Tax Deficiency
Over their career, every tax practitioner has had many client-taxpayers against whom a government’s taxing authority – be it federal, state, or local – has asserted and then assessed a tax deficiency.
There are many reasons why a taxpayer – whether an individual, corporation, partnership, estate or trust – has unpaid tax liabilities. For example, the taxpayer has: miscalculated the amount of tax owed, carelessly omitted an item of income, mistakenly deducted a non-deductible expense, or claimed a tax treatment for an item on their tax return with which the government disagreed.
There are also many reasons why a taxing authority, like the IRS, may have selected a taxpayer’s return for examination,[i] during the course of which issues such as those identified above, as well as others, are discovered.
Following such an exam, the IRS may propose changes to the taxpayer’s return. If the taxpayer doesn’t agree with these changes, they may exercise certain appeal rights within the agency. If the taxpayer is not successful in its appeal, or if it decides to forgo the exercise of these rights, the IRS will issue a Notice of Deficiency (the “90-Day Letter”), informing the taxpayer of their right to challenge the proposed IRS adjustments in the U.S. Tax Court by filing a petition within 90 days of the date of the notice.[ii]
Assuming the taxpayer strikes out at every venue, the IRS will assess[iii] the tax deficiency against the taxpayer by formally recording the taxpayer’s name and tax liability.
Collecting the Tax
The IRS has 10 years from the date a tax deficiency is assessed against the taxpayer to collect the tax from the taxpayer.[iv] If the taxpayer does not pay the tax voluntarily, the IRS may file a notice of federal tax lien,[v] it may serve a notice of levy, or it may offset a refund to which the taxpayer is otherwise entitled.[vi]
Unfortunately, taxpayers sometimes try to thwart the IRS’s collection of their tax liabilities by disguising and/or transferring property ownership, either prior to or after the tax liability is incurred.
Third Parties
That said, there are a variety of situations where a third party can be held liable for the tax liability of another taxpayer. For example, the IRS may seek to collect a taxpayer’s unpaid tax pursuant to some theory of transferee liability, as where the transfer by the taxpayer was made in violation of a state’s fraudulent conveyance statute.[vii]
Federal Priority Statute
Relevant to today’s post is the Federal Priority Statute (the “Statute”),[viii] which imposes personal liability on a fiduciary or representative of an insolvent taxpayer if the fiduciary has knowledge of the taxpayer’s outstanding federal tax debt, but satisfies other debts of the taxpayer before paying the government’s priority tax claims.
Personal liability under the Statute only applies if the fiduciary uses the taxpayer’s assets to pay a debt in violation of a federal priority; there is no personal liability if debts are paid ahead of federal claims if such debts have priority over the U.S.
It is also important to note that the fiduciary must have knowledge of the federal claim in order for the Statute to apply.
Finally, personal liability attaches only if the taxpayer is insolvent.
Even when such persona liability attaches, it is limited to the value of the assets that the fiduciary distributed in violation of the federal priority.
The IRS can assert personal liability against a fiduciary under the Statute either by filing a suit against the fiduciary in a federal district court, or by issuing a notice of fiduciary liability to the fiduciary.[ix]
Which brings us to the decision[x] described below, which is of interest primarily on account of the Court’s determination of the individual fiduciary to whom the Statute was applied.
Long-Time Client
The U.S. initiated an action pursuant to the Statute[xi] seeking a judgment against Defendant for transferring Corp’s assets to third parties before paying the government’s claim for income taxes at a time when Corp was insolvent.
Defendant
Defendant and his Partner were attorneys and principals of Law Firm. Defendant represented high-net-worth families and family enterprises. And his practice consisted of general business, family planning, and estate planning. Although Defendant was not a tax attorney, he gave tax advice to clients from a planning perspective.
Defendant & Corp
Client was one of Law Firm’s clients. Defendant was the “relationship partner” for Client; meaning, he was the individual at the firm who had “the primary contact with the client.” Defendant had represented Client and members of Client’s family with regard to business investments and planning since around 1990.
