IRS Obtains Promissory Note: Can it Collect on the Note?

In United States v. Spangler, the Eleventh Circuit Court of Appeals upheld a lower court order requiring a taxpayer to transfer a promissory note to the government so that the note payments would be credited towards the amount of the taxpayer’s court ordered tax restitution.

Given that the IRS has a poor track record in collecting taxes from taxpayers via the traditional avenues, this scenario raises the question as to whether the IRS would be able to collect tax payments from third parties via a promissory note.

Generally an individual – be it a taxpayer or the government – steps into the shoes of the person who holds a promissory note and it acquires the rights of that person. If the individual is a taxpayer whose promissory note is seized by the government or turned over to the government via a court proceeding, the analysis then focuses on what rights the individual taxpayer had in the note.

A more precise question is whether the taxpayer who held the note was a “holder in due course.” A “holder in due course” is any person that acquires a negotiable promissory note without knowledge of any claims or defenses associated with the note. The individual who makes payments on a note that is held by a “holder in due course” is generally not justified in refusing to pay the third party due to defenses or claims that he or she may have against the original note holder.

A taxpayer who committed fraud related to the note would probably not qualify as a “holder in due course,” because their fraud would create a claim and defense to payment of the note. Similarly, taxpayers could structure the promissory note so that it is non-negotiable and/or only acquire non-negotiable notes – which would ensure that the government or other parties would might obtain the note would never qualify as a “holder in due course.”

If the taxpayer were not a “holder in due course,” a third party who was subject to the note could raise the defense of fraud, duress or illegality of the transaction in an effort to rescind the note and to recover the instrument or its proceeds. If the note were held by the government, the person making the payments could raise these defenses in order to recover the note proceeds from the government and to rescind the note.

It would be even more interesting if the third party raised a fraud defense, as the government would have to argue that the taxpayer – the same taxpayer that it convicted of tax fraud – did not commit fraud in order for the government to collect on the promissory note. This could create a conflict of interest for the government – one that tax criminals could conceivably, given the right facts, use to overturn their criminal tax fraud sentences.

Does this mean that taxpayers who are facing criminal tax fraud charges can simply transfer assets to a third party in exchange for a promissory note, with the aim of having the third party rescind or void the note and reclaim the note proceeds once the government obtains possession of the note?

The answer is probably not, as the government would likely pursue the third party for fraud as well and/or impose transferee liability upon the third party. The risk is simply too great. Although, this type of case would raise some very interesting issues and the government may find itself running into more of these cases due to the rising number of mortgage foreclosures and the recent increase in private investors purchasing promissory notes.

March 20th, 2007 | No Comments »

“Rule of Thumb:” IRS Employees Not Subject to Ethical or Moral Standards

Unlike tax attorneys, IRS employees are not subject to any ethical or moral standards. Take the case of Wormley v. Department of the Treasury. The Wormley case presents the unusual question as to whether an IRS employee should be fired if she is arrested and convicted of assault for “biting off a portion of her neighbor’s thumb during a physical altercation.”

The court opinion sets out the following facts: Patricia Wormley was employed as an IRS tax examining clerk in Philadelphia. Wormely was belligerent with her manager when the manager attempted to discuss Wormley’s training period performance. The IRS discovered that Wormely had been arrested when the IRS was investigating Wormley’s background (apparently after Wormely was already employed with the IRS).

After Wormely was convicted of simple assault, the IRS issued a letter to Wormley indicating that she would be removed from her position due to (1) her attack upon her neighbor, (2) her assault conviction, and (3) her inappropriate behavior toward her manager. The letter also mentioned that Wormley had “three [prior] instances of misbehavior.”

Wormely appealed the IRS determination. The IRS, an administrative law judge, and the Court of Appeals for the Federal Circuit held that “the removal penalty was reasonable considering Ms. Wormley’s potential for behaving violently and that her job involved working in close proximity to her co-workers and dealing personally with the general public.”

The Wormely case highlights one of the major problems with the IRS; namely, IRS employees are not held to any ethical or moral standard. Three documented instances of “misbehavior” should be sufficient to warrant termination – absent an arrest for assault or confronting an IRS manager (If there were three documented instances of “misbehavior,” one is left wondering how many instances of “misbehavior” were not documented).

