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1. Audit Reconsideration

References:

Code Section 6404 and Reg. Sec. 301-6404-1

Publication 3598 http://www.irs.gov/pub/irs-pdf/p3598.pdf

Internal Revenue Manual, Section 4.13.1; http://www.irs.gov/irm/part4/ch13s01.html

The IRS has wide authority to reconsider assessments.  However, this authority is discretionary.  The general rule is that if a taxpayer wants to reconsider a closed audit or assessment, he or she must present new evidence, or demonstrate an inadequate opportunity to present the facts and law in the past proceedings.

Reconsideration can apply in two main types of cases: (1) a past audit where a return was filed, or (2) a substitute for return situation where the taxpayer submits true returns after the SFR assessments have been made.  The IRS will NOT reconsider any assessment that has been made final by a court decision, nor will it grant credits or refunds, or any other relief, that is time-barred.

For the first type, the Manual provides that the taxpayer must have filed a return, the assessment must remain unpaid (or the IRS has reversed credits the taxpayer is claiming), the taxpayer must identify the disputed items, and must present new evidence.

For the second type, reconsideration is automatic upon the submission of signed returns.  Note, however, that the IRS administratively will not “file” those returns. Instead it will adjust the SFR assessment to the numbers reflected on the “return” the taxpayer submits.  See “Learn More About…Substitutes for Return” for the reasons (Article 17 in this section).

The request for audit reconsideration is made by filing the request, in letter form, with the appropriate Service Center (now Campus).

Audt Recnsideraton

2. Correction of Errors on Tax Returns

References:

Reg. Section 1.451-1(a); 1.461-1(a)(3)(i)

Harris, “On Requiring the Correction of Error Under the Federal Tax Law,” 42 Tax Lawyer 515 (1989)

Ronan, “Do Clients Have a Duty to File Amended Tax Returns?”, 33 Practical Lawyer 25 (1987).

Circular 230, Section 10.21, 10.22; http://www.irs.gov/pub/irs-pdf/pcir230.pdf

The Internal Revenue Code does not require the correction of errors on prior returns.  The above regulations state that if a taxpayer discovers an omission of income in a prior year, or an erroneous deduction, the taxpayer “should” file an amended return.  Note the unusual language: “should,” not “must.”

If the taxpayer has made an innocent, good faith error on a prior return, no correction is required, though the taxpayer should consider filing an amended return according to the regulation.

If the error ramifies to a current return, however, the result is different.  Examples would include basis calculations (publicly traded stock, S corporation stock, etc.) or NOL carryforwards.  The current year’s figure can and often does depend on the prior years’ returns and calculations.  If the taxpayer discovers a prior error that ramifies to the current return, then a failure to at least recompute the prior years’ error could make the current return incorrect.  This feature places a duty on the taxpayer to recompute the prior error, and possibly to file an amended return to correct it.  See, e.g., Phoenix Coal Company v. United States,  231 F. 2d 420 (2nd Cir. 1956)  (IRS has authority to recomputed claimed NOL to reflect error in prior, closed tax year.)

Note also that if the taxpayer corrects a prior error without amending that year’s return, the period of limitations may be opened under the mitigation provisions, Sections 1311-1314.

Circular 230 requires that a tax practitioner advise the taxpayer of errors found in past years’ returns, advise of the penalties that could be imposed if the error is discovered by the IRS, and advise of the possibility of corrective action.  The AICPA’s Statements on Standards for Tax Services impose a similar requirement.

Correction of Errors on Tax Returns

3. Interest Abatement

References:

Section 6404(e) and Reg. Section 301-6404-2

The Code provides for mandatory interest on all taxes and penalties, compounded daily. Section 6601.  Section 6404(e) allows extremely limited abatement of interest, in cases of an IRS error in performing a “ministerial” or “managerial” act. No significant part of the delay must be attributable to the taxpayer.  A “ministerial” error is a procedural or mechanical act that occurs (or fails to occur), during the processing of a taxpayer’s matter, that does not involve the exercise of discretion or judgment.  Palihnich v. Commissioner, TC Memo 2003-297.  The example in Palihnich is the IRS’ loss of the taxpayer’s amended tax returns.

One obstacle even to this narrow window for interest abatement is the IRS’ argument that the taxpayers could have avoided interest accruals by simply paying their taxes.  Wright v. Commissioner,  2005-1 USTC par. 50,223.  In Palihnich,  the taxpayers avoided this rebuttal by asserting they would have paid their taxes if the IRS had not lost their returns.

A “managerial” error involves the exercise of discretion or judgment. Under the regulation, this is an administrative act that occurs during the processing of a taxpayer’s case involving the temporary or permanent loss of records or the exercise of judgment or discretion relating to management of personnel.  An example would be the case in which the agent is sent for additional training, or is granted sick leave, and nothing is done on the audit while the agent is away.

The regulation contains additional examples.

