018 by Leave a Comment

We welcome back guest blogger Sonya Watson who teaches at UNLV law school where she is an assistant professor in residence and the director of the Rosenblum Family Foundation Tax Clinic. As mentioned before, she is one of the new clinic professors now writing a regular feature which describes law review articles on tax procedure issues. She has selected an article I wrote a couple of years ago on taxpayer rights. Assisting her in the preparation of this post is her student, Vincent Kwan. Keith

In this article by Keith Fogg and Sime Jozipovic, the authors address the U.S. tax system and explore the rights of taxpayers in different countries for comparison. The article generally focuses its discussion on taxpayer rights and collections, but specifically on the enforcement mechanisms used by various governments.

Generally, the government’s inability to collect and enforce collection can be seen as a failure of the system that makes those who comply with tax laws feel as if others have an unfair advantage. However, the government must balance forced compliance against those who do not pay voluntarily with caution so as not to “drive [noncompliant taxpayers] to an underground economy, to discontinue producing income or to economic positions that fall through the necessary social safety net.” To properly and effectively enforce the tax laws, the government must consider the rights of the taxpayer as well as what the government can do to ensure compliance.

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According to Fogg and Jozipovic, there are three taxpayer rights that must be preserved to main an effective tax system, which include the right to be informed, the right to challenge the underlying liability and proposed collection action, and the right to a fair and just tax system. To give a more well-rounded and holistic view of the way in which the government can preserve taxpayer rights, the authors discuss the tax collection systems of the United States, England, Germany, Switzerland, Croatia, and Australia. The article highlights the differences between tax systems and taxpayer’s rights in each country, judging the efficacy of each system in protecting the rights of its citizens. The article concludes with a proposal on how to best structure the tax system to maximize taxpayer rights with an optimal collection strategy.

The authors start with the United States tax system and describe the process in detail; however, for the sake of brevity, we will note only the highlights. The collection of taxes begins with a volunteer assessment except when taxpayers fail to file a return, in which case the government will ultimately prepare a return for the taxpayer. After voluntary assessment, or an assessment that is the result of an examination, IRC Section 6303 requires the IRS to send a “Notice and Demand” letter within 60 days of the assessment, alerting the taxpayer that the collection process has begun. If the taxpayer has taxes owed, the letter states the amount of tax owed and requests payment within 10 days.

IRS collection alternatives provide debt relief for those taxpayers who are unable to pay. Collection alternatives include Currently Not Collectible status, Offer in Compromise, and installment agreements. Additionally, taxpayers can seek relief from all debts through bankruptcy by obtaining a discharge of taxes which have grown old. There is also the option of postponing and restructuring the payment of the taxes in the Bankruptcy Code’s reorganization chapters.

The Taxpayer Bill of Rights plays a large role in ensuring that IRS collections is fair and just. It mandates that taxpayers have the right to be informed and the right to pay no more than correct amount of tax. The IRS often falls short of honoring these rights. A few ways the IRS falls short is by sending taxpayers notices that are difficult to understand, by providing account transcripts that are difficult for taxpayers to read, and by failing to have adequate staff available to answer taxpayer questions about tax debt collection. To address this, the authors propose having “the IRS send taxpayers an account transcript with the annual statement of outstanding liability” and also “having an adequate phone presence with properly trained assistors who can explain the account transactions, which would ensure that taxpayers will have the opportunity to learn the basis of their liability when questions arise.” Such measures would help to ensure that taxpayers who cannot afford representation have as good a chance of obtaining a good result as those taxpayers who can afford representation. Not all taxpayers receive the same treatment when they owe taxes. Sometimes, there is discrimination of taxpayers based on who they work for, such as “encouraging” government employees to pay their federal taxes. However, doing so removes fairness from the system.

Through the Taxpayer Bill of Rights, the U.S. has tried to systematize the procedural rights of taxpayers around the world. However, due to the many differences and complexities between countries, systemization is somewhat difficult as there is great divergence in the various tax systems. The authors compare the U.S. tax system to solutions in the field of tax debt enforcement in the UK, Australia, Germany, Croatia, and Switzerland, analyzing the tax mechanism in those countries and what the U.S. can learn from them.