The Taxpayer Bill of Rights is the only body of rules that come close to imposing standards on IRS employees, but these Rights are so basic that they do not really address ethical or moral standards for IRS employees.

Compare this to the lengthy do and do-not standards imposed on tax attorneys via state bar ethics rules, administrative rulings, court cases, and even IRS proclamations.

As the tax practitioner community is well aware, the IRS has been working on Circular 230 and its Office of Professional Responsibility to “strengthen professional standards” for non-IRS employee tax practitioners.

My personal opinion is that the IRS should extend these new “high” Circular 230 standards to its own employees before even beginning to think about extending them to non-IRS tax practitioners. This seems like a logical step if the goal really is to “strengthen professional standards.”

If Wormley were subject to Circular 230, she would probably have found herself before the United States Merit Systems Protection Board much sooner — perhaps with her first, second or third instance of misconduct.

Until the IRS opts to impose any standards on its employees, non-IRS employee tax attorneys will have to advise their clients that the “rule of thumb” is that IRS employees are not bound by any moral or ethical standards and that, absent extreme circumstances, IRS employees who “misbehave” will not lose their jobs and they will not be subject to any other IRS sanctions.

March 16th, 2007 | No Comments »

IRS Incentive to Delay Processing Cases: Extra Tax Penalties & Interest

I think that most citizens would agree that the IRS should not benefit from failing to do its job in a timely manner. The recent United States v. Ryals case provides an example of how the IRS can benefit from denying taxpayer claims and delaying the collection of taxes.

Ryals owed taxes for tax years 1977 and 1978. The tax court found Ryals liable for these taxes in 1989 and the IRS assessed the taxes at that time. By March 2003 Ryals tax liability had grown (due to tax penalties and interest) from just over $500,000, which was the amount assessed, to just over $1,500,000.

Between 1989 and 2003 Ryals was convicted of a tax crime and he submitted two offers in compromise that were rejected by the IRS. The IRS filed suit against Ryals for the unpaid tax on May 20, 2003. The main question for the court was whether the IRS collection statute had expired.

The court looked at the impact of three Congressional amendments which addressed whether submitting an offer in compromise tolls the IRS collections statute, to conclude that the collections statute expired 19 days AFTER the IRS filed suit against Ryals – which, unfortunately for Ryals, made it possible for the IRS to maintain its tax court case.

Here is a quote from the court’s opinion that I couldn’t resist mentioning: “Whether or not such a construction is at odds with temporary regulations issued, congressional intent, or the initial position of the Government as stated in its motion for summary judgment is irrelevant because the clear words of the statute command this result.” I really like this sentence. It is powerful. There is nothing like a court disregarding IRS-created law, Congress, an IRS attorney, and a taxpayer all in one sentence….

The court did agree with the IRS position that an IRS wage levy by the IRS can in fact continue after an offer in compromise is “pending,” so long as the wage levy was filed prior to the IRS accepting an offer in compromise for consideration. I personally do not agree with this “law,” as it gives IRS employees a strong incentive to delay in accepting offers in compromise for consideration.

Many of us will remember last year’s move by the IRS to consolidate the offer in compromise program by having all offers that are submitted be screened by one IRS office – which was supposed to speed up the offer processing time. This move has not only slowed down the processing of offers in compromise (yes, the IRS is actually getting slower), it also puts the IRS in a very good position to delay processing offers where a wage levy should be filed against taxpayers (the very thing that the IRS chides taxpayers for doing – even though IRS employees do it too).

Under the old IRS procedure for processing offers in compromise, the appeals office would not be able to have direct and impermissible contact with the exam or collections function to determine whether a wage levy was appropriate. Now, the offer processing center probably can have this type of contact as it does not seem to be impermissible ex parte contact (in that the appeals officer or even office that ultimately considers the case is not the one that initially received the offer in compromise for processing).

Cases like this really are unfortunate. Taxpayers should not be penalized by coming forward to make offers to settle their tax liabilities.

Also, taxpayers should demand something more of their chief tax collection agency. Having to argue about 19 days when the IRS had over 20 years to collect this tax has to be embarrassing for IRS administrators and employees (to say the least) and having to live with a tax debt for two decades is unduly burdensome for taxpayers.