The application for interest abatement must be made first to the IRS, using Form 843.  If the IRS denies the claim, an appeal is available to the United States Tax Court.  The IRS denial is subject to the “abuse of discretion” standard.  Reported cases are rare, since the IRS’ discretion is subject to an “abuse of discretion” standard.

Interest abatement

4. Alter Ego and Nominee

Background:  When the IRS seeks collection of a corporation’s taxes (usually payroll taxes), that corporation is always primarily liable for payment.  If the corporation cannot pay, its options include asking the IRS to compromise the taxes, taking out a loan for payment, asking for an installment agreement, or bankruptcy.

Sometimes corporate officers think of another tactic: forming a new corporation, letting the old one die, and doing business under the new entity.  The IRS has seen this many times, and deals with the device by imposing liability (making an assessment, and/or filing a notice of tax lien) against the new entity as the “alter ego” or “nominee” of the old company.

The doctrine

Example (from Diversified Metal Products, Inc. v. T-Bow Company Trust, United States District Court for the District of Idaho, July 18, 1996).  Diversified owed payroll taxes.  Morgan was employed by Diversified.  Morgan was also the manager of T-Bow Trust.  The Trust entered into a contract with Diversified, with Morgan doing the same work at Diversified as he had done in the past.  The Trust billed Diversified for Morgan’s work, and Diversified paid Morgan’s wages to the Trust.  Morgan provided all the labor of the Trust.  The IRS made an “alter ego” or “nominee” assessment against Morgan.  The Court upheld the assessment.

The general rule is that property held in the name of a third party, but for the benefit of the true taxpayer, is subject to collection for the unpaid taxes.  United States v. O’Brien, ___ F. Supp. ___ (SD Ohio 1999).  This and similar cases look to several factors to determine whether an alter ego or nominee situation exists:

  1. The adequacy of consideration paid by the nominee

  2. Whether the timing indicates the property was being shielded because of creditors’ claims, while the transferor continues to control it.

  3. The closeness of the relationship between transferor and nominee.

  4. Whether the transferor retains possession of the property.

  5. Whether the transferor continues to enjoy the benefits of the property (e.g., does he or she still live in a personal residence that has been transferred).

  6. Whether the transfer was recorded.

Other courts in other contexts have applied these and other tests and factors.

Alter Ego and Nomiee

5. Collection Due Process Proceedings

References:

Code Sections 6320, 6330

Reg. Sections 301-6320, 301-6330

Publication 1660 (Collection Appeal Rights); http://www.irs.gov/pub/irs-pdf/p1660.pdf

“Collection Due Process” and IRS Seizures 

The law has always allowed the IRS to take property for back taxes.  The two types of takings are called “levies” and “seizures.”  A levy is for intangibles, such as salary, bank accounts, stock accounts, etc.  A seizure is for objects such as cars, trucks, boats, artwork, etc.  Before the IRS can seize any property, it must give a minimum 30 days’ notice to the taxpayer. Section 6330(a)(1).  These days, the IRS gives at least two, usually four, pre-levy notices, the final one being Letter 1058 (Final Notice Before Seizure).  Section 6330(a)(1)-(3) sets out statutory requirements for the contents and service of the notice.

The Final Notice itself allows you to appeal by requesting a “Collection Due Process Hearing.” (Form 12153).  However, the grounds for appeal are somewhat limited.  This “Collection Due Process Hearing” request is like an injunction, since it prevents further seizure, but only for the time it takes for this appeal to be decided.

Section 6330(b) requires that upon request, the taxpayer is entitled to a hearing before an “impartial officer” with no prior involvement in the case, i.e., the Office of Appeals.

Section 6330(c) sets out the available issues at the hearing.  These are “any relevant issue relating to the unpaid tax or the proposed levy.”  The statute specifically allows consideration of:

  1. Spousal defenses, such as innocent spouse

  2. Challenges to the appropriateness of collection actions

  3. Offers of collection alternatives, such as posting a bond, substitution of other assets, installment agreement, or offer in compromise.

The statute specifically excludes consideration of:

  1. Issues raised and considered at a prior hearing under Section 6320.

  2. Issues raised and considered in any other previous administrative or judicial proceeding, where the person participated meaningfully in that proceeding.

Section 6330(d) allows an appeal to the United States Tax Court to review the Appeals Office’s determination.  Accord, Murphy v. Commissioner, 125 TC ___, No. 15. This must be filed within 30 days of the date of that determination.  The taxpayer may appeal to a federal district court if the Tax Court lacks jurisdiction.  The Court may consider not only the administrative record, but additional evidence and testimony, in its discretion.  Murphy.  Where the underlying tax liability is at issue, the court’s review is de novo.  Where it is not, the court will apply an “abuse of discretion” standard.  Murphy. 

