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An IRS agent is generally required to get written approval from their manager for a tax penalty can be assessed. This is requirement is set out in the Code. This begs the question as to what happens if the agent does not get written approval before he closes the audit? The court addressed this in Graev v. Commissioner, 147 T.C. 16, which explains how taxpayers should deal with cases where the IRS agent does not get written approval for penalties before they close the audit.
In Graev, the IRS agent assessed a Sec. 6662(h) 40% gross valuation misstatement penalty. This penalty is in lieu of the 6662(a) 20% penalty for an underpayment attributable to negligence or a substantial understatement of income tax. Put another way, the IRS can only assess one of these penalties. When the IRS assesses the higher Sec. 6662(h) 40% gross valuation misstatement penalty, it will often assert the lesser penalties as an alternative or fall-back position.
In Graev, the IRS issued a Notice of Deficiency that only included the Sec. 6662(h) 40% gross valuation misstatement penalty. It then issued a revised Notice that included the other penalty as an alternative position.
The taxpayer challenged the underlying tax issue in the U.S. Tax Court and lost. It then challenged the penalty before the same court.
The court examined Sec. 6751(b), which is the Code section that requires IRS agents to get written approval before assessing penalties.
The majority of the court concluded that this Code section does not require the IRS agent to get approval before the audit is closed. It merely requires the IRS agent to get written approval before the penalty is assessed.
The majority of the court then noted that with cases that are considered by the U.S. Tax Court, tax assessments are not final until after the U.S. Tax Court enters a final order in the case and the case is not appealed. This is one of the defining features of the U.S. Tax Court, namely, that it provides taxpayers with a pre-assessment and pre-payment forum for litigating tax certain cases. So the court concluded that the IRS agent could get manager approval at any time before the court case was final–even if the IRS agent obtained written authorization during the court proceeding.
The lone dissenting opinion concluded that the penalty should not be upheld given the nature of the U.S. Tax Court’s role in determining what amount should be assessed. This is the very function of the U.S. Tax Court. So the dissent reasoned that it would not make sense to put the U.S. Tax Court in the middle of the penalty determination, as the majority court decided to do.
So what should a taxpayer do if he discovers that the IRS agent did not get manager approval before closing the audit? One option might be to not respond to the Notice of Deficiency and let the IRS assess the tax and penalty, pay the penalty, file a refund claim, and, if the IRS did not refund the money, sue the IRS in U.S. District Court. This would mean that the IRS assessed the penalty without first obtaining the required written approval.
A well drafted closing agreement can provide a level of certainty to an uncertain tax position. The agreements do this by binding the IRS and the taxpayer. They normally include language that says that the agreements are valid for all Federal income tax purposes. In Analog Devices, Inc. v. Commissioner, 147 T.C. 15, the court concluded that the word “all” does not actually mean “all.”
IRS Closing Agreements
The IRS enters into closing agreements with taxpayers in some circumstances. These agreements settle the taxpayer’s liability for particular types of taxes or specific matters that impact the tax liability. They apply only to the tax years that are included in the agreements.
The Tax Code grants the IRS the authority to enter into closing agreements, but the meaning of the terms included in the closing agreements are construed by Federal contract law. This law looks to the parties intent by focusing on the language included in the agreement and, if there is an ambiguity, to various cannons of statutory construction. The cannons are general rules for interpreting language in the context of the agreement, circumstances, etc.
The Analog Devices Case
In Analog Devices, the court considered the phrase “for all Federal income tax purposes” that was included in a closing agreement. The closing agreement required the taxpayer to establish an account receivable from its wholly owned foreign subsidiary to its U.S. parent entity as of the last day of specific tax years that had already passed. So the question for the court was whether this retroactive inter-company receivable was a “debt” for purposes of Sec. 956. Sec. 956 is a Federal income tax statute and it is part of the Tax Code. So to be more precise, the question for the court was whether the phrase “for all Federal income tax purposes” includes Sec. 956 when the closing agreement is being applied retroactively. The court concluded that it does not.
The court reached this conclusion by factoring in its prior decision in BMC Software, Inc. v. Commissioner, 141 T.C. 224 (2013). In that case, the court concluded that the phrase “for Federal income tax purposes” included Sec. 956. On appeal, the Fifth Circuit Court of Appeals had reversed the decision in BMC Software. The Fifth Circuit reasoned that the debt did not exist until the closing agreement was entered into. So in Analog Devices, the court essentially applied the Fifth Circuit’s determination in BMC Software. The IRS may appeal the decision in Analog Devices to the First Circuit.
