Offer in Compromise – section 7122 – Documenting Expenses Above the Schedules
Petitioner asserted generally that the published expense schedules do not adequately reflect the cost of living in greater Los Angeles. The Court does not doubt that living in southern California is expensive. However, the scheme of national and local expense standards employed by the Commissioner reasonably attempts to consider regional and local costs. Local standards, for example, cover two necessary expenses: Housing and transportation.5 Housing standards are established for each county within a State. Transportation standards include not only ownership costs based on nationwide figures for loan or lease payments but also operating costs determined by census region and metropolitan area. IRM pt. 5.15.1.7(4) (2004). A taxpayer seeking a deviation from the expense standards must substantiate that he has necessary expenses exceeding the standards and that those expenses are reasonable. IRM pt. 5.8.5.5.1.2 (2005). Petitioner failed to document or otherwise substantiate that he has such reasonable and necessary expenses in excess of the standards. We hold that his generalized assertion is insufficient to require a deviation.6
T.C. Summary Opinion 2008-21]
Lawrence Jay Russ v. Commissioner.
Docket No. 4899-06S . Filed February 28, 2008.
[Code Sec. 6330]
Tax Court: Summary opinion: Collection due process. --
An IRS Appeals officer's determinations rejecting an individual's offer-in-compromise and that a lien was an appropriate collection action were not an abuse of discretion. The fact that the same Appeals officer was considering both issues did not violate the requirement of Code Sec. 6330(b)(3) that a Collection Due Process hearing be conducted by an officer who has had no prior involvement with the unpaid tax at issue. -
[Code Sec. 7122]
Tax Court: Summary opinion: Collection potential: Necessary expenses. --
Rejection of an individual's offer-in-compromise was not an abuse of discretion where the taxpayer failed to demonstrate that the standard calculation of his reasonable collection potential was misleading. The taxpayer failed to provide evidence supporting his contention that the standard allowances understated the cost of living in Southern California or that minimum payments on his credit card debts were necessary for the production of income or for the health and welfare of the taxpayer and his family. --
PANUTHOS, Chief Special Trial Judge: This case was heard pursuant to the provisions of section 7463 of the Internal Revenue Code in effect at the time the petition was filed. Pursuant to section 7463(b), the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case. Unless otherwise indicated, subsequent section references are to the Internal Revenue Code, and all Rule references are to the Tax Court Rules of Practice and Procedure.
Petitioner filed the petition in this case in response to a Notice of Determination Concerning Collection Action(s) Under Section 6320 and/or 6330. The only issue before the Court is whether respondent abused his discretion in sustaining the decision to file a Federal tax lien with respect to petitioner's income tax liabilities for the taxable years 1998, 1999, 2000, 2001, and 2002 (years in issue).1
Background
Petitioner resided in California when he filed the petition in this case. The parties did not file a stipulation of facts.
Petitioner filed delinquent Federal income tax returns for the years in issue. Each return reported tax owed, but payment was not included with the returns. Respondent selected petitioner's 1999 Federal income tax return for examination and determined a deficiency for that year. Respondent issued a notice of deficiency, and petitioner timely petitioned this Court for redetermination. Petitioner and respondent executed a stipulated decision which was entered by the Court.2
Respondent assessed a deficiency for 1999 in accordance with the stipulated decision. In addition, respondent assessed unpaid taxes for 1998, 2000, 2001, and 2002 based on the balance due returns petitioner filed for those years, as well as interest and additions to tax for late filing.
Petitioner submitted an offer-in-compromise (OIC) with respect to his tax liabilities for the years in issue. Petitioner offered $5,320, paid over 24 months, to settle an aggregate liability that exceeded $32,000 for the 5 tax years (not including interest and additions to tax). Respondent considered the OIC, determined that petitioner could pay the entire liability over time, and rejected the OIC. Petitioner requested an administrative review of the rejection of his OIC.
Respondent filed a notice of Federal tax lien for the years in issue in Ventura County, California, on March 17, 2005. The notice listed petitioner's unpaid balance as:
Table 1: Unpaid Taxes by Year
Tax Year Tax Due
1998 $6,577.17
1999 11,003.93
2000 5,752.52
2001 6,053.45
2002 3,260.58
Total 32,647.65
In response to the notice of Federal tax lien Filing and Your Right to a Hearing Under IRC 6320 sent to him on March 24, 2005, petitioner timely submitted a Form 12153, Request for a Collection Due Process Hearing.
On September 15, 2005, after consulting with petitioner, respondent consolidated the two appeals (the appeal of the rejection of the OIC and the appeal of the Federal tax lien filing) with one Appeals Officer (AO). The AO scheduled a hearing with petitioner for October 5, 2005.
Before the hearing, the AO analyzed petitioner's financial situation and determined what expenses were allowable under Internal Revenue Manual (IRM) guidelines. Petitioner's central complaint with the rejection of his OIC was the exclusion of his monthly credit card payments from the expenses allowed in computing his income available to pay his outstanding tax liabilities.
At the face-to-face conference between petitioner and the AO on October 5, 2005, petitioner sought approval of his OIC and did not challenge the underlying tax liabilities. The AO explained that the IRS could not accept the OIC because: (1) Petitioner's OIC computation reduced his income available to pay taxes by his credit card payments, and (2) petitioner had the ability to pay the full liability over time. The AO offered an installment agreement as a collection alternative, with monthly payments designed to pay the entire liability. The proposed installment amount was $800 per month for 2006 and $1,210 per month beginning in January, 2007. Petitioner rejected the installment agreement, asserting that he could not afford the proposed monthly payments.
On October 7, 2005, the AO wrote petitioner a letter explaining his determination and enclosed an installment agreement form. The AO determined petitioner's income history as follows:
Table 2: Income Earned by Year
Tax Year Income
2000 $88,804
2001 80,004
2002 68,985
2003 77,635
2004 87,637
Petitioner, the OIC examiner, and the AO analyzed petitioner's income, expenses, and ability to pay his taxes as follows:
Table 3: Analysis of Ability To Pay Tax Liabilities
Petitioner
OIC AO
Monthly income $6,334 $6,324 $7,303
Necessary living expenses
National expense 1,037 953 953
Local housing & utilities 1,500 1,500 1,500
Local transportation1 The record
does not explain the discrepancy
between the local transportation
allowances used by the OIC examiner
and the AO.
833 353 553
Other allowable expenses
Health care 76 114 114
Taxes 2,088 2,085 2,522
Other - non-priority debt 1,112 -0- -0-
Total expenses 6,646 5,005 5,642
Income available to pay taxes -0- 1,319 1,661
Realizable equity in assets -0- 4,152 4,152
Reasonable collection potential2
Reasonable collection potential is
calculated by multiplying petitioner's
monthly income available to pay taxes
by 60 months and adding the realizable
equity in petitioner's assets to the
product.
-0- 83,292 103,812
On February 3, 2006, respondent issued a Notice of Determination Concerning Collection Action(s) Under Section 6320 and/or 6330. Petitioner filed a timely petition for lien or levy action (collection action) with this Court.
The Court calendared this case for trial at the trial session of the Court commencing October 3, 2006, in Los Angeles, California. Respondent filed a motion for summary judgment on September 5, 2006. When the case was called from the calendar, the parties advised the Court that they had reached a basis of settlement and expected to submit settlement documents within 90 days. The parties indicated that petitioner was prepared to concede the case and to enter an installment agreement with respondent. The Court granted respondent's oral motion to withdraw the motion for summary judgment and ordered the parties to submit a status report or decision documents within 90 days.
After the Court allowed additional time to submit the decision documents, the parties indicated that they had not been able to execute a settlement agreement. The Court again set the case for trial commencing June 18, 2007. Respondent filed another motion for summary judgment on June 4, 2007.
When this matter was called for trial, petitioner made several oral motions, including: (1) Motion for dismissal of tax penalties; (2) motion for reduction of taxes due; (3) motion to accept original offer-in-compromise; and (4) motion to dismiss taxes and penalties for tax years 2001 and 2002. The Court took petitioner's oral motions and respondent's motion for summary judgment, filed June 4, 2007, under advisement, and the case was deemed submitted.
Discussion
The parties dispute whether petitioner's minimum monthly payments on his credit card debt represent an allowable expense against income available to pay taxes in consideration of an offer-in-compromise. Petitioner argues that not allowing such expenses amounts to discrimination against taxpayers with unsecured debts. Respondent asserts that the Federal tax lien has priority over these debts and that credit card payments are not necessary expenses properly allowable under IRM guidelines. Finally, respondent contends that: (1) Petitioner's future income available to pay taxes (monthly gross income less necessary expenses, not including the credit card payments) is sufficient to pay his tax liability in full before the end of the statutory period for collections; (2) because petitioner can fully pay the tax liability, he is not eligible for an offer-in-compromise; and (3) it was not an abuse of discretion for the AO to confirm the rejection of the OIC, to propose an installment agreement as the available collection alternative, and to sustain the collection action.
Section 6321 imposes a lien in favor of the United States on all property and rights to property of a taxpayer when the Secretary demands payment of the taxpayer's tax liability and the taxpayer fails to pay those taxes. Such a lien arises when an assessment is made. Sec. 6322. Section 6323(a) requires the Secretary to file a notice of Federal tax lien if the lien is to be valid against any purchaser, holder of a security interest, mechanic's lienor, or judgment lien creditor. Lindsay v. Commissioner, T.C. Memo. 2001-285, affd. 56 Fed. Appx. 800 (9th Cir. 2003).
Section 6320 provides that a taxpayer shall be notified in writing by the Secretary of the filing of a notice of Federal tax lien and provided with an opportunity for an administrative hearing. If timely requested, the Office of Appeals conducts an administrative hearing under section 6320 in accordance with the procedural requirements of section 6330.3 Sec. 6320(c). At the administrative hearing, a taxpayer is entitled to raise any relevant issue relating to the unpaid tax, including a spousal defense or collection alternatives such as an offer-in-compromise or an installment agreement. Sec. 6330(c)(2); sec. 301.6330-1(e)(1), Proced. & Admin. Regs. A taxpayer also may challenge the existence or amount of the underlying tax liability, including a liability reported on the taxpayer's original return, if the taxpayer "did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability." Sec. 6330(c)(2)(B); see also Urbano v. Commissioner, 122 T.C. 384, 389-390 (2004); Montgomery v. Commissioner, 122 T.C. 1, 9-10 (2004).
At the conclusion of the hearing, the AO must determine whether and how to proceed with collection. The AO must consider: (1) The Secretary's verification that the requirements of applicable law or administrative procedure have been met; (2) issues raised by the taxpayer at the hearing, including challenges to the appropriateness of the collection action and any collection alternatives proposed by the taxpayer; and (3) whether any proposed collection action balances the need for the efficient collection of taxes with the legitimate concern of the taxpayer that the collection action be no more intrusive than necessary. See sec. 6330(c)(3).
This Court has jurisdiction under section 6330 to review the Commissioner's administrative determinations. Sec. 6330(d); see Iannone v. Commissioner, 122 T.C. 287, 290 (2004). Where the underlying tax liability is properly at issue, we review the determination de novo. Goza v. Commissioner, 114 T.C. 176, 181-182 (2000). Where the underlying tax liability is not at issue, we review the determination for abuse of discretion. Id. at 182.
Petitioner received a notice of deficiency for the tax year 1999 and thus may not dispute the underlying deficiency for that year.4 For the remaining tax years, petitioner had the opportunity at the section 6320 hearing to challenge the underlying tax liabilities but did not. "This statutory preclusion is triggered by the opportunity to contest the underlying liability, even if the opportunity is not pursued." Bell v. Commissioner, 126 T.C. 356, 358 (2006); Goza v. Commissioner, supra at 182-183. Accordingly, we review respondent's determination for abuse of discretion.
Section 6159 authorizes the Secretary to enter into a written installment agreement with a taxpayer if such an agreement will facilitate the full or partial collection of the tax liability. Section 7122(a) permits the Secretary to compromise tax liabilities. Section 7122(c) requires the Secretary to prescribe guidelines for evaluating offers in compromise and to "develop and publish schedules of national and local allowances designed to provide that taxpayers entering into a compromise have an adequate means to provide for basic living expenses." Sec. 7122(c)(1) and (2)(A).
Regulations implementing section 7122 set forth three grounds for the compromise of a tax liability: (1) Doubt as to liability, (2) doubt as to collectibility, and (3) to promote effective tax administration. Sec. 301.7122-1(b), Proced. & Admin. Regs. Doubt as to liability is not an issue in this case.
Doubt as to collectibility exists in any case where the taxpayer's assets and income are less than the full amount of the liability. Sec. 301.7122-1(b)(2), Proced. & Admin. Regs. Where the reasonable collection potential of a case exceeds the taxpayer's liability, doubt as to collectibility is not a ground for compromise.
However, if collection of the full liability would cause the taxpayer economic hardship within the meaning of section 301.6343-1, Proced. & Admin. Regs., the Secretary may enter into a compromise on the ground of effective tax administration. Sec. 301.7122-1(b)(3), Proced. & Admin. Regs.; see also Murphy v. Commissioner, 125 T.C. 301, 310 (2005), affd. 469 F.3d 27 (1st Cir. 2006). Economic hardship is present when the taxpayer is unable to pay reasonable basic living expenses. Sec. 301.6343-1(b)(4), Proced. & Admin. Regs.
The Secretary has promulgated collection guidelines in IRM pt. 5.15. "Allowable expenses include those expenses that meet the necessary expense test." IRM pt. 5.15.1.7(1) (2004). "Necessary expenses" are defined as those necessary to provide for the production of income and/or for the health and welfare of the taxpayer and his family. Id. The sum of the necessary expenses establishes the minimum amount the taxpayer needs to live. Id.
A taxpayer's reasonable collection potential is determined, in part, using published guidelines for certain national and local allowances for basic living expenses. Income and assets in excess of those needed for basic living expenses are considered available to satisfy Federal income tax liabilities. This strict formulaic approach is disregarded, however, on a showing by the taxpayer of special circumstances including, but not limited to, advanced age, poor health, history of unemployment, disability, dependents with special needs, or medical catastrophe, that may cause an offer to be accepted notwithstanding that it is for less than the taxpayer's reasonable collection potential. Lemann v. Commissioner, T.C. Memo. 2006-37.
Petitioner asserted generally that the published expense schedules do not adequately reflect the cost of living in greater Los Angeles. The Court does not doubt that living in southern California is expensive. However, the scheme of national and local expense standards employed by the Commissioner reasonably attempts to consider regional and local costs. Local standards, for example, cover two necessary expenses: Housing and transportation.5 Housing standards are established for each county within a State. Transportation standards include not only ownership costs based on nationwide figures for loan or lease payments but also operating costs determined by census region and metropolitan area. IRM pt. 5.15.1.7(4) (2004). A taxpayer seeking a deviation from the expense standards must substantiate that he has necessary expenses exceeding the standards and that those expenses are reasonable. IRM pt. 5.8.5.5.1.2 (2005). Petitioner failed to document or otherwise substantiate that he has such reasonable and necessary expenses in excess of the standards. We hold that his generalized assertion is insufficient to require a deviation.6
In contrast to necessary expenses, "conditional expenses" are those expenditures that do not meet the necessary expense test. IRM pt. 5.15.1.7(6) (2004). In general, the IRS expects a taxpayer to pay toward his liability the difference between his gross income and his necessary, allowable expenses. The Secretary instructs that installment agreements will be based on a taxpayer's maximum ability to pay; "i.e., how quickly a taxpayer can fully pay the tax liability." IRM pt. 5.15.1.2(6) (2004).