The IRS will not oppose the litigation of the existence or amount of the tax liability at a CDP hearing, but only if there was no prior opportunity to challenge the merits.  Montgomery v. Commissioner,  122 TC 1 (200__); Poindexter v. Commissioner, 122 TC No. 15. Thus, taxpayers who dispute their liability, even on a duly filed return, may do so at a CDP hearing, so long as they did not receive a notice of deficiency.  Montgomery, supra.  But if the taxpayer had an opportunity to contest a liability and simply failed to do so, the merits of the taxes cannot be raised at a CDP hearing . Dami v. Commissioner, ____________.

Appeals officers will consider offers in compromise made at the CDP level.  However, if the offer is rejected there, the only recourse is a Tax Court petition, where the abuse of discretion standard applies.  Taxpayers considering whether to file an offer should be aware that an offer made at the Service Center can be appealed administratively to the Office of Appeals if it is rejected.

An untimely CDP hearing request does not stop collection action, nor is the collection statute of limitations tolled.  An “equivalent hearing” is available for untimely CDP requests, and the IRS will normally grant such a hearing.  Reg. Section 301-6330-1(i).

Statute of Limitations

All collection action (except filing of notice of lien) and the period of limitations on collection is suspended from the date of a timely filing of a CDP request for the pendency of the appeal, plus 90 days.

Collection Due Process Proceedings

6.“Disregarded Entities” and the collection of taxes

“Disregarded” Entities – The limited liability company

In recent years, the limited liability company, or “LLC,” has gained wide acceptance and popularity.  However, the IRS implications of choosing this form of business organization were not well developed (and still are not fully developed).  Last year, the IRS issued guidance on collection of taxes against an LLC – and these should give everyone pause when choosing this type of entity.

Summary: Essentially, the IRS has taken the position that it may freely collect back taxes of an LLC by collecting against THE OWNERS, that is, the “members” of the LLC, from their own personal assets.

Explanation:

Treasury Regulation Section 301.7701 and following regulations are widely known as the “check the box” regulations.  Among other things, they provide that an LLC may be “disregarded” for federal tax purposes, and the tax implications would flow through to the owners individually.  These provisions respond to the hybrid nature of an LLC: an organization, authorized under state law, that combines limitation of personal liability with a “pass through” of income tax liability to the owners.

With this definition in mind, the IRS has drawn certain legal conclusions

“Disregarded Entities” and the collection of taxes

7. Federal Tax Lien -Definition and General Rules

References:

Code Sections 6321, 6322, 6323

Regulation Sections 301-6321-1; 301-6323-1

Internal Revenue Manual, Section 5.12 (Federal Tax Liens); http://www.irs.gov/irm/part5/index.html

Internal Revenue Manual, Section 5.17.2 (Legal Reference Guide for Revenue Officers – Federal Tax Liens); http://www.irs.gov/irm/part5/ch17s02.html

The federal tax lien (excluding the estate tax lien) is an encumbrance or charge on the taxpayer’s property to secure payment of the tax debt.  Section 6321 provides that the lien arises whenever any person liable to pay any tax “neglects or refuses” to pay it after demand.  Thus, the lien does not arise immediately, or at all, upon the filing of a tax return.  Moreover, normally the lien never arises because taxpayers pay a balance due with the return itself.

When an income tax filer fails to pay the balance due, or a corporation or other entity files a balance due return (such as a payroll tax return), the IRS makes an “assessment,” a key term in the tax process.  The IRS officially makes the assessment by the act of recording the taxpayer’s liability on the records of the IRS, usually by using the internal Form 23-C.  Reg. Section 301-6203-1.  (The assessment officer signs a Summary Record of Assessments, which are all done by computer.)  The IRS then must send “notice and demand” for payment, normally by mail.  Section 6303.  If the taxpayer fails to pay within 10 days, a lien automatically arises and relates back to the date of the assessment.

The lien then automatically and instantly attaches to “all property and rights to property, whether real or personal, belonging to such person.”  Section 6321.  That language is intentionally broad.  “All” means everything, wherever located in the world.

However, the taxpayer’s right to property may be restricted, such as the “right” to the cash surrender value of a whole life policy, rather than to the proceeds.  In such a case the lien attaches only to the taxpayer’s interest.  United States v. Bess, 357 U.S. 51 (1958).  The shorthand question to ask is: “Does the taxpayer have a right to this property? Can he or she get it?”  If so, the IRS lien attaches to it.

The lien also attaches to after-acquired property as of the moment the taxpayer acquires an interest.  If the taxpayer loses a property interest, the lien is defeated.  For example, where a taxpayer’s interest in an option expires, the lien disappears.  Rev. Rul. 54-154, 1954-1 CB 277.

However, if the taxpayer who already has a lien on file buys a home (a “purchase money” mortgage), the IRS has ruled that the lien attaches only to the equity, that is, the market value less the intended first mortgage; this permits taxpayers to buy homes they would otherwise not be in position to acquire.  Revenue Ruling 68-57, 1968-1 CB 553.

Property rights are determined by state, not federal, law.  Aquilino v. United States, 363 U.S. 509 (1960).  Once the nature and extent of the property is determined under state law, federal law prescribes the consequences of lien attachment.

