What Constitutes An Attempt To Evade Or Defeat Taxes For Purposes Of Section 523(a)(1)(C) Of The Bankruptcy Code: The Ninth Circuit Parts Company With Other Circuits (Part 2)

In yesterday’s post A. Lavar Taylor discussed the case law in other circuits and the bankruptcy opinion in Hawkins v Franchise Tax Board. Today’s post turns to the Ninth Circuit and its decision to part ways with the other circuits. Lavar explains why he believes for both legal and practical reasons the Ninth Circuit’s view is correct. Les

Now I turn to why the Ninth Circuit reached the correct result in Hawkins by concluding that “improper” expenditures, by themselves, do not constitute an attempt to evade or defeat a tax liability. There are both legal and practical reasons why the Ninth Circuit’s holding in Hawkins is the correct one.  I first discuss the legal reasons.

The Legal Reasons Why the Ninth Circuit Is Correct

The Ninth Circuit noted that the purpose of a bankruptcy discharge is to give an individual debtor a “fresh start.” It noted that this “fresh start” philosophy argues for a more narrow  interpretation of the “attempt to evade or defeat” exception from discharge. The Ninth Circuit also concluded that both the structure of section 523(a) of the Bankruptcy Code and its legislative history support a narrow reading of the “attempt to evade or defeat” exception to discharge.


The Ninth Circuit also took note of the Supreme Court’s holding in Kawaauhau v. Geiger, 523 U.S. 57 (1998), in which the Supreme Court narrowly construed the term “willfully” for purposes of section 523(a)(6) of the Bankruptcy Code.

But the key to the Ninth Circuit’s ruling is the fact that the Supreme Court, in Spies v. United States, 317 U.S. 492 (1943),  held that a mere willful failure to file a return, coupled with a mere willful failure to pay the tax, does not constitute a willful attempt to evade or defeat the tax for purposes of section 7201 of the Internal Revenue Code. Section 7201 uses language almost identical to the language in section 523(a)(1)(C) of the Bankruptcy Code.  The Supreme Court held in Spies that the taxpayer must take some sort of “willful commission” (in addition to the willful omissions), or engage in an “affirmative act,” in an effort to evade the tax, in order to commit tax evasion under section 7201.  Whether a particular act taken by a taxpayer is an affirmative act taken in an effort to evade the tax is to be decided by the trier of fact.

Because the language in section 523(a)(1)(C) of the Bankruptcy is virtually identical to the language in section 7201 of the Internal Revenue Code, it makes sense to construe section 523(a)(1)(C) in the same manner in which the Supreme Court construed section 7201 of the Internal Revenue Code in Spies.  The elements discussed above in  in the Fretz case, which were used by Judge Carlson in the Hawkins case and were used by all other Courts of Appeal to consider this issue, are elements required to convict a taxpayer of a willful failure to file or a willful failure to pay under IRC section 7203. See, e.g., United States v. Tucker, 686 F.2d 230 (5th Cir. 1982).

Section 7203 uses very different language than the “willful attempt in any manner to evade or defeat” language contained in IRC §7201 and Bankruptcy Code section 523(a)(1)(C).  The failure by Congress to incorporate the language of IRC §7203 into section 523(a)(1)(C) of the Bankruptcy Code, coupled with the incorporation into section 523(a)(1)(C) of the language contained in section 7201, indicates that the holdings of the other Courts of Appeal were in error.

The Practical Reasons Why the Ninth Circuit is Preferable  

The Ninth Circuit’s approach is also preferable for practical reasons.  The most obvious practical problem for courts relying on the standard used in other Circuits is determining in a principled manner what expenditures by the debtor are “unnecessary” once the duty to pay the taxes arises. Only a principled approach can provide future guidance to courts,  future litigants, debtors who wish to avoid a fight over whether they attempted to evade or defeat the taxes that they owed, and professionals who advise debtors who wish to avoid this fight.

Judge Carlson offered precious little principled guidance  on how to decide what expenditures are “unnecessary” in other factual contexts. We know that a “nuanced approach” should be used, depending on the debtor’s pre-existing income and lifestyle, but we know very little about how to define those “nuances” or about how to apply those “nuances” in future cases where the taxpayer’s circumstances differ from those of Mr. Hawkins.

Can a debtor pay for extraordinary medical expenses for a parent or for a beloved pet, at the expense of not paying their taxes? What about paying modest private school tuition for their children? What about paying tuition for the debtor to obtain an advanced degree in the hopes that the debtor will obtain a much higher paying job? Does the potential level of earnings once the degree is earned make a difference?  Can the debtor pay to go on any vacations at all? What if the debtor’s therapist recommends that the debtor take a vacation because of stress related to a difficult marriage or related to financial difficulties?

What about debtors who owe business debts? Will some of these debts be deemed “necessary” and other “unnecessary?”  Will it matter if payment of the business debt will give rise to a tax deduction which would reduce the amount of taxes owed? If a debtor pays state taxes without paying federal taxes, is that an attempt to evade or defeat the federal taxes? If the debtor pays federal taxes without paying state taxes, is that an attempt to evade or defeat the state taxes? What about payment of alimony and child support?

For those debtors who are living a good lifestyle but are greeted by an overwhelmingly large tax liability, how long do they have to reduce their expenditures before their pre-existing level of expenditures becomes “unnecessary?” Six months?  A year? If they attempt to sell their expensive house and find no buyers at a reasonable price after a year, are debtors required to sell at a fire sale or to stop paying their mortgage?

If the debtor reasonably believes that he owns property that will  appreciate enough for him to fully pay his taxes within several years, must the debtor lower his or her level of living  expenses while waiting for  the property to appreciate? Will the expenses paid while waiting for the property to appreciate be deemed to be “excessive” through hindsight if property values suddenly and unexpectedly decline?

The number of questions regarding “necessary” and “unnecessary” expenses which could arise under the standard employed by Judge Carlson and other Circuits is virtually limitless. Under this standard, courts, debtors and their counsel can look forward to innumerable Circuit splits on all of the exciting issues mentioned immediately above, among many others.

Simply put, if the standard for determining whether a taxpayer/debtor has attempted to evade or defeat the tax is whether the taxpayer/debtor made “inappropriate” expenditures, there is no principled way for courts  to draw the line between what expenditures are “appropriate” and what expenditures are “inappropriate.”  Cases will be decided based on the whims and fancies of individual judges, each of whom will have their own sense of what expenses are “appropriate” and what expenses are “inappropriate.” One judge may conclude that it was entirely proper for a taxpayer to spend $25,000 furthering their education in an effort to significantly increase their earnings capacity instead of paying the money over to the IRS, while another judge may conclude that the taxpayer attempted to evade or defeat the tax by spending $25,000 on educational expenses instead of paying the $25,000 over to the IRS.

In addition, IRS and other tax agencies could invoke the “attempt to evade or defeat” exception merely because they do not like the way the debtor/taxpayer spent their money. Such a standard carries with it a significant potential for abuse of taxpayers by tax agencies.  The potential for abuse drastically decreases if tax agencies are required to prove the traditional elements of tax evasion in order to invoke the “attempt to evade or defeat” exception in section 523(a)(1)(C).

Under the standard used by Judge Carlson, it is impossible for tax professionals to advise their clients on whether the clients can make certain expenditures, assuming that the use of bankruptcy to discharge tax liabilities is  a possibility at the time the advice is solicited.  If the standard used by Judge Carlson applies, no competent professional will ever offer meaningful advice on this subject out of fear of the potential consequences of giving incorrect advice.

The Dissent

As a final note, I have several comments about the dissenting opinion in Hawkins. First, this dissent makes a statement that is downright scary. At page 17 of the Slip Opinion, the dissent states:

At the family court hearing, Hawkins’ bankruptcy attorney “testified that Hawkins’ intent was not to pay the tax debt, but to discharge it in bankruptcy. . . .” Id., p. 19. This testimony is a strong indication of a willful intent to avoid the payment of taxes by hook or by crook.

