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Taxpayers often regret agreeing to IRS audit adjustments. These agreements are not necessarily final when the paperwork is signed. The taxpayer typically still has time to change their mind. In Sandoval Lua v. United States, No. 2016-1313 (5th Cir. 2016), the court considered a case where the taxpayer changed his mind, but failed to act in a way that would preserve his right to change his mind.
The Facts and Procedural History
The facts and procedural history for the case are as follows:
- The IRS audited the taxpayer’s 2003, 2004, and 2005 income tax returns.
- The IRS proposed adjustments and signed a Form 4549 to waive their right to a notice of deficiency for 2003 and 2004.
- The taxpayer hired a tax adviser, who promptly submitted an audit reconsideration request.
- The IRS agent assessed deficiencies for 2003 and 2004 and continued to work with the taxpayer to prepare amended returns for 2003 and 2004.
- The amended returns were filed in 2008 that were substantially similar to the tax the IRS assessed and the taxpayer paid the tax for 2003 and 2004.
- The taxpayers filed amended returns in 2010 for the 2003 and 2004 tax year to recoup the amounts paid in 2008.
- The IRS and the Federal Claims Court denied the refunds, which the taxpayer appealed.
The IRS Notice of Deficiency Requirement
The IRS is generally prohibited from assessing or collecting income taxes until it issues a notice of deficiency to the taxpayer. The notice of deficiency gives the taxpayer the ability to petition the U.S. Tax Court. It is often referred to as a 90-day letter, as the taxpayer has to petition the tax court within 90 days.
Waiving the Notice of Deficiency Requirement
One of the exceptions to this rule is where the taxpayer waives the requirement that the IRS issue a notice of deficiency. The taxpayer generally does this by signing the Form 4549. The Form 4549 is the form the IRS typically uses to compute the amount of the tax. It is a two page form that often includes several pages of tax calculations. The waiver language is at the bottom of the second page of the Form 4549. Taxpayers sign this form to close the IRS audit as an “agreed audit” that does not end up going to appeals or to the U.S. Tax Court.
Taxpayers are not necessarily stuck with the results in the Form 4549. The Regulations say that the taxpayer can withdraw the wavier up until the tax is assessed. The term “assessment” refers to the recording of a tax liability on the IRS’s books. There may be quite a long time between the time the taxpayer signs the Form 4549 and the time the IRS makes the assessment. This is what happened in the Sandoval Lua case.
The Withdrawal of the Waiver Cannot be Implied
In the Sandoval Lua case, the tax adviser filed an audit reconsideration request without ensuring that the tax had already been assessed. In court, the taxpayer then argued that the premature audit reconsideration–which was not really an audit reconsideration request given that the audit was not previously closed–was really a withdraw of its notice waiver. The taxpayer argued that this withdrawal was implied, given that the audit reconsideration request showed that they did not agree with the adjustments in the Form 4549.
This argument is supported by the fact that the regulations do not provide any specific procedures for withdrawing the waiver. The premature audit reconsideration request would have put the IRS on notice that the taxpayer did not agree with the adjustments.
The appeals court did not agree. While the court did not directly say that the taxpayer has to provide a written statement to withdraw its waiver, the implication is just that. Since the premature audit reconsideration request in the Sandoval Lua case did not mention withdrawal or waiver, the court concluded that the waiver was not withdrawn.
So the takeaway from the Sandoval Lua case is that taxpayers who would like to withdraw their consent to IRS adjustments made on audit have time to change their minds. To do so, they should check to see whether the tax has been assessed and, if it has not been assessed, the taxpayers should send the IRS a letter expressly withdrawing their waiver of the notice of deficiency requirement.
Bankruptcy can be a great way to get rid of older tax debts. The bankruptcy process is supposed to provide a fresh start. The In re Christensen, 15-29773, 15-29783 (2016 Bankr. D. Utah), case is an example where the IRS attempted to use the bankruptcy process not to provide a fresh start, but to collect more taxes than it might have otherwise been able to collect.
Facts and Procedural History
The taxpayer filed for Chapter 7 bankruptcy. He owned his residence at the time. The property was subject to a mortgage. It was also subject to IRS and state tax liens for non-dischargeable taxes (taxes for older years are generally discharegable; whereas, taxes for newer years are not). The mortgage and tax liens totaled $417,494.84. This total amount was approximately the same as the fair market value of the property.