8. Federal Tax Lien – Priorities 

Reference:

Code Section 6323; Reg. Section 301-6323-1-3

Rev. Rul. 68-57, 1968-1 CB 553.

Internal Revenue Manual, Section 5.17.2 (Legal Reference Guide for Revenue Officers – Federal Tax Liens); http://www.irs.gov/irm/part5/ch17s02.html

Once the tax lien attaches to property, its priority against competing liens is normally determined by the “first in time is first in right” rule.  Thus, the federal tax lien is not valid against four types of competitors until notice of the lien is filed.  Those four are: purchasers, holders of security interests, mechanics lienors, and judgment lien creditors.  Section 6323(a).  These four classes of creditors cover most situations: home mortgages, mechanics lien holders and “materialmen’s” liens, UCC liens, and judgment liens.  A purchaser is one who acquires property for “adequate and full consideration in money or money’s worth.”  Section 6323(h)(6).  The interest must also be protected under local (i.e., state) law against a subsequent purchaser who had no actual notice of the lien.

Even if the competitor actually knows of the tax lien’s existence, if notice of the lien is not filed, that competitor prevails.

However, case law has imposed the additional requirement that these competing liens be “choate.”  The identity of the lienor, the amount of the lien, and the identity of the property to which the lien attaches must all be established for that lien to prime the federal tax lien. United States v. Security Trust & Savings Bank, 340 U.S. 47 (1950).  For example, under some state laws a judgment lien is not “perfected” against property until a writ of attachment is issued to the Sheriff and the Sheriff actually seizes property.  Such a lien would fail the “choateness” test until the act of attachment.

Federal Tax Lien – Priorities
Federal Tax Lien – Priorities 

9. Federal Tax Lien – Super Priorities 

Even if notice of the federal tax lien has been filed, that lien is not valid against ten “superpriority” classes of creditors.  Section 6323(b) enumerates these superpriority categories.  In most of these, the idea is to allow the free flow of commercial transactions and trade without the buyer having to check whether the seller’s property is subject to a federal tax lien.

  1. A security bought without prior knowledge of the lien, and a security encumbered by a security interest. This provision allows normal trading of securities in markets. Section 6323(b)(1).

  2. Motor vehicle bought without prior knowledge of the tax lien, so long as the buyer obtains possessions of the vehicle before such knowledge and does not give the vehicle back to the seller. Section 6323(b)(2).

  3. Personal property bought at retail by a buyer in the ordinary course of the seller’s business, unless the buyer intends or knows the purchase to hinder, evade, or defeat the tax. Section 6323(b)(3) Example: Bloomingdale’s is in bankruptcy, with multiple federal tax liens; your wife or husband buys a product there; the lien does not attach.

  4. Personal property bought in a casual sale (e.g., garage sale.) if the buyer has no knowledge of the lien and the amount is less than $1,000. Section 6323(b)(4).

  5. Personal property encumbered by a possessory lien to a repairman, such as auto mechanics. Section 6323(b)(5). The lien must be authorized by local law, the price must be reasonable, and the lienholder must have actual, continuous possession of the property. Example: an auto repair shop.

  6. Real property tax lien or special assessment, where the lien has priority, under local law, over security interests in that property, and the lien secures payment of ad valorem taxes, special assessments, and charges for utilities or public services furnished to the property by the United States or states. Example: a county real estate tax assessment. Section 6323(b)(6).

  7. Mechanic’s liens, as to residential realty (no more than four dwelling units), if the contract price for the work is no more than $5,000. Section 6323(b)(7).

  8. Attorney’s liens, where the attorney “creates the fund” that thereupon becomes subject to the tax lien. The amount must be reasonable. The superpriority does not extend to funds where the US can offset it against a prior liability of the taxpayer to the US.  Section 6323(b)(8).

  9. Insurance contracts, and endowment and annuities. The insurance company has priority at any time before it learns of the lien, and even after, where it is required to make payments under the contract (if the contract was entered into before the insurance company learned of the lien.  Section 6323(b)(9).

  10. Savings deposit, share or other account with an institution described in Code Section 581, where the loan is made without knowledge of the tax lien and the loan is secured by the taxpayer’s deposits. Section 6323(b)(10).

10. Federal Tax Lien – Commercial financing

Section 6323(c) sets out the rules for commercial financing transactions.  Basically, the rules protect factors and other qualifying lenders from the priority of the federal tax lien, but only for 45 days after the lien is filed.  For example, if an account receivable lender learns of the filing of a lien notice, its first priority is protected for 45 days with respect to (a) any new loans made, and (b) any new collateral that comes into existence.  This rule forces such lenders to check every 45 days if there is a danger of a lien filing.

Three types of commercial financing are covered under this section:

  1. Commercial transactions financing agreement

  2. Real property construction or improvement financing agreement.

  3. Obligatory disbursement agreement.

All of these must also be protected, under local law, against judgment liens arising out of unsecured debts.  Section 6323(c)(1).

