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Use Your Imagination

Imagine the IRS notifies Taxpayer that they have an outstanding tax liability with respect to Tax Year, and that the agency intends to levy on Taxpayer’s property to collect the allegedly unpaid tax. Taxpayer challenges the levy, arguing they had already paid the tax. The IRS Office of Appeals sustains the levy, and Taxpayer petitions the U.S. Tax Court to review that decision.

Imagine also, while the issue of the levy is pending before the Court, the IRS withholds from Taxpayer a refund for a later tax period, to which Taxpayer is concededly entitled, and that is unrelated to the levy.  

Then imagine the IRS applies the refund – an amount that is owing from the federal government to Taxpayer – against what the agency has asserted is Taxpayer’s unpaid tax liability for Tax Year, thereby satisfying it in full.

Finally, imagine the IRS subsequently files motion to dismiss the Tax Court proceeding for mootness, which the Court grants because the tax liability challenged by Taxpayer no longer exists thanks to the unilateral action of the IRS.

Hard to imagine? Unfortunately for Taxpayer, no.[i]  

Taxes Paid – But for Whom?

Taxpayer and her then Spouse prepaid their estimated tax liability for Tax Year. Specifically, in June of that year, the couple submitted an estimated tax payment of $20,000 to the IRS. The check was drawn from a bank account that listed both Taxpayer’s and Spouse’s names. The accompanying Form 1040-ES also listed both of their names. In January of the immediately succeeding year, Spouse sent an estimated tax payment of $30,000 for the Tax Year. The check Spouse used to make the payment listed only his name. The cover letter accompanying the check, however, listed both Taxpayer’s and Spouse’s names. 

When they made these payments, Taxpayer and Spouse did not specify how they wanted the IRS to allocate the payments to their respective tax liabilities. What’s more, Taxpayer’s late-filed return for Tax Year did not even mention the estimated payments.

After processing Spouse’s return, the IRS sent him a notice that showed it had applied the full $50,000 in estimated payments to offset the tax due on Spouse’s individual return for Tax Year.

Amended Returns

In the next succeeding year, Taxpayer filed an amended tax return to report additional income from a retirement account distribution, causing additional tax due for Tax Year. On that return, Taxpayer claimed the benefit of the same $50,000 in estimated tax payments (that the IRS had applied to Spouse’s tax liability for that year) and requested a refund.

The IRS assessed Taxpayer the additional tax she reported,[ii] but it did not refund or otherwise credit her for the $50,000 in estimated payments that she claimed.

Soon after, Spouse filed an amended tax return for Tax Year. He included a statement that he was amending his return in part to notify the IRS that there were estimated payments of $50,000 made with respect to Tax Year that should be allocated to Taxpayer, thereby indicating his approval of Taxpayer’s previously filed amended return in which she claimed the benefit of the estimated payments (though he failed to mention on his tax return that the IRS had already allocated the $50,000 in estimated payments to him or that he had an offer-in-compromise pending).

The IRS, however, did not adjust the allocation of the $50,000 from Spouse to Taxpayer.

Spouse subsequently submitted an amended offer-in-compromise to increase the amount of his offer, which the IRS accepted. Despite Spouse’s earlier direction that the estimated payments should be allocated to Taxpayer, the IRS gave him a document showing it had credited the $50,000 in estimated payments to his outstanding tax liability.

The Levy

Following Taxpayer’s failure to pay the tax shown as owing on her amended return, the IRS sent Taxpayer a “Final Notice of Intent to Levy and Notice of your Right to a Hearing.” That notice informed Taxpayer that the IRS intended to levy on her property for failing to pay her remaining tax liability for Tax Year and that she had thirty days to appeal the levy by requesting a Collection Due Process (CDP) hearing with the IRS Office of Appeals.[iii]

Taxpayer timely requested a CDP hearing and, because she did not previously receive a notice of deficiency or “otherwise have an opportunity to dispute [her] tax liability,” she exercised her right to challenge “the existence or amount of the underlying tax liability” in the CDP proceedings.[iv] 

Specifically, Taxpayer alleged that the $50,000 of estimated tax payments credited to Spouse should have been credited to her, thereby eliminating her underlying tax liability.[v]

During the CDP hearing, the IRS told Taxpayer that the IRS could not credit any of the estimated payments to Taxpayer’s liability because the payments had already been credited to Spouse’s account, which had been subject to an accepted offer-in-compromise.

With that, the Office of Appeals sustained the IRS’s proposed levy, stating it was “not in a position” to move credits from Spouse’s account to Taxpayer’s.

Taxpayer timely disputed the IRS’s determination by filing a petition with the Tax Court in which she asked the Court to review her underlying tax liability and to conclude that the $50,000 in estimated tax payments should be applied to her account.