I am troubled by the dissent’s language, given that, at the time the statement was made by the attorney, Hawkins was insolvent and lacked the ability to pay the taxes in full. (I will ignore the fact that this statement regarding Hawkins’ intent was not made by Hawkins himself.) In addition, 3DO was in financial difficulties and headed for chapter 7. Planning to discharge taxes in bankruptcy at a time when you are insolvent and lack the ability to pay the taxes in full is not an attempt to evade or defeat a tax liability. And Hawkins paid to the IRS and the FTB many millions of dollars between the date of that statement and the date of the bankruptcy petition.

I am also troubled by the dissent’s conclusion that the majority opinion “gives Hawkins a pass.” The majority opinion does no such thing. The majority remands the case so that the trial court can apply the correct legal standard. The trial court may now have to decide the issue previously ducked by Judge Carlson (who has now retired from the bench), namely, whether Hawkins acted with intent to defraud in filing the tax returns in question. At a minimum, the trial court will have to decide whether the actions taken by Hawkins leading up to his chapter 11 bankruptcy were taken with Spies-type intent to evade the tax liability.  Hawkins has not been given a “pass.”  Rather, his conduct is going to be judged under the appropriate legal standard, rather than under a standard that is no standard at all.

For those of you who disagree with my statement that the standard relied upon by Judge Carlson (and by the dissent and by other Circuits) is no standard at all, I invite you to carefully review Judge Carlson’s opinion and tell me how you would apply the “standard” set forth in that opinion to the vast majority of taxpayers whose financial circumstances are much more modest than those of Mr. Hawkins.  I’ve read and re-read Judge Carlson’s opinion.  All I can take away from that opinion is that some expenditures are “appropriate,” some expenditure are “inappropriate,” that Bankruptcy Judges must take a “nuanced approach” in deciding which expenditures are “appropriate” and “inappropriate” for purposes of determining whether the debtor “attempted to evade or defeat” a tax liability, and that, if you continue spending “too much” money in the face of known tax liabilities for “too long,” you will have engaged in an “attempt to evade or defeat” the tax liabilities, regardless of your motives for spending that money.

How you apply that standard to all other taxpayers other than Mr. Hawkins in a principled manner I haven’t a clue. Which is why I believe the Ninth Circuit got it right in Hawkins.


What Constitutes An Attempt To Evade Or Defeat Taxes For Purposes Of Section 523(a)(1)(C) Of The Bankruptcy Code: The Ninth Circuit Parts Company With Other Circuits (Part 1)

A. Lavar Taylor of the Law Offices of A. Lavar Taylor discusses this week’s important Hawkins v Franchise Tax Board decision in the Ninth Circuit. In the first post, Lavar discusses how other courts have approached the issue. In tomorrow’s post, Lavar discusses the Ninth Circuit opinion and describes why he believes its approach is correct.

In Hawkins v. Franchise Tax Board, — F.3d – (9th Cir. No. 11-16276, Sept. 15, 2014),  an opinion released on Monday that can be found here, the Ninth Circuit addressed the question of what the IRS and other taxing agencies must prove to establish that a tax liability cannot be discharged by an individual in a chapter 11 or chapter 7 bankruptcy because the debtor/taxpayer “willfully attempted in any manner to evade or defeat” a tax liability for purposes of section 523(a)(1)(C) of the Bankruptcy Code. Breaking ranks with the other Courts of Appeal which have addressed this issue, the Ninth Circuit construed this language in pari materia with the nearly identical language contained in section 7201 of the Internal Revenue Code, as interpreted by the U.S. Supreme Court in the case of Spies v. United States, 317 U.S. 492 (1943).

The Ninth Circuit’s holding in Hawkins departs from the holdings of virtually every other Court of Appeals to consider this issue.  Before discussing prior case law and why I believe that the Ninth Circuit reached the right result,  I want to warn readers that I am no innocent bystander on this issue.  I authored a brief as amicus curiae filed in the Hawkins case, and the Hawkins majority opinion’s discussion of the Spies case and its applicability to cases involving section 523(a)(1)(C) adopts the position I advocated in the brief as amicus curiae.  For those  interested in reading that amicus brief, it can be found here. The amicus brief includes a detailed discussion of the differences between sections 7201 and 7203 and the case law construing those two provisions.


Case Law in Other Circuits

Now to the case law in the other Circuits construing section 523(a)(1)(C) which preceded the Ninth Circuit’s holding in Hawkins. In Toti v. United States (In re Toti), 24 F.3d 806 (6th Cir. 1994), the Court was faced with a situation where the debtor had failed to timely file returns and had failed to pay the taxes owed, but, per the trial court, had not committed an “affirmative act” of evasion. The trial court held that the taxes were discharged because there was no willful attempt to evade or defeat the taxes in that situation. The Sixth Circuit on appeal, however,  reversed the trial court and held that Toti had “willfully attempted to evade or defeat the taxes” within the meaning of §523(a)(1)(C).

The Court attempted to justify its outright reversal of the finder of fact (as opposed to a remand to apply the legal standard adopted by the Sixth Circuit) by stating that the standard of “willfulness” under  section523(a)(1)(C) should be the same standard of “willfulness” used by the courts in imposing criminal liability under section 7203 of the Internal Revenue Code, as opposed to section 7201 of the Code.  The District Court’s ruling, which was affirmed by the Sixth Circuit, explicitly approved of the standard of “willfulness” used in imposing liability under section 6672 of the Internal Revenue Code.  141 B.R. 126 (E.D. Mich. 1993).

Other Courts of Appeal followed the rationale of Toti. The Eleventh Circuit, in Fretz v. United States (In re Fretz),  244 F.3d 1323 (11th Cir. 2001), reversed a finding by the trial court that the debtor had not attempted to evade or defeat the taxes in question. The debtor had failed to file his returns and had failed to pay the taxes owed. The Eleventh Circuit  held that this was sufficient to render the taxes non-dischargeable under §523(a)(1)(C) and that this section does not contain a requirement that the debtor engage in an affirmative act of evasion to render the taxes non-dischargeable. The Court stated as follows:

Thus, all the government must prove is that Dr. Fretz    (1) had a duty to file income tax returns and pay taxes; (2) knew he had such a duty; and (3) voluntarily and intentionally violated that duty.   244 F.3d at 1330.

The Seventh Circuit has ruled in a similar manner. See United States v. Fegley (In re Fegeley), 118 F.3d 979, 984 (3d Cir. 1997).  Most recently, the Tenth Circuit followed this logic in holding that taxes were not dischargeable.  Vaughn v. Comm’r (In re Vaughn),  – F.3d –  2014 WL 4197347 (10th Cir. 2014). [Ed note: Keith discussed Vaughn here] Additional opinions on this issue from other Courts of Appeal are discussed in the Ninth Circuit’s opinion.

The Bankruptcy Opinion

Before discussing why the Ninth Circuit reached the correct result in Hawkins, it is useful to review the opinion of Bankruptcy Judge Carlson.  Judge Carlson’ opinion can be read here. Judge Carlson wrote in part as follows:

William M. “Trip” Hawkins (Trip) is a very sophisticated businessman. He received an undergraduate degree in Strategy and Applied Game Theory from Harvard College, and an M.B.A. from Stanford University. He was an early employee of Apple Computer, where he rose to director of marketing. In 1982, he left Apple and became one of the founders of Electronic Arts, Inc. (EA), which became the largest supplier of computer entertainment software in the world. By 1996, Trip had a net worth of approximately $100 million, primarily from his holdings of EA shares.

*  * *

In 1990, EA created a wholly owned subsidiary, 3DO, for the purpose of developing and marketing the devices on which computer games are played. Trip Hawkins left EA to run 3DO. 3DO went public in 1993. In 1994, Trip began to sell large amounts of his EA common stock to invest heavily in 3DO.

The story from that point forward is not unfamiliar to practitioners who have represented those taxpayers who “invested”  in various “products” hawked by certain tax professionals. Hawkins invested in the FLIP and OPIS tax shelter products and claimed losses from these “investments.” These losses  were used to offset large gains generated from the sale of EA stock. The IRS then audited the income tax returns of Hawkins for the years 1996 through 2000, and Hawkins retained highly respected counsel to represent him in the audit. Hawkins attempted to participate in the settlement program announced in IRS Announcement 2002-97, but he was told that he was not eligible for that program.