Section 6323(c)(2) – Commercial Transactions Financing

  1. A commercial transactions financing agreement is defined as an agreement made in the ordinary course of a trade or business

  2. to make loans to the taxpayer secured by commercial financing security acquired by the taxpayer in the ordinary course of his trade or business, OR

  3. to purchase commercial financing security (other than inventory) acquired by the taxpayer in the ordinary course of business.

This language covers UCC Article 9 interests, such as contract rights, documents, chattel paper, commercial paper, accounts receivable financing by asset-based lenders who lend money and take security interests (or who buy) the taxpayer’s accounts receivable, mortgages on real property, and inventory.  Section 6323(c)(2)(C).

However, the statute then limits such an “agreement” to loans or purchases made before the 46th day after the lien is filed, or (if earlier) before the lender or purchaser had actual knowledge of the lien filing.  Section 6323(c)(2)(A) (flush language).  The term “qualified property” is also limited to commercial financing security acquired by the taxpayer before the 46th day after the tax lien is filed.  Section 6323(c)(2)(B).

The result: A lender who lends after the 45th day is not protected against the lien.  A lender who, on the first day after the lien filing, learns of it, is no longer protected for future loans.

Section 6323(c)(3) – Real Property Construction or Improvement Financing

This section applies chiefly to contracts to construct or improve real property, and to finance the raising or harvesting of crops or livestock.  Under this provision, the lender is protected for any advances made under such agreements.  There is no 45-day rule or any time limit, so long as the agreement was entered into before the tax lien was filed.

Section 6323(c)(4) – Obligatory Disbursement Agreement

This section applies chiefly to sureties on contracts (e.g., construction contracts) and banks issuing letters of credit.  The agreement must be entered into before the tax lien is filed and must be protected under local law against other creditors; however, the priority of these lenders (or sureties) does not depend on any 45-day rule.  Any disbursement made pursuant to a qualifying agreement or contract is protected against the priority of the tax lien.

Security interest – additional protection under 6323(d)

Section 6323(a) protects the holder of a security interest until notice of the tax lien is filed.  Section 6323(d) adds additional protection.  If the security agreement is entered into before the tax lien is filed, and then the lien is filed, the lender is protected as to any disbursements made under the agreement within 45 days after the lien is filed.  However, actual knowledge of the lien filing will destroy this priority.

Federal Tax Lien – Commercial financing

11. Federal Tax Lien – Release, Discharge, Subordination

The IRS must release a tax lien within 30 days after it determines that the liability has been paid or become unenforceable, or where the taxpayer posts a bond for the unpaid taxes.  Section 6325(a).

The IRS will normally grant a discharge of property from the lien (vs. a release of the lien) under four circumstances.

First, if the property remaining subject to the lien is double (in value) the amount of the tax lien and other prior liens, the property can be discharged.

Second, if the taxpayer sells the property and pays the IRS the equity subject to the lien, the property will be discharged.  Third, if the prior liens exceed the value of the property, so that the lien is “valueless,” then the property will be discharged from the lien.  Code Section 6325(b)(2).

Third, the IRS and the property seller can agree to sell the property, with the sale proceeds subject to the liens in the same priority as on the property itself (substituting the sale proceeds).  Section 6325(b)(3).

Fourth, the property owner can pay a deposit, or post a bond, in the amount equal to the value of the lien on the property.  Section 6325(b)(4) (“Substitution of value”)

The IRS will often subordinate the federal tax lien if there is paid to the IRS an amount equal to the value of the lien (rare) or if collection will be “facilitated.”  Code Section 6325(d).  The “collection will be facilitated” rationale is routinely used where a taxpayer is using a lender such as a factor with a prior lien, or desires to enter into a factoring agreement.  Barring such an agreement, the credit facility will not be available.  Under such circumstances, and often with a cash payment, the IRS will consider a subordination.

The IRS will issue a certificate of non-attachment of the federal tax lien where there is a confusion of names and the person involved will be injured if it appears the lien attaches to his or her property (and it does not).  This technique is often used in cases of family members, such as where the lien attaches to the husband but the wife or a child with the same name needs a certificate of non-attachment to obtain credit.

Federal Tax Lien – Release, Discharge, Subordination

12. Tenancy by the Entirety

References:

IRS Notice 2003-60, 2003-39 IRB 643; http://www.irs.gov/irb/2003-39_IRB/ar13.html

Tenants by the Entirety and the IRS

Can the IRS sell your home if only you, not your spouse, owes federal taxes?  Probably.  That conclusion will surprise many who thought the doctrine of “tenancy by the entirety” protected them.  But when the Supreme Court decided the Craft case in 2002 (United States v. Craft, 535 U.S. 274, 122 S. Ct. 1414 (2002), all of this changed.