However, the "Five Year Rule" of IRM pt. 5.15.1.2(5) (2004), provides that excessive necessary and conditional expenses may be allowed if the expenses are reasonable and the tax liability, including projected accruals, will be fully paid within 5 years. Necessary expenses above the national and local standards are "excessive necessary" expenses. This flexibility is limited, however, to cases where the taxpayer will fully pay his liability within 5 years.7
IRM pt. 5.8 provides guidelines for offers in compromise. In evaluating an OIC, the IRS estimates the taxpayer's reasonable collection potential (RCP). The RCP is calculated by determining, then adding together: (1) The taxpayer's "net realizable equity"; i.e., quick sale value less amounts owed to secured lien holders with priority over Federal tax liens; and (2) the taxpayer's "future income"; i.e., the amount collectible from his expected future gross income after allowing for necessary living expenses. IRM secs. 5.8.5.3.1, 5.8.5.5 (2005). "Generally, the amount to be collected from future income is calculated by taking the projected gross monthly income less allowable expenses and multiplying the difference times the number of months remaining on the statutory period for collection." IRM pt. 5.8.5.5.5.1 (2005).
In a compromise, the Government will not collect the full amount of the tax. As a result, the conditional expenses rules for an OIC differ from the rules for installment agreements. IRM pt. 5.8.5.5.3.1 (2005). With respect to conditional expenses, such as credit card payments, "although the payment may be allowed in an installment agreement where the tax will be paid in full, it [the conditional expense] will not be allowed for computation of an acceptable offer amount because the Federal government has priority rights to the funds."8 IRM pt. 5.8.5.5.3.8 (2004).
The AO followed published guidelines in computing petitioner's future income and determined that petitioner's RCP exceeded $100,000.
Petitioner complains that the AO inappropriately increased petitioner's monthly income based on a year-end bonus that was not guaranteed. The record does not disclose the precise reason the AO determined that petitioner and the OIC examiner had understated petitioner's 2004 income. However, even the original OIC examiner determined that petitioner's RCP was more than $80,000. Both RCPs are substantially greater than petitioner's tax liability and both demonstrate that respondent determined that petitioner can pay his liability in full.
The record indicates that the AO determined that the requirements of applicable law and administrative procedure were satisfied. The AO considered petitioner's proposed OIC and confirmed the rejection of that OIC on the basis of a proper application of the IRM guidelines. Finally, the AO determined that the lien balanced the need for efficient collection against the taxpayer's concern that the collection action be no more intrusive than necessary. We conclude that respondent has not abused his discretion.
Petitioner's Motions
At trial the Court explained to petitioner that its jurisdiction in collection appeals cases is strictly limited by statute and that the Court can only review whether respondent abused his discretion. Petitioner asked the Court for various forms of relief, including dismissal of tax penalties, reduction of taxes due, acceptance of his original OIC, and dismissal of taxes and penalties for certain years.
The Tax Court is a court of limited jurisdiction, and we may exercise our jurisdiction only to the extent provided by Congress. See sec. 7442; see also GAF Corp. & Subs. v. Commissioner, 114 T.C. 519, 521 (2000). Following a hearing under section 6320, section 6330(d)(1) permits the taxpayer to appeal the Commissioner's determination to the Tax Court. Iannone v. Commissioner, 122 T.C. at 290. However, as previously indicated, where, as here, the underlying tax liability is not at issue, the Tax Court's review is limited to determining whether the Commissioner abused his discretion when issuing the notice of determination. See Goza v. Commissioner, 114 T.C. at 181-182. The Court is not authorized to provide the relief petitioner requests. As a result, the Court will deny petitioner's motions.
An appropriate order and decision will be entered.
1 Respondent moved for summary judgment pursuant to Rule 121. Having called this case for trial and taken petitioner's testimony, we will deny respondent's motion for summary judgment and decide this case on the merits. Petitioner also made several oral motions at trial. For reasons discussed infra pp. 18-19, we will deny petitioner's motions.
2 Docket No. 2721-02, stipulated decision entered Jan. 9, 2003.
3 Sec. 6330(b)(3) ensures a measure of impartiality by requiring that, unless the taxpayer waives the requirement, the sec. 6330 hearing be conducted by an AO who has had no prior involvement with the unpaid tax at issue in the hearing. Murphy v. Commissioner, 125 T.C. 301, 324-325 (2005), affd. 469 F.3d 27 (1st Cir. 2006). Respondent filed the notice of Federal tax lien on Mar. 17, 2005, and assigned the administrative appeal of the OIC to an AO on Mar. 18, 2005. Respondent sent petitioner a Notice of Federal Tax Lien Filing and Your Right to a Hearing Under IRC 6320 dated Mar. 24, 2005. Respondent initially assigned petitioner's request for a sec. 6320 hearing, submitted Apr. 28, 2005, to a different AO. On Sept. 15, 2005, the OIC AO consulted with petitioner, took responsibility for both the OIC appeal and the sec. 6320 hearing, and scheduled a face-to-face hearing for Oct. 5, 2005. Sec. 6330(c)(2)(A)(III) requires the AO to consider collection alternatives raised by the taxpayer, which, in this case, include the reconsideration of the rejected OIC. Petitioner has not claimed that the AO's assignment to both the OIC appeal and the sec. 6320 hearing violated sec. 6330(b)(3). In any event, we conclude that it did not, because the OIC appeal and the sec. 6320 hearing were conducted simultaneously by an AO with no prior involvement with the unpaid taxes at issue.
4 Furthermore, petitioner already petitioned this Court for redetermination of the deficiency for 1999. As mentioned supra p. 3, that case resulted in a stipulated decision, and respondent assessed the deficiency stipulated in that decision.
5 National standards combine five necessary expenses: Four from the Bureau of Labor Statistics Consumer Expenditure Survey, namely food, housekeeping supplies, apparel and services, and personal care products and services; and a discretionary amount, categorized as miscellaneous, established by the Internal Revenue Service. IRM pt. 5.15.1.7(3) (2004).
6 Petitioner explains that his unemployment was the major cause of his unpaid taxes. However, the Court notes that the only period of unemployment reflected in the record occurred between approximately August 2001 and April 2002; yet most of petitioner's tax liability, more than 70 percent, results from unpaid taxes for tax years 1998, 1999, and 2000. See Table 1, supra p. 4. Petitioner has also not indicated that he anticipates future unemployment. Petitioner is an engineer working in the high-tech industry, as opposed to a seasonal worker subject to regular lay-offs, for example. On the record before the Court, we conclude that petitioner has not demonstrated a history of unemployment sufficient to require a deviation from the reasonable collection potential formula.
7 Given that the 60-month reasonable collection potentials calculated by the OIC examiner and by the AO both substantially exceed petitioner's aggregate tax liability, it appears that a 5-year installment plan may permit petitioner to make some payments toward his credit card debt. Excluding interest and penalties, the monthly installment amount required to pay the aggregate liability reflected on the notice of Federal tax lien filing in full over 5 years is $475. The installment agreement mailed to petitioner after the face-to-face hearing specified an initial monthly installment payment of $800. Both amounts are substantially smaller than petitioner's income available to pay taxes as determined by the OIC examiner ($1,319) and the AO ($1,661). See Table 3, supra p. 6.
8 If a taxpayer justifies and substantiates that expenses for unsecured debts like credit card minimum payments are necessary for either the production of income or for the health and welfare of the taxpayer and his family, those expenses are allowable. Lemann v. Commissioner, T.C. Memo. 2006-37 n.13. Petitioner testified vaguely: (1) That some of his credit card debt resulted from the purchase of household items and living expenses; (2) that he did not remember what he purchased; and (3) that he used a credit card when he did not have sufficient cashflow, whether employed or unemployed. He did not remember whether he bought food with his credit cards. He may have charged dinners but not necessarily groceries. Petitioner does not specifically allege that his credit card debt resulted from necessary expenditures for the production of income or for his family's health and welfare. Accordingly, we conclude that this unsecured debt is not allowable as an expense in an offer-in-compromise. See id.
Friday, February 29, 2008
Thursday, February 28, 2008
Offer in Compromise - section 7122
If an offer accepted for processing does not contain sufficient information to permit the IRS to evaluate whether the offer should be accepted, the IRS will request that the taxpayer provide the needed additional information. Sec. 301.7122-1(d)(2), Proced. & Admin. Regs.
William J. and Lois J. DiCindio v. Commissioner.
Dkt. No. 7029-03L , TC Memo. 2007-77, April 2, 2007.
[Appealable, barring stipulation to the contrary, to CA-3. --CCH.]
[Code Secs. 6330 and 7122]
Notice of Levy and right to hearing: Collection Due Process hearing: Abuse of discretion. --
The IRS's determination to reject a married couple's offer-in-compromise (OIC) and proceed with collection of tax liabilities was not an abuse of discretion. Returning the OIC for additional information was not arbitrary and capricious, and the decision not to process the OIC because the couple failed to provide additional requested information was consistent with the prescribed guidelines and was a reasonable exercise of the IRS's discretion. It was also not an abuse of discretion to reject the couple's OIC because they failed to submit additional information before the court ruled on their pending motion for reconsideration. An extension of any deadlines related to the IRS's processing of the OIC would not have changed the OIC's disposition. --CCH.
MEMORANDUM OPINION
COLVIN, Chief Judge: Respondent sent a Notice of Determination Concerning Collection Action(s) Under Section 6320 1 and/or 6330 to petitioners in which respondent determined that it was appropriate to sustain collection action with respect to petitioners' unpaid income taxes for 1985-89 and 1991-2001 (the years in issue).2 Thereafter petitioners timely filed a petition in which they requested our review of respondent's determination. The issue for decision is whether respondent's determination to reject petitioners' offer-in-compromise (OIC) and proceed with collection was an abuse of discretion. We hold that it was not.
Background
Some of the facts have been stipulated and are so found. Petitioners are married and resided in Edison, New Jersey, at the time the petition was filed.
Respondent issued a Final Notice of Intent to Levy and Notice of Your Right to a Hearing to petitioners on September 5, 2002. Petitioners timely requested a collection due process hearing on October 1, 2002. Petitioners' outstanding tax liability is $463,496 plus statutory additions. Petitioners did not challenge the assessments or the underlying tax liabilities. A settlement officer (SO) from respondent's Appeals Office (Appeals) spoke on the telephone with petitioners' representative on February 4, 2003. The SO told petitioners' representative that collection alternatives such as an OIC or an installment agreement would not be considered because of petitioners' poor compliance record. Respondent issued the notice of determination on April 8, 2003, sustaining the levy.
In the petition, petitioners alleged errors in the notice of determination, specifically that Appeals failed to give them a fair hearing and that Appeals failed to act properly with regard to the collection activity. After the petition was filed, counsel for respondent requested that Appeals discuss collection alternatives with petitioners at a face-to-face hearing. Petitioner3 and respondent's SO met on September 9, 2003, and discussed collection alternatives. Petitioners submitted an OIC on November 6, 2003. On December 1, 2003, the SO sent petitioners a letter requesting that they complete missing items on the form and submit additional information.
This case was calendared for trial at the May 3, 2004, session of this Court in New York, New York. Petitioners filed a motion for continuance in which they stated that they would be submitting an OIC. The Court granted the motion. The case was then calendared for trial at the session of this Court beginning on January 24, 2005. Petitioners filed another motion for continuance in order to retain counsel. The Court granted the motion and ordered petitioners to submit an OIC to respondent no later than March 1, 2005. Petitioners filed a status report on March 1, 2005, stating that they had decided not to submit an OIC because they would have no way of paying the debt. Trial was held on September 19, 2005, in New York, New York.
Following trial, the Court ordered petitioners to provide counsel for respondent a complete Form 656, Offer in Compromise, and an updated Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals. Counsel for respondent received petitioners' OIC on November 15, 2005, and sent it to an offer specialist (OS) for consideration. In the following months, the OS requested that petitioners provide additional information by various deadlines. Petitioners did not meet any of these deadlines.
In April 2006, petitioners requested that the Court keep the pending OIC open for consideration until August 15, 2006, so that petitioner could file his 2005 income tax return. The Court denied petitioners' request. Thereafter, respondent returned the pending OIC to petitioners and closed their file because petitioners had failed to provide additional information necessary to determine the acceptability of their offer and they failed to verify their compliance with the estimated income tax requirements for 2005 and 2006.
Discussion
Petitioners contend that respondent's refusal to consider their offer-in-compromise submitted on November 15, 2005, for the years in issue was an abuse of discretion. We disagree. Section 7122(c)(1) provides that the Secretary shall prescribe guidelines for the Internal Revenue Service (IRS) to use in determining whether to accept an OIC. The decision to accept or reject an OIC, as well as the terms and conditions to which the IRS agrees, is left to the discretion of the Secretary. Sec. 301.7122-1(c)(1), Proced. & Admin. Regs.
Petitioners contend that returning their OIC for additional information was arbitrary and capricious. We disagree.
If an offer accepted for processing does not contain sufficient information to permit the IRS to evaluate whether the offer should be accepted, the IRS will request that the taxpayer provide the needed additional information. Sec. 301.7122-1(d)(2), Proced. & Admin. Regs. On three separate occasions, respondent's OS contacted petitioners to request additional information. The OS explained that this additional information was necessary to account for discrepancies between petitioners' Form 433-A and the information they had previously submitted. Petitioners failed to provide the requested information. If the taxpayer does not submit the requested information to the IRS within a reasonable time after a request, the IRS may return the offer to the taxpayer. Id. The decision not to process petitioners' OIC on account of their failure to provide additional information was consistent with the prescribed guidelines and was a reasonable exercise of respondent's discretion.
Petitioners contend that respondent's rejection of their OIC while a motion for reconsideration was pending before the Court was an abuse of discretion. We disagree.
The granting of a motion to reconsider rests in the discretion of the Court. Louisville & Nashville R. Co. v. Commissioner [81-1 USTC ¶9212], 641 F.2d 435, 443-444 (6th Cir. 1981), affg. on this issue and revg. on other issues [Dec. 34,014] 66 T.C. 962 (1976); Estate of Halas v. Commissioner [Dec. 46,522], 94 T.C. 570, 574 (1990); Vaughn v. Commissioner [Dec. 43,183], 87 T.C. 164, 166-167 (1986). Motions to reconsider will not be granted unless unusual circumstances or substantial error is shown. Estate of Halas v. Commissioner, supra at 574; Vaughn v. Commissioner, supra at 167. Petitioners submitted their offer-in-compromise to respondent on November 15, 2005. However, they failed to respond to respondent's repeated requests for additional information. In April 2006, petitioners requested an extension until August 15, 2006, so that petitioner could file his 2005 income tax return. The Court was not persuaded that petitioners were entitled to an extension of any deadlines related to respondent's processing of the OIC and denied their motion. In the interim, respondent rejected petitioners' OIC.