 

Switzerland

Unlike the U.S., where taxation is generally centralized in the federal government, there is a high level of decentralization in the Swiss tax system in that the Swiss regional entities— cantons—can implement their own taxes and their own measures of tax collection.

By relying on preventive distraints, the Swiss tax law has a developed system to prevent tax collection default. Preventive distraints can be voluntary and involuntary. Voluntary distraints exist “with the consent of the taxpayer pursuant to a compromise agreement between the taxpayer and the tax authorities.” On the other hand, an involuntary preventive distraint can only occur under certain circumstances defined by law such as “where the taxpayer has no permanent residence or headquarters in Switzerland, and where the tax authorities have objective reasons to believe that it may not be possible to collect the tax.” The term “Sicherungsverfügung” describes the administrative act that contains the reasoning of the taxing authority and the measures to apply. If the taxpayer fails to pay on time, taxing authorities utilize a preventive distraint, which permits them to take possession of “property of the taxpayers valuable enough to satisfy the tax liability, including any interest and penalties, while title to the property remains with the taxpayer.”

As far as tax debt forgiveness, there is a unified system to regulate forgiveness of federal taxes. The procedure begins with the taxpayer’s request. “If the tax authorities agree to settle the debt, they can decrease, forgive or defer the debt and as mentioned above, if they deem necessary, include a voluntary preventive distraint as requirement.”

Regarding taxpayer rights, there are few guidelines published for taxpayers and they only briefly touch on taxpayer rights. Generally, most taxpayer rights such as the right to equal treatment, the right to be informed, and the right to challenge the underlying liability, have their basis in the Swiss Federal Constitution (“Bundesverfassung”). The general provision in “article 8 of the Federal Constitution guarantees equal treatment before the law, and article 127 (2) guarantees equal treatment of taxpayers and taxation based on the economic capacity of an individual.” Also, see Article 29 (1) for procedure before a public authority, Article 29 (2), for the right to be heard in any procedure before a public body, and Article 36 (3) for the rule of proportionality. 

Australia 

Similar to the U.S., Australia primarily uses a centralized taxing authority. Regarding tax collection enforcement, if a taxpayer does not satisfy a tax obligation, the taxing authorities file a claim of summons with the court to have the court recognize that the debt is duly owed. The taxing authorities then have several methods for enforcement to seize a taxpayer’s personal and real property to satisfy a liability. Also, taxing authorities can force both corporations as well as individual taxpayers into a bankruptcy proceeding. On the extreme end, if the company [d]oes not pay or enter a payment plan within 21 days, the tax authority can place it into a liquidating procedure, also known as a “wind-up.” If this occurs, a trustee will liquidate the company and assuming sufficient assets exist, the creditors will receive payment from the liquidated assets.”

Also similar to the U.S. tax system, there are many ways to discharge a tax liability in full, including deferral rules, agreements with taxpayers, and special hardship rules. Also, taxpayers can enter into an installment plan, but the decision rests within the discretion of the taxing authorities. If there is hardship, there is a limit on certain individual taxes and duties, requiring that relief “must have a positive effect on the economic situation of the taxpayer; accordingly, a taxpayer who would be insolvent regardless of the hardship release would not be granted tax forgiveness.”

Unlike the U.S. and other countries, Australia does not have a taxpayer bill of rights. Instead, Australia has a taxpayer charter—a sort of bill of rights that taxpayers can expect in their interactions with taxing authorities. However, it is not as comprehensive as that of the U.S. Therefore, Australian taxpayers have scant rights. Three rights of significance in the charter include the right to receive an explanation of decisions, the right to fair and reasonable treatment, and the right for an independent review.