Before this case, the law in almost every state held that the doctrine of “tenancy by the entirety” (“TBE”) protected property held in that form of ownership.  The legal fiction was that neither husband nor wife owned the property.  Instead, a fictitious entity called “the entirety” (husband and wife together, as one) owned it.  Each of husband and wife was a “tenant” of the property, a “tenant by the entirety.”  This fiction meant that if one tenant owed a debt (any type of debt, including taxes), creditors could not sell the home to pay the debt because the debtor/tenant did not own it.  And, if the debtor died, the co-tenant obtained the entire ownership interest, unencumbered by any debt of the decedent.

In 1983, the Supreme Court held that the IRS, as a creditor, could request federal court approval to sell property held by “joint tenants.”  United States v. Rodgers, 461 U.S. 677(1983).  This form of ownership was not tenancy by the entirety. Instead each joint tenant held an interest, usually undivided, in a percentage of the entire property.  For example, if brother and sister, or partners, owned real estate, as joint tenants, that real estate could be sold for taxes under federal law allowing such sales for taxes.  But in the Rodgers case, the Court refrained from opining on whether that doctrine would extend to TBE property.  In Craft, the Court ruled that one tenant did in fact have a property interest as a tenant by the entirety that was “property” under state law.

The practical effect of Craft is to require that the IRS be paid its interest when real estate (or other property held by the entireties) is sold, even if only one tenant owes taxes.  Normally that interest is one half of the net proceeds.

Tenancy by the Entirty

13. Innocent Spouse

Major references:

Code section 6015 and Regulations Section 301-6015

IRS Publication 971

CCN Releases: Guidance Regarding Innocent Spouse Relief FAQs (CC-2005-011)

Rev. Proc. 2000-15, 2000-1 CB 447

Rev. Proc. 2003-61 (Guidance on Equitable Relief)

Rev. Proc. 2003-19 (Administrative Appeal Rights for Nonrequesting Spouse)

Innocent spouse website: http://www.hq.irs.gov/ISWP/index.htm

 

Useful links from the IRS website:

 

Innocent Spouse Tax Relief Eligibility Explorer

http://www.irs.gov/individuals/article/0,,id=96786,00.html

Innocent Spouse Questions and Answers

http://www.irs.gov/individuals/article/0,,id=109283,00.html

Innocent Spouse Relief

http://www.irs.gov/individuals/article/0,,id=129862,00.html

Tax Information for Innocent Spouses

http://www.irs.gov/individuals/content/0,,id=130302,00.html

Applying for Innocent Spouse Relief

http://www.irs.gov/individuals/article/0,,id=102176,00.html

Introduction to Innocent Spouses

http://www.irs.gov/individuals/article/0,,id=130518,00.html

Internal Revenue Manual 4.11.34

http://www.irs.gov/irm/part4/index.html

 

Code Section 6012 requires taxpayers to file returns, and Section 6013 allows married persons to elect to file joint returns.  By filing a joint return, each spouse is jointly and severally liable for the taxes shown on that return, and for any additional taxes assessed for that return (plus penalties and interest).  Until 1971, spouses who were in the dark about the other spouse’s tax problems had no statutory avenue of relief.

Former Code Section 6013(e), the first “innocent spouse” provision, allowed limited relief if the spouse could prove a series of elements.  The IRS heavily litigated this statute at almost every turn.

New Section 6015, enacted effective in 1998, liberalized and expanded innocent spouse relief.  Now, relief of three types is potentially available:

  1. Traditional innocent spouse relief.

  2. Separate liability election.

  3. Equitable Relief.

Traditional Innocent Spouse relief

To merit this relief, the spouse must prove five things (Section 6015(b):

  1. The couple filed a joint return.

  2. The return had an “understatement of tax” attributable to “erroneous items” of one spouse.

  3. The innocent spouse shows that in signing the return, he or she did not know, and had no reason to know, of the understatement.

  4. It would be inequitable to hold the innocent spouse liable, considering all the circumstances.

  5. The innocent spouse elects the relief within 2 years of the start of IRS collection (after July 22, 1998).

Of these elements, the first two are normally easily met.  Note, however, that if the erroneous item was of both spouses, relief is not available.  Also, the return must understate the tax; relief is therefore not available simply for taxes reported on the return, but not paid.

The fifth element can easily be met, but is effectively a built-in statute of limitations on this relief.  The “start of collection activity” normally means the first IRS notice.

The third and fourth elements are where the fights take place.  These are fact-intensive tests; the IRS in the real world is skeptical, and very reluctant to see things the spouse’s way.

Separate liability election

This form of relief is available to spouses who are no longer married.  It has six requirements:

  1. The requester is not married, is legally separated, or has lived apart for 12 months, from the co-signer of the return.