We have no reason to believe that an extension to August would have changed the disposition of petitioners' offer-in-compromise. The reason for the requested extension was to file petitioner's 2005 income tax return. However, the filing of petitioner's 2005 income tax return was not a requirement of respondent's acceptance of the offer. The OS knew that petitioner had requested an extension for filing his 2005 taxes. The information that the OS needed, however, had to do with additional information to verify and confirm the data on the submitted OIC. Therefore, it was not an abuse of discretion to reject petitioners' OIC on account of their failure to submit additional information before the Court ruled on petitioners' pending motion for reconsideration.
We conclude that respondent may proceed with collection of petitioners' tax liabilities for 1985-89 and 1991-2001 because respondent's rejection of petitioners' offer-in-compromise was not an abuse of discretion.
Decision will be entered for respondent.
1 Unless otherwise indicated, section references are to the Internal Revenue Code as amended.
2 In the petition, petitioners also disputed the collection action for taxable year 1990. No notice of determination was issued to petitioners for that year. By separate order, the Court dismissed this case as it relates to taxable year 1990.
3 References to petitioner are to William J. DiCindio.
William J. DiCindio; Lois J. DiCindio, Appellants v. Commissioner of Internal Revenue.
U.S. Court of Appeals, 3rd Circuit; 07-3476, February 20, 2008.
Unpublished opinion, vacating and remanding in part, affirming in part, per curiam, the Tax Court, Dec. 56,884(M); 93 TCM 1060; TC Memo. 2007-77.
[ Code Sec. 7122]
Notice of Levy and right to hearing: Collection Due Process hearing: Offers-in-compromise: Abuse of discretion. --
The IRS's determination to reject a married couple's offer-in-compromise (OIC) and proceed with collection of tax liabilities was not an abuse of discretion. The couple's OIC was rejected because they failed to provide additional requested information needed to evaluate the offer. Further, the couple had been given several opportunities and extensions of time to file their completed OIC. Moreover, they were not current with their estimated taxes.
Before: Ambro, Fuentes and Fisher, Circuit Judges.
OPINION
PER CURIAM: William and Lois DiCindio appeal the Tax Court's decision allowing the appellee to proceed with a collection action. The procedural history of this case and the details of the DiCindios' claims are well known to the parties, set forth in the Tax Court's thorough opinion, and need not be discussed at length. Briefly, the DiCindios filed a petition in the Tax Court challenging a notice of determination with respect to fourteen years of unpaid tax liabilities. The DiCindios did not challenge the amount of the taxes that they owe. During the Tax Court proceedings, appellee agreed to evaluate an offer in compromise from the DiCindios. The offer was returned to the DiCindios because they failed to provide the information needed to evaluate the offer. They had also not shown that they had paid estimated income tax for 2005 and 2006. The Tax Court upheld the notice of determination. The DiCindios filed a timely notice of appeal, and we have jurisdiction under 26 U.S.C. §7482(a)(1).
On appeal, the DiCindios argue that the Tax Court erred by not directing appellee to request and evaluate two offers in compromise. However, the offer specialist who evaluated the offer noted that she was overlooking the absence of two offers and other processing deficiencies because the offer had been submitted by order of the Tax Court. Moreover, the offer was rejected because the DiCindios failed to provide the necessary information to evaluate the offer, not because there were not two separate offers.
The DiCindios further argue that the appellee will not process an offer in compromise unless the taxpayers are current with their estimated taxes. Therefore, they contend that the Tax Court erred by denying their request to stay the case and their motion for a reconsideration because they had filed a request for an extension of time to pay their taxes. However, by filing a Form 4868, a taxpayer can only request an extension of time to file a return; filing the form does not entitle one to an extension of time to pay the taxes owed. See Deaton v. Commissioner, 440 F.3d 223, 224 (5th Cir. 2006). The DiCindios were given several opportunities and extensions of time to file their completed offer in compromise. Their arguments are without merit.
The DiCindios' final argument is that the appellee closed the file on their offer in compromise while their motion for reconsideration was still pending before the Tax Court. We agree with the Tax Court that this was not an abuse of discretion.
Appellee notes that a final notice of intent to levy was not sent for the tax years of 1988 and 2001 and that the Tax Court lacked jurisdiction over those years. Appellee requests that the case be remanded to the Tax Court for removal of those years from the decision. Accordingly, we will vacate the Tax Court decision in part and remand the matter with instructions to correct the decision to remove the tax years 1988 and 2001. In all other respects, we will affirm the decision of the Tax Court for the above reasons as well as those set forth by the Tax Court.
If an offer accepted for processing does not contain sufficient information to permit the IRS to evaluate whether the offer should be accepted, the IRS will request that the taxpayer provide the needed additional information. Sec. 301.7122-1(d)(2), Proced. & Admin. Regs.
William J. and Lois J. DiCindio v. Commissioner.
Dkt. No. 7029-03L , TC Memo. 2007-77, April 2, 2007.
[Appealable, barring stipulation to the contrary, to CA-3. --CCH.]
[Code Secs. 6330 and 7122]
Notice of Levy and right to hearing: Collection Due Process hearing: Abuse of discretion. --
The IRS's determination to reject a married couple's offer-in-compromise (OIC) and proceed with collection of tax liabilities was not an abuse of discretion. Returning the OIC for additional information was not arbitrary and capricious, and the decision not to process the OIC because the couple failed to provide additional requested information was consistent with the prescribed guidelines and was a reasonable exercise of the IRS's discretion. It was also not an abuse of discretion to reject the couple's OIC because they failed to submit additional information before the court ruled on their pending motion for reconsideration. An extension of any deadlines related to the IRS's processing of the OIC would not have changed the OIC's disposition. --CCH.
MEMORANDUM OPINION
COLVIN, Chief Judge: Respondent sent a Notice of Determination Concerning Collection Action(s) Under Section 6320 1 and/or 6330 to petitioners in which respondent determined that it was appropriate to sustain collection action with respect to petitioners' unpaid income taxes for 1985-89 and 1991-2001 (the years in issue).2 Thereafter petitioners timely filed a petition in which they requested our review of respondent's determination. The issue for decision is whether respondent's determination to reject petitioners' offer-in-compromise (OIC) and proceed with collection was an abuse of discretion. We hold that it was not.
Background
Some of the facts have been stipulated and are so found. Petitioners are married and resided in Edison, New Jersey, at the time the petition was filed.
Respondent issued a Final Notice of Intent to Levy and Notice of Your Right to a Hearing to petitioners on September 5, 2002. Petitioners timely requested a collection due process hearing on October 1, 2002. Petitioners' outstanding tax liability is $463,496 plus statutory additions. Petitioners did not challenge the assessments or the underlying tax liabilities. A settlement officer (SO) from respondent's Appeals Office (Appeals) spoke on the telephone with petitioners' representative on February 4, 2003. The SO told petitioners' representative that collection alternatives such as an OIC or an installment agreement would not be considered because of petitioners' poor compliance record. Respondent issued the notice of determination on April 8, 2003, sustaining the levy.
In the petition, petitioners alleged errors in the notice of determination, specifically that Appeals failed to give them a fair hearing and that Appeals failed to act properly with regard to the collection activity. After the petition was filed, counsel for respondent requested that Appeals discuss collection alternatives with petitioners at a face-to-face hearing. Petitioner3 and respondent's SO met on September 9, 2003, and discussed collection alternatives. Petitioners submitted an OIC on November 6, 2003. On December 1, 2003, the SO sent petitioners a letter requesting that they complete missing items on the form and submit additional information.
This case was calendared for trial at the May 3, 2004, session of this Court in New York, New York. Petitioners filed a motion for continuance in which they stated that they would be submitting an OIC. The Court granted the motion. The case was then calendared for trial at the session of this Court beginning on January 24, 2005. Petitioners filed another motion for continuance in order to retain counsel. The Court granted the motion and ordered petitioners to submit an OIC to respondent no later than March 1, 2005. Petitioners filed a status report on March 1, 2005, stating that they had decided not to submit an OIC because they would have no way of paying the debt. Trial was held on September 19, 2005, in New York, New York.
Following trial, the Court ordered petitioners to provide counsel for respondent a complete Form 656, Offer in Compromise, and an updated Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals. Counsel for respondent received petitioners' OIC on November 15, 2005, and sent it to an offer specialist (OS) for consideration. In the following months, the OS requested that petitioners provide additional information by various deadlines. Petitioners did not meet any of these deadlines.
In April 2006, petitioners requested that the Court keep the pending OIC open for consideration until August 15, 2006, so that petitioner could file his 2005 income tax return. The Court denied petitioners' request. Thereafter, respondent returned the pending OIC to petitioners and closed their file because petitioners had failed to provide additional information necessary to determine the acceptability of their offer and they failed to verify their compliance with the estimated income tax requirements for 2005 and 2006.
Discussion
Petitioners contend that respondent's refusal to consider their offer-in-compromise submitted on November 15, 2005, for the years in issue was an abuse of discretion. We disagree. Section 7122(c)(1) provides that the Secretary shall prescribe guidelines for the Internal Revenue Service (IRS) to use in determining whether to accept an OIC. The decision to accept or reject an OIC, as well as the terms and conditions to which the IRS agrees, is left to the discretion of the Secretary. Sec. 301.7122-1(c)(1), Proced. & Admin. Regs.
Petitioners contend that returning their OIC for additional information was arbitrary and capricious. We disagree.
If an offer accepted for processing does not contain sufficient information to permit the IRS to evaluate whether the offer should be accepted, the IRS will request that the taxpayer provide the needed additional information. Sec. 301.7122-1(d)(2), Proced. & Admin. Regs. On three separate occasions, respondent's OS contacted petitioners to request additional information. The OS explained that this additional information was necessary to account for discrepancies between petitioners' Form 433-A and the information they had previously submitted. Petitioners failed to provide the requested information. If the taxpayer does not submit the requested information to the IRS within a reasonable time after a request, the IRS may return the offer to the taxpayer. Id. The decision not to process petitioners' OIC on account of their failure to provide additional information was consistent with the prescribed guidelines and was a reasonable exercise of respondent's discretion.
Petitioners contend that respondent's rejection of their OIC while a motion for reconsideration was pending before the Court was an abuse of discretion. We disagree.
The granting of a motion to reconsider rests in the discretion of the Court. Louisville & Nashville R. Co. v. Commissioner [81-1 USTC ¶9212], 641 F.2d 435, 443-444 (6th Cir. 1981), affg. on this issue and revg. on other issues [Dec. 34,014] 66 T.C. 962 (1976); Estate of Halas v. Commissioner [Dec. 46,522], 94 T.C. 570, 574 (1990); Vaughn v. Commissioner [Dec. 43,183], 87 T.C. 164, 166-167 (1986). Motions to reconsider will not be granted unless unusual circumstances or substantial error is shown. Estate of Halas v. Commissioner, supra at 574; Vaughn v. Commissioner, supra at 167. Petitioners submitted their offer-in-compromise to respondent on November 15, 2005. However, they failed to respond to respondent's repeated requests for additional information. In April 2006, petitioners requested an extension until August 15, 2006, so that petitioner could file his 2005 income tax return. The Court was not persuaded that petitioners were entitled to an extension of any deadlines related to respondent's processing of the OIC and denied their motion. In the interim, respondent rejected petitioners' OIC.
We have no reason to believe that an extension to August would have changed the disposition of petitioners' offer-in-compromise. The reason for the requested extension was to file petitioner's 2005 income tax return. However, the filing of petitioner's 2005 income tax return was not a requirement of respondent's acceptance of the offer. The OS knew that petitioner had requested an extension for filing his 2005 taxes. The information that the OS needed, however, had to do with additional information to verify and confirm the data on the submitted OIC. Therefore, it was not an abuse of discretion to reject petitioners' OIC on account of their failure to submit additional information before the Court ruled on petitioners' pending motion for reconsideration.
We conclude that respondent may proceed with collection of petitioners' tax liabilities for 1985-89 and 1991-2001 because respondent's rejection of petitioners' offer-in-compromise was not an abuse of discretion.
Decision will be entered for respondent.
1 Unless otherwise indicated, section references are to the Internal Revenue Code as amended.
2 In the petition, petitioners also disputed the collection action for taxable year 1990. No notice of determination was issued to petitioners for that year. By separate order, the Court dismissed this case as it relates to taxable year 1990.
3 References to petitioner are to William J. DiCindio.
William J. DiCindio; Lois J. DiCindio, Appellants v. Commissioner of Internal Revenue.
U.S. Court of Appeals, 3rd Circuit; 07-3476, February 20, 2008.
Unpublished opinion, vacating and remanding in part, affirming in part, per curiam, the Tax Court, Dec. 56,884(M); 93 TCM 1060; TC Memo. 2007-77.
[ Code Sec. 7122]
Notice of Levy and right to hearing: Collection Due Process hearing: Offers-in-compromise: Abuse of discretion. --
The IRS's determination to reject a married couple's offer-in-compromise (OIC) and proceed with collection of tax liabilities was not an abuse of discretion. The couple's OIC was rejected because they failed to provide additional requested information needed to evaluate the offer. Further, the couple had been given several opportunities and extensions of time to file their completed OIC. Moreover, they were not current with their estimated taxes.
Before: Ambro, Fuentes and Fisher, Circuit Judges.
OPINION
PER CURIAM: William and Lois DiCindio appeal the Tax Court's decision allowing the appellee to proceed with a collection action. The procedural history of this case and the details of the DiCindios' claims are well known to the parties, set forth in the Tax Court's thorough opinion, and need not be discussed at length. Briefly, the DiCindios filed a petition in the Tax Court challenging a notice of determination with respect to fourteen years of unpaid tax liabilities. The DiCindios did not challenge the amount of the taxes that they owe. During the Tax Court proceedings, appellee agreed to evaluate an offer in compromise from the DiCindios. The offer was returned to the DiCindios because they failed to provide the information needed to evaluate the offer. They had also not shown that they had paid estimated income tax for 2005 and 2006. The Tax Court upheld the notice of determination. The DiCindios filed a timely notice of appeal, and we have jurisdiction under 26 U.S.C. §7482(a)(1).
On appeal, the DiCindios argue that the Tax Court erred by not directing appellee to request and evaluate two offers in compromise. However, the offer specialist who evaluated the offer noted that she was overlooking the absence of two offers and other processing deficiencies because the offer had been submitted by order of the Tax Court. Moreover, the offer was rejected because the DiCindios failed to provide the necessary information to evaluate the offer, not because there were not two separate offers.
The DiCindios further argue that the appellee will not process an offer in compromise unless the taxpayers are current with their estimated taxes. Therefore, they contend that the Tax Court erred by denying their request to stay the case and their motion for a reconsideration because they had filed a request for an extension of time to pay their taxes. However, by filing a Form 4868, a taxpayer can only request an extension of time to file a return; filing the form does not entitle one to an extension of time to pay the taxes owed. See Deaton v. Commissioner, 440 F.3d 223, 224 (5th Cir. 2006). The DiCindios were given several opportunities and extensions of time to file their completed offer in compromise. Their arguments are without merit.
The DiCindios' final argument is that the appellee closed the file on their offer in compromise while their motion for reconsideration was still pending before the Tax Court. We agree with the Tax Court that this was not an abuse of discretion.