As the authors note “The European Union serves as a supranational body limited to influencing just those areas of legislation of the member states within the competences explicitly transferred to the EU.” Many aspects of European law overlap with tax collection and enforcement. Such overlap results from the EU fundamental freedoms which include the free movement of capital, the free movement of goods, the free movement of persons, and the free movement of services. In this vain, the EU’s laws limit the types and amounts of relief that its member states may provide. Additionally, the EU’s Tax Claims Recovery Act, an enforcement network covering all of the EU, affects how tax compliance is enforced. However, member nations can use their own enforcement mechanisms to collect tax debt. However, because the EU strictly limits debt forgiveness, debt forgiveness is largely the result of state aid.

Germany

The German tax collection system, like the U.S. system, is built around the country’s federal structure. Tax collection is within the competences of the Länder, the German federal states, which agree on an interstate contract, defining the basic procedures of tax collection. Germany has been a stable country economically, requiring little restricting compared to other EU states.

Enforced tax collection in Germany is executed by either the authority that issued the primary tax assessment or by any other tax authority in the country as the result of cooperation rules. Enforcement methods include seizure of personal and real property, forced insolvency proceedings in the case of corporation, and forced property evaluations for individuals. Once an assessment is made, taxpayers have limited options to protect themselves from enforced collection.

However, debt forgiveness is available based on the German Duties Act (Abgabenordung, AO), which “contains the essential material rules of tax forgiveness.” There are two main rules regarding tax forgiveness: a substantive rule contained in section 227 for tax forgiveness in cases defining application of the merits of the imposition of tax, and a procedural rule contained in the interstate agreement called a deferral agreement “Stundungserlass” which addresses forgiveness from a collection perspective.” While tax debt forgiveness is possible for every taxpayer in Germany, and the German system exhibits a good measure equitable treatment for all taxpayers, the German system is very rigid in granting the tax relief. The German Fundamental Law, “Grundgesetz,” the de facto constitution, of Germany has rules that form basis for taxpayer rights, but does not contain rules that specifically apply in matters of tax law.

Croatia

While Croatia has membership in the EU, it is the least developed country analyzed in this article. Despite reforms in recent years, it still has not achieved the efficiency and sophistication of the systems of Western European countries. This likely stems from Croatia’s economic crisis, which results from “a nation-wide high unemployment rate and significant private debt have lead in recent years to a steep increase of tax collection problems. Currently in Croatia, about 8% of the adult citizens and more than 40,000 corporations have blocks on their bank accounts.”

Regarding enforced tax collection, like in the U.S., Croatian taxing authorities in have the right to seize tangible property, funds in bank accounts, and tax refunds. Croatian taxpayers do have to receive notice about their tax debt but not necessarily the right to be heard regarding the tax debt. Only when taxing authorities fail to at least attempt to provide appropriate notice to taxpayers prior to taking collection action do taxpayers possibly have the right to challenge the decision of the taxing authority. Also like in the U.S., Croatian taxing authorities may levy a taxpayer’s salary until a tax debt is satisfied.

Unlike in the U.S., Croatia does not provide for tax debt forgiveness through insolvency (bankruptcy). Therefore tax debts remain on the books until the expiration of the statute of limitations plus four years after the statute of limitations and tax collection is not possible, or until taxing authorities decide to remove the debt from the books. However, pre-insolvency “procedure allows the creditors and the taxpayer to reach an agreement on debt forgiveness, payment plans, potential debt-equity swaps or the transfer of certain property between the taxpayer and the creditors.”

In Croatia, the constitution provides the main source of general tax principles, and in comparison to the other analyzed systems, the Croatian tax system is simpler, aiming to have a system that the citizens can understand. The Croatian General Tax Code (Opći porezni zakon), regulates the fundamental procedural issues for all types of taxes, and contains its own bill of procedural taxpayer rights. Unfortunately, only corporations may receive tax debt forgiveness in Croatia, which leaves individuals, for whom only forbearance is available, vulnerable. This policy promotes noncompliance in individuals, making them likely to work “under the table” rather than voluntarily participate in the tax system.

United Kingdom

Like the U.S., the United Kingdom has a highly developed tax system, based on a federal agency that is responsible for the collection. Also like the U.S., it has a special department for enforcement procedures. Before the taxing authority may proceed with enforced collection, there must be a fixed and determined tax liability and a demand for payment which the taxpayer refuses. Enforcement methods include seizure of income and property as well as initiation of bankruptcy proceedings. While debt relief generally may occur only through a bankruptcy proceeding, other debt relief options include forbearance and installment agreements.