  2. The requester must make the election within 2 years of the start of collection activity.

  3. The requester must prove the portion of the deficiency that is allocable to the other spouse.

  4. There must be a deficiency or understatement of tax.

  5. No asset transfers between spouses.

  6. No actual knowledge of the item giving rise to the tax deficiency.

Equitable Relief

Section 6015(f) provides for relief if it would be “inequitable” under all the circumstances to hold the requesting spouse liable.  Rev. Proc. 2000-15 is the key document that spells out the standards of equitable relief.  There are 7 requirements:

  1. A joint return was filed.

  2. Relief is not available under the other innocent spouse provisions.

  3. The requester applies for relief within 2 years after the IRS’ first collection activity after July 22, 1998.

  4. The liability remains unpaid (with certain exceptions).

  5. No assets were transferred between the spouses.

  6. No “disqualified” assets were transferred to the requesting spouse by the other spouse. If there were such transfers, relief is curtailed.

  7. The requesting spouse did not file the return with fraudulent intent.

Fulfilling these tests is just the start.  Then the IRS will “ordinarily” grant relief if all of these conditions are met:

  1. At the time of the request, the requester is not married to, or is legally separated from, the other spouse, or has not lived in the same household as the other spouse for 12 months.

  2. When the return was signed, the requester has no knowledge or reason t know that the tax would not be paid. He or she must show it was reasonable to believe the other spouse would pay.

  3. The requester will suffer economic hardship if relief is not granted.

Beyond these tests, the IRS will see these factors as favoring relief:

  1. The couple is separates or divorced.

  2. The requester was abused.

  3. The requester did not know or have reason to know the liability would not be paid.

  4. The other spouse has a legal obligation under a divorce decree or similar order to pay the liability.

  5. The taxes are attributable to the other spouse’s income or activity.

Federal Tax Lien – Commercial financing

  1. The unpaid taxes is attributable to the requesting spouse.

  2. The requester had knowledge (as explained above).

  3. The requester significantly benefited (beyond normal support) fro the unpaid tax liability OR the items giving rise to the deficiency. Reg. Sec. 1.6013-5(b).

  4. The requester has no economic hardship if relief is not granted. Reg. Sec. 301.6343-1(b)(4).

  5. The requester is otherwise delinquent in following the tax laws.

  6. The requester has a legal obligation under the divorce decree to pay the liability.

Procedural Points

The nonrequesting spouse must be notified of the requesting spouse’s application for relief.  He or she may then participate in the appeal, including the filing of a written protest.  Rev. Proc. 2003-19.  This ruling follows the Tax Court’s decision in Maier v. Commissioner, Dec. 54,937.  The nonrequesting spouse may also intervene in the requesting spouse’s Tax Court proceeding under Section 6015.  King v. Commissioner, 115 TC No. 8 (2000).  Innocent spouse relief is not eliminated after a bankruptcy, but only if the bankruptcy court did not adjudicate the issue.  Rev. Rul. 2006-16.

Equitable Relief

If the spouse fails the first two tests, relief can be granted under 6015(f) where it would be “inequitable” under all the circumstances to hold the spouse liable for an understatement OR an underpayment of tax.  This relief differs importantly from the first two, which do not allow relief for taxes correctly reported on a joint return.  Notice 98-61, 1998-51 IRB 13.

The IRS’ denial of relief can be overturned upon a showing of “abuse of discretion” in a Tax Court proceeding.  This standard does not mean the Court simply disagrees with the IRS’ determination; the IRS’ decision must be abusive.  Generally, the Tax Court will defer to the standards in Rev. Proc. 2000-15 (see discussion above) in determining whether to grant relief. Here are some cases where abuse of discretion was proved:

  1. Siddons v. Commissioner, summary opinion 2005-160. IRS abused its discretion where the taxes due were attributed solely to the husband’s income, the wife had essentially no involvement in his business, an accountant maintained the business books, and the wife did not know her husband had a prior tax liability.  She would suffer economic hardship if required to pay the tax, and she had no reason to believe the taxes would not be paid.

  2. Hendricks v. Commissioner, TC Memo. 2005-72. Husband made all the financial, business and tax decisions, did not ask the wife, so that wife had no actual knowledge of the investment that resulted in the tax liability.  Her education was limited; she only paid the family’s normal bills.  She had no duty to inquire about the tax losses, since these were reported on Schedule E and the face of the return did not flag the tax issue.

Innocent Spouse

14. Offer in Compromise

References:

Code Section 7122

Regulation Section 301-7122

Internal Revenue Manual Section 5.8 (Select Offer in Compromise):

http://www.irs.gov/irm/part5/index.html

Rev. Proc. 2003-71, 2003-2 CB 517

IRS website resources:

Revised Offer Application  http://www.irs.gov/businesses/small/article/0,,id=109628,00.html

Filing an Offer in Compromise

http://www.irs.gov/businesses/small/article/0,,id=131467,00.html

Is An Offer in Compromise Right for You? http://www.irs.gov/businesses/small/article/0,,id=109622,00.html

Offer in Compromise – FAQs

http://www.irs.gov/businesses/small/article/0,,id=108356,00.html

Tax Topics: Offer in Compromise

http://www.irs.gov/taxtopics/tc204.html

 

Code Section 7122, as amended by the 1998 reform act, allows the IRS to compromise tax liabilities based on (a) doubt as to collection potential (by far the largest category of offers), (b) doubt as to liability, and (c) Effective Tax Administration.  An information “fourth” category of offer is “special circumstances.”