The Take Away
If the court in Analog Devices is correct, the case stands for the proposition that an IRS closing agreement for specific matters does not have any impact on tax laws that are not cited in the agreement. This could impact any closing agreement that establishes the tax treatment for a period prior to the time the closing agreement was entered into. This means that taxpayers should revisit the language in their closing agreements to confirm their understanding of what the agreement actually does and taxpayers who enter into closing agreements should put more time into thinking about the language used and opportunities and pitfalls that could come up given their other tax positions.
If the IRS fails to mail or mails a notice to a taxpayer and uses the wrong address, should the taxpayer be faulted for missing the deadline set out in the IRS notice? The Seventh Circuit Court of Appeals says “yes” in Adolphson v. Commissioner, No. 15-2242.
The facts and procedural history are as follows:
- The IRS “issued” a Notice of Intent to Levy to the taxpayer, but it could not prove that it mailed the notice and it eventually conceded that the notice was sent to the wrong address.
- The taxpayer missed the 30 day period to respond to the IRS notice to request a CDP hearing.
- The IRS levied on the taxpayer’s assets.
- The taxpayer filed suit in U.S. Tax Court, asking the court to invalidate the levy because the taxpayer was prevented from requesting a CDP hearing due to the IRS’s failure to mail a Final Notice of
- Intent to Levy to the proper address.
- The IRS moved to dismiss the tax court petition–arguing that the U.S. Tax Court lacked jurisdiction over the matter because the taxpayer did not request a CDP hearing timely.
- The tax court granted the IRS’s motion to dismiss, reasoning that it lacked the authority to grant relief without a notice of determination.
So both the IRS and the taxpayer were arguing that the U.S. Tax Court did not have jurisdiction.
The process whereby a taxpayer files a petition with the U.S. Tax Court and then asks the court to dismiss their own petition is not new. It is also not something that is found in the Code. It is a process that has been developed in the case law. As noted by the Seventh Circuit, there are quite a we court cases where the U.S. Tax Court invalidated IRS’s levies after the taxpayer filed his petition and the court dismissed it.
In reviewing the prior cases, the Seventh Circuit noted that whether the IRS complied with its notice requirements is not a jurisdictional issue: “[a] decision invalidating administrative action for not following statutory procedures is a quintessential merits analysis, not a jurisdictional ruling. The Buffano line of cases therefore represents an improper extension of the tax court’s statutorily defined jurisdiction.” Because it is a challenge on the merits, not a jurisdictional challenge, the Tax Anti-Injunction Act bars the taxpayer from bringing suit before first paying the tax and suing for a refund. So the Seventh Circuit concluded that the levy must stand. This effectively puts an end to this process for taxpayers in the Seventh Circuit.
The court’s holding seems unfair. It seems like taxpayers should have a judicial remedy prior to seizure of their assets when the IRS fails to mail a Final Notice of Intent to Levy and, through no fault of their own, the taxpayers miss the 30-day window to request a CDP hearing. The U.S. Tax Court’s procedure afforded that remedy. It will be interesting to see if the IRS provides an equivalent administrative process to fill this void or if Congress does so.
There are tax laws that provide significant tax advantages to banks. One of these laws allows banks to deduct capital losses against ordinary income. This allows banks to deduct losses immediately when others might have to carryover the loss to other tax years. There are other tax laws that are specific to banks. These laws raise the question as to what business can be considered as banks for Federal income tax purposes. The Fifth Circuit Court of Appeals addressed this in Monegram International, Inc. v. Commissioner, No. 15-60527 (2016).
Facts and Procedural History
Moneygram is in the money transfer industry. It took the position that it was a bank on its 2007 and 2008 tax returns, by deducting its capital losses against its ordinary income. The IRS did not agree that Monegram was a bank. The U.S. Tax Court agreed with the IRS. Moneygram appealed the decision to the Fifth Circuit.
What is a Bank?
State laws define what businesses are considered to be banks and the states set various requirements to be a bank. This state classification does not dictate whether a bank is considered to be a bank for Federal income tax law. The Tax Code imposes additional requirements; however, the language in the Tax Code is not entirely clear. This language was what was in dispute in Monegram.
To be considered a bank for Federal income tax purposes, the taxpayer must not only be a bank under state law, its banking activities must be a substantial part of its business. The U.S. Tax Court and the Fifth Circuit agreed on this point.
The courts also agreed that taxpayer must engage in these activities to be a bank:
- the receipt of deposits from the general public, repayable to the depositors on demand or at a fixed time,
- the use of deposit funds for secured loans, and
- the relationship of debtor and creditor between the bank and the depositor.
What are Deposits?