In 2001, Law Firm organized Corp on behalf of Client. Although Client’s family had “economic ownership” of Corp, Defendant and Partner were the only individuals who held any “official” position with Corp. Indeed, as Corp’s only director, Defendant was authorized to manage Corp’s property and business, and to act on behalf of Corp without any meeting or approval from its shareholders.
In his capacity as director, Defendant appointed (a) himself president and treasurer, and (b) Partner as vice president and secretary, of Corp. Under Corp’s by-laws, Defendant had authority, as president, to “sign and execute all authorized bonds, contracts, or other obligations” on behalf of Corp. The by-laws further provided that Partner, as treasurer, “shall have custody of all the funds and securities” of Corp and “shall disburse the funds” as ordered by the director. Both Defendant and Partner were authorized to sign documents on behalf of Corp.
Defendant testified that although he had authority to borrow money on behalf of Corp, he “took all of [his] direction from [Client.]” Defendant further testified that he took “full responsibility,” but he was “not involved in the mechanics” of Corp’s investments, financial transactions, or tax returns.
CPA Firm performed accounting, bookkeeping, and tax preparation services for the business entities owned by Client, including Corp. Accountant was a partner and founder of CPA Firm.
Related Companies
Corp operated as a holding company for Client’s investments. Corp held investments in various partnerships and made investments in the U.S.; for example, Corp joined a partnership that owned Building.[xii]
Holdings, a foreign corporation, was Corp’s sole shareholder. Defendant was Holdings’ only director.
Lender was another foreign corporation. It loaned money to U.S.-based companies, including Corp, that were owned by Client’s family so those companies could make investments. Defendant was the director of Lender from 2002 to 2009.
The Loans
Corp loaned to and borrowed money from other entities owned by Client’s family, which were all related companies owned by the same trusts for the benefit of Client’s family. According to Partner, if one entity needed money, “in order to respect the various corporate existences of the entities, we . . . fashioned [the transfers] as loans.” At the end of each year when the entities’ respective books were reconciled, CPA Firm would classify some of these transfers as loans and others as a repayment of principal, a payment of interest, or something else.[xiii]
In 2002, Defendant executed a document that authorized Corp to borrow from Holdings and from Lender. Between 2002 and 2018, Corp borrowed various sums from Holder or from Lender. Some of the loans helped to fund Corp’s investment in Building; this included an $850,000 loan from Lender that bore interest at the rate of 18 percent.[xiv]
In 2002, Corp borrowed $850,000 from Lender at an 18 percent interest rate.[xv] This loan was for Corp to make an investment in Building.[xvi] Sometime prior to December 2009, Lender loaned Corp approximately $1.35 million on an interest-free basis.
The balance of the loans payable from Corp to Lender at the end of 2018 was approximately $8.82 million.
Corp’s Financial Status
Corp “did not have a cash account” or “its own independent cash.” Corp used Law Firm’s client trust account[xvii] in lieu of having a separate bank account. Law Firm logged Corp’s financial transactions in a client-matter trust ledger, which detailed the activity within Corp – that is, the transfers into and out of Corp. At the conclusion of each tax year, CPA Firm used Law Firm’s client-matter trust ledgers to prepare the balance sheets reported on Corp’s tax returns.[xviii] CPA Firm created trial balance sheets (which reported assets, liabilities, capital, and expenses) and used those to prepare Corp’s tax returns each year. The firm did not create balance sheets other than for the purposes of filing Corp’s tax returns.
For the tax years 2010 through 2020, Corp reported liabilities on the balance sheet of its federal return[xix] that consisted primarily of the Lender loans. The balance sheets reported on Corp’s tax returns constituted the final balance sheets for those years.
During these same tax years, Corp claimed substantial tax deductions each year for the 18 percent interest accruing on the 2002 Lender loan.