The IRS’s Plan
With respect to the taxpayer’s residence, the bankruptcy trustee is generally required to abandon the property if its sale would not generate funds for the benefit of the bankruptcy estate. This would have been the case here, as the secured creditors claims equaled the fair market value of the property. If the trustee abandoned the property, the bankruptcy estate would not have sufficient assets to satisfy the taxes that were due to the IRS. The IRS would then have to attempt to collect from the taxpayer on its own.
Instead of doing this, the IRS suggested that the bankruptcy trustee administer and sell the property in exchange for the trustee being paid $10,000. This would allow the IRS to recoup nearly all of the tax as part of the bankruptcy and, leave the taxpayer with a small amount of non-dischargeable taxes that would be subject to the IRS’s existing lien.
To carry out this plan, the trustee had to deny the taxpayer’s homestead exemptions (which amounted to $51,000) and get the court to approve the sale and the $10,000 payment. Despite the taxpayer’s objections, the bankruptcy trustee put the property up for sale. A third party offered to buy the property for $425,000. The trustee then asked the court to approve the sale and $10,000 payment.
The Bankruptcy Court Rejected theh IRS’s Plan
The court described the IRS’s plan as follows:
At the behest of the IRS, the trustee agreed to market and sell the debtors’ homes despite the fact that they were over-encumbered. In exchange, the IRS agreed to subordinate its lien insofar as necessary to provide $10,000 to the estate, while the trustee and his counsel would use 11 U.S.C. § 724(b) to have their fees and costs paid in full from the sale proceeds prior to the IRS. The debtors, however, would not receive any payment in satisfaction of their claimed homestead exemptions. Instead, they would lose their homes without any funds in return with which to acquire a new place to live, and proceeds from the sale of the homes would go to the trustee and his counsel instead of toward the IRS’s claim.
The court noted the tax aspect of the harm that would befall the taxpayer given the IRS’s plan:
These types of arrangements between trustees and the IRS have the potential to cause another devastating consequence for debtors. …. In essence, by paying a trustee and trustee’s counsel before the IRS, the value in the debtor’s home that would ordinarily be available to pay tax debts would instead be used to pay the trustee’s administrative expenses, leaving unpaid tax debts that are foisted onto that debtor’s shoulders. If this bargain were permitted, trustees would sell debtors’ homes, potentially force debtors to pay for it, and give nothing to debtors from the sales.
The court noted that the trustee was only entitled to be paid for work that benefitted the bankruptcy estate. It concluded that the only benefit of selling the over encumbered property was to benefit the trustee and the IRS, to the taxpayer’s detriment. The court even said that this plan pushed by the IRS was not the fresh start contemplated by the Bankruptcy Code. The court denied the trustee’s request for compensation.
If a sole proprietor is able to deduct an expense he incurred in the year he died for property that was not used up in the year he died, must his estate then report the amount as income in the following year for the amount of taxes saved by the deduction in the prior year? This question is answered by considering the tax benefit rule. The court addressed this for the first time in Estate of Backemeyer,147 T.C. 17, concluding that the tax benefit rule does not apply to transfers at death.
Estate of Backemeyer
In Estate of Backemeyer, the husband purchased farm inputs (supplies) and died in year 1 and his surviving wife, who had inherited the farm inputs, used the farm inputs in operating the farm in year 3.
The IRS agreed that the tax benefit rule did not apply to the surviving wife’s farming activity. That was not in dispute.
Instead, the IRS argued that the husband’s estate had to include income in Year 3 in the amount of the tax benefit he received from his prior deduction for the farm inputs, due to the tax benefit rule.
About the Tax Benefit Rule
The tax benefit rule requires an amount be included in income in the current year in the amount of the tax benefit the taxpayer received in a prior year, if the assumptions underlying the deduction in the prior year turn out to be false.
For example, if a sole proprietor deducts the costs of supplies in year 1 and then uses the supplies personally in year 2, he must include an amount in income in year 2 equal to the tax benefit from year 1. This is required because the assumption in year 1 that the item would be used in a business, rather than the item being used personally, turned out not to be true in year 2. Without this rule, taxpayers would be able to deduct the same expense in year 1 and then again in year 2. This would create an impermissible double deduction.