In the meantime, Hawkins’ investment in 3DO was going south. He loaned over $12 million to this company. The net result was that 3DO filed a chapter 11 bankruptcy in May of 2003, and the bankruptcy was converted to a chapter 7 (liquidation) later that year.

There was more bad news for Hawkins. In July of 2003, he received a revenue agent’s report from IRS asserting that he owed roughly $16 million of taxes and penalties for the years covered by the audit.  Hawkins had previously divorced his first wife. Trying to make lemonade out of lemons, in July of 2003 Hawkins filed a motion in the family law court to reduce child support payments due under the existing order, citing the fact that he owed the IRS and FTB over $25 million combined and his mounting losses associated with 3DO.  The family law court granted Hawkins partial relief but required him to place certain assets in trust for his children and imposed a judicial lien on those assets in an effort to protect them from seizure by IRS and FTB.

Hawkins consented to the assessment of the IRS tax deficiencies in December, 2004, and the IRS assessed the deficiencies in March, 2005. The California FTB assessed their “piggyback” audit deficiencies in September of 2005. In October of 2005, Hawkins submitted an Offer in Compromise to the IRS. This OIC was ultimately rejected.  In July of 2006, Hawkins sold a residence, and the IRS received $6.5 million from this sale.  The FTB received $6 million as the result of levies on financial accounts in August of 2006.

In September of 2006, Hawkins filed a chapter 11 bankruptcy petition. He confirmed a plan of reorganization in July, 2007. The IRS received roughly $3.4 million under the plan. But substantial amounts remained due and owing to both the IRS and the FTB after consummation of the chapter 11 plan. Hawkins then filed suit to determine whether the unpaid taxes owed to IRS and FTB were discharged in the Chapter 11 bankruptcy.

In the litigation, the IRS made two arguments in support of its position that the unpaid tax liabilities had not been discharged.  First, they argued that Hawkins had filed fraudulent returns by claiming the tax shelter losses on those returns. Those of you who are familiar with Jack Townsend’s excellent blog  Federal Tax Crimes know that Jack has wondered for quite some time why the IRS has not asserted the civil fraud penalty more frequently against taxpayers who “invested” in tax shelters.  In this particular case, the IRS argued that Hawkins filed a fraudulent return.   So there you go, Jack. They finally claimed that a taxpayer acted fraudulently in claiming losses from a tax shelter on their income tax return, albeit in the context of bankruptcy dischargeability litigation, where the standard of proof for proving fraud is only a preponderance of the evidence.

Judge Carlson, however, explicitly refused to decide whether Hawkins acted with intent to defraud in filing the tax returns in question. Instead, Judge Carlson held that Hawkins had attempted to evade or defeat the taxes in question.  Judge Carlson made it very clear that the basis for his holding  that Hawkins had attempted to evade or defeat the taxes in question was that Hawkins had done nothing more than engage in “unnecessary” expenditures. Here is what Judge Carlson had to say:

The Government has met the required burden with respect to Trip Hawkins by establishing that for more than two and one-half years before filing for bankruptcy protection, he caused Debtors to make unnecessary expenditures in excess of Debtors’     earned income, while he acknowledged that Debtors had a tax liability of $25 million, while he relied upon that tax liability in seeking a reduction of child support payments,    while he knew Debtors were insolvent, while Debtors paid other creditors, and while Debtors planned to file bankruptcy to discharge their tax obligations.

Judge Carlson then commented extensively on Hawkins’ lifestyle, stating as follows:

From the time of their 1996 marriage onward, Debtors maintained a lifestyle that was commensurate with the great wealth they enjoyed at the time they were first married. In 1996, Debtors purchased a home in Atherton, California for $3.5 million. In 2000, Debtors purchased an $11.8 million private jet that they used for family vacations as well as for business trips.  In 2002, Debtors purchased an ocean-view condominium in La Jolla, California for $2.6 million. From the date of their marriage to the date of their bankruptcy petition, Debtors employed various gardeners and household attendants.

Debtors altered this lifestyle very little after it became apparent in late 2003 that they were insolvent. Although they sold the private jet in 2003, they continued to maintain both the Atherton house and the La Jolla condominium until July 2006. In October 2004, Debtors purchased a fourth vehicle costing $70,000.

Debtors’ personal living expenses exceeded their earned income long after Trip had acknowledged that Debtors were insolvent. In the Collection Information Statement accompanying their October 2005 Offer in Compromise, Debtors disclosed annual after-tax earned income of $150,000 and annual living expenses of more than $1.0 million. In the schedules filed in their bankruptcy case in September 2006, Debtors disclosed annual after-tax earned income of $272,000 and annual living expenses of $277,000. The components of Debtors’ living expenses are discussed in more detail below.

* * *

Before examining Hawkins’ expenditures, it is appropriate to examine Hawkins’ earned income. For the purpose of this decision, this court assumes that it should take some account of a debtor’s earned income in determining what expenditures are culpable under section 523(a)(1)(C) as unduly lavish. It may not be appropriate to require a CEO earning hundreds of thousands of dollars per year to live in an apartment suitable for a clerical employee, even if that CEO is insolvent. The effort and skill required to earn such sums require a nuanced approach in determining what living expenses are necessary.  Even the most nuanced approach, however, does not excuse living expenses greatly in excess of earned income over an extended period of time.

Debtors provided two snapshots of their income and expenses between January 2004 and September 2006. In October 2005, Debtors submitted a Collection Information Statement, signed under penalty of perjury, in support of their Office in Compromise. In September 2006, Debtors filed schedules in their chapter 11 case, also signed under penalty of perjury. The October 2005 Collection Information Statement indicated monthly after-tax earned income of $12,500. Bankruptcy Schedule I indicated monthly after-tax earned income of $22,180. All of this income was earned by Trip; Lisa was not employed outside the home at any time during this period.

Against this backdrop, the Debtors’ personal living expenses from January 2004 to September 2006 are truly exceptional. After Trip represented to the family court that he was liable for $25 million in federal and state taxes and that he was insolvent as a result, Debtors spent between $16,750 and $78,000 more than their after-tax earned income each month.

In the Collection Information Statement submitted in October 2005, Debtors stated that their personal living expenses were more than seven times their after-tax earned income, and exceeded that income by more than $78,000 per month.

* * *

Several aspects of this Statement are worthy of note. The $33,600 housing expense included expenses for a 5-bedroom, 5.5 bath house in Atherton (later sold for $10.5 million), and a 4-bedroom, 3.5 bath condominium in La Jolla (later sold for $3.5 million). The transportation expense covers four vehicles for a family with only two drivers, and includes a $70,000 Cadillac SUV purchased ten months after Trip Hawkins had acknowledged Debtors’ tax liability and insolvency in the family court proceeding.

* * *

The schedules filed in Debtors’ bankruptcy case indicate that Debtors’ personal living expenses greatly exceeded their after-tax earned income until just before they filed their bankruptcy petition in September 2006. Debtors sold the Atherton house just before the bankruptcy petition was filed. Debtors sold the La Jolla condominium after the bankruptcy petition was filed. If one adds the minimum amount they could have been spending for housing before the July 2006 sale of the Atherton house, together with the income and living expenses that Debtors reported in their bankruptcy schedules, Debtors’ living expenses greatly exceeded their after-tax earned income through July 2006.

* * *

Debtors made expenditures in excess of earned income for more than two-and-one-half years after Trip Hawkins acknowledged in January 2004 that Debtors were insolvent and would not pay their tax debt in full. Debtors did not sell the Atherton home until July 2006. They did not sell the La Jolla condominium until after filing for bankruptcy protection in September 2006. 24 They reported in their bankruptcy schedules that on the petition date they were still making the expenditures for the Cadillac SUV, child care, and recreation noted above. Debtors’ high level of expenditure also continued well after they consented to assessment of tax by the IRS in the amount of $21 million in December of 2004, and well after the assessments were recorded in March 2005. The Collection Information Statement indicates that Debtors’ monthly living expenses were seven times their earned income ten months after they consented to assessment and seven months after the IRS formally assessed the additional tax. This is not a case where the taxpayers acted appropriately once the tax was formally assessed, perhaps suggesting that their earlier failure to pay was based on some innocent misconception of their duty.