“Effective Tax Administration” offers are available where the IRS concludes the tax can be paid in full, but doing so would cause economic hardship, such as by leaving the taxpayer without the means of normal support.  “Special circumstances” offers are available where the taxpayer would suffer economic hardship if the IRS collected the “reasonable collection potential” (of less than the full amount due) or circumstances otherwise justify the offer based on public policy or equity considerations.  Rev. Proc. 2003-71.  Such determinations are rare though not unheard of.

A pending offer (of any type) stops tax collection.  Section 6331(k).  It also suspends the period of limitations on collection.  An offer is “pending” when the IRS accepts it for processing. Rev. Proc. 2003-71.   That occurs when the appropriate IRS official signs page four of the offer form, indicating a processible offer.  The “pending” date is then entered on the taxpayer’s Master File, where it is accessible by the taxpayer.

Offers in Compromise during bankruptcy.  The IRS will not consider such offers, and has indicated it will not acquiesce in contrary court decisions such as In re Macher, 2003-2 USTC ¶50,537;  AOD 2004-03.

Offer in Compromise
Statutes of Limitation in tax matters

15. Statutes of Limitation in tax matters

The following chart sets forth the most common periods of limitation in tax matters, and the circumstances under which these periods can be extended.

16. Levies and Seizures for taxes 

References:

Code Section 6331, Regulation Section 301.6331.

Internal Revenue Manual, Section 5.10, 5.11

http://www.irs.gov/irm/part5/index.html

Regular Levies

Section 6331(a) authorizes the IRS to levy on “all property and rights to property” (with some exemptions) belonging to the taxpayer or on which there is a federal tax lien. The only requirements are that the IRS give a “final notice” before levy,  Section 6331(d), and that the IRS make a “thorough investigation of the status” of property to be levied and sold.  Section 6331(j).

Wage Levies – Section 6331(e)

A regular levy is a one-time seizure.  A wage levy is continuous until released.     

“Continuous” Levies for federal payments – 6331(h)

Code section 6331(h) allows “continuous” levies of up to 15% of certain “specified payment[s] due to or received by a taxpayer.”  This phrase means the following types of payments:

  1. Any federal payment except those based on income or assets (or both). Thus, social security payments can be seized.

  2. Unemployment compensation

  3. Worker’s compensation

  4. Wages, salary or other income up to the minimum of IRS levy exemption.

  5. Supplemental social security income for the blind, aged, and disabled

  6. State or local public welfare payments based on needs or income.

  7. Annuity or pension under the Railroad Retirement Act or benefit under the Railroad Unemployment Insurance Act.

The IRS is disabled from levying while and offer in compromise or installment agreement request is pending.  Section 6331(k).  Similarly, the IRS may not levy while a Collection Due Process hearing request is pending.  Section 6330(e).   An application for a Taxpayer Assistance Order under Section 7811 also suspends collection action AND the period of limitations on collection.  Section 7811(d).

Levies and Seizures for taxes

17. Substitutes for Return

References:

Code Section 6020; Temp. Reg. Section 301-6020-1T.

What if you don’t file an income tax (or other) return, and all extensions of time have expired?  Of course, the IRS can investigate you for the criminal offense of willful failure to file, or for tax evasion.  But usually, the most the agency wants is for you to rejoin the vast majority of taxpayers and file!

If you don’t, the IRS has three options.  By law, it can (1) prepare a return for you and ask you to sign (Section 6020(a) of the Internal Revenue Code), or (2) prepare such a return and sign it for you (Section 6020(b)).  Either of these returns is valid “for all legal” purposes (but not really all – see below).  The third option the IRS uses is a “substitute for return.”  That means they set up an account for you for the missing year on the IRS’ Master File, then calculate your tax, and penalties, based on gross income information and very few deductions or exemptions.  In that way, they have a large liability on the books that they can collect.

The IRS very recently (July –) enacted new regulations to beef up the IRS-signed return procedures, because a court recently held the agency could not impose penalties on the bare bones “returns” the IRS was filing.

Why does the IRS use a “substitute for return,” a creature nowhere found in the tax code?  The reason may lie in the fact that the taxes on such an “SFR” are not dischargeable in bankruptcy; so all courts have so far ruled.  (Note: Federal income taxes on filed tax returns are often dischargeable in bankruptcy if a complicated set of rules is fulfilled.)  So the IRS has the best of both worlds: a large liability they can collect, and on taxes the taxpayer can’t discharge in bankruptcy.

What to do about this if you are an SFR victim?  Normally you can follow SFRs with true returns, and the IRS will automatically adjust your account down to the figures you provide.  However, so far the IRS still successfully resisted discharging those true return taxes in bankruptcy, even where you filed a true return following an SFR.

Substitutes for Return

18. Child Support Obligations

References:

Internal Revenue Manual 5.1.12.11.

Child Support Obligations
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