The constitution of the UK is composed of various sources, such as the Human Rights Act of 1998, and the European Convention on Human Rights, which have a very narrow impact in the area of tax law and tax procedure. Instead, the UK has a separate Charter of Taxpayers’ Rights. There are many rights, such as the right to be treated even-handedly, the right to appeal, the right to “be respected,” and the right to have the taxpayer’s personal circumstances considered. UK taxpayers also have “the right to help and support to get things right [which] includes a broad right to information about which taxes are owed and why.”

Conclusions

Not surprisingly, the basis and presentation of taxpayer rights vary among countries. The right to information and equal treatment are generally accepted principles in all jurisdictions. However, “access to information and the right to protest are, albeit present in all jurisdictions, to a certain extent handled differently.” As the authors illustrate, developing a strong tax system grounded in due process is paramount to taxpayer rights. It is vital that taxpayers receive due process prior to enforced collections.

Despite the relatively advanced nature of the U.S. tax system compared to that of other countries, the U.S. system still leaves much to be desired. Even though due process exists, for some taxpayers, particularly low-income taxpayers, it can be inaccessible because the process is so complex. Looking to the German model, the U.S. should consider the “presented civil law model, which grants the taxpayers in most civil law countries a direct remedy against statutes or actions by tax authorities.” Furthermore, while a direct discrimination of a taxpayer would under most civil law constitutions be considered unconstitutional, and therefore such an approach as illegal, the problem in the United States does not lie with the case-by-case discrimination of taxpayers. It rather lies in the inherent discrimination of low-income taxpayers who do not have the same access to information and legal advice, and who therefore depend much more on an efficient tax authority for direction.

The authors propose that “one solution could be a fast-track insolvency procedure which would allow taxpayers to start over after just a few years similar to the solution in the UK. The authors further propose that more collection would be better pursued through regular tax procedure rather than collection enforcement procedures. They also not that a more accurate withholding system could prevent enforcement from being necessary. Additionally, the U.S. should consider reforming the procedures that take place before enforcement, which would help clean up the “complex system of debt forgiveness, information distribution, enforcement and taxpayer protection,” even though these procedures in the U.S. are more developed than those in other countries.

 

 

 

 

 

 

Filed Under: TBOR Tagged With:

Two Years Later: Form 1042-S Frozen Refunds

September 8, 2017 by 7 Comments

We welcome back a former student of Les and mine, Sonya Miller, who is now an Assistant Professor-in-Residence at the William S. Boyd School of Law, University of Nevada, Las Vegas.  She also directs the brand new Russell M. Rosenblum Tax Clinic Program serving low income taxpayers in the Las Vegas area.  Sonya wrote one of the most popular posts we have had at PT about the IRS program directed at nonresidents and their requests for refunds.  In today’s post she updates us on the program.  The program seems to be a situation in which someone saw abuse and the IRS chose a blunt an instrument to combat that abuse.  In doing so it caught a lot of people in its net that did not belong there, spent more of its own resources than necessary and paid out several million dollars in interest.  The program may have had successes that we do not chronicle because we do not know about them.  Perhaps we will learn about them in some future TIGTA audit.  Keith

Around this time in 2015, while I was directing the Federal Tax Clinic at the University of South Dakota School of Law, it came to the clinic’s attention that the Service was freezing refunds from Form 1042-S withholding for nonresident students at the University. The clinic and I wrote about the issue in Procedurally Taxing here. At that time, dealing with the Service to represent these taxpayers was extremely frustrating; it was like talking to a brick wall. Repeated phone calls to the practitioner priority line yielded virtually no information. We contacted the Taxpayer Advocate Service (TAS) for assistance and still it was slow going. This is likely because, as the National Taxpayer Advocate (NTA) noted in her Fiscal Year 2016 Objectives Report to Congress, the Service directed taxpayers to contact the Taxpayer Advocate Service (TAS) for assistance but had not provided TAS with any specific procedures or protocols that could be followed to assist these taxpayers. Indeed, in her Fiscal Year 2017 Objectives Report to Congress, the NTA notes that the Service was no more forthcoming with TAS than it was with other third parties: “The National Taxpayer Advocate and her staff raised concerns about the matching program and the student Form 1042-S issues. These concerns, however, were repeatedly dismissed by the IRS officials charged with operating the program.” On behalf of affected taxpayers, TAS issued mass Operation Assistance Requests and developed Taxpayer Assistant Orders.