There is one point not focused on by Judge Carlson but of potential relevance to the resolution of the case under the standard relied on by him.  The IRS taxes were not assessed until March of 2005, some 18 months after the family court hearing. Assuming that Hawkins did not knowingly sign  fraudulent tax returns when he claimed the tax shelter losses on those returns, his duty to pay the audit deficiency assessments did not arise until after the taxes were assessed and notice and demand for payment was sent in 2005. See, e.g., §6651(a)(3) of the Internal Revenue Code, which imposes a penalty for the taxpayer’s failure to pay a deficiency in income taxes only after the taxpayer has received notice and demand for payment after the tax deficiency has been assessed.

Based on the premise that Hawkins had no duty to pay the additional taxes until they were properly assessed, I have difficulty with Judge Carlson’s reliance on the pre-assessment conduct of Hawkins to determine that he attempted to evade or defeat the taxes in question.   Pre-assessment conduct of a taxpayer is certainly relevant for purposes of determining whether a taxpayer engaged in Spies-type evasion of taxes under section 7201.  See, e.g., United States v. Voorhies, 658 F.2d 710 (9th Cir. 1981).  But I am unaware of any case in which the IRS has ever charged or convicted a taxpayer for a failure to pay a tax under section 7203 based on the taxpayer’s conduct prior to the tax being assessed and billed to the taxpayer.

The 6707A Penalty With a Nod to the Superseding Return Concept

I am a fan of the hardworking Lew Taishoff and his blog which provides timely updates on Tax Court matters. This week he posted a strong discussion of Yari v Commissioner. The case is a regular TC case of first impression that considered the proper way to calculate a penalty for failing to disclose a listed transaction under Section 6707A. 6707A imposes a penalty on “[a]ny person who fails to include on any return or statement any information with respect to a reportable transaction which is required under section 6011 to be included with such return or statement.” Prior to 2010 the penalty for failing to disclose a listed transaction was a flat fee–$100,000 for individuals. In 2010, facing a backlash that the penalty was too harsh, Congress retroactively amended 6707A, with the penalty set to “75 percent of the decrease in tax shown on the return as a result of such transaction (or which would have resulted from such transaction if such transaction were respected for Federal [income] tax purposes).” Sec. 6707A(b)(1) (emphasis added). For individuals, amended 6707A also prescribed minimum and maximum penalties of $5,000 and $100,000, respectively.

The issue in Yari was how to calculate the penalty when the taxpayer amended the return that eliminated the taxpayer’s income tax liability. If the penalty amount is derived from the original return, then the taxpayer in Yari was subject to the maximum $100,000 penalty. Using the amended return and the decrease in tax shown on that return, the taxpayer would be subject to the minimum penalty of $5,000.


The Dispute Under 6707A

Mr. Taishoff sets the case up well. The taxpayer’s problem in 2004 stems from as he says “the old story of putting stock from a Sub S in a Roth, having an operating entity (here an LLC) pay the Sub S for “management fees”, and funneling the deductible fees into the nontaxable Roth. See Notice 2004-8, 2004-1 C.B. 333, for more about this nefarious scheme.”

During the course of the audit the taxpayer amended his 2004 return a first time and then again during deficiency proceedings. In the second amended return, the taxpayer claimed a NOL carryback of over $2.8 million, resulting in negative taxable income. The taxpayer and the IRS entered into a closing agreement in 2011 relating to 2004 and other years resulting in a stipulated decision in Tax Court.

Because 6707A is an assessable penalty the opinion walks through how CDP gives the Tax Court jurisdiction to consider the proper way to apply the 2010 changes to 6707A. For those who are interested in statutory interpretation, the case discusses what is and is not legislative history (sorry Blue Book fans) and some of the difficulties courts face in figuring out what Congress had in mind when enacting legislation.

The court concludes that the plain language of the statute supports the IRS’s interpretation.

We think the statute is clear and unambiguous: The penalty is calculated with reference to the “tax shown on the return”. Sec. 6707A(b). When we look to the penalty provision as a whole, it is clear that Congress has penalized the failure to disclose participation in a listed or otherwise reportable transaction on the return or other information statement giving rise to the disclosure obligation. If the taxpayer fails to report the transaction on that return or information statement, then the penalty is based on the tax shown on that return or information statement, not some other, later filed return or some hypothetical tax. Congress did not say that the penalty should be calculated by reference to tax shown on a return; it did not say to calculate the penalty using the tax required to be shown; and it did not say to calculate the penalty using the decrease in tax resulting from participation in the transaction. Congress very clearly linked the penalty to the tax shown on a particular return–the return giving rise to the reporting obligation. Absent a“‘clearly expressed legislative intent to the contrary’”, we will regard the clear and unambiguous language of the statute as conclusive (notes omitted)

In reaching its conclusion, the court noted how in other penalty provisions (such as 6651(a)(2), the failure to pay penalty) the Code allows for a reduction in the penalty if the correct tax liability is lower than that on the original return. Section 6651(c)(2) provides that if the amount required to be shown as tax on a return is in fact less than that on the return, to compute the penalty you use the lower correct tax rather than what you originally reported as tax. From that, Yari concludes that Congress knew how to get to the result that the taxpayers wanted here but “that it did not do so in section 6707A tends to bolster our holding that the penalty applies to the amount shown on petitioner’s first filed return.”

Superseding Returns

To that last point the court dropped footnote 8, stating that the taxpayer filed its amended returns after the due date for the original return and that it expressed “no opinion as to the result had he filed his first amended return before that date.” The note cited the Goldstone Tax Court case from 1975 where that court noted that amended returns have been rejected in certain circumstances but that “courts had upheld the validity of amended returns in other circumstances, such as where the amended returns were filed before the filing deadline for the subject tax year.”We have not spoken much about amended returns, but note 8 in Yari reminds me of a point in the Saltzman Book discussion of tax returns considering when a taxpayer submits a subsequent return prior to the due date of the original return. In a number of administrative announcements IRS has referred to that submission as a superseding return, which the IRS treats in effect as the original return taking the place of any other prior return and accompanying schedules and disclosure statements. It has done so even when the taxpayer submits an extension request and files an original return on a timely basis and then submits a new return prior to the extended due date. The Tax Adviser in an article from last year has a brief practical discussion of the point and some of the cases and administrative announcements considering the issue.

While Yari does not reach the issue, I doubt that the IRS would have disagreed with the taxpayer’s view if its subsequent return was filed before the due date and in effect was not an amended return but just a superseding original return. That the taxpayer filed the later amended returns well after the original return’s due date contributed to the court’s holding that the amended return had no significance for the penalty computation, a result that is consistent with tax procedure norms.

Tax Court Finds Reliance On Advisor In Messy Small Business Setting

There are complex jurisdictional issues relating to TEFRA partnerships. Earlier this month in VisionMonitor Software v Commissioner the Tax Court discussed the odd TEFRA penalty landscape and also blessed a reliance defense in far from pristine circumstance where members claimed outside basis for notes they contributed to an LLC to satisfy the demands of an outside funder. Goosing outside basis for contribution of your own notes ran afoul of the partnership rules. In Vision Monitor for good measure IRS socked a 20% accuracy related penalty the partners would ultimately have to pay and possibly fight in separate refund proceedings.

In this post, I will briefly review the penalty aspects of the opinion. While reliance cases are notoriously fact specific, VisionMonitor is a useful case for practitioners seeking a reliance defense even when advice does not come in the way of a formal opinion, and the advice and corporate formalities reflect less than perfect attention to detail. In other words, this case is representative of the way many small businesses operate.


Factual Background

As readers of the blog may know, one of my favorite writers on the Tax Court is Judge Holmes. His opinions are clear and straightforward. Here is the summary of the facts from the opinion:

Torgeir Mantor and his partner Alan Smith started VisionMonitor Software, LLC back in 2002. They contributed a good deal of their savings and labor, but VisionMonitor lost money for the first several years. Another partner, a deep-pocketed corporation, was willing to contribute nearly 2million dollars to keep the firm afloat, but it wanted Mantor and Smith to place themselves at greater risk. Mantor and Smith responded by contributing their own promissory notes to VisionMonitor in both 2007 and 2008. VisionMonitor recorded the notes on its books as additional capital and accrued interest on them–but neither Mantor nor Smith funded them during either year.