There is something wrong with the IRS being rewarded for incompetence by being able to obtain a court judgment for a million dollars worth of penalties and interest that it would not have been entitled to collect had it done its job sooner rather than later.

March 15th, 2007 | No Comments »

Section 104 Survives Non-Murphy Constitutional Challenge

The now famous Murphy decision has left some uncertainties with regard to whether compensation for a personal injuries that are unrelated to lost wages or earnings are taxable. There can be little doubt that the IRS will ask the Supreme Court to settle the issue if the IRS is not successful in the coming Murphy rehearing. Two days ago the Ninth Circuit Court of Appeals issued its opinion in Polone v. Commissioner, solidifying its view that this type of compensation is in fact taxable and upholding Section 104 in light of a different Constitutional challenge.

Polone was a talent agent for United Talent Agency (UTA). UTA fired Polone and its agents allegedly made defamatory statements about Polone’s termination. Polone brought an action against UTA for wrongful termination and defamation. Polone and UTA agreed to settle the claims on May 3, 1996. Four million dollars of the six million dollar settlement was to compensate Polone for UTA’s alleged defamatory statements. The $4 million was to be paid in four biannual installment payments starting on May 3, 1996.

Polone did not report the first payment on his tax return, but he did report the second payment. Polone, believing that none of the installment payments were taxable, then filed an amended tax return seeking a refund of the taxes paid on the second settlement installment payment. The IRS asserted that Polone must report every one of the four payments and tax litigation ensued.

The tax court and the ninth circuit held the last three installment payments were taxable, but the first installment payment was not taxable. The courts concluded that the first payment was not taxable because it was received before the date that Congress amended Section 104 to exempt only payments on account of physical injuries.

Polone was not successful in arguing that the entire amount of the settlement payments was not taxable due to the agreement being finalized prior to Congress amending Section 104, because, according to the Ninth Circuit Court, California law provides that defamation claims are not transferable; therefore, applying Section 1001, the court took the position that Polone was selling his right to sue for defamation (i.e., a chose in action) in incremental sales with each sale being made at the time an installment payment was received.

According to the Ninth Circuit Court, the payments would not have been taxable if Polone entered into a formal agreement eight months prior to the date that the settlement agreement was entered into, because that agreement would have fit in to the grandfather exclusion provision set out in the new amended Section 104.

Polone argued that it was unconstitutional for Congress to enact a tax law that changes the tax consequences for his settlement agreement, because the change only provides a grandfather clause for agreements that were entered into one year or more prior to the enactment of the law (Section 104 was amended effective on August 20, 1996, the grandfather provision exempts agreements in effect as of September 13, 1995, and Polone’s agreement was entered into on May 3, 1996). In other words, Polone argued that Section 104, as amended, amounted to retroactive legislation that violated his Fifth Amendment due process rights.

The Ninth Circuit Court rejected Polone’s Constitutional argument because it held that the last three installment payments did not arise until after Section 104 was amended.

The Ninth Circuit Court of Appeals did not address the direct question of whether Section 104 is Constitutional (as challenged in the Murphy decision) because Polone did not specifically raise that issue; however, the Polone case represents yet another ninth circuit opinion that has held that personal injuries that are unrelated to lost wages or earnings are taxable.

March 14th, 2007 | No Comments »

IRS Uses Taxpayer Records to Secure Tax Fraud Conviction

Taxpayers who are being investigated for tax fraud should be very careful about turning over incriminating records to third parties. The recent Yang v. United States case provides an excellent example of how this can be a problem.

The Yang brothers and their parents were being investigated by the IRS for tax fraud related to the family’s China Buffet Restaurant. You Bin Yang was living with his parents when he called the local police to report that his house was burglarized. The burglars had taken $2,500 from his parents bedroom and a DVD player from You Bin’s bedroom.

During the burglary investigation the local police evidence technician discovered five unsealed notebooks on You Bin’s parents bedroom dresser. Three of the notebooks had a year inscribed on the cover. The evidence technician obtained You Bin’s permission to take the notebooks so that the technician could process them for fingerprints.