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The NTA further noted in her report the unfair burden the Service placed on compliant nonresident taxpayers in an attempt to catch a few bad actors, while leaving compliant taxpayers with virtually no recourse for proving that they were entitled to the frozen refunds. Indeed, this was our experience at the South Dakota clinic. Early on in representing our student taxpayers, we contacted the University’s comptroller and received proof that the University had in fact withheld taxes from the students and had turned the money over to the Service. Still, the Service refused to release the refunds. It took so long to get the refunds released that I cannot be sure that it was our representation of the students that caused the Service to finally release the refunds. By the time the students contacted us, the refunds from their 2014 Forms 1040NR had been frozen for five months or more. Some of the students waited over a year to receive their refunds.

To be fair to the Service, it was trying to prevent fraud. Even so, no such burden exists for domestic taxpayers whose withholding agents fail to turn over withholdings. When an employer fails to turn over payroll tax to the Service, domestic taxpayers are still entitled to receive a refund from any over withheld taxes. Moreover, the Service’s means (trying to match the information in each and every Form 1042-S reported by withholding agents to each and every Form 1040NR or 1040NR-EZ filed by taxpayers) to reach the end of preventing fraud, was a blunder, which the Service recognizes in hindsight. However, the Service does attempt to place more of the burden on withholding agents by disincentivizing bad behavior. Withholding agents face hefty penalties if they fail to meet the requirement to file Forms 1042-S. They also face penalties for failing to furnish correct Forms 1042-S to recipients. Failing to ensure that Forms 1042-S reported to the Service exactly match the forms provided to the taxpayer is one common mistake that withholding agents make. Treasury Regulation 1.1461-1(h) lists the code sections for all of the penalties to which withholding agents may be subject.

However, notwithstanding its limited resources, as the NTA highlights, the Service could always do more to use its resources effectively.  In her Fiscal Year 2017 Report to Congress, the NTA states that the Service’s verification process for refunds based on Forms 1042-S “has not only been costly for taxpayers, but for the IRS, which has estimated that an extension of the freezes through early 2016 would generate an interest expense of over $4 million.” She further states that the Service could have maximized its resources had it “simply used technology already developed and pre-tested in the domestic withholding context” rather than using a separate, systemic matching program.

In an effort to “try harder and do better,” it has been reported (full text on file with the author) that the Service will no longer systemically freeze all refunds based on Forms 1042-S and will manually review all frozen refunds. The service describes its matching program in IRM 21.8.1.11.14.2. Unfortunately, we the people are not privy to most of the information in this IRM—the Service has heavily redacted it. It seems that the Service redacts information for fear that people will use the information to game the system. So, if I had to hazard a guess, in line with the de minimis exception in IRS Notice 2015-10, the redacted information probably says something about which refunds will be systemically frozen and which will not and that there’s a threshold amount to make this decision. Nevertheless, in IRM 21.8.1.11.14.3, the Service does set out what the matching program looks for in determining a good match. Where refunds are frozen, the freeze will systemically release after a little over five months. Also, IRM 21.8.1.1.13, informs IRS employees that nonresident taxpayers have rights under the Taxpayer Bill of Rights, which means that the Service cannot just keep nonresident taxpayers in the dark regarding the status of their refund claims. Change has been somewhat slow but the Service has taken responsibility for its transgressions and appears to be moving in the right direction.

 

 

 

 

 

 

Filed Under: refund claim Tagged With:

Freezing the Refunds of Our Guests

October 2, 2015 by 8 Comments

PT is excited to put up its 500th post today.  We thank you for following us on this journey into the nooks and crannies of tax procedure.