The dispute in Moneygram focused on the definition of the term “deposits.” The U.S. Tax Court concluded that the term means “funds that customers place in a bank for the purpose of safekeeping” that are “repayable to the depositor on demand or at a fixed time” and which are held “for extended periods of time.” The Fifth Circuit agreed with all but the last clause of this definition. According to the Fifth Circuit, deposits did not have to be held for extended periods of time. This is obviously not something that Monegram does given that it is in the money transfer business.
What are Loans?
The dispute in Moneygram also focused on the definition of the term “loan.” The U.S. Tax Court concluded that the term means a memorialized instrument that is repayable with interest, and that “generally has a fixed (and often lengthy) repayment period.” The U.S. Tax Court focused on the fact that the instrument used to memorialize this agreement is facially a trust agreement and not a loan agreement and it emphasized that no interest was charged.
The Fifth Circuit did not agree with this definition. It looked to the well established definition of a loan, which sets out eight factors that are to be considered in determining whether a transaction is a bona fide loan. According to the Fifth Circuit, the U.S. Tax Court erred by not using this definition. The Fifth Circuit also noted that interest is not required.
The Fifth Circuit remanded the case to the U.S. Tax Court. So the U.S. Tax Court will decide whether a Moneygram is a loan, which is an interesting issue in and of itself.
What are the Consequences?
If a Moneygram is a bank that makes loans, it would be able to take advantage of the tax laws that favor being a bank. This raises questions as to whether other taxpayers who have taken the position that they are banks are actually banks for Federal income tax purposes. It also raises questions as to whether different businesses like Moneygram could qualify as being a bank or what this means other parties to the loans made by Moneygram.
The IRS recently issued Publication 1494, Tables for Figuring Amount Exempt From Levy on Wages, Salary, and Other Income – Forms 668-W(ACS), 668-W(c)(DO) and 668-W(ICS), for 2017. This publication provides the amount of wage and salary that are exempt from the IRS’s levy.
The monthly wage and salary amounts for 2017 are as follows:
This is about a 1% increase from the 2015 numbers, which were:
About the IRS Wage & Salary Levy
The IRS issues a wage and salary levy using a Form Form 668-W(c)(DO). The form is mailed to the taxpayer’s employer. The employer is then obligated to calculate the amount of the wage or salary to be remitted to the IRS.
The amount remitted to the IRS depends on the information the taxpayer provides to the employer about his or her exemptions (i.e., him or herself and his or her dependents) and the amount of pay that the taxpayer earned. The employer is supposed to solicit the exemption information from the taxpayer, including the names and social security numbers for the taxpayer’s dependents. The IRS can personally assess the tax balance and impose penalties on an employer who does not comply with the levy.
Releasing an IRS Wage & Salary Levy
The IRS’s wage and salary levy remains in place until the IRS releases the levy (either because the taxpayer made arrangements to pay the tax or releasing the levy will facilitate collection of the tax or the levy is creating a financial hardship) or the tax is paid. The levy can also be released by operation of the bankruptcy automatic stay on collections.
Tax matters can be litigated in a number of different courts. One of the advantages of bringing suit in U.S. Tax Court is that the tax does not have to be paid prior to bringing suit. For tax matters litigated in the U.S. District Courts or the Court of Federal Claims, the tax has to be full-paid prior to bringing suit. There is an exception whereby a portion of the tax can be paid if the tax is divisible. The United States Court of Appeals for the Federal Circuit recently addressed this exception in Diversified Group, Inc. v. United States, No. 2016-1014.
The facts and procedural history for the case are as follows:
- The Diversified Group, Inc. was in the business of selling tax shelters.
- The IRS assessed two Sec. 6707 reportable transaction penalties against the taxpayer for not registering its tax shelters with the IRS.
- Each penalty was computed based on the two separate tax shelters that the taxpayer did not register.
- Combined, the penalties were $42 million. The $42 million was computed by taking the amount Diversified’s clients invested in the tax shelters, times one percent.
- The taxpayer made a payment of $15,500 to the IRS, which was the portion of the penalty that it incurred for one of the tax shelters for a single client (technically there were two taxpayers and a refund claim from both, but this post will only address Diversified to make it easier to follow).
- The taxpayer filed a refund claim, which the IRS disallowed, and the taxpayer brought suit in the Court of Federal Claims to recover the $15,500 it paid.
On appeal, the issue was whether the Court of Federal Claims had jurisdiction given that the taxpayer did not full-pay the entire amount of the penalty before bringing suit. The full-pay rule is often referred to as the Flora rule, which is a reference to the court case that established the rule. The exception to the Flora rule is found in the Boynton case, which says that a divisible tax need not be full-paid prior to bringing suit to recoup a refund. This brings us to the Diversified Group case. It explains whether the Sec. 6707 penalty is divisible.