The Audit
The IRS began examining Corp’s tax returns in 2014 or 2015, and over the next five years the IRS examined Corp’s returns for the 2010 through 2015 tax years. Corp was represented by counsel not affiliated with Law Firm (outside counsel) in connection with the IRS’s audit. Defendant’s role was to assist outside counsel. During the examination, Defendant and Partner responded to document requests through Corp’s outside counsel and were interviewed multiple times.
By 2018, the IRS preliminarily concluded that the loan interest deductions claimed on Corp’s 2010-2015 returns were improper. In June 2018, the IRS sent Corp a preliminary report of its findings. Defendant was aware of the IRS’s findings by July 2018. In March 2019, the IRS mailed a letter that described IRS’s proposed changes to Corp’s tax returns to Corp in care of Law Firm, and to Corp’s outside counsel. This letter stated, among other things, that the IRS did not believe the Lender loans were bona fide and, therefore, the IRS was disallowing the interest expenses attributable to those loans.[xx] Corp, Defendant, and Partner each received a copy of this letter.
Corp did not (i) agree to the proposed changes, (ii) appeal the proposed changes, or (iii) pay the proposed tax.
In November 2019, the IRS mailed a Notice of Deficiency that identified approximately $1.44 million in unpaid taxes and penalties (exclusive of interest) to Corp in care of Law Firm, and to Corp’s outside counsel. Corp received the Notice of Deficiency around the same time it was mailed. The Notice of Deficiency advised Corp of its right to challenge the proposed assessments in U.S. Tax Court and that failure to do so would result in the assessment of the proposed deficiencies.
Corp did not agree with the Notice of Deficiency, but did not challenge it in Tax Court. The IRS assessed Corp’s tax deficiencies in July 2020. In November 2020, the IRS issued to Corp a Final Notice of Intent to Levy in the amount of approximately $2.1 million.
The Repayment Plan
While the post-audit process ran its prescribed course, Defendant, Partner, and Accountant made plans to repay the amounts owed by Corp to Lender,[xxi] notwithstanding that by that time they understood the IRS’s position to be that the Lender loans were actually capital contributions by the Client’s family into various companies and that Corp’s interest deductions would be disallowed.
Accountant discussed the repayment plan with Defendant, Partner, and Client. Defendant was involved when the plan was developed conceptually. Defendant also engineered certain aspects of the plan.
Although Client was ultimately responsible for making the decision to implement the repayment plan, Defendant, as Law Firm’s relationship partner for Client, had the principal responsibility for ensuring that the plan was “properly attended to.”
As part of the repayment plan – the progress of which was monitored by Defendant – Law Firm called Corp’s loans receivable from other Client-related entities. The receivables were either wired into Law Firm’s IOLTA or booked as a debit from a Client-entity’s ledger and as a corresponding credit to Corp’s ledger. In addition, Defendant arranged for Holdings to wire funds to Corp.
The funds Corp received were used to repay the Lender loans. Between June 2019, and March 2020, Corp transferred over $8.8 million to Lender. By the end of 2020, Corp repaid the Lender liabilities in full.
Neither Accountant nor Partner nor Defendant told the IRS about the repayment plan.
IRS’s Collection Efforts
At the IRS’s request, in December 2020, Corp submitted a Form 433-B (Collection Information Statement for Businesses) – signed on behalf of Corp by Defendant as president – which indicated, among other things, that Corp had no cash on hand or in banks, no investments, no available credits, and no real property. Corp stated that notwithstanding the IRS’s position during the examination “that the loans were not true loans,” Corp “has continued to treat the transactions as loans on its books and in its tax returns.”
In 2021, the IRS served a Notice of Levy on Law Firm for money it held on Corp’s behalf. Defendant acknowledged receipt and reported that there were no funds available. In 2022, the IRS served a Notice of Levy on Law Firm as Corp’s alter ego.
Solvency
The IRS next tried to determine Corp’s solvency, and retained Expert who assessed Corp’s solvency under the balance sheet test, which “addresses the question of whether the liabilities of an entity exceed the fair market value of its assets.” Specifically, Expert used the information reported in Corp’s tax returns and Law Firm’s client-matter trust ledgers to create balance sheets to evaluate Corp’s solvency on the dates Corp transferred funds out in connection with the repayment plan.
