Enforcement
Earlier this year the IRS announced that, as part of its larger compliance efforts begun last fall under the Inflation Reduction Act,[i] the agency’s stepped-up enforcement activity with respect to high wealth, high income individuals had generated more than $1 billion in collections of past-due taxes.
One would be hard-pressed to seriously dispute that every taxpayer must pay the correct amount of income tax; no more, no less. That means a taxpayer has the right to pay only the amount of tax that is legally due and the right to have the IRS apply all tax payments properly.[ii]
Proper Amount of Tax
In order to ensure this outcome, a taxpayer has the right to raise objections and provide documentation in response to IRS actions that seek to determine the taxpayer’s correct income tax liability. The taxpayer also has the right to expect that the IRS will consider their timely objections and documentation promptly and fairly. In addition, a taxpayer is entitled to a fair and impartial administrative appeal of most IRS decisions, though they may also avail themselves of the federal courts.
If a taxpayer believes they have overpaid their taxes for a particular taxable year, they have the right to file a claim for a refund and to provide documentation to support their claim. If an overpayment is established, it must be paid over to the taxpayer, though the IRS may, instead, credit the amount thereof against any income tax owed by the taxpayer in respect of an earlier taxable year.
Before considering whether a petition for cert recently filed by the federal government seeks to impinge upon the foregoing rights of an individual taxpayer (“Taxpayer”), it may behoove us to briefly review the examination and collection context in which the challenge to such taxpayer’s rights arose.
Examination
Individual taxpayers, including business owners, who have been the unfortunate target of IRS enforcement activity probably have less than fond memories of the audit process, which began with a letter from the IRS notifying the taxpayer that their income tax return had been selected for examination, and providing a list of questions for the taxpayer to address regarding various items shown on the return.[iii]
In addition to asking several questions regarding the items reported on the return, the IRS may also have requested the production of certain information or supporting material relating to entries on the return.[iv]
Statute of Limitations
Depending upon the size and complexity of the tax return, the examiner may need more time to complete the audit[v] and process the audit results.
If that is the case, the examiner may ask the taxpayer to agree to an extension of the statute of limitations for the assessment of any tax deficiency that may ultimately be determined.[vi]
Notice of Deficiency
If the IRS proposes changes to the taxpayer’s return with which the taxpayer disagrees – i.e., a tax deficiency or a reduced refund for the taxable year in question – the taxpayer may file a protest with the IRS Office of Appeals,[vii] provided there is enough time remaining on the statute of limitations.
Otherwise, the IRS will send the taxpayer a notice of deficiency which, in addition to giving the taxpayer legal notice that the IRS is proposing a tax deficiency, also tolls[viii] the statute of limitations.[ix]
Tax Court
The taxpayer will have the right to challenge the proposed adjustments and the resulting deficiency in the U.S. Tax Court by filing a protest within 90 days of the date of such notice.[x]
The Court cannot acquire jurisdiction with respect to the taxpayer’s return for the taxable year in question prior to the IRS’s formal assertion of a tax deficiency for such year – no deficiency, no jurisdiction.[xi]
Once the Tax Court has jurisdiction over the taxpayer’s matter, it may determine the correct amount of tax owed;[xii] it may also order that any overpayments be refunded to the taxpayer.[xiii]
Collection
If the taxpayer agrees with the tax deficiency asserted by the IRS or fails to timely petition the Tax Court after receiving a notice of deficiency, or if the Tax Court ultimately agrees with the IRS’s position, the additional tax owing will be formally assessed[xiv] and the IRS will issue a notice and demand for payment[xv] of the deficiency.[xvi]
If the taxpayer fails to pay the additional tax after such demand, the amount owed becomes a lien upon all of the taxpayer’s property (including after-acquired property),[xvii] and the IRS may collect such tax by levy upon all property and rights to property belonging to the taxpayer.[xviii]
Due Process
However, before the IRS levies on the taxpayer’s property, it must notify the taxpayer of its intentions and provide the taxpayer an opportunity for a hearing to contest the levy.[xix]