Today we welcome first time guest blogger Sonya Miller.  Sonya was my student and clinic co-worker at Villanova where she obtained her LLM.  Villanova’s LLM program has tuition assistance for students who work 20 hours per week in the clinic while studying for their LLM.  Sonya was one of the amazing recruits to Villanova as a result of this program.  (If you know someone seeking an LLM that also wants tax controversy experience, tell them to check out the program.)  She clerked after her LLM and is now starting a new tax clinic herself.  She writes to talk about a group of cases that her clinic has encountered as it starts up.

Refund freezes are not a new thing.  For those practicing in the earned income tax credit (EITC) area, you know that the IRS routinely freezes the refunds of individuals seeking the refundable EITC.  So, the IRS does not just pick on guests but freezes refunds of other vulnerable citizens.  The IRS usually engages in freezing refunds where it feels vulnerable itself because sending out the refund will be the last it sees of those dollars and the circumstances surrounding the claim suggest that the taxpayer may not qualify for the requested amount.  The decision to freeze may make perfect sense as a tactic to avert inappropriate revenue loss; however, the lack of communication to the affected individuals coupled with the blunt rather than surgical use of the tactic lands the IRS once again in the doghouse. 

Taxpayers have remedies although they may not be easy remedies to pursue.  For those who read the recent post on bypassing normal channels at the IRS, take a look at the excellent comments it has drawn suggesting additional strategies.  In effect Sonya is exercising the strategy suggested by one commentator – publicity of the problem.  The other commentator suggests litigation and that soon will be available to Sonya’s clients.

It can be easy to forget that a tax return is a refund claim.  If the IRS freezes a taxpayer’s refund for more than six months, the door to the district courts swings open.  This is a strategy that Rob Nassau who directs the tax clinic at Syracuse has employed for frozen EITC refunds.  The next post from Sonya may describe the best procedure for bringing suits in these cases and her dealings with the Department of Justice Tax Division.  Keith

 

The Federal Tax Clinic at the University of South Dakota School of Law began operations this fall. We are aware of a group of nonresident taxpayers (taxpayers that fall under the rules for aliens temporarily present in the United States as students, trainees, scholars, teachers, researchers, exchange visitors, and cultural exchange visitors) who had their 2014 refunds frozen. Their refunds were the result of Form 1042-S (Foreign Person’s US Source Income Subject to Withholding) withholdings. The taxpayers were not aware of why their refunds had been delayed. We believe that they are among the many nonresident taxpayers whose refunds the IRS began systemically freezing this year.

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In an IRM Procedural Update issued January 30, 2015, IRM 21.8.2.12.2.3, the Service advises that beginning January 1, 2015, it will systemically freeze a taxpayer’s entire refund where the taxpayer filed Form 1120-F and any portion of the refund is supported by a Form 1042-S. The freeze lasts up to 168 days, during which time Compliance will check the validity of the refund. If Compliance finds that the refund is not valid, the IRS will extend the freeze. If a taxpayer calls the IRS inquiring into the status of the refund, then the Service will advise the taxpayer that “[t]he IRS will need additional time to process your return. Please allow IRS up to six months from the original due date or the actual filing date of the return whichever is later to receive your refund.”  The IRM provides that no notices will be generated regarding the systemic freeze. However, if taxpayers call the IRS and claim hardship as the result of not having received their refund, the IRS will refer them to the Taxpayer Advocate Service. Although IRM 21.8.2.12.2.3 presumably applies only to taxpayers filing Form ll20-F, i.e. foreign corporations, it appears that the IRS is also applying the IRM to systemically freeze the refunds of individuals who filed Form 1040NR.

After inquiring into the status of one refund (the taxpayer filed Form 1040NR), the IRS advised us that there was a 168-day hold on the refund because of the taxpayer’s Form 1042-S. IRM 21.8.2.12.2.3 is the only IRS literature we have found that references a 168-day freeze for refunds supported by a Form 1042-S, which causes us to conclude that the IRS is likely applying this IRM, meant for Forms 1120-F, to Forms 1040NR. Additionally, similar to the language found in the IRM, the IRS has posted a statement to its website advising taxpayers who filed a Form 1040NR with Form 1042-S that the Service will need up to six months from the due date of the return or the date the return is received, whichever is later, to process the return and issue any refund.