You Bin subsequently contacted the police to see if he could pick up the notebooks. The police officer, who knew of the IRS tax fraud investigation, then examined the contents of the notebooks and discovered that they appeared to be the Yang family financial records. They were written in Chinese. The police officer then contacted the IRS Criminal Investigations special agent and the special agent obtained a grand jury subpoena for the copies that the police officer had made (with You Bin’s permission) of the notebooks.

The government translated the notebooks into English and used the notebooks to indict You Bin and his brother for “for conspiracy to commit tax fraud, filing false tax returns, and conspiracy to structure currency transactions for the purpose of evading currency transaction reporting requirements.”

You Bin and his brother filed a motion to suppress the notebook evidence, arguing that the contents were protected under the Fourth Amendment. The district court and the Seventh Circuit Court of Appeals held that the notebooks are not protected by the Fourth Amendment because You Bin and his brother had no expectation of privacy in the copies of the unsealed notebooks that You Bin had turned over to the police.

Based on the Seventh Circuit’s opinion, it appears that You Bin would have prevailed if the notebooks were sealed and if he did not give the local police permission to copy the notebook contents. Of course, the Yang brothers might have avoided prosecution altogether had the taxpayer not turned the records over to the local police in the first place….

March 12th, 2007 | No Comments »

IRS Estate Tax Liens Might Not be as Helpful/Harmful as One Would Think

It can take years (if not decades) to resolve property disputes resulting from a taxpayer’s demise. The IRS uses the general unfiled estate tax lien to protect its interest in a decedent’s assets during this period. The federal estate tax lien is by far the IRS’ primary estate tax collection tool, yet the estate tax lien system is not as efficient as many taxpayers would expect.

The general estate tax lien arises when the estate does not pay an estate tax liability that is due and owing. This tax lien does not have to be filed or perfected in order to be valid and it attaches to all property that is included in the decedent’s gross estate (The general estate tax lien does not attach to property that is outside of the decedent’s gross estate or to assets that are included in the decedent’s gross estate that are expended for court-approved estate expenses).

Very few taxpayers end up with a gross estate that has a large enough value to incur an estate tax liability; however, owners of small (or large) businesses often do have taxable estates due to their business ownership (many wealthy non-business owners tend to hold their investments in business entities for the estate tax savings; entities which do qualify as legitimate businesses).

Congress has provided relief to business owners whose estates (i.e., whose businesses) are not able to immediately pay the full amount of their estate tax liability. Specifically, Congress has provided that executors for business owners can elect to pay the estate’s estate tax liability over a number of years if the primary asset of the estate is an interest in a closely-held business. The IRS imposes a Section 6324A special estate tax lien in these cases.

This type of special estate tax lien is only valid with regard to the specific assets agreed upon by the executor and the IRS, which usually consists of a security interest in the business entity (which, in many cases, is the only substantial estate asset). The special estate tax lien must generally be filed or otherwise perfected to be valid against third parties.

Once a special estate tax lien is filed, there is some uncertainty with regard to whether the general estate tax lien is extinguished. In a footnote in Chief Counsel Advice Memorandum 20070801F the IRS Office of Chief Counsel explains that “The Service’s position is that the general estate tax lien continues to attach all estate property except the property subject to the section 6324A [special estate tax] lien.” This may or may not be correct (The IRS attorneys also admit that this issue has never been directly decided by the courts).

Section 6324A(d)(4) does provide that “If there is a [special estate tax] lien … on any property with respect to any estate, there shall not be any [general estate tax] lien … on such property with respect to the same estate.” This section does not address whether the general estate tax lien survives the filing of a special estate tax lien.

As a practical matter, a filed or perfected special tax lien has the potential to mislead third parties who search the applicable records if the general estate tax lien is not extinguished by the filing of the special estate tax lien. Even though the special estate tax lien identifies the property that the lien attaches to, third parties may assume that the estate has resolved or fully addressed its estate tax obligations via this special estate tax lien and/or that the IRS does not intend to pursue any estate assets other than those listed in the special estate tax lien.