Appellee notes that a final notice of intent to levy was not sent for the tax years of 1988 and 2001 and that the Tax Court lacked jurisdiction over those years. Appellee requests that the case be remanded to the Tax Court for removal of those years from the decision. Accordingly, we will vacate the Tax Court decision in part and remand the matter with instructions to correct the decision to remove the tax years 1988 and 2001. In all other respects, we will affirm the decision of the Tax Court for the above reasons as well as those set forth by the Tax Court.
Wednesday, February 27, 2008
Economic Substance
A taxpayer is not entitled to loss deductions pursuant to §165(c)(2) if his claimed losses stem from transactions that lack economic substance. See Iles v. C.I.R [ 93-2 USTC ¶50,525], 982 F.2d 163, 165 (6th Cir. 1992). Moreover, "when a taxpayer claims a deduction, it is the taxpayer who bears the burden of proving that the transaction has economic substance." Coltec Industries, Inc. v. United States [ 2006-2 USTC ¶50,389], 454 F.3d 1340, 1355 (Fed. Cir. 2006).
Richard M. Nault v. United States of America.
U.S. District Court, Dist. N.H.; Civ. 04-cv-479-PB, February 9, 2007.
[ Code Sec. 165]
Sham transactions: Economic substance. --
MEMORANDUM AND ORDER
BARBADORO, District Judge: Richard Nault brings this action against the United States to recover income tax refunds for several tax years. Nault's claims stem from investments he made in several agriculture-based limited partnerships (collectively the "AMCOR Partnerships"). In 2001, the tax court entered orders resolving a claim by the United States that the AMCOR Partnerships were sham transactions lacking economic substance. The parties agree that Nault's entitlement to the refunds he now seeks depends upon the meaning and legal effect of the tax court orders.
The matter is before me on cross motions for summary judgment.
I. BACKGROUND
This case falls within the purview of the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"). Accordingly, I begin by explaining TEFRA's legal framework. I then describe Nault's investments in the AMCOR Partnerships and the tax court litigation challenging the legitimacy of the partnerships' tax returns.
A. The TEFRA Framework 1
TEFRA establishes a "single unified procedure for determining the tax treatment of all partnership items at the partnership level, rather than separately at the partner level." Callaway [ 2000-2 USTC ¶50,744], 231 F.3d at 108. Whether an item is a partnership item or a nonpartnership item is the threshold inquiry under TEFRA. Id. Partnership items are "subject to TEFRA's centralized audit procedures," while "the treatment of nonpartnership items is determined at the level of the individual partner's return...." Id. Under TEFRA, taxpayers are not "permitted to raise nonpartnership items in the course of a partnership proceeding." Id. Correlatively, taxpayers cannot raise partnership items at partner level proceedings. Id.
TEFRA further mandates that a partner file "an income tax return that is consistent with the partnership return." Id. "The partner's distributive share of any partnership item must be reported in the same manner as on the partnership's information return ( i.e., it must have the same amount, the same characterization, the same timing)." Id. at 108-09 (citations omitted).
"The [Internal Revenue Service ("IRS")] may adjust partnership items only at the partnership level and only after following TEFRA procedures." Id. at 109. Specifically, "[t]o audit a partnership return, the IRS must send notice of the beginning of an administrative proceeding ('NBAP') to the partners entitled to notice (the 'notice partners')." 2 Id. "[A]ny partner has the right to participate in any administrative proceeding relating to the determination of partnership items at the partnership level." Id. (citing I.R.C. §6224(a)). "[I]f after completing its audit the IRS adjusts the partnership return, it must send the notice partners a notice of final partnership administrative adjustment ('FPAA')." Id. (citing I.R.C. §6223(a)(2), (d)(2)).
"Within 90 days of the date the IRS mails the FPAA notice, the partnership's 'tax matters partner' (TMP) 3 may contest the FPAA by filing a petition for readjustment in Tax Court, the Court of Federal Claims or the appropriate federal district court." Id. (citing I.R.C. §6226(a)). "If the TMP does not file a petition within this period, then any notice partner may file a petition for readjustment within the next 60 days. Id. (citing I.R.C. §6226(b)(1)). "Regardless whether the petition for judicial readjustment is filed by the TMP or by a notice partner, all other partners are treated as parties to the suit, provided that they have an ongoing interest in the outcome of the proceedings. Id. (citing I.R.C. §6226(c), (d)). "In this manner TEFRA allows all partners, if they choose, to litigate a dispute with the IRS in a single proceeding that binds all." Id.
"After the FPAA adjustments become final ( i.e., after they go unchallenged for 150 days or are judicially resolved in a section 6226 [tax court, district court, or Court of Federal Claims proceeding]), the IRS may assess partners with the tax which properly accounts for their distributive share of the adjusted partnership items, without notice, as a computational adjustment." Id. at 109-10 (citing I.R.C. §§6225(a), 6230(a) (1), 6231(a)(6)). "In certain cases, where no further factual determinations are necessary at the partner level, an assessment attributable to an 'affected item' may also be made by computational adjustment." Id. at 110. An "affected item" is "any item to the extent such item is affected by a partnership item. Id. In the event of an unfavorable court decision, the TMP, a notice partner, or a 5-percent group make seek appellate review in the appropriate forum. I.R.C. §6226(g).
B. Tax Treatment of Nault's Investments 4
Nault invested in the AMCOR Partnerships between 1984 and 1986. Each partnership reported significant losses in its first year of existence and comparatively smaller amounts of income in subsequent years. Nault took deductions based on his distributive share of partnership losses and paid taxes on his share of partnership income disbursements throughout the course of his investments. 5
In 1987, the IRS examined the AMCOR Partnerships' tax returns and issued FPAA notices disallowing deductions claimed by each partnership. In the FPAA notices, the IRS explained that the adjustments resulted from, inter alia, an IRS determination that the AMCOR Partnerships' activities constituted a series of sham transactions lacking economic substance.
Following the issuance of the FPAA notices, certain AMCOR partners --not including the TMP --filed Petitions for Readjustment of Partnership Items in the United States Tax Court pursuant to I.R.C. §6226. In July 1999, the TMP for each AMCOR Partnership intervened in each AMCOR tax court proceeding.
In 2001, after years of litigation, the IRS and the TMP entered into an agreement providing that the IRS would disallow approximately 72 percent of the AMCOR Partnerships' losses but allow the partnerships to retain all of their claimed Investment Tax Credits. The agreement also provided that the AMCOR partners would not file amended returns restating any reported income from the AMCOR Partnerships on which they had already paid income taxes.
The IRS ultimately filed Motions for Entry of Decision in the tax court, and the tax court entered decisions with respect to each AMCOR Partnership reflecting the terms of the settlement agreement. Each of the tax court decisions contained the following language:
ORDERED AND DECIDED:...[t]hat the foregoing adjustments to partnership income and expenses are attributable to transactions which lacked economic substance, as described in former I.R.C. §6621(c)(3)(A)(v), so as to result in a substantial distortion of income and expenses....
After the tax court litigation was resolved, the IRS issued adjustments to Nault's 1984, 1985, and 1986 income tax returns based on the disallowed deductions. Nault then paid the additional taxes resulting from the adjustments.
While the tax court litigation was ongoing, each of the AMCOR Partnerships terminated. Nault had no remaining basis in his partnership interests when the partnerships terminated apart from any "restored" basis he might be entitled to claim based upon the tax court's disallowance of his prior deductions.
In September 2002, Nault sought tax refunds by filing amended federal income tax returns for 1995, 1996, 1998, 1999, 2000, and 2001. In the amended returns, Nault claimed an ordinary loss deduction in the year each partnership terminated as well as carryover adjustments for other years affected by the termination year losses. Along with his refund claims, Nault attached statements explaining why he was entitled to the refunds. Specifically, Nault asserted that the Tax Court's 2001 disallowance of 72 percent of the AMCOR Partnership deductions --and derivatively, his share of the deductions --resulted in a restoration of his basis in those partnerships by corresponding amounts. As a result of this adjustment to his basis, he argued, he was entitled to loss deductions in the exact amount of his previously disallowed deductions because the partnerships became worthless upon termination.
On December 18, 2002, the IRS denied Nault's refund claims. Nault timely filed this action on December 17, 2004.
II. STANDARD OF REVIEW
Summary judgment is appropriate "if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." Fed. R. Civ. P. 56(c). "Cross-motions for summary judgment do not alter the basic Rule 56 standard, but rather simply require [the court] to determine whether either of the parties deserves judgment as a matter of law on facts that are not disputed." Adria Int'l Group, Inc. v. Ferre Dev., Inc., 241 F.3d 103, 107 (1st Cir. 2001) (citation omitted).
III. ANALYSIS
In claiming a loss deduction, Nault relies upon 26 U.S.C. §165(a), which permits individuals to take tax deductions for losses "not compensated for by insurance or otherwise." Another statutory provision --26 U.S.C. §165(c) --adds important limitations to such deductions. It provides:
In the case of an individual, the deduction under subsection (a) shall be limited to --
(1) losses incurred in a trade or business;
(2) losses incurred in any transaction entered into for profit, though not connected with a trade or business; and
(3) except as provided in subsection (h), losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft.
Nault does not allege that he was involved in a trade or business in connection with the AMCOR Partnerships. Nor does he allege that his losses arose from fire, storm, shipwreck, or other casualty. Thus, Nault's claimed loss deductions can only be grounded in §165(c)(2): "a loss incurred in a transaction entered into for profit."
A taxpayer is not entitled to loss deductions pursuant to §165(c)(2) if his claimed losses stem from transactions that lack economic substance. See Iles v. C.I.R [ 93-2 USTC ¶50,525], 982 F.2d 163, 165 (6th Cir. 1992). Moreover, "when a taxpayer claims a deduction, it is the taxpayer who bears the burden of proving that the transaction has economic substance." Coltec Industries, Inc. v. United States [ 2006-2 USTC ¶50,389], 454 F.3d 1340, 1355 (Fed. Cir. 2006). The government relies on these accepted principles in contending that Nault is not entitled to the deductions he seeks because, it argues, the tax court determined that the transactions on which Nault's deductions are based lacked economic substance.
Nault recognizes that he is not entitled to take deductions pursuant to §165(c)(2) unless he can establish that his claimed losses are attributable to transactions that had economic substance. He also agrees that the tax court orders are determinative on this issue. Thus, this case turns on how the tax court orders are construed.
The government offers a straightforward interpretation of the tax court orders. Its position is that the parties to the tax court proceeding settled their dispute by agreeing to the entry of court orders recognizing that the losses disallowed pursuant to the orders were "attributable to transactions which lacked economic substance." Because the orders clearly provide that the transactions on which Nault's claims are based lacked economic substance, the government argues, Nault cannot rely on the disallowed losses to "restore" his basis in his investments.
Nault focuses on the effect of the court orders rather than their specific terms in arguing that the tax court actually determined that the AMCOR Partnerships had economic substance. In making this argument, Nault relies primarily on the basic principle that "a transaction that lacks economic substance simply is not recognized for federal taxation purposes, for better or worse...." ACM P'ships v. Comm'r of Internal Revenue [ 98-2 USTC ¶50,790], 157 F.3d 231, 261 (3d Cir. 1998) (citation and internal quotation marks omitted). He then reasons that if the tax court acted consistently with this principle, it must have determined that the AMCOR Partnerships had economic substance because the court allowed partners to retain their Investment Tax Credits and a portion of their partnership's losses and because the settlement agreement that gave rise to the orders barred partners from filing amended returns restating any reported income generated by the partnerships.
I am not convinced that courts are required to apply the economic substance doctrine in quite so inflexible a manner as Nault suggests. However, I need not delve into this complex issue to resolve this case because Nault fails to appreciate the significance of the fact that the orders on which his claims depend were issued pursuant to a settlement. The government argued in the tax court proceeding that the AMCOR Partnerships were sham transactions that were completely lacking in economic substance. The TMP disagreed. After extensive litigation, the parties compromised their claims by settlement and, in so doing, they agreed to the precise language that was used in the court orders that resolved the parties' dispute. That language plainly provides that the disallowed losses on which Nault's current claims are based were attributable to transactions that lacked economic substance. It is unsurprising and ultimately insignificant for our purposes that the settlement also represented something less than a complete victory for either side. All that matters here is that the settlement resulted in the issuance of court orders that plainly resolved the issue that is now before the court.
Accordingly, I hold that the tax court decisions determined that the disallowed deductions were attributable to transactions that lacked economic substance. Those decisions are binding on Nault in this proceeding. Thus, Nault has no claim to loss deductions resulting from a restored basis because transactions lacking economic substance cannot give rise to losses under §165(c).
IV. CONCLUSION
For the reasons set forth herein, I grant the government's motion for summary judgment (Doc. No. 34) and deny Nault's crossmotion for summary judgment (Doc. No. 43). The clerk is instructed to enter judgment accordingly.
SO ORDERED.
1 In Callaway v. Comm'r, the Second Circuit provided a thorough and enlightening explanation of TEFRA. See [ 2000-2 USTC ¶50,744] 231 F.3d 106, 107-12 (2d Cir. 2000). I rely heavily on Callaway in explaining TEFRA's legal framework.
2 A notice partner is "a partner entitled to notice under section 6223(a)." Id. (citing I.R.C. §6231(a)(8)). "When a partnership has 100 or more partners, a notice partner is generally one who owns at least a one percent interest in the partnership." Id. (citing I.R.C. §6223(b)(1)). It is unclear from the record whether Nault was a notice partner in any of the AMCOR Partnerships.
3 The TMP is "the general partner designated in the partnership agreement to handle tax matters." Id. (citing I.R.C. §6231(a)(7)).
4 The facts in this section are drawn from the parties' Joint Statement of Background Facts and Background Discussion of Law Regarding Taxation of Partnership Interests (Doc. No. 31) and certain exhibits in the summary judgment record. The record is construed in the light most favorable to Nault.
5 Nault's reported income and loss amounts for the AMCOR Partnerships are represented in a chart appended to the parties' Joint Statement of Background Facts. A copy of the chart is included with this Memorandum and Order as Appendix A.
Richard M. Nault, Plaintiff, Appellant v. United States, Defendant, Appellee.
U.S. Court of Appeals, 1st Circuit; 07-1455, February 15, 2008.
Affirming a DC N.H. decision, 2007-1 USTC ¶50,326.
[ Code Sec. 165]
Loss deductions: Sham transactions: Economic substance. --
Before: Torruella and Lynch, Circuit Judges, and Stahl, Senior Circuit Judge.
STAHL, Senior Circuit Judge: Plaintiff-appellant Richard M. Nault appeals the district court's decision denying his motion for summary judgment and granting summary judgment in favor of the United States. Nault argues that the district court erred in its interpretation of several agreed judgments entered by the Tax Court ("the Tax Court decisions"), embodying the terms of a settlement between the Internal Revenue Service ("IRS") and Frederick H. Behrens, as Tax Matters Partner ("TMP"), regarding the proper tax treatment of several agriculture-related limited partnerships organized by American Agri-Corp., Inc. ("AMCOR") 1 a California corporation (collectively the "AMCOR Partnerships" or "Partnerships"). For the reasons discussed below, we affirm.
I.