The taxpayer has thirty days to request a so-called Collection Due Process (“CDP”) hearing,[xx] which is an administrative proceeding before the IRS Office of Appeals in which the taxpayer may raise any relevant issue relating to the unpaid tax or the proposed levy.[xxi] The request for a hearing generally suspends the levy action at issue, as well as the running of the limitations period relating to the collection of tax after assessment.[xxii]
The taxpayer may even use this opportunity to challenge the existence or amount of the underlying tax liability if they did not receive a notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute the tax liability.[xxiii]
Once the Office of Appeals makes a determination on the taxpayer’s challenges, the taxpayer has thirty days to petition the Tax Court to review any issues that were properly raised at the CDP hearing.[xxiv]
The Offset
With the foregoing procedures in mind, let’s consider the case of Taxpayer:
- Taxpayer files an amended income tax return to report additional income for Tax Year – thus, the tax thereon was self-assessed;
- Taxpayer claims a credit against this increased tax liability based upon what she believes was an overpayment of estimated tax for Tax Year;
- The IRS assesses the additional income tax, but does not credit the overpayment claimed by Taxpayer;[xxv]
- The IRS notifies Taxpayer that she has an outstanding tax liability with respect to Tax Year and demands payment;[xxvi]
- The agency informs Taxpayer that it intends to levy on her property to collect the unpaid tax for Tax Year;
- Taxpayer timely challenges the levy at a CDP hearing,[xxvii] arguing she has already paid the tax;
- The IRS Office of Appeals sustains the levy;
- Taxpayer petitions the U.S. Tax Court to review that decision;
- While the issue of the levy is pending before the Court, the IRS withholds from Taxpayer a refund to which the IRS agrees she is entitled for a later taxable year (the “Refund”);
- The IRS applies the Refund amount against what the agency has asserted is Taxpayer’s unpaid tax liability[xxviii] for Tax Year, thereby satisfying such liability in full;
- The IRS moves to dismiss the Tax Court proceeding for mootness because the income tax liability challenged by Taxpayer no longer exists;
- The Court grants the IRS’s motion because there is no longer an unpaid tax liability upon which the levy could be based – a “live controversy”;
- Consequently, the Court also dismisses Taxpayer’s petition;
- Taxpayer timely appeals the Tax Court’s decision to the federal Third Circuit Court of Appeals.[xxix]
The Court of Appeals
The Circuit Court framed the dispute before it as “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.”
According to the Court, “[t]he answer is no.”
Although the Code allows the IRS to apply any refund amount owing to a taxpayer as a setoff against the taxpayer’s unpaid tax debt,[xxx] the Court rejected the application of this rule “when debts are disputed;” i.e., a creditor cannot set off a disputed debt with an undisputed one.
The IRS’s reading of the Code, the Court stated, amounted to “an exercise in pure bootstrapping.” Taxpayer alleged 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.
The whole point of the Code’s authorization of CDP hearings, the Court explained, 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.[xxxi]
The Court stated that because the IRS’s setoffs were invalid, Taxpayer’s claims were not rendered moot when the IRS withdrew its levy. With that, 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.
Petition for Cert
The Office of the Solicitor General[xxxii] recently asked the U.S. Supreme Court to review and overturn the Circuit Court’s Taxpayer-favorable opinion.[xxxiii]
The government explained that because Taxpayer’s liability had been satisfied by the above-described offset, there was no longer a live dispute over the proposed levy that gave rise to the proceeding.
Moreover, the government argued, the Circuit Court was wrong to imply that the Tax Court had jurisdiction to review whether the IRS had validly exercised its statutory authority to apply Taxpayer’s overpayment for a later year to offset Taxpayer’s liability for the earlier year to which the proposed levy related.
More specifically, the government continued, when the IRS declares that it no longer needs or intends to take the taxpayer’s property by levy, a pre-levy proceeding becomes moot. The point of the proceeding, it stated, is to determine whether the IRS may proceed with the proposed levy. Thus, when the IRS declares that it no longer has any basis for a levy, the issue that prompted the proceeding is no longer “live,” the IRS ceased to have any “legally cognizable interest” in a determination sustaining the proposed levy, and the taxpayer ceased to have any “legally cognizable interest” in a determination rejecting the proposed levy.