The opinion discusses how the members came to contribute the notes rather than cash and how they came to the decision to treat the notes as increasing their outside basis:

Mantor and Smith didn’t have the liquidity to contribute cash. So they called their longtime attorney, Rick Sympson, to discuss some ideas. Smith asked Sympson about the tax implications of contributing promissory notes to a partnership. Sympson did some cursory research to make sure that the notes “would get him basis,” but testified that he relied mainly on the fact that Mantor and Smith were required by the other investors to contribute something more to the company. He knew the notes were enforceable, and that the partnership would put them down as assets on its balance sheet. So he told Mantor and Smith that the notes were appropriate capital contributions and “would create partnership basis.”

The advice from Sympson did not come via written opinion, and he apparently did not look at any of the underlying corporate documents.

This was still good enough for Mantor and Smith, and Mantor and Smith agreed at the start of 2007 to a “Resolution of the Managing Members” of VisionMonitor. They agreed to freeze their salaries, to provide personal credit to the “Company vendors * * * to ensure continued uninterrupted operations,” and to “indebt themselves through notes payable to the Company to improve the Company’s financial position.” The resolution was the formal authorization for the issuance of the promissory notes from Mantor and Smith to VisionMonitor.

The two members contributed differing notes totaling about $200,000 in 2007 and 2008. The notes were full of drafting errors; some even reflected an incorrect corporate name for the borrower. Some were not notarized. The corporate books were hard to reconcile fully with the nominal loan amounts. The opinion details the sloppiness. Here is an example:

And the nominal amount [of a particular note] seems to be a carryover from a prior draft of the note that sloppy proofreading didn’t catch, but the amounts that the partners now claim as the face values of the notes are the values actually reported in VisionMonitor’s books, although neither the nominal amount nor the amount in the parentheses matches the amount that is identified on the VisionMonitor return as Smith’s 2007 and 2008 contributions.

The Law at Issue

The substantive advice Sympson gave to the members was wrong, and the partners should not have increased their outside basis from an unfunded promise to pay. For those who want some substantive partnership tax, the opinion goes through the black letter law on that point. Because of the error, IRS also argued that the 20% accuracy-related penalty should apply.

VisionMonitor reminds us of the TEFRA penalty landscape following Woods last year, where the Supreme Court attempted to navigate the murky jurisdictional waters surrounding TEFRA partnerships and accuracy-related penalties:

TEFRA gives courts in partnership-level proceedings jurisdiction to determine the applicability of any penalty that could result from an adjustment to a partnership item, even if imposing the penalty would also require determining affected or non-partnership items such as outside basis.” Woods, 571 U.S. at ___,134 S. Ct. at 564. Therefore, the actual assessment of a penalty relating to an adjustment of a partnership item is done at the partner level but is based on partnership-level determinations. Partnership-penalty law gets even more complicated when one looks at defenses because jurisdiction over them can exist at both the partnership and partner levels. The partnership itself may have a defense to a penalty that would shield all its partners; one partner may have a defense to the penalty that’s all his own. Our Court has jurisdiction to rule on any partnership-level defense, but partners have to take their partner-level defenses to a refund forum. [citations omitted]

This case concerned a partnership level defense. As a defense to the penalty, the partnership argued good faith reliance on the advisor, Sympson. Citing the Neonatoogy case, the opinion implicated the three factors that courts have looked to under Section 6664 to determine if the reliance amounts to reasonable cause/good faith:

  1. Was the adviser a competent professional who had sufficient expertise to justify reliance?
  2. Did the taxpayer provide necessary and accurate information to the adviser?
  3. Did the taxpayer actually rely in good faith on the adviser’s judgment?

In analyzing the first and third factors, the court found that the facts supported the taxpayer. As to competence, Sympson was a longtime attorney and tax preparer for the LLC and Mantor, who was the tax matters partner. As to reliance and good faith, the court also found in favor of the taxpayer:

We have little problem in finding that VisionMonitor actually relied on Sympson’s advice–his conclusion that the notes were additions to VisionMonitor’s capital (and the capital accounts of Smith and Mantor) was set out on the company’s returns. And we have little trouble in finding that this reliance was in good faith. In a case like this one–where VisionMonitor secured Smith [the other member] and Mantor’s promises to increase their personal risk alongside their promise to extend their personal credit to the firm’s vendors–advice from a longtime tax adviser that this increased Smith’s and Mantor’s bases would seem reasonable to Mantor.

What makes this a taxpayer friendly case is the opinion’s discussion of the second Neonatology factor. The requirement that the taxpayers provide necessary and accurate information to the advisor seems to be inconsistent with the sloppiness of the notes themselves and the way that the LLC reflected the debt on its books. The opinion notes the many drafting errors and found that the tax advisor Sympson himself did not look at any documents in connection with the advice he gave. Holmes is frank in addressing this part of the test, noting that “[t]hese problems may push Neonatology’s second prong to poke at VisionMonitor’s defense, but we don’t think they push hard enough to puncture it.”

Here is where the opinion parses the second prong in a taxpayer friendly way:

The test tells us to look at whether VisionMonitor provided necessary and accurate information to Sympson. Because a penalty is applicable as a result of a position taken on a return, we look to see if VisionMonitor provided what information it had before it filed its returns and not just when Sympson was giving his oral advice to Mantor. We think accuracy here means holding nothing back and letting the professional give his opinion on the notes and associated records in all theirconfusing messiness. And on this point we find both Mantor and Sympson credible in saying that Sympson had access to all the records he needed when he prepared the returns, as he had for many years in the past. We also believe Sympson’s testimony that Mantor discussed the factual background with him. (emphasis added)

Some Thoughts on the Case’s Implications

The opinion distinguishes some cases where the taxpayer did not establish the advisor had access to all the information, including the Ohana case I wrote about earlier this year where the Tax Court held that the taxpayer did not receive advice when the taxpayer mostly was dealing with a receptionist rather than the advisor himself. What makes the VisionMonitor case helpful for taxpayers is that it does not condemn taxpayers when they may fail to dot the i’s and cross the t’s, but who are not really in a position to second guess tax advice. That the advisor had access to the corporate records and was someone who had a longstanding relationship with the parties was key. Through Sympson’s return preparation and prior relationship he had detailed information about the business. What he lacked was the time or inclination to do the research on the specific question but the individuals did not and should not have been held to know that his off the top response was wrong, even though the individuals were fairly sophisticated. Tax law is complicated, and partnership tax is especially complicated. Moreover, unlike some of the recent cases where the Tax Court has been skeptical of advice, there was no conflict of interest, and the LLC was a real business that in later years actually turned a profit.

This result seems fair. As a practical matter, it does not penalize small business taxpayers. Given TEFRA’s odd rules, it also did not force the individual partners to have to raise accuracy-related defenses in a separate proceeding that would not likely have been made in a pre-payment forum.


Summary Opinions for 9/5/14

Mostly me talking about other folks publishing great content this week, although we do touch on a few cases.  SumOp has some interesting news on the Service getting sued, inversions, and the proper way to value your conservation easement.