Expert explained that “for solvency purposes, as of March 2019, Corp was aware that there was a tax liability pending.”
In the solvency analysis, Expert reclassified the $8.82 million loan due to Lender from a long-term liability into a current liability because of the repayment plan, which scheduled repayment of the loan within a year. In other words, once the amount due to Lender became an obligation in the repayment plan, it was a financial obligation that had to be accounted for on Corp’s balance sheet.
Ultimately, Expert concluded that Corp was insolvent on each of the solvency testing dates before and after the transfers Corp made under the repayment plan.
In November 2022, the U.S. initiated an action in Federal District Court pursuant to the Statute, in which it sought a judgment that Defendant was personally liable for Corp’s outstanding tax liability.
The Court’s Decision
The Court began by stating that the government’s sole cause of action was under the Statute, which provides that “[a] claim of the United States Government shall be paid first when. . . a person indebted to the Government is insolvent and … the debtor without enough property to pay all debts makes a voluntary assignment of property. . . [or] . . . an act of bankruptcy is committed.”
The Court then dismissed Defendant’s argument that the Statute did not govern the IRS’s claim against him.
Next, the Court turned to the question of whether the government had proven each element of its claim under the Statute by preponderant evidence.
There was no question that taxes owed to the U.S. fell within the scope of a “claim of the Government” under the Statute’s terms. The Court also found that the government had proven Corp’s insolvency.
The Court then considered the final element – whether Corp either made a voluntary assignment of property or committed an act of bankruptcy.
Defendant argued that the Court should require the government to treat the Lender loans as equity transactions – as it had consistently maintained throughout the audit and as it did to claim taxes due from Corp. According to Defendant, the U.S. was prohibited from advancing contradictory positions that the Lender loans were not bona fide liabilities for tax assessment purposes, but that they were liabilities for the purpose of assessing Corp’s solvency.
The Court determined that Defendant’s argument was flawed. First, the U.S. did not take contradictory positions as to the validity of the Lender loans. The IRS audited Corp’s tax returns and concluded that the interest deduction for the Lender loans should be disallowed, which ultimately resulted in a notice of tax deficiency.
The IRS’s disallowance of Corp’s interest deductions, the Court stated, was not a determination for any other purposes and it was not the right test for whether to include the debt for valuation purposes.
The U.S. retained Expert, an expert in solvency and valuation, to evaluate Corp’s solvency before and after each transfer of the repayment plan in place that obligated Corp to transfer $8.8 million to Lender irrespective of whether the Lender loans were treated as debt or equity. The U.S., therefore, did not take contradictory positions with respect to whether the Lender loans were bona fide. The Court also determined that the elements of judicial estoppel were not satisfied, especially the requirement that “the party sought to be estopped must have intentionally misled the court to gain unfair advantage,” which the Court stated was “determinative.”
According to the Court, there was no allegation that the U.S. acted in bad faith or intentionally misled an administrative or judicial tribunal. “Without bad faith, there can be no judicial estoppel,” the Court stated.
Those required elements are lacking in the case at bar. Thus, the Court found that Expert appropriately categorized as a liability the almost $8.82 million Corp transferred to Lender. Regardless of whether the Lender loans were bona fide for tax assessment purposes, Corp assumed an $8.82 million obligation through the repayment plan.
Next, the Court explained that the Statute requires a statutorily defined triggering event to occur for the U.S.’s claim to have priority. The U.S. had to prove that Corp either made a voluntary assignment of property or committed an act of bankruptcy.[xxii] The U.S. advanced multiple theories of liability,[xxiii] and Defendant raised several legal arguments challenging the existence a triggering event.
The Court explained that “a preferential transfer is a transfer . . . of any of the property of a debtor to or for the benefit of a creditor for or on account of an antecedent debt, made or suffered by such debtor while insolvent.”