When Taxpayer overpaid their taxes for a later year, the IRS exercised its statutory authority to “credit the amount of such overpayment” against Taxpayer’s existing tax “liability” instead of refunding that amount to Taxpayer.[xxxiv] The elimination of the tax liability eliminated the previous need for a levy.
According to the government, the Circuit Court was incorrect in holding that the CDP hearing in question (a pre-levy proceeding) was not moot even though the IRS no longer sought to take Taxpayer’s property by levy.
The government acknowledged that a taxpayer may challenge the existence or amount of her underlying tax liability in a CDP hearing, and may raise “any relevant issue relating to the unpaid tax,” but it quickly added that such right obtained only in the context of determining whether the proposed levy may “proceed.”
When the “proposed levy is moot,” the government stated, a taxpayer “has no independent basis to challenge the existence or amount of her underlying tax liability in CDP hearing,” just as a taxpayer could not have used such a hearing to seek those findings if no levy had been proposed in the first place.[xxxv]
The petition never addresses the principal basis for the Circuit Court’s holding – that the IRS’s setoffs were invalid; at best, it tries to slalom around it.
For example, it states that a court cannot manufacture a live dispute to give the Tax Court jurisdiction merely by deeming the offsets invalid. After all, it explains, “the IRS has no basis for pursuing a levy so long as the overpayments that respondent made remain in the government’s pocket.”
Then it adds, “even if the offsets were invalid the . . . proceeding in this case would still be moot. And not even the court of appeals suggested that the Tax Court would be able to order the IRS to refund those overpayments.”
The government concludes its substantive discussion with this:
“None of this is to say that taxpayers may not challenge the IRS’s allocation of estimated payments or its use of overpayments to offset their liability. Taxpayers may do so through a post-deprivation suit for a refund – the traditional mechanism for disputing the assessment or collection of a federal tax.”
In other words, even if the offset was improper – as in Taxpayer’s case – a taxpayer may still challenge the IRS’s application of the credit by commencing a refund suit.[xxxvi] Of course, to bring a refund suit, a taxpayer must first request a refund from the IRS.[xxxvii] If the refund is denied – assuredly the outcome here – the taxpayer may sue to recover the disputed amount in federal district court or the Court of Federal Claims.
At no point does the petition address the Circuit’s argument that the IRS should not be allowed to so easily deny a taxpayer the opportunity to dispute what the IRS claims the taxpayer owes in taxes before the IRS takes any steps to collect such taxes, including the offset of a valid refund.
Parting Thoughts
Taxpayer was granted an extension of time, to December 16, 2024, to file its response to the government’s petition,[xxxviii] in which it will argue why the Supreme Court should not hear the case.
After considering the government’s petition and Taxpayer’s brief in opposition, the Supreme Court will enter the appropriate order.[xxxix]
One can only hope that, if the Justices grant cert, they will ultimately agree with the substantive basis for the Third Circuit’s decision, and not be persuaded by the government’s literal application of the procedural elements of collection due process without regard to their underlying purpose.
As pointed out earlier, a taxpayer has the right to pay only the amount of tax that is legally due and the right to have the IRS apply all tax payments properly.
Stay tuned.
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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] Pub. L. 117-169.
[ii] The Taxpayer Bill of Rights. Pub. L. 105-206.
[iii] Form 4564, Information Document Request (“IDR”). The IRS is authorized to issue IDRs under IRC Sec. 7601 and Sec. 7602.
Hopefully, the first person whom the taxpayer contacted after being notified of the audit, and to whom the taxpayer forwarded the IRS’s request for information, was the accountant who prepared the return in question, as well as any tax adviser who assisted with any transaction reported on such return.
[iv] Because the taxpayer’s response to the IRS’s initial request for information will typically be the first “substantive” exchange of the audit and, thereby, may set the tone for future interactions with the IRS examiner, it probably behooves the taxpayer to authorize their return preparer or other tax professional[iv] to respond on their behalf.
[v] Which may include the issuance of additional IDRs (often following up on the taxpayer’s earlier responses).