Nault allegedly invested approximately $1,230,000.00 in five AMCOR Partnerships between 1984 and 1986. In 1987, the IRS began scrutinizing the AMCOR Partnerships' tax returns and issued Final Partnership Administrative Adjustment Notices disallowing certain deductions on the basis that the Partnerships' activities constituted a series of sham transactions lacking economic substance. After years of litigation, the IRS and the TMP reached a settlement in which 72% of the Partnerships' deductions were disallowed, the government agreed not to disallow investment tax credits claimed by the partners, and the partners agreed not to file amended returns modifying any reported income from the Partnerships on which the partners had paid income taxes. Upon motion of the IRS, the Tax Court entered decisions with respect to each Partnership reflecting the terms of the settlement agreement.
Based upon the Tax Court decisions, the IRS issued adjustments to Nault's 1984, 1985, and 1986 income tax returns, and Nault paid the additional taxes resulting from the adjustments. Each of the Partnerships terminated during the lengthy Tax Court litigation, leaving Nault without any remaining basis in his partnership interests. In September 2002, Nault filed amended income tax returns for 1995, 1996, 1998, 1999, 2000, and 2001, asserting that his basis in the Partnerships should be "restored" to a level inversely proportionate to the Tax Court decisions' disallowance of 72% of the Partnerships' loss deductions. Nault claimed that he was entitled to an ordinary loss deduction for the taxable basis that was "restored" to his then-worthless partnership interests.
On December 18, 2002, the IRS denied Nault's request for a refund. Nault filed a complaint in federal district court on December 17, 2004, seeking to recover his purported overpayment of income tax pursuant to 26 U.S.C. §7422 and 28 U.S.C. §1346(a)(1). On February 9, 2007, the district court ruled on the parties' cross motions for summary judgment, granting summary judgment in favor of the government and denying summary judgment to Nault. See Nault v. United States, Civil No. 04-cv-479, 2007 WL 465310 (D.N.H. Feb. 9, 2007). This appeal ensued.
II.
We review de novo a district court's grant of summary judgment based on contract interpretation. See John Hancock Life Ins. Co. v. Abbott Labs., 478 F.3d 1, 7 (1st Cir. 2006). Summary judgment is appropriate where the evidence shows that "there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law." Fed. R. Civ. P. 56(c).
The parties agree that tax deductions are not permitted for transactions that lack economic substance and that the inquiry at hand --whether the Partnerships or transactions relevant to this appeal lacked economic substance --is confined to interpretation of the Tax Court decisions implementing the settlement between the IRS and the TMP. Thus, a detailed recitation of the substantive law underlying the parties' dispute is unnecessary. See United States v. ITT Cont'l Baking Co., 420 U.S. 223, 233, 236-37 (1975) (explaining that settlements incorporated into judicial decisions are self-contained within their four corners and, consequently, are detached from the substantive law giving rise to the litigation).
In construing a settlement subsequently adopted by a court, we apply the same basic rules that govern the interpretation of ordinary contracts. See id. at 235-37; Rodi v. Ventetuolo, 941 F.2d 22, 28 (1st Cir. 1991); see also Smart v. Gillette Co. Long-Term Disability Plan, 70 F.3d 173, 178 (1st Cir. 1995) (explaining that federal common law requires us to be "guided by common-sense canons of contract interpretation" (citation omitted)). Interpretation of the terms of an unambiguous contract is a matter of law, subject to judicial resolution. See id. Quite simply, "[a]n unambiguous contract must be enforced according to its terms...." Senior v. NSTAR Elec. & Gas Corp., 449 F.3d 206, 219 (1st Cir. 2006). Moreover, terms within a contract are accorded their "plain, ordinary, and natural meaning." Filiatrault v. Comverse Tech., Inc., 275 F.3d 131, 135 (1st Cir. 2001).
A contract is ambiguous where the disputed terms are facially inconsistent or reasonably susceptible to multiple, plausible interpretations. See Smart, 70 F.3d at 178. If a contract is ambiguous, we will consider extrinsic evidence to give effect to the parties' intent in forming the contract. Id. "The question of whether a contract is ambiguous is generally a question of law for the judge...." Senior, 449 F.3d at 219.
Nault contends that the Tax Court decisions should not be interpreted to mean that the Partnerships or the underlying transactions lacked economic substance. In support, he asserts that the disputed language of the Tax Court decisions is ambiguous, that principles of construction favor his suggested interpretation, and that extrinsic evidence conclusively establishes that the parties intended to effectuate his interpretation. These arguments are not well-founded.
First, the plain language of the Tax Court decisions unambiguously favors the government's interpretation. Section II of each Tax Court decision states:
That the foregoing adjustments to partnership income and expense are attributable to transactions which lacked economic substance, as described in former I.R.C. §6621(c)(3)(A)(v), so as to result in a substantial distortion of income and expense, as described in I.R.C. §6621(c) (3)(A)(iv), when computed under the partnership's cash receipts and disbursements method of accounting; and
That liabilities [in varying amounts] lack economic substance.
The district court held that this language unmistakably signaled that the adjustments of the loss deductions were made because the underlying transactions lacked economic substance, thus preventing Nault from now claiming tax deductions. 2
To escape this seemingly inexorable conclusion, Nault asserts that the presence of the phrase "so as to result in a substantial distortion of income and expenses" generates ambiguity. He argues that this phrase indicates that the underlying transactions may not have entirely lacked in economic substance, but merely distorted the Partnerships' balance sheet. To buttress this conclusion, he points out that the very next sentence simply declares that "liabilities" in varying amounts lacked economic substance without any such qualifying language. Thus, Nault argues, the district court violated the time-honored maxim that variances in language should not be treated as superfluous.
Nault is mistaken. The reference to former 26 U.S.C. §6621(c)(v) (1988), which helps to define "tax motivated transactions," confirms that the transactions were "sham[s] or fraudulent transaction[s]," and therefore lacked economic substance. See, e.g., Durrett v. Comm'r, 71 F.3d 515, 517 (5th Cir. 1996). The phrase "so as to result in a substantial distortion of income and expense" simply tracks the language of the former 26 U.S.C. §6621(c)(3)(iv) (1988), which likewise helps to define "tax motivated transactions." Thus, each phrase independently establishes that the adjustments were attributable to the Partnerships' tax-motivated activities. Admittedly, Nault is correct that transactions that lack economic substance are treated differently from those that merely result in a substantial distortion of income. Compare Dewees v. Comm'r, 870 F.2d 21, 30-31 (1st Cir. 1989) (refusing to permit deductions for sham transactions), with Mantell v. Comm'r, 66 T.C.M. (CCH) 697, 1993 WL 347409, at *10 (T.C. Sept. 13, 1993) (approving adjustments based on accounting methods that created a substantial distortion of income).
Nevertheless, the plain language of the Tax Court decisions still firmly establishes that the underlying transactions lacked economic substance. 3 Here, the greater implies the lesser --because the underlying transactions lacked economic substance, they necessarily resulted in a substantial distortion of income. Thus, the government's interpretation --that "[t]he decisions . .. state that the transactions resulted in a substantial distortion of income and expense because they lacked economic substance" --is by far the most natural reading of the disputed language. At the very least, it is logically consistent; Nault's proposed construction eviscerates the entire sentence. Under Nault's interpretation, the "substantial distortion" language must be read to modify the "lacked economic substance" language. We decline the invitation to mangle the English language by adopting an approach that defies basic rules of syntax and diction; the Tax Court clearly stated that the lack of economic substance "result[ed] in" the distortion of income, not the other way around.
Nault seeks additional support from the fact that the distortion language was not used in the next paragraph, which concerned the Partnerships' liabilities. The most obvious explanation for why this language was not used in reference to the Partnerships' liabilities is simply that the first paragraph referred to the underlying transactions themselves, while the second paragraph referred to the liabilities claimed by the Partnerships. Naturally, the erroneous liabilities themselves did not "result in a substantial distortion of income or expense." They simply lacked economic substance. Moreover, we will not declare perfectly clear language ambiguous merely because the Tax Court did not reiterate it verbatim in the very next sentence in dealing with a related, but not identical, matter.
Next, Nault argues that because the settlement "did not treat the Partnerships as lacking economic substance," the Tax Court decisions are ambiguous. 4 Nault's contention is based on a fundamentally erroneous conception of the Tax Court decisions, which approved a settlement. See Miller Tabak Hirsch & Co. v. Comm'r, 101 F.3d 7, 10 (2d Cir. 1996) (explaining that in a judicially-approved settlement parties are "free to settle the case in any manner not violative of law or public policy, regardless of what the result might have been had the parties gone to trial"). Parties to a settlement, almost by definition, eschew the possibility of obtaining some portion of what they would like in exchange for certain terms with which they can live. See Rodi, 941 F.2d at 27 (stating that a settlement "`normally embodies a compromise,' within the limits of which the litigants...must be prepared to live" (quoting United States v. Armour & Co., 402 U.S. 673, 681 (1971))). The fact that the IRS chose to settle rather than risk the hazards of litigation is no more a concession that the transactions at hand possessed economic substance than a defendant's decision to settle a dubious lawsuit for pennies on the dollar is a concession that the suit had merit. Indeed, there is little doubt that parties occasionally settle claims simply to avoid the hassle, uncertainty, and expense of litigation even where a favorable outcome seems all but certain.
Here, it was perfectly permissible for the IRS to insist upon language that declared the transactions to lack economic substance --perhaps anticipating claims plaintiffs such as Nault might make --while simultaneously making certain concessions to the taxpayers. It was incumbent upon the TMP to dispute any language that he did not wish included in the Tax Court decisions. See Rodi, 941 F.2d at 27 (admonishing that litigants must abide by terms of a settlement even where they prove more onerous than originally anticipated). In the end, therefore, Nault remains confined to the language agreed to in the settlement. See In re New Seabury Co. Ltd. P'ship, 450 F.3d 24, 31, 39 (1st Cir. 2006) (rejecting the district court's "functional analysis" of the parties' stipulation in favor of the bankruptcy court's analysis of its plain language).
Finally, Nault argues that, even if the plain language of the Tax Court decisions is unambiguous, the district court nevertheless erred by failing to consider extrinsic evidence. First, it is elementary that we do not ordinarily examine extrinsic evidence to alter or clarify the terms of an otherwise unambiguous contract. See Smart, 70 F.3d at 179. Nevertheless, "in the exceptional case, a latent ambiguity in seemingly clear contract language may require us to consider extrinsic evidence to determine the actual object of the parties' agreement." Coffin v. Bowater Inc., 501 F.3d 80, 97 (1st Cir. 2007).
This is not such a case. Nault's proposed interpretation of the Tax Court decisions is not merely strained, but flatly contradictory to the plain meaning of its terms. In essence, he "argue[s] that the [disputed] language does not mean what it says."Id. at 98. If the language of the Tax Court decisions does not comport with what the parties intended, then the TMP should have insisted upon different language.
Finally, we note that Nault dramatically overstates the persuasive force of the extrinsic evidence that he has proffered. It is by no means so conclusive as he suggests. 5 He directs our attention to a written summary regarding the settlement, prepared by the IRS, stating, inter alia, that each partner "may have a capital gain or loss upon his termination from the partnership" (emphasis added). This summary, however, was nonbinding, the specific section in question was designated as informational, the clause was permissive, and the provision referred only to the partner's capital contribution. Nault also points to a letter he received from the IRS indicating that the Service had made "[a] determination...that allow[ed] for capital treatment of these losses." This statement is certainly peculiar --and inconsistent with the IRS's current position. This letter, however, cannot serve as a definitive guide for our interpretation of Tax Court decisions executed more than a year previously. Additionally, the court notes that the same letter notified Nault of the IRS's rejection of his claims for a deduction for an ordinary loss related to his "restored" basis in the Partnerships.
In summary, Nault's arguments obfuscate what is, in reality, a very simple case. The plain language of the Tax Court decisions indicates that the disallowed loss deductions were based on transactions that lacked economic substance. We have no jurisdiction to determine whether the relevant transactions actually did have economic substance --the sole matter within our purview is determining what the Tax Court meant by its decisions. The Tax Court's determination, that the transactions lacked economic substance, is unambiguous.
III.
The judgment of the district court is affirmed.
1 For a partial history of AMCOR and the related litigation, see Crop Assocs.-1986 v. Comm'r, 80 T.C.M. (CCH) 56, 2000 WL 976792, at *1-7 (T.C. July 17, 2000).
2 Nault argues that the government has waived the position that the underlying transactions lacked economic substance, in favor of the position that the Partnerships themselves lacked economic substance. This contention is irrelevant. The district court unequivocally held that "the disallowed deductions were attributable to transactions that lacked economic substance." Nault, 2007 WL 465310, at *5 (emphasis added). We are not limited in our review by the fact that the district court rendered its decision on grounds that the government may or may not have urged below. Nault's position, if accepted, would confine the lower court to choosing between the rationales submitted by the parties. This is not the law. See Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 99 (1991) (holding that a "court is not limited to the particular legal theories advanced by the parties").
3 Albeit in dicta, the Court of Federal Claims has reached a similar conclusion about these decisions. See Keener v. United States, 76 Fed. Cl. 455, 457 & n.2 (Fed. Cl. 2007) (stating that the Tax Court found "the various partnership transactions to be sham transactions"); see also Howell v. Comm'r, 94 T.C.M. (CCH) 104, 2007 WL 2126593, at *1 (T.C. July 25, 2007) (stating that the IRS and TMP "stipulated that the partnerships entered into transactions that lacked economic substance and created substantial distortions of partnership income") (emphasis added).
4 Nault cites the Eleventh Circuit's decision in Fickling v. United States, 507 F.3d 1302 (11th Cir. 2007), as authority for this proposition. Nault, however, ignores a crucial factual distinction between the two cases. There is no indication that the disputed settlement discussed in Fickling contained any language labeling the transaction in question as lacking economic substance. Indeed, the Eleventh Circuit characterized the settlement in question as "noncommittal" concerning whether the underlying transaction was a sham. Id. at 1305.
5 In addition to noting the limited probative value of Nault's extrinsic evidence, we observe that the government likewise adduced extrinsic evidence --an affidavit from Margaret K. Hebert, an IRS attorney responsible for the AMCOR litigation --to buttress its own position. We need not discuss this evidence further, however, because it is unnecessary to our conclusion.
Transactions Entered Into for Profit: Economic substance
Despite the fact that the venture was rather risky and that tax savings were a critical element in investing in the venture, limited partners in a partnership formed to exploit a synthetic fuel process were able to claim their share of partnership losses. There was a business purpose behind the venture, investors had a reasonable possibility of realizing profit, and the venture "had practicable income effects other than the creation of tax losses."
D.B. Smith, CA-6, 91-2 USTC ¶50,326.
To the contrary.
A partnership that was to develop the market for a new way of harnessing energy was a sham devised to bring tax benefits to its investors, and deductions for a partner's share of partnership losses were denied.
J. Karr, CA-11, 91-1 USTC ¶50,113, 924 F2d 1018.
A partnership allegedly created to pursue production of an alternative energy source was not entitled to deductions for licensing fees and research and development fees. The partnership's activity lacked economic substance because of the amount and structure of the fees paid, the inexperience of the promoters, conflicts of interest among the promoters and the heavy emphasis placed on the tax benefits that would be gained by the partners.