The tax benefit rule is summarized using a four-part test. This test says that:
an amount must be included in gross income in the current year if, and to the extent that: (1) The amount was deducted in a year prior to the current year, (2) the deduction resulted in a tax benefit, (3) an event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and (4) a nonrecognition provision of the Internal Revenue Code does not prevent the inclusion in gross income.
Death is Not Inconsistent With the Deduction
In Estate of Backemeyer, the question was whether there was an event that was inconsistent with the deduction. The taxpayer argued that there was no event that was fundamentally inconsistent with the premises on which the deduction was originally based. The court agreed with the taxpayer.
It distinguished the leading court case on point in which the tax benefit rule was applied to a corporation that was liquidated, nothing that the:
liquidation of a corporation or a sale of expensed business inputs entails some level of forethought and affirmative intent to act accordingly, death ordinarily does not involve such planning. As the Court of Appeals for the Eighth Circuit has observed, while death may be beneficial for tax purposes, it is difficult to regard it as a tax avoidance scheme.
Based on this, the court concluded that a transfer at death is not “fundamentally inconsistent with the premise” on which the business deduction is initially based. So the tax benefit rule does not apply to transfers at death.
Taxpayers who have had the IRS raise this issue on audit should contact a tax advisor to discuss this case and what it means for them.
Taxpayers who are assessed trust fund recovery penalties need to take note of the U.S. Tax Court’s recent decision in Anderson v. Commissioner, T.C. Memo. 2016-219. The decision highlights a potential foot fault they may make when trying to resolve their trust fund recovery penalties at the IRS administrative level.
Facts and Procedural History
The facts and procedural history for the case are as follows:
- The taxpayer was a partner in a law firm.
- The IRS assessed trust fund recovery penalties against him when the law firm’s employment taxes were not paid over to the IRS.
- The IRS issued the taxpayer the equivalent of a 30-day letter for several of the tax periods (the trust fund recovery penalty is proposed in a 60-day letter, a Letter 1153).
- In response, the taxpayer filed a protest to contest his liability for the penalties.
- Appeals closed the case and the IRS issued a levy notice to collect the unpaid penalties.
- The taxpayer requested a CDP hearing.
- The CDP hearing was suspended pending a criminal investigation.
- During this time, the taxpayer submitted an offer in compromise, doubt as to liability, contending that he was not a responsible person for the penalties.
- Appeals eventually closed the CDP hearing case and rejected the offer in compromise, without having a hearing.
- The taxpayer filed a petition with the court to have the case re-opened in Appeals.
The question before the court was whether the taxpayer could contest the liability in a CDP hearing and, by extension, in court.
An Opportunity to Contest the Liability
Section 6330 permits a taxpayer to challenge the existence or amount of his underlying liability in a CDP proceeding only if the taxpayer did not receive a notice of deficiency or otherwise have a prior opportunity to contest the liability. This begs the question as to what qualifies as an opportunity to contest the liability when it comes to the trust fund recovery penalty? The U.S. Tax Court addressed this in Anderson by considering several prior cases.
Challenging the Liability for the Penalty
In Siquieros v. United States, 94 A.F.T.R.2d (RIA) 2004-5518 (W.D. Tex. 2004), the taxpayer was assessed trust fund recovery penalties. The taxpayer submitted an offer-in-compromise, doubt as to liability. The taxpayer then submitted a CDP hearing request and asked the court to review the case when the hearing was not successful. In Siquieros, the court concluded that the taxpayer did not have a prior opportunity to contest her liability, so the taxpayer in that case was allowed to raise the issue in the CDP hearing and, as a result, in court. This decision was handed down by a U.S. District Court in Texas and affirmed by the Fifth Circuit Court of Appeals.
Challenging the Amount of the Tax
The U.S. Tax Court has weighted in on this issue as well. It did so in Baltic v. Commissioner, 129 T.C. 178 (2007), in which the taxpayer received a notice of deficiency for an income tax and he filed an offer in compromise, doubt as to liability, as part of a CDP hearing. In Baltic, the U.S. Tax Court concluded that the taxpayers were challenging the amount of the tax during the CDP hearing and by submitting an offer, not their liability for the tax vs. the liability of other persons. So the court concluded that the taxpayer could not raise the issue in the CDP hearing or, as a result, in court.