[vi] In general, the amount of any additional income tax must be assessed against the taxpayer within 3 years after the taxpayer’s return was filed. IRC Sec. 6501(a). However, IRC Sec. 6501(c)(4) provides as follows:
“Where, before the expiration of the time prescribed for the assessment of any tax imposed by this title, except the estate tax provided in chapter 11, both the Secretary and the taxpayer have consented in writing to its assessment after such time, the tax may be assessed at any time prior to the expiration of the period agreed upon. The period so agreed upon may be extended by subsequent agreements in writing made before the expiration of the period previously agreed upon.”
[vii] In response to a 30-day letter.
[viii] Suspends its running.
[ix] IRC Sec. 6212; IRC Sec. 6503.
[x] IRC Sec. 6213.
[xi] The Tax Court does not acquire jurisdiction upon the issuance of a 30-day letter, notice of rejection of a claim for refund, or other similar notices with respect to the taxpayer’s tax liability. If a notice of deficiency has not been issued because the tax year is still under examination, the petition is premature.
[xii] IRC Sec. 6214(a).
[xiii] IRC Sec. 6512(b).
[xiv] IRC Sec. 6201.
[xv] IRC Sec. 6303.
[xvi] Where the assessment of tax is made within the period of limitation, the tax may be collected by levy or by a proceeding in court, but only if the levy is made or the proceeding begun within 10 years after the assessment of the tax. IRC Sec. 6502.
[xvii] IRC Sec. 6321; Reg. Sec. 301.6321-1.
[xviii] IRC Sec. 6331. In other words, it may seize and sell the taxpayer’s property to satisfy the taxpayer’s tax liability.
[xix] IRC Sec. 6330(a)(1).
[xx] IRC Sec. 6330(a)(3)(B).
[xxi] IRC Sec. 6330(c)(2)(A).
[xxii] IRC Sec. 6330(e)(1).
[xxiii] IRC Sec. 6330(c)(2)(B).
If the taxpayer could have commenced a deficiency proceeding before the CDP hearing, the hearing provides a forum to challenge the unpaid tax and proposed levy only. But if the taxpayer had no opportunity to commence a deficiency proceeding, the CDP hearing provides a forum to challenge the unpaid tax, the proposed levy, and the underlying tax liability.
[xxiv] IRC Sec. 6330(d)(1).
[xxv] Instead, the IRS credited the estimated tax payments to Taxpayer’s ex-spouse.
[xxvi] For more of the factual background, see https://www.taxslaw.com/2024/04/irs-cannot-offset-taxpayers-refund-with-a-disputed-tax-liability/.
[xxvii] Recall that Taxpayer self-assessed the additional tax on her return; thus, a notice of deficiency was not issued pursuant to which she could have challenged the tax liability earlier.
[xxviii] When a taxpayer overpays their taxes for a particular year, the IRS “may credit the amount of such overpayment” against the taxpayer’s existing tax “liability” instead of refunding that amount to the taxpayer. IRC Sec. 6402(a).
[xxix] Zuch v. Commissioner, No. 22-2244 (3rd Cir. Mar. 22, 2024).
[xxx] IRC Sec. 6402(a).
[xxxi] 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.
[xxxii] The OSG supervises and conducts the federal government’s litigation in the U.S. Supreme Court.
[xxxiii] The request is made by filing a petition for cert.
The Circuit Court’s decision was dated March 2024. The government’s request for a rehearing was denied in June.
According to Rule 13 of the U.S. Supreme Court Rules, a petition for cert to review a judgement of the U.S. Court of Appeals must be filed within 90 days after entry of judgment, though a Justice may, for good cause, extend the time to file for a period not exceeding 60 days.
In September, the government requested, and the U.S. Supreme Court granted, an extension of time to file a petition for cert. The government submitted its petition for cert to the Supreme Court on October 11, 2024.
On October 15, Taxpayer requested an extension of time to file a response to the government’s petition. The Supreme Court granted an extension to December 16, 2024.
[xxxiv] IRC Sec. 6402(a).
[xxxv] Can you say tautological? C’mon. Seriously.
[xxxvi] IRC Sec. 7422(a).
[xxxvii] IRC Sec. 6511 and Sec. 7422(a).
[xxxviii] The government may file a reply brief to address any new points raised in Taxpayer’s brief in opposition. Rule 15 of the U.S. Supreme Court Rules.
[xxxix] Four of the nine Justices must vote to grant a writ of cert (i.e., accept a case), which leads to a review on the merits.