The Court observed there was no dispute that Corp transferred over $8.8 million to Lender. The consistent testimony of Accountant, Partner, and Defendant was that these transfers were undertaken to repay the Lender loans, obligations that predated the IRS’s assessment of a tax liability. Corp was insolvent at the time of each of the transfers. These transfers, therefore, constituted preferential transfers that satisfied the triggering event element of the U.S.’s claim.
Defendant’s “Representative” Liability
The Statute provides that a “representative . . . paying any part of a debt of the person . . . before paying a claim of the Government is liable to the extent of the payment for unpaid claims of the Government.”[xxiv]
The U.S.’s cause of action against a debtor’s representative is “wholly independent” from its cause of action against the debtor and accrues “once the acts which trigger the representative’s liability occur.”
Although the statutory language suggested strict liability, courts have interpreted the Statute as requiring evidence that: (1) the representative transferred or distributed the debtor’s assets before paying an antecedent claim of the U.S.; (2) when the debtor was insolvent; and (3) with knowledge or notice of the U.S.’s claim.
Under the third element, the representative “must have knowledge of the debt owed . . . to the United States or notice of facts that would lead a reasonably prudent person to inquire as to the existence of the debt owed before making the challenged distribution or payment.”
As stated previously, Corp was insolvent at the time of the transfers; further, the parties concurred that Defendant had knowledge of the U.S.’s claim.
Thus, the only remaining questions were whether Defendant – i.e., Client’s attorney – was Corp’s representative and whether he transferred or distributed Corp’s assets.
The Court answered both questions in the affirmative.
Defendant was Corp’s only director, as well as its president and treasurer. Under Corp’s by-laws, Defendant had authority to act on behalf of Corp, sign contracts and documents, borrow money, and manage Corp’s property and business. The Court noted that it had previously found that the term “representative” included corporate officers, among others.
According to the Court, the evidence also established that although Client was ultimately responsible for making the decision to implement the repayment plan, Defendant was integral to the development and execution of that plan to pay Lender before paying the government. Defendant helped develop the plan, directed that the plan include and exclude certain Client entities, monitored its implementation and progress, and overruled outside counsel’s decision to put the repayment plan on hold.[xxv]
The Court observed that other courts had found corporate directors and officers who took similar actions with similar fact patterns personally liable. they were fully aware of a taxpayer’s debt to the U.S., and they paid other creditors without due regard to the government’s statutory priority. “Corporate officers or directors, such as Defendant, who have knowledge or notice of a debt owed by an insolvent corporation to the United States and who authorized payments of corporate funds constituting an act of bankruptcy, without first paying the debts owed to the United States, become personally liable to the United States to the extent of the payments.”
Accordingly, the Court concluded that the U.S. had established every required element of the Federal Priority Statute.
For the foregoing reasons, the Court found Defendant personally liable as to the U.S.’s claim under such Statute.
Lesson
Most of us are probably used to seeing the Federal Priority Statute applied to executors and trustees.
However, as the Court noted above, corporate directors and officers (i) who are in control of a corporation’s assets, (ii) who are aware of the corporation’s debt to the U.S.,[xxvii] and (iii) who pay other creditors of the corporation without due regard to the government’s statutory priority, become personally liable to the U.S. to the extent of the payments made.
The question in the case described above is the capacity in which Defendant was acting.
Was he really a director or officer when he took direction from the Client in carrying out his duties?
When he exercised discretion with respect to formulating and implementing the repayment plan, was he acting more as a legal adviser to Client and Client-related entities, as opposed to one of Corp’s executives?
There’s a cautionary note there regarding the degree to which an attorney should become involved in a client’s business.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] For example, based solely on a statistical formula, or when it involves issues or transactions with other taxpayers, such as business partners or investors, whose returns were selected for examination, or based on information received from third parties which doesn’t match information reported on one’s return.
[ii] At some point in the not-so-distant future, the U.S. Supreme Court may be deciding whether the 90-days requirement is jurisdictional. https://www.taxslaw.com/2025/09/responding-timely-to-a-90-day-letter-is-it-jurisdictional/ .