In Anderson, without explanation, the U.S. Tax Court cited two of its prior opinions for the proposition that a challenge to the liability for the trust fund recovery penalty is a challenge to the amount of the penalty. It then cites its Baltic opinion to conclude that the taxpayer in Anderson was able to contest his liability for the penalty and he did so prior to the CDP hearing.
So according to the U.S. Tax Court, a taxpayer cannot challenge his responsibility for trust fund recovery penalties and not contest the amount of the penalty, and thereby preserve his right to a CDP hearing for the liability and for the U.S. Tax Court to have jurisdiction over the IRS’s decisions for the penalty. The law is not settled on this issue, however. This is particularly true for taxpayers who are in the Fifth Circuit.
Taxpayers who are assessed trust fund recovery penalties should take note of the Anderson case. They should be very clear in their protests and in any offer in compromises that they submit, that they are only contesting the liability for the penalties as a responsible person, and not the amount of the penalties themselves. This may help preserve their CDP hearing rights and, ultimately, the right to have the U.S. Tax Court review the liability.
Innocent spouse relief can allow a taxpayer to avoid joint liability for taxes that arose during the marriage. If granted, the tax is generally computed as if each spouse filed their tax returns separately. If the couple is divorced at the time, there is an exception that can prevent the would-be innocent spouse from qualifying for relief. This exception asks whether the would-be innocent spouse had actual knowledge of the item that resulted in the tax. The U.S. Tax Court addressed this limitation in McDonald v. Commissioner, T.C. Summary Opinion 2016-79, making it possible for taxpayers to qualify for relief even if it seems clear that they have “actual knowledge.”
The Facts & Procedural History
The facts and procedural history of the case are as follows: The taxpayers were divorced. The IRS audited their income tax returns and, among other things, proposed a tax adjustment related to rental real estate that the taxpayers owned. The real estate was located out of state, the taxpayers had local property managers who managed the properties, and the (ex)husband oversaw the rental real estate and kept the books for the real estate. The real estate produced tax losses in excess of $25,000 a year and the taxpayers deducted these amounts each year. The IRS adjusted the losses to $25,000 a year pursuant to the passive activity loss rules. The (ex)wife requested innocent spouse relief. The IRS concluded that she was entitled to relief. The issue for the court was whether the (ex)wife should be granted innocent spouse relief despite the (ex)husband’s objection.
Innocent Spouse Relief
Without going into the details, there are three types of innocent spouse relief. The one at issue in this case applies if the taxpayers are divorced. As mentioned above, there is an exception that can prevent an ex-spouse from qualifying for relief. This exception says that the taxpayer will not qualify for relief if the IRS demonstrates that the would-be innocent spouse had actual knowledge, at the time she signed the return, of any item giving rise to a deficiency or a portion thereof, which is attributable to the other spouse.
This exception has traditionally been applied to cases where the innocent spouse was not aware of an item of income that was not reported on the tax returns. The exception is easier to apply in these cases, as the income is not reflected on the tax returns that the innocent spouse signed. So it is plausible that the innocent spouse may not have been aware of the income that was omitted.
In the McDonald case, the tax losses were reported on the tax returns that the innocent spouse signed. The evidence also showed that the innocent spouse knew of the real estate, the losses, and she even believed that her CPA had told her that she satisfied the tax rules that would allow the losses. It would seem that this is sufficient to establish that she had actual knowledge of the rental losses.
The court concluded that she did not have actual knowledge of the rental losses. The court noted that this exception, by its very terms, puts the burden on the IRS to make the showing. In this case, the IRS agreed that the (ex)wife qualified for innocent spouse relief. The (ex)husband was the only party that objected to granting innocent spouse relief. The law does not address this scenario, so the court applied the exception using a more liberal standard for determining “actual knowledge.”
If the court was correct in applying this standard, the takeaway is that a divorced taxpayer may qualify for innocent spouse relief, even if it is clear that they do not satisfy the exception, as long as they have a sympathetic IRS employee who is assigned to work the case. So it seems that the would-be innocent spouse should err on the side of requesting relief with the hope that they happen to draw an IRS employee who will not contest the issue, rather than not requesting relief.
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.