Peat Oil and Gas Assoc., 100 TC 271, Dec. 48,944. Aff'd, sub nom. R. Ferguson, CA-2, 94-2 USTC ¶50,357.
Summary judgment against an investor was reversed because a material issue of fact existed concerning the economic substance of investment trades.
C.P. Brown, CA-7, 92-2 USTC ¶50,564, 976 F2d 1104.
Loss deductions claimed by investors in a corporation involved in the cattle business were disallowed. Regardless of whether the taxpayers had a profit motive, their expenditures to enter and stay in the cattle program, as well as their additional costs for the purchase of embryos and calves, were nondeductible because the program lacked economic substance. Even assuming that the investment constituted a bona fide business transaction, no showing was made that an investment loss or a theft loss was sustained during the tax years at issue.
R.E. Daoust, 67 TCM 2914, Dec. 49,832(M), TC Memo. 1994-203.
An individual was denied loss deductions relating to an alleged diamond mining venture because he did not own any rights in the venture.
G.M. Osserman, 71 TCM 2892, Dec. 51,319(M), TC Memo. 1996-205.
Investors in a limited partnership involved in oil and gas recovery were denied a loss deduction for their cash investment because the entity's activities and transactions lacked economic substance. They had agreed to be bound by the ruling in G.E. Krause, Dec. 48,383, affirmed sub nom. R.A. Hildebrand, CA-10, 94-2 USTC ¶50,305, a test case involving identical partnership transactions. Pursuant to that decision, loss deductions were disallowed because the entity did not engage in for-profit business transactions. Although the investors conceded that no profit objective existed at the partnership level, they contended that the profit-objective test should be measured only at the individual partner level. However, because the partnership's transactions lacked economic substance, their loss deduction was disallowed despite their individual profit objective in making the investment.
M.L. Marinovich, 77 TCM 2075, Dec. 53,399(M), TC Memo. 1999-179.
As to deductions claimed with respect to transactions lacking economic substance and a profit motive, see ¶12,177.59.
Corporations that acquired two debt instruments structured so that the value of one was expected to increase significantly at the same time that the value of the other one decreased significantly, could not recognize a current loss on the sale of the debt instrument that that decreased in value while not recognizing the gain on the other debt instrument.
Rev. Rul. 2000-12, 2000-1 CB 734.
The profit objectives of individuals who invested in enhanced oil recovery limited partnerships had to be measured at the partnership level because the parties' stipulation that the activities of the partnerships were not entered into with a profit objective did not affect the status of the partnerships for federal tax purposes. The finding that the partnerships' activities lacked profit motives was not tantamount to a holding that the investors intended to create entities other than partnerships. Rather, the partnerships entered into transactions, formed joint ventures, operated gas wells, and conducted themselves as partnerships.
A.C. Copeland, CA-5, 2002-1 USTC ¶50,420, 290 F3d 326.
A corporation's transfer of interests in multilayered leases of computer equipment and related trusts lacked economic substance and expense deductions claimed in relation to the transaction were denied. The transaction was solely motivated by tax considerations. There was no real obligation on behalf of the taxpayer or profit potential in connection with the transaction and the taxpayer's expert testimony as to the credibility of the transaction was inaccurate and unconvincing.
Nicole Rose Corp., 117 TC 328, Dec. 54,578.
Losses generated by claiming an inflated basis as the result of a transfer of assets in which the taxpayer becomes joint and severally liable for the transferor's indebtedness on the assets in excess of the fair market value of the assets lack economic substance. Although the basis of an asset is its fair market value or cost, including the amount of the transferor's liability assumed by the taxpayer-transferee, the inclusion of such liabilities into the basis of the asset is predicated on the assumption that the liabilities will be paid in full by the transferee.
Notice 2002-21, 2002-1 CB 730.
An equipment lease-financing company did not have a legitimate nontax business purpose for engaging in a lease-stripping transaction in which it claimed large rental expense deductions in exchange for an investment of less than one percent of the anticipated deductions. The taxpayer did not have a business reason for the transaction apart from tax consequences and there was no possibility of economic profit from the transaction. Deductions and losses claimed in connection with the transaction were disallowed.
CMA Consolidated, Inc., 89 TCM 701, Dec. 55,917(M), TC Memo. 2005-16.
An investor in several limited partnerships was not entitled to claim loss deductions because the disallowed deductions on which his claim was based lacked economic substance. The Tax Court's orders were binding on the individual because the government and the partnership's tax matters partners (TMP) compromised their claims by settlement and, in so doing, agreed to the precise language used in the court orders. Although the Tax Court disallowed a portion of the partnership deductions and allowed partners to retain their investment tax credits, the individual could not rely on the disallowed losses to restore his basis in his investments.
R.M. Nault, DC N.H., 2007-1 USTC ¶50,326.
A taxpayer is not entitled to loss deductions pursuant to §165(c)(2) if his claimed losses stem from transactions that lack economic substance. See Iles v. C.I.R [ 93-2 USTC ¶50,525], 982 F.2d 163, 165 (6th Cir. 1992). Moreover, "when a taxpayer claims a deduction, it is the taxpayer who bears the burden of proving that the transaction has economic substance." Coltec Industries, Inc. v. United States [ 2006-2 USTC ¶50,389], 454 F.3d 1340, 1355 (Fed. Cir. 2006).
Richard M. Nault v. United States of America.
U.S. District Court, Dist. N.H.; Civ. 04-cv-479-PB, February 9, 2007.
[ Code Sec. 165]
Sham transactions: Economic substance. --
MEMORANDUM AND ORDER
BARBADORO, District Judge: Richard Nault brings this action against the United States to recover income tax refunds for several tax years. Nault's claims stem from investments he made in several agriculture-based limited partnerships (collectively the "AMCOR Partnerships"). In 2001, the tax court entered orders resolving a claim by the United States that the AMCOR Partnerships were sham transactions lacking economic substance. The parties agree that Nault's entitlement to the refunds he now seeks depends upon the meaning and legal effect of the tax court orders.
The matter is before me on cross motions for summary judgment.
I. BACKGROUND
This case falls within the purview of the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"). Accordingly, I begin by explaining TEFRA's legal framework. I then describe Nault's investments in the AMCOR Partnerships and the tax court litigation challenging the legitimacy of the partnerships' tax returns.
A. The TEFRA Framework 1
TEFRA establishes a "single unified procedure for determining the tax treatment of all partnership items at the partnership level, rather than separately at the partner level." Callaway [ 2000-2 USTC ¶50,744], 231 F.3d at 108. Whether an item is a partnership item or a nonpartnership item is the threshold inquiry under TEFRA. Id. Partnership items are "subject to TEFRA's centralized audit procedures," while "the treatment of nonpartnership items is determined at the level of the individual partner's return...." Id. Under TEFRA, taxpayers are not "permitted to raise nonpartnership items in the course of a partnership proceeding." Id. Correlatively, taxpayers cannot raise partnership items at partner level proceedings. Id.
TEFRA further mandates that a partner file "an income tax return that is consistent with the partnership return." Id. "The partner's distributive share of any partnership item must be reported in the same manner as on the partnership's information return ( i.e., it must have the same amount, the same characterization, the same timing)." Id. at 108-09 (citations omitted).
"The [Internal Revenue Service ("IRS")] may adjust partnership items only at the partnership level and only after following TEFRA procedures." Id. at 109. Specifically, "[t]o audit a partnership return, the IRS must send notice of the beginning of an administrative proceeding ('NBAP') to the partners entitled to notice (the 'notice partners')." 2 Id. "[A]ny partner has the right to participate in any administrative proceeding relating to the determination of partnership items at the partnership level." Id. (citing I.R.C. §6224(a)). "[I]f after completing its audit the IRS adjusts the partnership return, it must send the notice partners a notice of final partnership administrative adjustment ('FPAA')." Id. (citing I.R.C. §6223(a)(2), (d)(2)).
"Within 90 days of the date the IRS mails the FPAA notice, the partnership's 'tax matters partner' (TMP) 3 may contest the FPAA by filing a petition for readjustment in Tax Court, the Court of Federal Claims or the appropriate federal district court." Id. (citing I.R.C. §6226(a)). "If the TMP does not file a petition within this period, then any notice partner may file a petition for readjustment within the next 60 days. Id. (citing I.R.C. §6226(b)(1)). "Regardless whether the petition for judicial readjustment is filed by the TMP or by a notice partner, all other partners are treated as parties to the suit, provided that they have an ongoing interest in the outcome of the proceedings. Id. (citing I.R.C. §6226(c), (d)). "In this manner TEFRA allows all partners, if they choose, to litigate a dispute with the IRS in a single proceeding that binds all." Id.
"After the FPAA adjustments become final ( i.e., after they go unchallenged for 150 days or are judicially resolved in a section 6226 [tax court, district court, or Court of Federal Claims proceeding]), the IRS may assess partners with the tax which properly accounts for their distributive share of the adjusted partnership items, without notice, as a computational adjustment." Id. at 109-10 (citing I.R.C. §§6225(a), 6230(a) (1), 6231(a)(6)). "In certain cases, where no further factual determinations are necessary at the partner level, an assessment attributable to an 'affected item' may also be made by computational adjustment." Id. at 110. An "affected item" is "any item to the extent such item is affected by a partnership item. Id. In the event of an unfavorable court decision, the TMP, a notice partner, or a 5-percent group make seek appellate review in the appropriate forum. I.R.C. §6226(g).
B. Tax Treatment of Nault's Investments 4
Nault invested in the AMCOR Partnerships between 1984 and 1986. Each partnership reported significant losses in its first year of existence and comparatively smaller amounts of income in subsequent years. Nault took deductions based on his distributive share of partnership losses and paid taxes on his share of partnership income disbursements throughout the course of his investments. 5
In 1987, the IRS examined the AMCOR Partnerships' tax returns and issued FPAA notices disallowing deductions claimed by each partnership. In the FPAA notices, the IRS explained that the adjustments resulted from, inter alia, an IRS determination that the AMCOR Partnerships' activities constituted a series of sham transactions lacking economic substance.
Following the issuance of the FPAA notices, certain AMCOR partners --not including the TMP --filed Petitions for Readjustment of Partnership Items in the United States Tax Court pursuant to I.R.C. §6226. In July 1999, the TMP for each AMCOR Partnership intervened in each AMCOR tax court proceeding.
In 2001, after years of litigation, the IRS and the TMP entered into an agreement providing that the IRS would disallow approximately 72 percent of the AMCOR Partnerships' losses but allow the partnerships to retain all of their claimed Investment Tax Credits. The agreement also provided that the AMCOR partners would not file amended returns restating any reported income from the AMCOR Partnerships on which they had already paid income taxes.
The IRS ultimately filed Motions for Entry of Decision in the tax court, and the tax court entered decisions with respect to each AMCOR Partnership reflecting the terms of the settlement agreement. Each of the tax court decisions contained the following language:
ORDERED AND DECIDED:...[t]hat the foregoing adjustments to partnership income and expenses are attributable to transactions which lacked economic substance, as described in former I.R.C. §6621(c)(3)(A)(v), so as to result in a substantial distortion of income and expenses....
After the tax court litigation was resolved, the IRS issued adjustments to Nault's 1984, 1985, and 1986 income tax returns based on the disallowed deductions. Nault then paid the additional taxes resulting from the adjustments.
While the tax court litigation was ongoing, each of the AMCOR Partnerships terminated. Nault had no remaining basis in his partnership interests when the partnerships terminated apart from any "restored" basis he might be entitled to claim based upon the tax court's disallowance of his prior deductions.
In September 2002, Nault sought tax refunds by filing amended federal income tax returns for 1995, 1996, 1998, 1999, 2000, and 2001. In the amended returns, Nault claimed an ordinary loss deduction in the year each partnership terminated as well as carryover adjustments for other years affected by the termination year losses. Along with his refund claims, Nault attached statements explaining why he was entitled to the refunds. Specifically, Nault asserted that the Tax Court's 2001 disallowance of 72 percent of the AMCOR Partnership deductions --and derivatively, his share of the deductions --resulted in a restoration of his basis in those partnerships by corresponding amounts. As a result of this adjustment to his basis, he argued, he was entitled to loss deductions in the exact amount of his previously disallowed deductions because the partnerships became worthless upon termination.
On December 18, 2002, the IRS denied Nault's refund claims. Nault timely filed this action on December 17, 2004.
II. STANDARD OF REVIEW
Summary judgment is appropriate "if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." Fed. R. Civ. P. 56(c). "Cross-motions for summary judgment do not alter the basic Rule 56 standard, but rather simply require [the court] to determine whether either of the parties deserves judgment as a matter of law on facts that are not disputed." Adria Int'l Group, Inc. v. Ferre Dev., Inc., 241 F.3d 103, 107 (1st Cir. 2001) (citation omitted).
III. ANALYSIS
In claiming a loss deduction, Nault relies upon 26 U.S.C. §165(a), which permits individuals to take tax deductions for losses "not compensated for by insurance or otherwise." Another statutory provision --26 U.S.C. §165(c) --adds important limitations to such deductions. It provides:
In the case of an individual, the deduction under subsection (a) shall be limited to --
(1) losses incurred in a trade or business;
(2) losses incurred in any transaction entered into for profit, though not connected with a trade or business; and
(3) except as provided in subsection (h), losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft.
Nault does not allege that he was involved in a trade or business in connection with the AMCOR Partnerships. Nor does he allege that his losses arose from fire, storm, shipwreck, or other casualty. Thus, Nault's claimed loss deductions can only be grounded in §165(c)(2): "a loss incurred in a transaction entered into for profit."
A taxpayer is not entitled to loss deductions pursuant to §165(c)(2) if his claimed losses stem from transactions that lack economic substance. See Iles v. C.I.R [ 93-2 USTC ¶50,525], 982 F.2d 163, 165 (6th Cir. 1992). Moreover, "when a taxpayer claims a deduction, it is the taxpayer who bears the burden of proving that the transaction has economic substance." Coltec Industries, Inc. v. United States [ 2006-2 USTC ¶50,389], 454 F.3d 1340, 1355 (Fed. Cir. 2006). The government relies on these accepted principles in contending that Nault is not entitled to the deductions he seeks because, it argues, the tax court determined that the transactions on which Nault's deductions are based lacked economic substance.
Nault recognizes that he is not entitled to take deductions pursuant to §165(c)(2) unless he can establish that his claimed losses are attributable to transactions that had economic substance. He also agrees that the tax court orders are determinative on this issue. Thus, this case turns on how the tax court orders are construed.
The government offers a straightforward interpretation of the tax court orders. Its position is that the parties to the tax court proceeding settled their dispute by agreeing to the entry of court orders recognizing that the losses disallowed pursuant to the orders were "attributable to transactions which lacked economic substance." Because the orders clearly provide that the transactions on which Nault's claims are based lacked economic substance, the government argues, Nault cannot rely on the disallowed losses to "restore" his basis in his investments.