[iii] The IRS can usually assess tax within 3 years after a taxpayer’s return was due, including extensions, or, if the taxpayer filed late, within 3 years after the IRS received the return, whichever is later. The taxpayer and the IRS will often agree to extend this assessment period during an examination of the taxpayer’s return. The IRS must issue a 90-Day Latter before the expiration of the period. Assuming the taxpayer files a timely petition with the Tax Court, the running of the assessment period will be further suspended from the day the letter is mailed and ends 60 days after a final Tax Court decision.
[iv] Together with any associated penalties and interest.
[v] The IRS files a Notice of Federal Tax Lien in the public record to notify a taxpayer’s creditors of the tax debt. A federal tax lien is a legal claim to the taxpayer’s property, including property acquired after the lien arises. The federal tax lien arises automatically when the IRS sends the first notice demanding payment of the tax debt assessed against the taxpayer and the taxpayer fails to pay the amount in full.
[vi] Relatedly, see Zuch v. Commissioner, U.S. Supreme Court, No. 24–416 (Decided June 12, 2025).
[vii] IRC Sec. 6901. Legal title to the taxpayer’s property was transferred and no federal tax lien attached prior to the transfer.
[viii] 31 U.S.C. Sec. 3713.
(a) (1) A claim of the United States Government shall be paid first when—
(A) a person indebted to the Government is insolvent and—
(i) the debtor without enough property to pay all debts makes a voluntary assignment of property;
(ii) property of the debtor, if absent, is attached; or
(iii) an act of bankruptcy is committed; or
(B) the estate of a deceased debtor, in the custody of the executor or administrator, is not enough to pay all debts of the debtor.
(2) This subsection does not apply to a case under title 11.
(b) A representative of a person or an estate (except a trustee acting under title 11) paying any part of a debt of the person or estate before paying a claim of the Government is liable to the extent of the payment for unpaid claims of the Government.
[ix] IRC Sec. 6901(a)(1)(B).
[x] United States v. Neuberger, No. 1:2022cv02977 – Document 144 (D. Md. 2025).
[xi] 31 U.S.C. Sec. 3713.
[xii] Partnership was a partnership of four entities, including Corp. Defendant signed the partnership agreement on behalf of all four partner-entities. Associates was a partnership of three entities, including Corp. Defendant signed the partnership agreement on behalf of all three partner-entities.
[xiii] This is what happens when related parties do not transact with one another on an arm’s length basis. Some will tout the “flexibility” of this approach, but it’s “tauric defecation” as one of my high school teachers used to say.
[xiv] It appears these loans were unsecured, and did not contain repayment terms other than the interest rate. One of the loans was payable on demand.
[xv] This was an unsecured loan. The promissory note did not contain any repayment terms other than the interest rate, and the payment due date.
[xvi] In 2005, Corp divested its interest in Building, and in 2011, the loan from Holdings was converted to a capital contribution.
[xvii] Known as an “interest on lawyer’s trust account” or IOLTA.
[xviii] Sch. L of IRS Form 1120, U.S. Corporation Income Tax Return.
[xix] On IRS Form 1120.
[xx] The IRS also proposed penalties for failure to timely file returns for the 2010-2013 tax years and a penalty for negligent failure to accurately report income and deductions for all tax years under examination.
[xxi] This repayment plan required 124 individual booking entries that transferred money among various entities on various loans. The repayment plan did not involve only Corp; it involved multiple companies.
[xxii] 31 U.S.C. Sec. 3713(a)(1)(A)(i), (iii).
[xxiii] The IRS argued that Corp’s transfers to Lender were voluntary assignments, preferential transfers, constructively fraudulent transfers, and fraudulent transfers.
[xxiv] 31 U.S.C. § 3713(b).
[xxv] Defendant testified that “I take full responsibility. . . I’m not shirking any responsibility.” The Court added that the purpose of the statute was “to make those into whose hands control and possession of the debtor’s assets are placed, responsible for seeing that the Government’s priority is paid.”
[xxvii] They may even be presumed to know of the corporation’s debt.