In Diversified Group, the taxpayers argued that the Sec. 6707 reportable transaction penalties were divisible. It reasoned that the penalties were assessed for each of the 192 instances in which it implemented the tax shelters for clients. It noted that a separate Form 8264, the form by which a tax shelter is registered, would need to be filled out for each of the 192 instances.
The IRS disagreed. It argued that the reportable transaction penalties were not divisable. It viewed the penalties as just two penalties, the liability for each of which was triggered by a single event, namely, the failure to register the tax shelter. The IRS focused on the number of registrations, not the number of times the tax shelter was sold. As only two penalties, the IRS argued that the reportable transaction penalties had to be full-paid before the taxpayer could bring suit.
The court agreed with the IRS. It concluded that the liability arises from a single event–the failure to register a tax shelter–Sec. 6707 penalties are not divisible into the individual transactions or investors that may comprise a single tax shelter.
Compare this to other types of taxes and penalties, such as the Sec. 6672 trust fund recovery penalty in Boynton. In that case, the court concluded that the trust fund recovery penalty is divisable. So paying a single employee’s wages for one quarter suffices.
The disparate treatment for the Sec. 6707 reportable transaction penalties in Diversified Group and the Sec. 6672 trust fund recovery penalties in Boynton is difficult to reconcile. The trust fund recovery penalty is computed based on the individual employee withholding for each employee. Following the rationale in Diversified Group, it seems that the court in Boynton should have concluded that the failure to pay over the withholdings was a single event that triggered the penalty and, therefore, the penalty was not divisable.
The administrative summons is one of the IRS’s primary tools for obtaining information from taxpayers and third parties. There are very few requirements that the IRS has to satisfy in issuing summones. In Maxcrest Limited v. United States, Case No. 15-mc-80270-JST, the U.S. District Court for the Northern District of California addressed whether the IRS can fix a defective summons by issuing a second summons.
The facts and procedural history are as follows:
- The Russian Federation made an “exchange of information request” to the United States regarding the tax liabilities of NefteGasIndustriya-Invest (“NGI”) pursuant to the U.S.-Russia Tax Treaty.
- Russia was seeking information about Platten Overseas (“Platten”), which was previously owed by Maxcredst.
- The IRS issued two third-party summonses directed to Google Inc. (“Google”) regarding the email account information of Platten.
- Maxcrest filed a petition to quash the IRS summones.
- The IRS withdrew the first summons after Maxcrest filed a petition requesting that this Court quash the first summons due to procedural violations.
- Maxcrest then sought discovery to pursue its claim that the Government acted in bad faith in issuing the first summons.
- The IRS then issued a second similar summons on Platten which was issued without the procedural defects of the first summons.
- The court dismissed Maxcrest’s petition to quash based on the second summons.
- Maxcrest appealed, arguing that an improper purpose for the first summons tainted the second summons.
The issue before the court was whether a taxpayer may rely on allegations of bad faith related to an earlier withdrawn summons to establish that the IRS acted in bad faith with respect to a second, reissued summons.
Defects with the IRS’s First Summons
Maxcrest pointed out the following acts of bad faith by the government with respect to the first summons:
- When giving Platten notice of the first summons, the IRS did not include the statutorily required form notifying Platten of its right to challenge the summons;
- the IRS took thirty-five days to respond to Google’s request to send a copy of the first summons to Maxcrest, during which time the twenty-day period to challenge the summons had expired; and
- the IRS used U.S. Mail service to send notice to Platten in the British Virgin Islands.
Maxcrest argued that the IRS should not be able to “simply reissue an identical summons once litigation has begun and wash away all negative inferences that can be drawn from its prior deficient notice.”
Investigation as to Improper Purpose
In a separate but somewhat recent case, the U.S. Supreme Court concluded that a taxpayer has a right to conduct an examination of IRS officials regarding their reasons for issuing an administrative summons when the taxpayer points to specific facts or circumstances plausibly raising an inference of bad faith. This issue has been in dispute more frequent given the procedures the IRS has adopted to enforce information document requests (IDRs), which may cause more summonses to be issued.
So the issue in Maxcrest is whether the IRS can do an end run around this prior Supreme Court case by simply re-issuing summonses once litigation has started. This would be easy enough for the IRS to do. The summons itself is nothing more than a piece of paper and issuing it only takes the IRS a few minutes. This would render most procedural challenges to IRS summonses moot.
The court appears to have recognized this. It agreed that this presents an issue of first impression that warrants further consideration. The case will be sent to the Ninth Circuit Court of Appeals for a decision.