Diverted Refunds

Throughout the years that Taxpayer was arguing with the IRS about her tax liability for Tax Year, including in the CDP hearing and in the Tax Court, the IRS was taking tax refunds that Taxpayer was owed for later years – years in which she had clearly overpaid taxes – and applying them to what the IRS determined was her allegedly unpaid income tax liability for Tax Year.[vi] After doing this six times, Taxpayer’s balance due for Tax Year, as asserted by the IRS, was eliminated.

With no remaining unpaid tax on which to execute a levy, the IRS moved to dismiss the Tax Court proceeding as moot. Despite Taxpayer’s opposition, the Tax Court granted the motion and dismissed Taxpayer’s petition because there was no longer an “unpaid liability … upon which a levy could be based.” In other words, there was no longer a disputed tax liability

Taxpayer timely appealed the Tax Court’s order to the federal Third Circuit Court of Appeals.

The Circuit Court

After confirming its jurisdiction, as well as the Tax Court’s, over Taxpayer’s matter, the Court of Appeals (hereinafter the “Court”) stated:

“The dispute comes down to this: whether, in the midst of litigation over a contested tax liability, the IRS is free to deprive the Tax Court of jurisdiction by the expedient of taking the taxpayer’s tax refunds and applying them to that liability. The answer is no. The IRS’s arrogation to itself of the power to eliminate pre-deprivation judicial review of liability by seizing a taxpayer’s money to cover a disputed debt is not supported by relevant statute, common law . . . , or mootness principles.”

The Court observed that both parties were in agreement that the Tax Court is not required to hear a case when there is no longer a live controversy between the litigants. At that point, a case is moot and the court is deprived of jurisdiction to hear the case.  

The Court then rejected the IRS’s argument that, because there was no levy and no unpaid tax, Taxpayer’s challenge to the proper allocation of the estimated tax payments was extinguished. After describing the IRS’s position as “nothing but self-serving word play,” the Court added that Taxpayer’s tax liability “did not exist in a vacuum, separate from payments she made on that liability. She would only have an underlying liability if the tax was unpaid after she filed her amended return.”

According to the Court, a taxpayer’s “challenge to the existence or amount of the underlying tax liability” involves whether and how much the taxpayer has paid on that liability. 

It explained that a dispute over whether the IRS appropriately credited a taxpayer’s account with estimated tax payments was a dispute over the taxpayer’s underlying tax liability.

Therefore, Taxpayer’s argument that her estimated tax payments were erroneously allocated to Spouse was a challenge to her underlying tax liability and was appropriate for the Tax Court to consider.

The Setoffs

Next, the Court considered what it called the IRS’s “unlawful credit setoffs.”

Under the Code,[vii] the IRS normally must refund to taxpayers any tax payments in excess of their liability for a taxable year. However, the Code also allows the IRS to apply any refund amount owing to a taxpayer as a setoff against the taxpayer’s unpaid tax debts, thus lowering or eliminating the amount of the refund.[viii]

The IRS contended that the Code stripped the Tax Court of its jurisdiction to review setoffs, citing a provision of the Code which states that the “Tax Court shall have no jurisdiction under this subsection to restrain or review any credit or reduction made by the Secretary” under its authority to make credits or refunds.[ix]

The Court rejected the IRS’s interpretation, pointing out that the provision cited was limited to describing the Tax Court’s overpayment and refund jurisdiction in a deficiency proceeding – not a CDP proceeding. Thus, the cited provision was inapplicable to Taxpayer’s case.[x]  

The Court then turned its attention to the IRS’s application of its “right of setoff.” This right, the Court explained, allows parties that owe each other money to apply their mutual debts against each other, thereby avoiding “the absurdity of making A pay B when B owes A.”

The right to apply mutual debts to offset each other, the Court continued, “does not apply when the debts are disputed.” Accordingly, a creditor cannot set off a disputed debt with an undisputed one. “That is a matter of black letter law,” the Court observed. 

Although the Code allows the IRS to credit overpayments to “any liability” of the taxpayer, the Court pointed out that the IRS’s reading of the statute amounted to “an exercise in pure bootstrapping.” Taxpayer alleged that she did not have a liability – the IRS could not simply dismiss Taxpayer’s challenge by declaring that she did have such a liability and then claim it was allowed to effect a setoff.

According to the Court, the law is exactly to the contrary. The whole point of the Code’s authorization of CDP hearings, the Court continued, was to give taxpayers “protections in dealing with the IRS that are similar to those they would have in dealing with any other creditor.”  Allowing offsets such as the ones applied by the IRS – i.e., the IRS’s obligation to provide refunds that arose from Taxpayer’s overpayment of taxes – against Taxpayer’s disputed liability defeated the entire purpose of a CDP hearing.[xi]  

The Court added that the setoffs in question also violated mootness principles. “One scenario in which we are reluctant to declare a case moot is when the defendant argues mootness because of some action it took unilaterally after the litigation began.” Stated differently, the IRS may not unilaterally remove a matter from the Tax Court’s jurisdiction, as it did with respect to Taxpayer, by taking her money without her consent.

The Court stated that because the IRS’s setoffs were invalid, Taxpayer’s claims were not rendered moot when the IRS withdrew its levy. 