The IRS could easily remedy this situation by filing the general estate tax lien at the time that it files the special tax lien. The IRS should be required to make this additional filing given that it is the party who is in the best position to remedy the situation. The IRS should not be entitled to reap any benefits of an unfiled general estate tax lien if the IRS fails to make this filing.

At some point a taxpayer is going to litigate this tax issue, and there is some chance that the courts may not agree with the IRS’ current position.

This type of estate tax collection issue has not received as much fanfare as estate tax repeal; however, this type of tax collection issue can go a long way in reducing the impact, and ultimately the perceived injustice, of the federal estate tax regime. If opponents of the estate tax cannot secure a full repeal of the federal estate tax, they might be able to modify the tax collection rules to achieve their aims….

March 11th, 2007 | No Comments »

The IRS Appeals Office is NOT Independent or Unbiased

The IRS Appeals Office was created with the aim of providing taxpayers with an impartial and informal forum to have taxpayer and IRS disputes reviewed and tax controversies resolved. This function serves a vital role in our government’s system of administering our tax laws, yet appeals office employees frequently and blatantly violates IRS policies and our tax laws. The IRS’ recent announcement that it does not agree with the Tax Court’s determination in the Moore v. Commissioner case provides an example.

In the Moore case the IRS appeals offer and the IRS appeals offer specialist (the person that reviews offers in compromises that are submitted by taxpayers) had direct communication with two revenue officers – in violation of Section 1001(a) of the Revenue Restructuring Act of 1998. More specifically, the Revenue Officers passed along their belief to the appeals employees that the taxpayer had concealed assets from the IRS, which ultimately led the IRS Appeals Office to reject the taxpayer’s offer in compromise.

Section 1001 was enacted by Congress to prevent IRS appeals office employees from conspiring with the IRS collections employees (i.e., IRS debt collectors) and/or the IRS exam employees (or IRS auditors), to the detriment of the taxpayer. This is the key provision that allows the IRS Appeals Office to claim to provide taxpayers with “independent” and “unbiased” review of cases.

While the IRS has agreed that the IRS appeals office employees acted illegally in the Moore case, the IRS disagrees that the taxpayer in that case is entitled to a second independent appeals hearing. Thus, the IRS is saying the equivalent of “yes our employees got caught committing an illegal act, but our illegal act that harmed the taxpayer should not entitle the taxpayer to a fair review.” This highlights the flawed logic that is embraced by many IRS employees.

The Revenue Restructuring Act also provides that IRS employees employment must be terminated if there is a final adjudication or determination that the IRS employee violated our tax laws. One is left wondering if the IRS employees involved in the Moore case were fired. The reality is that most IRS employees are not fired, despite the law dictating that their employment must be terminated.

In many cases IRS managers will claim that an IRS employee who was caught breaking the law is not to be fired due to there being no official and/or final adjudication that the IRS employee acted illegally – even though there is no doubt that the IRS employee behavior was 100% illegal.

Even then, IRS managers are often the last people who should be making these decisions. In my experience the IRS managers often have a worse track record than their employees (one IRS manager that I met likes to brag to his employees that he used to start every taxpayer audit by asking the taxpayer what time it was and pointing out that he does not wear a watch due to IRS audits taking way too long, in an effort to intimidate taxpayers).

This isn’t to say that there are not good, decent, and honest people working for the IRS. It is to say that these bad apples exist and, in my opinion, the number of bad apples is much greater than the good apples and the bad apples often rule the roost. Unfortunately taxpayers have no way of knowing who they are talking to when they speak to IRS employees. I have often wondered if Congress should require all such complaints against IRS employees be reduced to writing and be made available to the public, so that taxpayers can check to see if their IRS employee is a good or bad apple.

There have been a number of tax practitioners who have questioned whether the IRS Appeals Office is truly an independent forum that provides an opportunity to have an unbiased review for tax controversies. Based on my experience, I would say that the answer is clearly “no” (and that does not take into account the fact that most IRS Appeals Office employees started out working for the IRS collection function, and they have not shed the “my only mission in life is to collect as much in taxes as possible no matter what the tax laws say” mentality).

The IRS Appeals Office’s illegal collusion was discovered by the taxpayer in the Moore case. I would guess that most taxpayers are not that lucky.

March 7th, 2007 | No Comments »