  • Frank Agostino’s firm has published its September newsletter, available here.  The newsletter has articles about the review standard of assessable international penalties, the professionals’ duty to report, and the collections statute of limitations as it applies to installment agreements.  The articles are very well written; sort of like very practical and helpful law review articles.
  • The Service was served with a class action lawsuit over tax preparer user fees this week, with the class having a whole lot of potential members.  Tax Girl has coverage at Forbes, which can be found here.  Unfortunately, my sixty-five bucks will go back to my firm.  The complaint seems to be twofold: first, the requirement is invalid; and second, the vast majority of the cost is not specifically allocated to any IRS actual cost.  Allen Buckley is one of the two attorneys representing the preparers.  His name may be familiar as the named party in a very similar lawsuit from last year where the user fee was upheld in the Northern District of Georgia. We touched on that in a prior SumOp.  Nice to trade up to the class action.  Way better payout if he is successful (1/3x$150MM>$65).
  • “The World On Time” kind of indicates a certain level of control over when and where the FedEx drivers are going to be, but FedEx has always treated its drivers as independent contractors.  In 2010, the Northern District of Indiana held that this was true in 23 states, but the drivers were employees in three others (95 page opinion!  I didn’t read that).  The Ninth Circuit has reversed as the holding as to California and Oregon.  Checkpoint tells me that the IRS has previously reviewed this issue as to FedEx, and determined for federal purposes, the drivers are independent contractors.
  • The Tax Court in Schmidt v. Comm’r has issued a very detailed opinion on the calculation of a conservation easements and the proper application of the discounted cashflow method in the case.
  • Joe Kristan has a good write up of Vanney Associates v. Comm’r, where a C corp was making yearend bonus “distributions” to its owner/employee, and then doing book entries for loans back to the company in order to zero out the income, minimize tax, and not actually take the funds out of the company.  The owner never cashed the checks in question, and the tax court held there was no actual distribution.
  • We have not covered inversions much yet, but I had to linked to the Mauled Again blog discussing comments made by Mark Zandi of Moody’s discussing the negative impact of inversions and some of the reasons certain types of companies consider inversions.  Both men are very smart, and the post and underlying article are both worth a read.  I should note, I had Professor Maule for at least three tax classes, maybe four, during law school, and Moody’s Analytics, which I believe Mr. Zandi helped co-found, is about 10 yards away from my office.

A Proposal to Amend Flora or Collection Due Process for Individuals Examined by Correspondence Who Do Not Pick Up or Process Their Mail

I recently wrote about the Tax Court’s decision in Onyango v. Commissioner, 142 T.C. No. 24 (2014) in which the Court held that an individual who received the certified mail notification that would/should have led that individual to go to the post office and pick up the notice of deficiency had, for purposes of I.R.C. 6330(c)(2)(B), received the notice of deficiency. Instead of timely going to the post office, the individual made no effort, or no timely effort, to go to the post office to pick up the notice and the Court, properly in my view, determined that this failure precluded the individual from contesting the merits of his tax liability through the CDP statute even though he never “had” the opportunity to do so prior to the assessment. 

Because this individual’s behavior mirrors the behavior of many clients who come to my clinic and who come to clinics around the country, I want to talk about the current system and how it could change to address the situation created by fairly large class of individuals who do not either pick up, open or deal with their mail. As someone who has previously confessed to having some misgivings about CDP, my suggestion here may be too radical and may foster behavior we want to discourage but the current system fails many individuals. If we really want CDP to work, it may be worth examining taxpayer behaviors matched against statutory requirements. 


The traditional system of tax assessment, as it has morphed over the past three to four decades, does not work for a large class of citizens. With the advent of correspondence examination (Corr Exam) and automated collection sites (ACS) in the 1980s, the IRS makes no personal touch on a segment of the population most in need of a personal touch in order to understand their rights. 

Instead, we have created a system that sends correspondence to the least competent taxpayers rather than giving them an individual in their community assigned to their case. So, the current system of examining the poorest individuals consists of sending 2-3 letters, which a high percentage of individuals ignore or misplace and then granting the IRS permission through the statute to assess an additional tax liability. We follow up the first letter writing campaign, which was so successful, with another one, consisting of 3-4 letters before the statute gives the IRS the right to levy. 

The IRS levies and takes the taxpayer’s wages or bank account or social security payments. It now has the attention of the taxpayer who now has almost no statutory rights to contest either the liability or the collection process. It is too late to go to Tax Court either to contest the underlying merits of the assessment or to use the CDP process. Just when these taxpayers are ready to address their problem, they have a limited, almost entirely administrative path remaining. The nicely paved road to Tax Court has given way to a goat path up the hill to administrative relief. 

To its credit, the IRS did not even need to create the goat path but it does make it possible for the taxpayer to address the merits through audit reconsideration, the collection through an equivalent hearing or a CAP appeal or an offer in compromise based on doubt as to liability. Still, the taxpayer has lost all rights to go to court should the administrative path prove unsuccessful. The inventories of low income taxpayer clinics are filled with these taxpayers because the impersonal Corr Exam and ACS process to which low income people are assigned does not meet their needs. 

Perhaps we say they get what they deserve because they are making the decision to ignore their mail. We might say that we tried in 1998 by creating CDP to take care of the problem created by the 1980s development of Corr Exam and ACS. I think there is another way to look at the situation. 

When the current procedures for tax administration were built, the rich or upper middle class were the ones interfacing with the tax system. The refund process served as the relief valve everyone thought existed when a bad assessment occurred. The Flora rule, which goes back to ancient times before Corr Exam and ACS, effectively bars low income taxpayers, as well as many others, from using the Courts through the refund process to redress a bad assessment (See Flora v. U.S., 362 U.S. 145 (1960) (holding that a taxpayer generally must pay the full amount of income tax deficiency assessed by IRS before he or she may challenge its correctness by suit in federal district court or Court of Federal Claims for refund under 28 U.S.C. § 1346(a)(1)); see also 26 U.S.C. § 7422 (requiring taxpayers to file claim with IRS prior to commencing refund suit)). The less friendly confines of the District Court compared to the Tax Court also makes the refund route an uphill procedural battle for the unrepresented or poorly represented taxpayer. 

The creation of the CDP remedy and the potential relief valve of tax merits litigation during the collection period, may have seemed like an idea that would provide relief to many who missed the initial opportunity to contest the tax – for whatever reason, but for most taxpayers the CDP opportunity which wraps the notice of intent to levy in a package that can result in litigation on the collection activity if not the underlying merits, comes in yet another envelope, usually number 7 or 8, that the taxpayer will toss or set aside not knowing or understanding the importance of their actions. 

The decision in Onyango v. Commissioner and a recent post on the low income taxpayer listserv (published at the end of this post) by a relatively new tax clinician struggling through the possibilities for remedial action made me think about the problem and possible solutions. For a client who has squandered the statutory opportunities for merits relief something other than the illusive opportunity for such relief through CDP needs to happen. The necessary relief should provide a meaningful opportunity for a group of taxpayers, by and large but not exclusively low income, who are now a part of the tax procedure system which developed its procedures before they joined the party. 

What might be done to rethink how this group of individuals who did not participate in the tax system when the procedures developed and who only get examination or collection contacts from a unit of IRS employees but never receive an individual case assignment? My first facetious thought was to just levy first. If you go ahead and take their money at the front you have their attention. Then give them rights instead of waiting until all of their statutory rights are gone, as a result of correspondence, before taking their money and getting their attention. While this idea is relatively simple in concept, I cannot put it forward with any sense that it represents the right thing to do. 

Instead, we might rethink Flora or rethink CDP. 

Suppose we were building the refund rule at a time when the highest number of examinations, by a long shot, were done by Corr Exam and most of the people ending up with tax liabilities had no ability to fully pay the taxes. Would we have ended up with the Flora rule? Would the Supreme Court have required the low income taxpayers now caught up in the tax system because we have decided to use the tax system to deliver social benefits to fully pay the tax in order to get into court? I do not think it would. I think the Flora decision reflects the times. At that time people who chose not to go to Tax Court generally were middle class or upper class citizens or entities that missed the Tax Court without the systemic impediments facing low income taxpayers. Once they missed the Tax Court, they generally, but not always, had the means to go after the liability by paying and suing in district court. 

What if we changed Flora or changed 6330(c)(2)(B) to allow a taxpayer to raise the merits of the underlying liability in Tax Court after a levy had occurred if the taxpayer was examined by Corr Exam instead of by an individual examiner assigned specifically to their case? If the change occurred by revoking Flora in Corr Exam cases, taxpayers could file a claim for refund after the collection of any amount of the taxes assessed as a result of the Corr Exam and not just after full payment. Such a change would acknowledge that examining taxpayers through correspondence often fails to meaningfully engage them in the process and allowing them to go through the full refund claim process, including the opportunity to go to Court if agreement were not reached, provides on the back end the full consideration of their case that Corr Exam does not offer. I would also open the doors to Tax Court in this type of litigation because the Tax Court has developed that type of procedures and culture that works better for low income taxpayers than the current procedures in District Court. 