In a follow up communication, the IRS advised us that it issued 3064C Letters to the nonresident taxpayers in mid-September 2015 (about five months after the taxpayers filed their returns) informing them that the Service needed more time to process the returns. We have not seen these letters. However, it is our understanding that the IRS does not address why the taxpayers’ refunds have been frozen or what the taxpayers can do to expedite the process. Prior to these letters, the IRS had not made any attempt to individually notify the taxpayers of the refund delays. As Yogi Berra is quoted to have said, “It’s déjà vu all over again.” The IRS has a significant history of silently freezing refunds.

The National Taxpayer Advocate (NTA) raised the issue of frozen refunds in her Annual Report to Congress as early as 2003 and as recently as 2013. In her 2005 Report the NTA listed Criminal Investigation Refund Freezes as one of the most serious problems within the IRS. Criminal Investigation Refund Freezes are a part of the Questionable Refund Program, which was “designed to identify fraudulent returns, to stop the payment of fraudulent refunds and to refer identified fraudulent refund schemes to Criminal Investigation (CI) field offices.” Although we believe the systemic freeze of refunds supported by a Form 1042-S is more likely the result of proposed Treasury Regulations detailed in IRS Notice 2015-10 than the result of the Questionable Refund Program, the same concerns regarding taxpayer rights noted in the NTA’s 2003, 2005, and 2013 Annual Reports applies.

Notice 2015-10 proposes regulations that affect the treatment of claims for refund and credits made by taxpayers subject to withholding rules under I.R.C. §§1441 – 1443 and §§1471 – 1472. The proposed regulations will allow the IRS to deny refunds to the extent that withholding agents have not deposited the correct amount of withholdings under I.R.C. §6302 and to the extent that reported withholdings are fictitious. As with cases in the Questionable Refund Program, the IRS is understandably concerned about the potential for fraud. This is especially true for withholdings reported on Form 1042-S because both the claimant and the withholding agent may be outside of the United States, making recovery of erroneously issued refunds nearly, if not actually, impossible.

Nevertheless, the problem with systemically freezing taxpayer refunds to investigate the validity of the refunds is that inevitably the “innocent” get caught in a net meant for “bad” actors. Regarding withholdings reported on Form 1042-S, the IRS acknowledges in Notice 2015-10 that perhaps there should be an exception for withholding agents who have a history of compliance or where the refund claimed is de minimis. However, judging from the frozen refunds, it appears that the IRS currently is not applying any such exceptions. If it were, we would think that the withholding agent in many of these cases—e.g., domestic withholding agents that are subject to IRS jurisdiction and have an excellent record of tax compliance (such as U.S. educational institutions), would be excepted from lengthy queries or that the taxpayers’ refunds (sometimes just a few hundred dollars each) would be viewed as de minimis.

The NTA has repeatedly emphasized the IRS’ need to implement proactive handling and management procedures to notify taxpayers that their refunds have been frozen and to provide a reason for such action and an opportunity to address the issue so that the refund claim may be resolved as expeditiously as possible. In 2006 the New York Times reported that the IRS would begin notifying taxpayers regarding frozen refunds, quoting then Commissioner Mark W. Everson as saying “I believe that appropriate notification should be given when refunds are frozen … Honest taxpayers expecting a refund deserve to be treated fairly.” Since then Mr. Everson’s belief that taxpayers deserve to be treated fairly has been made a priority, if not a reality. The Taxpayer’s Bill of Rights gives taxpayers the right to be informed, the right to quality service, the right to challenge the IRS’ position and be heard, and the right to a fair and just tax system. A systemic freeze of taxpayers’ refunds without prompt notice infringes upon these rights. A vague letter to the taxpayer requesting more time to review the return five months after the IRS has already frozen the taxpayer’s refund does not amount to fair treatment.

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