According to the Court, the provision of the Code[xii] under which Taxpayer brought her challenge permits a taxpayer to “also raise at the hearing challenges to the existence or amount of the underlying tax liability … if the person did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.” Taxpayer met these prerequisites. The rights provided under this provision are not restricted, the Court explained, by any requirement that they relate to an unpaid tax[xiii] or proposed levy. Consequently, there is nothing to suggest that Taxpayer’s right to challenge the existence or amount of her underlying tax became moot once the levy was no longer being enforced or the tax was satisfied.

The broader purpose of the CDP process in the overall statutory scheme, the Court stated, was to “collect the correct amount of tax.” Allowing a taxpayer to challenge their underlying tax liability in a case such as Taxpayer’s, even after the IRS ceases collection, supports that objective and comports with fundamental due process.

Notwithstanding any overpayment or refund jurisdiction, a live dispute as to underlying liability does not become moot based upon payment of the “unpaid” tax. The Code “grants the Tax Court jurisdiction to review a CDP determination regarding a taxpayer’s properly raised challenge to the existence or amount of her underlying tax liability, full stop.” That jurisdiction does not change until the dispute is resolved.

For the foregoing reasons, the Court vacated the Tax Court’s order of dismissal and remanded the case to that court to determine whether Taxpayer  was entitled to receive credit for any amount of the estimated tax payments at issue.

You Can’t Make It Up

The IRS clearly overreached in Taxpayer’s case. Thankfully, the Third Circuit did what the Office of Appeals or the Tax Court should have done – preserved Taxpayer’s opportunity to dispute what the IRS claimed she owed in taxes before the IRS took any steps to collect such taxes.

It is worth noting there are basically two basic ways by which taxpayers can dispute what they owe the IRS before any collection activity is undertaken.

The first involves a deficiency proceeding, which arises when the IRS determines that a taxpayer owes more than the amount of tax reported on their tax return. At that point, the IRS mails the taxpayer a “notice of deficiency.”[xiv] The taxpayer may challenge the IRS’s tax determination by filing a petition with the Tax Court within ninety days after the mailing of the notice of deficiency.[xv] The Tax Court may then determine the correct amount of tax owed by the taxpayer.  

The second involves a CDP hearing, which arises after a taxpayer fails to pay the amount of tax that the IRS says is owed. At that point, the IRS may seize and sell the taxpayer’s property to satisfy the tax liability.[xvi]   Before doing so, however, the IRS must provide the taxpayer an opportunity for a hearing to contest the levy. After the IRS notifies the taxpayer of its intent to levy, the taxpayer has thirty days to request a hearing by the IRS Office of Appeals. As explained above, the CDP hearing affords the taxpayer an opportunity to challenge the existence or amount of their underlying tax liability if the taxpayer did not receive a notice of deficiency regarding such liability or did not otherwise have an opportunity to dispute it. After the Office of Appeals makes a determination on the taxpayer’s challenge, the taxpayer has thirty days to petition the Tax Court to review any issues that were raised at the CDP hearing.

A taxpayer who is confronted with a notice of deficiency or a notice of intent to levy would be well-served to seek the advice of a tax professional.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Zuch v. Commissioner, No. 22-2244 (3rd Cir. Mar. 22, 2024).

[ii] The tax was self-assessed; thus Taxpayer never received a notice of deficiency. In other words, she did not have a previous opportunity to challenge the underlying tax liability.

[iii] IRC Sec. 6330.

[iv] IRC Sec. 6330(c)(2)(B).

[v] Prior to the hearing, Taxpayer’s counsel submitted a signed declaration from Spouse directing the IRS to apply the $50,000 to Taxpayer’s personal tax liability. This was dated several months after Spouse had received credit for the estimated payments pursuant to his amended offer-in-compromise.

[vi] Significantly, the IRS provided no evidentiary support that notice of the setoffs was sent to Taxpayer.

[vii] IRC Sec. 6402.

[viii] IRC Sec. 6402(a).

[ix] IRC Sec. 6512(b)(4).

[x] The Court also rejected the IRS’s argument that Congress did not affirmatively grant the Tax Court the power to review setoffs in a CDP case. Such power, the Court stated, was implicitly granted the Tax Court.

[xi] Reg. Sec. 301.6330-1(g)(2), Q&A (G)(3) (2006) provides that the IRS may offset overpayments against the unpaid tax in a CDP proceeding during the pendency of the CDP hearing and appeals process. According to the Court, to the extent the regulation provides that the IRS can take an undisputed debt (i.e., an overpayment of taxes, giving rise to an obligation by the government to provide a refund) and apply it against a disputed one (like Taxpayer’s alleged tax liability), such interpretation was untenable.

[xii] IRC Sec. 6330(c)(2)(B).

[xiii] I.e., one that is not disputed but remains outstanding.

[xiv] IRC Sec. 6212(a).

[xv] IRC Sec. 6213.

[xvi] IRC Sec. 6331(a).