Alternatively, and less satisfactorily in my view, CDP could change to allow taxpayers to address the merits in the CDP process if they did not receive the notice using the current test or if they were examined by Corr Exam. This option still limits relief to those who open and process their incoming mail and does not address my concern that many taxpayers do not react to mail but react to a taking of their property. The merits litigation, if allowed, would follow the traditional rules. The Tax Court would examine that aspect of the CDP determination consistent with its deficiency jurisdiction, i.e., de novo. The taxpayer would have the burden of raising the amount or existence of the liability in the request for CDP relief. I note that CDP cases could initially go to either Tax Court or District Court but now go exclusively to Tax Court which I think is a good result. 

I doubt that either of the changes I am proposing would result in a massive opening of litigation on the merits of taxes but it would have the effect of saying to a group of people who were not around when the current tax procedures were developed that we value them. We want to give them an opportunity to contest their liability in a court proceeding if it cannot be resolved administratively and even though we, as a government, do not have the resources to examine their returns individually rather than on a group basis, we still want them to have every opportunity to contest the liability if they feel they do not owe it. 

CDP sought to relieve the pressure created by Corr exam and ACS. I think it has provided some relief but fails in the area of underlying merits for the reasons identified by the Tax Court in its recent opinion. The IRS seeks to relieve the pressure through its creation of the audit reconsideration process but without the opportunity for court that does not offer full relief when administrative resolution fails. The tax procedure system needs to adapt to the inclusion in the process of a group of individuals not contemplated when it was built. We can say that those individuals need to adapt to the system but that ignores reality. Making a change will cost very little compared to the fairness it would provide. 

Here is the recent post on the low income taxpayer listserv that highlights the dilemma clinicians representing low income taxpayers regularly face: 

For some reason, although 26 USC 6330(c)(2)(b) and the instructions to a CDP request form state that you can’t raise the underlying liability in a CDP hearing if the taxpayer had received the Statutory Notice of Deficiency, I had been thinking that the taxpayer could still submit an Offer In Compromise based upon doubt as to liability in the CDP context. 

Upon further reflection and reading of the Internal Revenue Manual, I now think that if I submit an OIC-DATL in this situation it is just going to get rejected. 

But, I would still like to challenge the underlying liability.  

It strikes me that the options are either (a) withdraw the CDP and file the OIC-DATL outside of the CDP context, or (b) to file a Request for Audit Reconsideration, which as I understand it would also be separate and apart from the CDP process, and not entitled to any judicial review – if we went this route, client would lose the CDP opportunity, and then if the Audit Reconsideration was rejected, client wouldn’t have recourse to CDP and attendant judicial review 

Alternatively, even though it doesn’t directly attack the underlying liability, could we file an OIC-ETA based upon Public Policy/Equity (assuming that the debt will be determined collectible or not otherwise addressable as an ETA Hardship), which could be done in the CDP hearing context and which would be subject to judicial review if rejected? 

Does anyone have any thoughts about whether it would be better to pursue the Audit Reconsideration/OIC-DATL and forgo the CDP opportunity, or to pursue an OIC-ETA Public Policy/Equity in the CDP context?  



Limiting the Right to Contest the Underlying Tax Liability in a Collection Due Process Case

Earlier this summer, we mentioned the Tax Court case Onyango v. Commissioner in Summary Opinions and almost a year ago Professor Book wrote about Collection Due Process and When is a Document Establishing Liability Received. The Tax Court in Onyango v. Commissioner, 142 T.C. No. 24 has placed a new limitation on the ability of taxpayers to contest the underlying tax liability. The decision draws a logical distinction between someone who does not receive the notice of deficiency and someone who does not bother to retrieve their mail. Making this distinction will create more contests when a taxpayer seeks to litigate the merits of a tax liability through collection due process (CDP). Up to this point the ability to contest the underlying tax liability turned mostly on the taxpayer saying/proving that he did not receive the notice in time to petition the Tax Court. Now, the government has an additional argument it can make to prevent the taxpayer from arguing the merits.


The IRS sent Mr. Onyango a notice of deficiency. They sent it to his last known address and, as required by statute, sent it by certified mail. The postal service made several attempts to deliver the certified correspondence. Mr. Onyango did not pick up his mail and did not follow the instructions on the certified mail delivery cards to come to the post office and sign for the notice of deficiency. The evidence suggested that he eventually reacted to the certified mail and checked with the post office but by that time the post office had returned the notice to the IRS. He lived at the address to which the notice was mailed and could have picked up the notice had he sought to do so.

Because he did not pick up the notice of deficiency, he did not file a Tax Court petition within 90 days of the notice. Because he did not file a Tax Court petition, the IRS assessed the liability against him and eventually began the collection process. Because he did not pay the liability after receiving notices from the IRS regarding the outstanding liability, the IRS eventually sent a notice of intent to levy in which he received CDP rights. He timely filed a CDP request with Appeals and subsequently received a notice of determination sustaining the proposed levy. From the notice of determination he timely filed a petition with the Tax Court challenging the merits of the assessed liability pursuant to IRC 6330(c)(2)(B) asserting that he did not receive the notice of deficiency within 90 days.

Section 6330 (c)(2)(B) provides that a taxpayer in a CDP hearing may “raise at the hearing challenges to the existence or amount of the underlying tax liability for any tax period 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.” The IRS argued that this provision did not give a taxpayer the right to challenge the merits of the underlying liability on the basis of non-receipt of the notice of deficiency if the taxpayer chose not to pick up his mail. It argued that here the failure in receipt resulted directly from the taxpayer’s choice and not any failure of delivery and that any of his testimony contrary to that conclusion was not credible and “should be given no weight.”

The Court agreed with the IRS that Mr. Onyango’s testimony lacked credibility in certain respects. It accepted his testimony that he did not know about the certified mail notices and that when he went to the post office the certified mail had already been returned to the IRS. It found that he stayed at the residence to which the notice was mailed approximately 30-40% of the time and simply declined to check for his mail.

Without going to the record, I remain unclear as to the aspects of Mr. Onyango’s testimony contradicting the conclusion that he failed to pick up the mail despite having the opportunity to do so. Enough testimony came out on direct or cross to make it clear that he lived a fair percentage of the time at the address where the certified mail was delivered and that he did not present the certified mail to the post office until too late. Denying a CDP petitioner the opportunity to argue the merits of tax liability seems consistent with the original intention of the statute. It seems odd that it has taken over 15 years since the first CDP case became a possibility to get to this case. The Court issued the opinion as a “full” Tax Court opinion indicating that the Tax Court felt the opinion broke new ground. This case will no doubt get used regularly in the future to bar petitioners seeking to argue the merits of their tax liability in CDP cases.

The area of lack of receipt of the notice has come up in a number of cases. In Montgomery v. Comm’r, 122 T.C. 1 (2004), the Tax Court concluded that the underlying tax liability described in § 6330(c)(2)(B) includes self-assessed amounts and therefore the statute supports a taxpayer challenge from a taxpayer filing a balance due return because such a taxpayer has not received a notice of deficiency in connection with the liability and the taxpayer has not had an opportunity to dispute the liability (See also, Cooley v. Comm’r, 2004 T.C. 49 (2004)). In Sherer v. C.I.R., T.C. Memo. 2006-29, the Tax Court allowed the taxpayer to contest underlying tax liability at pre-levy collection due process hearing, based on the fact that he did not receive the notice of deficiency because he did not live at either of two addresses where the notice had been sent, rather than being due to deliberate refusal of delivery. In Tatum Jr. v. Comm’r, T.C. Memo 2003-15, where the taxpayers did not deliberately refuse service and the Post Office made only one attempt to deliver a deficiency notice, the Tax Court held that the taxpayers should have been allowed to challenge their underlying tax liabilities at the CDP hearing. Frequently, the IRS or the Court faces the issue of why the taxpayer did not receive it but no previous case took head on the taxpayer’s own failure as the basis for non-receipt and the consequences of the taxpayer’s inaction.