Nault focuses on the effect of the court orders rather than their specific terms in arguing that the tax court actually determined that the AMCOR Partnerships had economic substance. In making this argument, Nault relies primarily on the basic principle that "a transaction that lacks economic substance simply is not recognized for federal taxation purposes, for better or worse...." ACM P'ships v. Comm'r of Internal Revenue [ 98-2 USTC ¶50,790], 157 F.3d 231, 261 (3d Cir. 1998) (citation and internal quotation marks omitted). He then reasons that if the tax court acted consistently with this principle, it must have determined that the AMCOR Partnerships had economic substance because the court allowed partners to retain their Investment Tax Credits and a portion of their partnership's losses and because the settlement agreement that gave rise to the orders barred partners from filing amended returns restating any reported income generated by the partnerships.
I am not convinced that courts are required to apply the economic substance doctrine in quite so inflexible a manner as Nault suggests. However, I need not delve into this complex issue to resolve this case because Nault fails to appreciate the significance of the fact that the orders on which his claims depend were issued pursuant to a settlement. The government argued in the tax court proceeding that the AMCOR Partnerships were sham transactions that were completely lacking in economic substance. The TMP disagreed. After extensive litigation, the parties compromised their claims by settlement and, in so doing, they agreed to the precise language that was used in the court orders that resolved the parties' dispute. That language plainly provides that the disallowed losses on which Nault's current claims are based were attributable to transactions that lacked economic substance. It is unsurprising and ultimately insignificant for our purposes that the settlement also represented something less than a complete victory for either side. All that matters here is that the settlement resulted in the issuance of court orders that plainly resolved the issue that is now before the court.
Accordingly, I hold that the tax court decisions determined that the disallowed deductions were attributable to transactions that lacked economic substance. Those decisions are binding on Nault in this proceeding. Thus, Nault has no claim to loss deductions resulting from a restored basis because transactions lacking economic substance cannot give rise to losses under §165(c).
IV. CONCLUSION
For the reasons set forth herein, I grant the government's motion for summary judgment (Doc. No. 34) and deny Nault's crossmotion for summary judgment (Doc. No. 43). The clerk is instructed to enter judgment accordingly.
SO ORDERED.
1 In Callaway v. Comm'r, the Second Circuit provided a thorough and enlightening explanation of TEFRA. See [ 2000-2 USTC ¶50,744] 231 F.3d 106, 107-12 (2d Cir. 2000). I rely heavily on Callaway in explaining TEFRA's legal framework.
2 A notice partner is "a partner entitled to notice under section 6223(a)." Id. (citing I.R.C. §6231(a)(8)). "When a partnership has 100 or more partners, a notice partner is generally one who owns at least a one percent interest in the partnership." Id. (citing I.R.C. §6223(b)(1)). It is unclear from the record whether Nault was a notice partner in any of the AMCOR Partnerships.
3 The TMP is "the general partner designated in the partnership agreement to handle tax matters." Id. (citing I.R.C. §6231(a)(7)).
4 The facts in this section are drawn from the parties' Joint Statement of Background Facts and Background Discussion of Law Regarding Taxation of Partnership Interests (Doc. No. 31) and certain exhibits in the summary judgment record. The record is construed in the light most favorable to Nault.
5 Nault's reported income and loss amounts for the AMCOR Partnerships are represented in a chart appended to the parties' Joint Statement of Background Facts. A copy of the chart is included with this Memorandum and Order as Appendix A.
Richard M. Nault, Plaintiff, Appellant v. United States, Defendant, Appellee.
U.S. Court of Appeals, 1st Circuit; 07-1455, February 15, 2008.
Affirming a DC N.H. decision, 2007-1 USTC ¶50,326.
[ Code Sec. 165]
Loss deductions: Sham transactions: Economic substance. --
Before: Torruella and Lynch, Circuit Judges, and Stahl, Senior Circuit Judge.
STAHL, Senior Circuit Judge: Plaintiff-appellant Richard M. Nault appeals the district court's decision denying his motion for summary judgment and granting summary judgment in favor of the United States. Nault argues that the district court erred in its interpretation of several agreed judgments entered by the Tax Court ("the Tax Court decisions"), embodying the terms of a settlement between the Internal Revenue Service ("IRS") and Frederick H. Behrens, as Tax Matters Partner ("TMP"), regarding the proper tax treatment of several agriculture-related limited partnerships organized by American Agri-Corp., Inc. ("AMCOR") 1 a California corporation (collectively the "AMCOR Partnerships" or "Partnerships"). For the reasons discussed below, we affirm.
I.
Nault allegedly invested approximately $1,230,000.00 in five AMCOR Partnerships between 1984 and 1986. In 1987, the IRS began scrutinizing the AMCOR Partnerships' tax returns and issued Final Partnership Administrative Adjustment Notices disallowing certain deductions on the basis that the Partnerships' activities constituted a series of sham transactions lacking economic substance. After years of litigation, the IRS and the TMP reached a settlement in which 72% of the Partnerships' deductions were disallowed, the government agreed not to disallow investment tax credits claimed by the partners, and the partners agreed not to file amended returns modifying any reported income from the Partnerships on which the partners had paid income taxes. Upon motion of the IRS, the Tax Court entered decisions with respect to each Partnership reflecting the terms of the settlement agreement.
Based upon the Tax Court decisions, the IRS issued adjustments to Nault's 1984, 1985, and 1986 income tax returns, and Nault paid the additional taxes resulting from the adjustments. Each of the Partnerships terminated during the lengthy Tax Court litigation, leaving Nault without any remaining basis in his partnership interests. In September 2002, Nault filed amended income tax returns for 1995, 1996, 1998, 1999, 2000, and 2001, asserting that his basis in the Partnerships should be "restored" to a level inversely proportionate to the Tax Court decisions' disallowance of 72% of the Partnerships' loss deductions. Nault claimed that he was entitled to an ordinary loss deduction for the taxable basis that was "restored" to his then-worthless partnership interests.
On December 18, 2002, the IRS denied Nault's request for a refund. Nault filed a complaint in federal district court on December 17, 2004, seeking to recover his purported overpayment of income tax pursuant to 26 U.S.C. §7422 and 28 U.S.C. §1346(a)(1). On February 9, 2007, the district court ruled on the parties' cross motions for summary judgment, granting summary judgment in favor of the government and denying summary judgment to Nault. See Nault v. United States, Civil No. 04-cv-479, 2007 WL 465310 (D.N.H. Feb. 9, 2007). This appeal ensued.
II.
We review de novo a district court's grant of summary judgment based on contract interpretation. See John Hancock Life Ins. Co. v. Abbott Labs., 478 F.3d 1, 7 (1st Cir. 2006). Summary judgment is appropriate where the evidence shows that "there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law." Fed. R. Civ. P. 56(c).
The parties agree that tax deductions are not permitted for transactions that lack economic substance and that the inquiry at hand --whether the Partnerships or transactions relevant to this appeal lacked economic substance --is confined to interpretation of the Tax Court decisions implementing the settlement between the IRS and the TMP. Thus, a detailed recitation of the substantive law underlying the parties' dispute is unnecessary. See United States v. ITT Cont'l Baking Co., 420 U.S. 223, 233, 236-37 (1975) (explaining that settlements incorporated into judicial decisions are self-contained within their four corners and, consequently, are detached from the substantive law giving rise to the litigation).
In construing a settlement subsequently adopted by a court, we apply the same basic rules that govern the interpretation of ordinary contracts. See id. at 235-37; Rodi v. Ventetuolo, 941 F.2d 22, 28 (1st Cir. 1991); see also Smart v. Gillette Co. Long-Term Disability Plan, 70 F.3d 173, 178 (1st Cir. 1995) (explaining that federal common law requires us to be "guided by common-sense canons of contract interpretation" (citation omitted)). Interpretation of the terms of an unambiguous contract is a matter of law, subject to judicial resolution. See id. Quite simply, "[a]n unambiguous contract must be enforced according to its terms...." Senior v. NSTAR Elec. & Gas Corp., 449 F.3d 206, 219 (1st Cir. 2006). Moreover, terms within a contract are accorded their "plain, ordinary, and natural meaning." Filiatrault v. Comverse Tech., Inc., 275 F.3d 131, 135 (1st Cir. 2001).
A contract is ambiguous where the disputed terms are facially inconsistent or reasonably susceptible to multiple, plausible interpretations. See Smart, 70 F.3d at 178. If a contract is ambiguous, we will consider extrinsic evidence to give effect to the parties' intent in forming the contract. Id. "The question of whether a contract is ambiguous is generally a question of law for the judge...." Senior, 449 F.3d at 219.
Nault contends that the Tax Court decisions should not be interpreted to mean that the Partnerships or the underlying transactions lacked economic substance. In support, he asserts that the disputed language of the Tax Court decisions is ambiguous, that principles of construction favor his suggested interpretation, and that extrinsic evidence conclusively establishes that the parties intended to effectuate his interpretation. These arguments are not well-founded.
First, the plain language of the Tax Court decisions unambiguously favors the government's interpretation. Section II of each Tax Court decision states:
That the foregoing adjustments to partnership income and expense are attributable to transactions which lacked economic substance, as described in former I.R.C. §6621(c)(3)(A)(v), so as to result in a substantial distortion of income and expense, as described in I.R.C. §6621(c) (3)(A)(iv), when computed under the partnership's cash receipts and disbursements method of accounting; and
That liabilities [in varying amounts] lack economic substance.
The district court held that this language unmistakably signaled that the adjustments of the loss deductions were made because the underlying transactions lacked economic substance, thus preventing Nault from now claiming tax deductions. 2
To escape this seemingly inexorable conclusion, Nault asserts that the presence of the phrase "so as to result in a substantial distortion of income and expenses" generates ambiguity. He argues that this phrase indicates that the underlying transactions may not have entirely lacked in economic substance, but merely distorted the Partnerships' balance sheet. To buttress this conclusion, he points out that the very next sentence simply declares that "liabilities" in varying amounts lacked economic substance without any such qualifying language. Thus, Nault argues, the district court violated the time-honored maxim that variances in language should not be treated as superfluous.
Nault is mistaken. The reference to former 26 U.S.C. §6621(c)(v) (1988), which helps to define "tax motivated transactions," confirms that the transactions were "sham[s] or fraudulent transaction[s]," and therefore lacked economic substance. See, e.g., Durrett v. Comm'r, 71 F.3d 515, 517 (5th Cir. 1996). The phrase "so as to result in a substantial distortion of income and expense" simply tracks the language of the former 26 U.S.C. §6621(c)(3)(iv) (1988), which likewise helps to define "tax motivated transactions." Thus, each phrase independently establishes that the adjustments were attributable to the Partnerships' tax-motivated activities. Admittedly, Nault is correct that transactions that lack economic substance are treated differently from those that merely result in a substantial distortion of income. Compare Dewees v. Comm'r, 870 F.2d 21, 30-31 (1st Cir. 1989) (refusing to permit deductions for sham transactions), with Mantell v. Comm'r, 66 T.C.M. (CCH) 697, 1993 WL 347409, at *10 (T.C. Sept. 13, 1993) (approving adjustments based on accounting methods that created a substantial distortion of income).
Nevertheless, the plain language of the Tax Court decisions still firmly establishes that the underlying transactions lacked economic substance. 3 Here, the greater implies the lesser --because the underlying transactions lacked economic substance, they necessarily resulted in a substantial distortion of income. Thus, the government's interpretation --that "[t]he decisions . .. state that the transactions resulted in a substantial distortion of income and expense because they lacked economic substance" --is by far the most natural reading of the disputed language. At the very least, it is logically consistent; Nault's proposed construction eviscerates the entire sentence. Under Nault's interpretation, the "substantial distortion" language must be read to modify the "lacked economic substance" language. We decline the invitation to mangle the English language by adopting an approach that defies basic rules of syntax and diction; the Tax Court clearly stated that the lack of economic substance "result[ed] in" the distortion of income, not the other way around.
Nault seeks additional support from the fact that the distortion language was not used in the next paragraph, which concerned the Partnerships' liabilities. The most obvious explanation for why this language was not used in reference to the Partnerships' liabilities is simply that the first paragraph referred to the underlying transactions themselves, while the second paragraph referred to the liabilities claimed by the Partnerships. Naturally, the erroneous liabilities themselves did not "result in a substantial distortion of income or expense." They simply lacked economic substance. Moreover, we will not declare perfectly clear language ambiguous merely because the Tax Court did not reiterate it verbatim in the very next sentence in dealing with a related, but not identical, matter.
Next, Nault argues that because the settlement "did not treat the Partnerships as lacking economic substance," the Tax Court decisions are ambiguous. 4 Nault's contention is based on a fundamentally erroneous conception of the Tax Court decisions, which approved a settlement. See Miller Tabak Hirsch & Co. v. Comm'r, 101 F.3d 7, 10 (2d Cir. 1996) (explaining that in a judicially-approved settlement parties are "free to settle the case in any manner not violative of law or public policy, regardless of what the result might have been had the parties gone to trial"). Parties to a settlement, almost by definition, eschew the possibility of obtaining some portion of what they would like in exchange for certain terms with which they can live. See Rodi, 941 F.2d at 27 (stating that a settlement "`normally embodies a compromise,' within the limits of which the litigants...must be prepared to live" (quoting United States v. Armour & Co., 402 U.S. 673, 681 (1971))). The fact that the IRS chose to settle rather than risk the hazards of litigation is no more a concession that the transactions at hand possessed economic substance than a defendant's decision to settle a dubious lawsuit for pennies on the dollar is a concession that the suit had merit. Indeed, there is little doubt that parties occasionally settle claims simply to avoid the hassle, uncertainty, and expense of litigation even where a favorable outcome seems all but certain.
Here, it was perfectly permissible for the IRS to insist upon language that declared the transactions to lack economic substance --perhaps anticipating claims plaintiffs such as Nault might make --while simultaneously making certain concessions to the taxpayers. It was incumbent upon the TMP to dispute any language that he did not wish included in the Tax Court decisions. See Rodi, 941 F.2d at 27 (admonishing that litigants must abide by terms of a settlement even where they prove more onerous than originally anticipated). In the end, therefore, Nault remains confined to the language agreed to in the settlement. See In re New Seabury Co. Ltd. P'ship, 450 F.3d 24, 31, 39 (1st Cir. 2006) (rejecting the district court's "functional analysis" of the parties' stipulation in favor of the bankruptcy court's analysis of its plain language).
Finally, Nault argues that, even if the plain language of the Tax Court decisions is unambiguous, the district court nevertheless erred by failing to consider extrinsic evidence. First, it is elementary that we do not ordinarily examine extrinsic evidence to alter or clarify the terms of an otherwise unambiguous contract. See Smart, 70 F.3d at 179. Nevertheless, "in the exceptional case, a latent ambiguity in seemingly clear contract language may require us to consider extrinsic evidence to determine the actual object of the parties' agreement." Coffin v. Bowater Inc., 501 F.3d 80, 97 (1st Cir. 2007).
This is not such a case. Nault's proposed interpretation of the Tax Court decisions is not merely strained, but flatly contradictory to the plain meaning of its terms. In essence, he "argue[s] that the [disputed] language does not mean what it says."Id. at 98. If the language of the Tax Court decisions does not comport with what the parties intended, then the TMP should have insisted upon different language.