The ability of taxpayers to get another bite at the tax merits apple through the CDP process exists because Congress heard complaints from numerous taxpayers in the period leading up to the legislation in 1998 that the IRS sought to collect from them and they never had the opportunity to contest the underlying liability. Based on the legislative history, the reason for the change was that the Senate Finance Committee believed that “taxpayers are entitled to protections in dealing with the IRS that are similar to those they would have in dealing with any other creditor. . . . [T]he Committee believe[d] that the IRS should afford taxpayers adequate notice of collection activity and a meaningful hearing before the IRS deprives them of their property.”  S. Rep. No. 105-174, at 67 (1998). Additionally, Nina Olson and tax procedure expert Michael Saltzman testified in support of introducing a third party to protect both the government’s and the taxpayers’ rights in the tax collection process.

The goal behind (c)(2)(B) had to be to help those taxpayers to whom the IRS had properly mailed the notice of deficiency to their last known address but the notice never made its way to the taxpayer. I say this because if the notice was not mailed to the taxpayer’s last known address the taxpayer could obtain redress by attacking the validity of the assessment. So, Congress must have put (c)(2)(B) into the code with the thought that properly mailed notices did not reach the intended recipient frequently enough for this to warrant a statutory exception.

Cases such as this, where the taxpayer alleges non-receipt despite the fact the IRS properly sent the notice have always seemed troublesome because the “why” of the non-receipt always left one wondering. Taking the issue head on and putting some of the responsibility for the non-receipt on the taxpayer as a necessary predicate to obtaining the ability to contest the merits makes great sense. Otherwise, taxpayers have a path to gaming the system. This issue will almost always turn on the taxpayer’s credibility and makes for a slightly uncomfortable hearing. The IRS will never know why a taxpayer did not act with the 90 days of the notice of deficiency. I expect more push back on the taxpayer’s credibility on this issue after the Tax Court’s opinion in this case.

Technology and Tax Administration: The Appeals Virtual Service Delivery Program

It is no wonder that many taxpayers facing IRS correspondence examinations fail to respond, even those whose returns may be  correct as filed. The mix of correspondence examinations, lower-income taxpayers with challenging personal circumstances like literacy and language barriers and inflexible work schedules makes audit participation a dicey proposition. It is also no wonder that even in the National Research Program EITC audits I wrote about last week where there is a concerted effort to reach taxpayers for an in person audit about 15% of taxpayers fail to respond.

The use of Campus Appeals in cases coming out of correspondence examinations compounds the problems that many taxpayers face, especially lower income taxpayers. Many taxpayers who have tried to participate in examinations but who have failed to resolve the matter may find the same frustration in dealing with Appeals. Rather than offering face to face conferences with taxpayers, the norm is remote Appeals Campus proceedings, done with phone calls and more correspondence. For many taxpayers, especially the working poor, the process often leads to frustration in the form of delayed refunds or, even if the return as filed was incorrect and no refund is due (or has to be repaid), a lack of understanding as to why the return is wrong. To be sure, low income taxpayer clinics and the Taxpayer Advocate Service can help, but those safety valves also come with their own barriers, including, for example with clinics, availability and location of the office relative to the taxpayer.

Is help via technology on the way? Well, the IRS does not have a great track record when it comes to using technology and its ability to maximize customer service. For example, last year’s annual TIGTA review of IRS information technology while noting improvements still classified the IRS’s modernization program a “major risk.” When I think about how technology has radically altered so much of my world, I wonder when the technology revolution will revolutionize tax administration and compliance beyond e-fling. With that in mind, I am curious about the Appeals Virtual Service Delivery (VSD) program and how distance technology may help overcome some of the barriers that so often prevent people from participating in the compliance process.


Just this past July, IRS issued guidance about VSD in the form of a memo called “Implementation of Virtual Service Delivery” to all employees discussing the program (hat tip to the September Deloitte Insights Newsletter which described the memo). The memo details some of the rules Appeals employees must follow in setting up the virtual conferences and discusses how the virtual conferences are to be conducted.

What is VSD? Here is what Appeals says:

VSD uses teleconferencing technology that permits parties to conduct face-to-face meetings from remote locations. VSD technology is installed in a number of IRS locations known as VSD “support” sites, including all six Appeals campus locations, which Campus ATEs can use to conduct VSD teleconferences. VSD technology is also installed in a number of “customer-facing” sites, where taxpayers and representatives can conduct VSD teleconferences. The customer-facing VSD sites include some IRS posts of duty, partner sites, and two Low Income Taxpayer Clinics (LITCs).

According to the memo, in cases not involving frivolous matters the Appeals campus “will offer a taxpayer or representative who requests a face-to-face conference the option of a VSD teleconference, when the taxpayer is located within 100 miles of a customer-facing VSD site.” Two of the “customer facing sites” are tax clinics; other locations include posts of duty and what Appeals calls partner sites.

The day may come when technology has advanced and all people may interact with IRS compliance functions right from their laptops but until that day VSD offers opportunities for people who are eligible for the service and who can find their way to VSD sites the experience of talking to a person, even if just on a monitor. The memo makes clear that IRS is prohibited from referring people to specific clinics (an issue Keith discussed and criticized earlier this year in his post Does Treasury’s Policy Restraining Referrals to Low Income Tax Clinics Harm Individuals and the Tax System?) though I guess Appeals could let someone know that a VSD location at a clinic is available if it is near the taxpayer. Use of VSD technology at clinics is dependent on the clinic representing the taxpayer using the service, which as I mentioned above is subject to issues such as clinic availability. I am not sure about some of the other VSD partner sites, but I know IRS has been heavily criticized for cutbacks in some of its old fashioned Taxpayer Assistance Centers. Those have been subject to major budget cuts and a retrenchment in services that the IRS offers. (TIGTA did a nice summary of TAC struggles in a report this past June).

I have not seen stats or even anecdotal evidence about the VSD platform. It occurs to me though that the technology can be very helpful as a way to exchange information that would otherwise not be available and also allow an Appeals employee to perhaps gauge credibility in a way that documents alone may not get across. For example, in some cases, taxpayers may not be able to get documentary evidence that Appeals and the correspondence examination have requested to corroborate a position, or correspondence and documentation may not be complete or is inconsistent in some way. The ability for a taxpayer or representative to explain documents in person might be best, but VSD technology allows potentially for a more robust means of exchange as compared to telephone conversations or letters alone. Moreover, allowing Appeals to view either the taxpayer (or potentially a witness) may help with issues where otherwise Appeals may choose to defer credibility determinations to a court.

In addition, in CDP cases a few circuits have parted with the Tax Court in Robinette v Commissioner  and have held that the Tax Court should not routinely allow supplementing the record in CDP cases that do not involve liability. I am not sure that Appeals will record the VSD meetings as a matter of right or even on request. However, as there are many disputes about what the record is in these cases and at least some circuits not agreeing with the Tax Court’s view in Robinette that the court can allow a taxpayer to introduce evidence outside the administrative record, this technology may facilitate a cleaner court review of those cases.

I reached out to Professor Scott Schumacher, Director of the University of Washington Graduate Tax program (and guest blogger here on PT), whose LITC is one of the two LITC facing sites. Scott’s comments are generally positive, though he thinks that “the IRS could do a better job of coordinating cases and getting more use out of the VSD system.  To be fair, since we are in Seattle and our local appeals office is just a few miles away, we often have real face-to-face hearings instead of remote hearings.”

On the positive side, Scott thinks “VSD has amazing potential.” According to Scott,

The technology they use is of very high quality.  Images are in high definition, the camera is adjustable so that documents can be viewed, and the IRS even added a document reader to aid in viewing receipts and other records.  It really does replicate a face-to-face hearing quite well.

And that’s the key.  The VSD changes the dynamic of a remote hearing.  Seeing the person, reading their body language, and being on the same page with record review (literally!) does make a difference.  Even in our preliminary discussions with IRS campus personnel where we set up the protocols for the appeals, our interactions were much more cordial over the VSD system than on the telephone.

The tax system and Appeals in particular has changed dramatically over the past thirty years in terms of the types of issues and cases in its dockets. Technology is available to allow people to interact with compliance functions beyond what is the norm. Remote video access has the potential to transform tax administration and bring taxpayers and the IRS together in a time of tight budgets and many challenges that permeate the system as is.  I suspect we are just starting to see the transformative possibilities that technology will play in tax compliance.