Finally, we note that Nault dramatically overstates the persuasive force of the extrinsic evidence that he has proffered. It is by no means so conclusive as he suggests. 5 He directs our attention to a written summary regarding the settlement, prepared by the IRS, stating, inter alia, that each partner "may have a capital gain or loss upon his termination from the partnership" (emphasis added). This summary, however, was nonbinding, the specific section in question was designated as informational, the clause was permissive, and the provision referred only to the partner's capital contribution. Nault also points to a letter he received from the IRS indicating that the Service had made "[a] determination...that allow[ed] for capital treatment of these losses." This statement is certainly peculiar --and inconsistent with the IRS's current position. This letter, however, cannot serve as a definitive guide for our interpretation of Tax Court decisions executed more than a year previously. Additionally, the court notes that the same letter notified Nault of the IRS's rejection of his claims for a deduction for an ordinary loss related to his "restored" basis in the Partnerships.
In summary, Nault's arguments obfuscate what is, in reality, a very simple case. The plain language of the Tax Court decisions indicates that the disallowed loss deductions were based on transactions that lacked economic substance. We have no jurisdiction to determine whether the relevant transactions actually did have economic substance --the sole matter within our purview is determining what the Tax Court meant by its decisions. The Tax Court's determination, that the transactions lacked economic substance, is unambiguous.
III.
The judgment of the district court is affirmed.
1 For a partial history of AMCOR and the related litigation, see Crop Assocs.-1986 v. Comm'r, 80 T.C.M. (CCH) 56, 2000 WL 976792, at *1-7 (T.C. July 17, 2000).
2 Nault argues that the government has waived the position that the underlying transactions lacked economic substance, in favor of the position that the Partnerships themselves lacked economic substance. This contention is irrelevant. The district court unequivocally held that "the disallowed deductions were attributable to transactions that lacked economic substance." Nault, 2007 WL 465310, at *5 (emphasis added). We are not limited in our review by the fact that the district court rendered its decision on grounds that the government may or may not have urged below. Nault's position, if accepted, would confine the lower court to choosing between the rationales submitted by the parties. This is not the law. See Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 99 (1991) (holding that a "court is not limited to the particular legal theories advanced by the parties").
3 Albeit in dicta, the Court of Federal Claims has reached a similar conclusion about these decisions. See Keener v. United States, 76 Fed. Cl. 455, 457 & n.2 (Fed. Cl. 2007) (stating that the Tax Court found "the various partnership transactions to be sham transactions"); see also Howell v. Comm'r, 94 T.C.M. (CCH) 104, 2007 WL 2126593, at *1 (T.C. July 25, 2007) (stating that the IRS and TMP "stipulated that the partnerships entered into transactions that lacked economic substance and created substantial distortions of partnership income") (emphasis added).
4 Nault cites the Eleventh Circuit's decision in Fickling v. United States, 507 F.3d 1302 (11th Cir. 2007), as authority for this proposition. Nault, however, ignores a crucial factual distinction between the two cases. There is no indication that the disputed settlement discussed in Fickling contained any language labeling the transaction in question as lacking economic substance. Indeed, the Eleventh Circuit characterized the settlement in question as "noncommittal" concerning whether the underlying transaction was a sham. Id. at 1305.
5 In addition to noting the limited probative value of Nault's extrinsic evidence, we observe that the government likewise adduced extrinsic evidence --an affidavit from Margaret K. Hebert, an IRS attorney responsible for the AMCOR litigation --to buttress its own position. We need not discuss this evidence further, however, because it is unnecessary to our conclusion.
Transactions Entered Into for Profit: Economic substance
Despite the fact that the venture was rather risky and that tax savings were a critical element in investing in the venture, limited partners in a partnership formed to exploit a synthetic fuel process were able to claim their share of partnership losses. There was a business purpose behind the venture, investors had a reasonable possibility of realizing profit, and the venture "had practicable income effects other than the creation of tax losses."
D.B. Smith, CA-6, 91-2 USTC ¶50,326.
To the contrary.
A partnership that was to develop the market for a new way of harnessing energy was a sham devised to bring tax benefits to its investors, and deductions for a partner's share of partnership losses were denied.
J. Karr, CA-11, 91-1 USTC ¶50,113, 924 F2d 1018.
A partnership allegedly created to pursue production of an alternative energy source was not entitled to deductions for licensing fees and research and development fees. The partnership's activity lacked economic substance because of the amount and structure of the fees paid, the inexperience of the promoters, conflicts of interest among the promoters and the heavy emphasis placed on the tax benefits that would be gained by the partners.
Peat Oil and Gas Assoc., 100 TC 271, Dec. 48,944. Aff'd, sub nom. R. Ferguson, CA-2, 94-2 USTC ¶50,357.
Summary judgment against an investor was reversed because a material issue of fact existed concerning the economic substance of investment trades.
C.P. Brown, CA-7, 92-2 USTC ¶50,564, 976 F2d 1104.
Loss deductions claimed by investors in a corporation involved in the cattle business were disallowed. Regardless of whether the taxpayers had a profit motive, their expenditures to enter and stay in the cattle program, as well as their additional costs for the purchase of embryos and calves, were nondeductible because the program lacked economic substance. Even assuming that the investment constituted a bona fide business transaction, no showing was made that an investment loss or a theft loss was sustained during the tax years at issue.
R.E. Daoust, 67 TCM 2914, Dec. 49,832(M), TC Memo. 1994-203.
An individual was denied loss deductions relating to an alleged diamond mining venture because he did not own any rights in the venture.
G.M. Osserman, 71 TCM 2892, Dec. 51,319(M), TC Memo. 1996-205.
Investors in a limited partnership involved in oil and gas recovery were denied a loss deduction for their cash investment because the entity's activities and transactions lacked economic substance. They had agreed to be bound by the ruling in G.E. Krause, Dec. 48,383, affirmed sub nom. R.A. Hildebrand, CA-10, 94-2 USTC ¶50,305, a test case involving identical partnership transactions. Pursuant to that decision, loss deductions were disallowed because the entity did not engage in for-profit business transactions. Although the investors conceded that no profit objective existed at the partnership level, they contended that the profit-objective test should be measured only at the individual partner level. However, because the partnership's transactions lacked economic substance, their loss deduction was disallowed despite their individual profit objective in making the investment.
M.L. Marinovich, 77 TCM 2075, Dec. 53,399(M), TC Memo. 1999-179.
As to deductions claimed with respect to transactions lacking economic substance and a profit motive, see ¶12,177.59.
Corporations that acquired two debt instruments structured so that the value of one was expected to increase significantly at the same time that the value of the other one decreased significantly, could not recognize a current loss on the sale of the debt instrument that that decreased in value while not recognizing the gain on the other debt instrument.
Rev. Rul. 2000-12, 2000-1 CB 734.
The profit objectives of individuals who invested in enhanced oil recovery limited partnerships had to be measured at the partnership level because the parties' stipulation that the activities of the partnerships were not entered into with a profit objective did not affect the status of the partnerships for federal tax purposes. The finding that the partnerships' activities lacked profit motives was not tantamount to a holding that the investors intended to create entities other than partnerships. Rather, the partnerships entered into transactions, formed joint ventures, operated gas wells, and conducted themselves as partnerships.
A.C. Copeland, CA-5, 2002-1 USTC ¶50,420, 290 F3d 326.
A corporation's transfer of interests in multilayered leases of computer equipment and related trusts lacked economic substance and expense deductions claimed in relation to the transaction were denied. The transaction was solely motivated by tax considerations. There was no real obligation on behalf of the taxpayer or profit potential in connection with the transaction and the taxpayer's expert testimony as to the credibility of the transaction was inaccurate and unconvincing.
Nicole Rose Corp., 117 TC 328, Dec. 54,578.
Losses generated by claiming an inflated basis as the result of a transfer of assets in which the taxpayer becomes joint and severally liable for the transferor's indebtedness on the assets in excess of the fair market value of the assets lack economic substance. Although the basis of an asset is its fair market value or cost, including the amount of the transferor's liability assumed by the taxpayer-transferee, the inclusion of such liabilities into the basis of the asset is predicated on the assumption that the liabilities will be paid in full by the transferee.
Notice 2002-21, 2002-1 CB 730.
An equipment lease-financing company did not have a legitimate nontax business purpose for engaging in a lease-stripping transaction in which it claimed large rental expense deductions in exchange for an investment of less than one percent of the anticipated deductions. The taxpayer did not have a business reason for the transaction apart from tax consequences and there was no possibility of economic profit from the transaction. Deductions and losses claimed in connection with the transaction were disallowed.
CMA Consolidated, Inc., 89 TCM 701, Dec. 55,917(M), TC Memo. 2005-16.
An investor in several limited partnerships was not entitled to claim loss deductions because the disallowed deductions on which his claim was based lacked economic substance. The Tax Court's orders were binding on the individual because the government and the partnership's tax matters partners (TMP) compromised their claims by settlement and, in so doing, agreed to the precise language used in the court orders. Although the Tax Court disallowed a portion of the partnership deductions and allowed partners to retain their investment tax credits, the individual could not rely on the disallowed losses to restore his basis in his investments.
R.M. Nault, DC N.H., 2007-1 USTC ¶50,326.
Tuesday, February 26, 2008
Section 7122 - Offer in Compromise and Bankruptcy
In a collection review proceeding, a taxpayer may raise challenges to the existence or amount of the underlying 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 the underlying liability. Sec. 6330(c)(2)(B). Where a taxpayer has filed a bankruptcy action, and the Commissioner has submitted a proof of claim for unpaid Federal tax liabilities in a taxpayer's bankruptcy action, we have held that the taxpayer has had the opportunity to dispute the liabilities for purposes of section 6330(c)(2)(B). See Kendricks v. Commissioner, 124 T.C. 69 (2005); Sabath v. Commissioner, T.C. Memo. 2005-222. A bankruptcy court may consider the amount or legality of taxes, including penalties and interest. 11 U.S.C. sec. 505(a) (2000)
Claude E. and Dana L. Salazar v. Commissioner.
Dkt. Nos. 2203-05L ; 23547-06L , TC Memo. 2008-38, February 25, 2008.
[Code Sec. 7122]
The IRS's rejection of married taxpayers' two offers-in-compromise with respect to both income and employment taxes was not an abuse of discretion. The taxpayers had already filed for bankruptcy when they submitted their first offer-in-compromise (OIC), and the Appeals officer rejected the offer after determining that it was less than what the IRS expected to receive from the bankruptcy distribution and because accepting that offer would risk, if not extinguish, all claims the IRS had to the bankruptcy estate's assets. The IRS also did not abuse its discretion when rejecting the taxpayers' second OIC with respect to the husband's employment tax liabilities because the taxpayers' financial situation had improved by the time the second OIC was submitted and the IRS determined that the taxpayers could pay such liabilities in their entirety. In addition, the taxpayers did not present any argument or evidence to suggest that the rejection of the second OIC was an abuse of discretion.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: These consolidated cases arise from petitions for judicial review of two notices of determination concerning collection action(s) under section 6320 and/or 6330.1 In response to a notice of intent to levy issued by respondent with respect to outstanding income tax liabilities, petitioners Claude and Dana Salazar (Mr. and Mrs. Salazar) submitted an offer-incompromise for all of their outstanding tax liabilities, which also included employment tax liabilities of Mr. Salazar. Petitioners also sought abatement of penalties for the period their bankruptcy petition was pending. After Mr. Salazar individually received a notice of intent to levy with respect to his employment tax liabilities, Mr. Salazar submitted a second offer-in-compromise and again challenged the assessment of penalties and interest during the pendency of petitioners' bankruptcy petition. Respondent issued separate notices of determination rejecting both offers-in-compromise and sustaining the proposed collection actions.
We have jurisdiction to review respondent's collection determination relating to the employment tax liabilities as well as the income tax liabilities under amended section 6330(d)(1) because respondent made his determination more than 60 days after August 17, 2006. See Callahan v. Commissioner, 130 T.C. __ (2008). Respondent has now admitted to assessing a penalty erroneously for petitioners' 1997 income tax year while their bankruptcy petition was pending and has agreed to correct this error. Because we find respondent did not abuse his discretion in rejecting petitioners' offers-in-compromise, and because we find that respondent did not otherwise erroneously assess penalties and interest, we sustain respondent's determinations.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of facts and related exhibits are incorporated herein by this reference. At the time the petitions were filed, petitioners, husband and wife, resided in New York.
Previously, petitioners were residents of Nevada, where they owned and operated a retail art gallery named Artistic Nature. While operated by both petitioners, the gallery was organized as a sole proprietorship in the name of Mr. Salazar. The operation, and ultimately the failure, of Artistic Nature has led to the current proceedings. Respondent seeks collection of petitioners' outstanding Federal income taxes, penalties, and interest for taxable years 1997, 1998, and 1999. Respondent also seeks to collect the outstanding employment tax liabilities of Mr. Salazar related to Artistic Nature from 1998 through 2001.
On January 23, 2001, when Artistic Nature was failing, petitioners filed for chapter 13 bankruptcy protection in the U.S. Bankruptcy Court for the District of Nevada. Petitioners captioned their bankruptcy petition as "Claude E. Salazar dba Artistic Nature and Dana Salazar dba Artistic Nature." The petition was later converted to a chapter 7 proceeding.
On February 1, 2001, respondent filed a proof of claim with the bankruptcy court, which respondent later amended. On respondent's last amendment to the proof of claim, filed on September 27, 2003, respondent listed a secured claim of $19,915.40, an unsecured priority claim of $43,673.45, and an unsecured general claim of $8,850.74. The secured claim related to a lien respondent had previously filed with respect to petitioners' 1997 and 1998 income tax liabilities, and it included penalties and interest. The unsecured priority claim also included interest. Petitioners, while represented by counsel, did not file an objection to respondent's claims. On July 25, 2002, petitioners received a discharge of debtor from all dischargeable debts. On August 22, 2005, the bankruptcy trustee disbursed $17,834.51 to respondent. The bankruptcy case was closed on March 30, 2006.
During the 2000, 2001, and 2002 tax years, petitioners allowed withholdings from income to exceed their income tax liabilities, which created overpayments totaling $15,814.91. On October 2, 2003, respondent applied these overpayments to petitioners' 1997 income tax liabilities. On October 6, 2003, respondent assessed $3,192.34 in interest and an additional $1,216.52 failure to file penalty for petitioners' taxable period ending December 31, 1997.
After petitioners received the discharge of debtor, respondent initiated collection on petitioners' liabilities. On October 27, 2003, respondent sent petitioners a separate letter for each of the outstanding liabilities stating that he intended to seek collection by levy. Respondent's notification of intent to levy indicated the following liabilities, including penalties and interest:
Tax From Form Period Ending Unpaid Balance
1040 12/31/1997 $437.21
1040 12/31/1998 5,923.33
1040 12/31/1999 6,923.71
941 12/31/1998 3,970.30
941 3/31/1998 6,248.92
941 6/30/1999 5,658.56
941 9/30/1999 7,000.45
941 12/31/1999 6,122.27
941 3/31/2000 5,006.08
941 6/30/2000 5,626.37
941 9/30/2000 6,575.15
941 12/31/2000 5,855.57
941 3/31/2001 5,118.99
941 6/30/2001 2,210.01
On or about December 6, 2003, respondent issued a final notice of intent to levy related to the income tax liabilities for 1997, 1998, and 1999. Respondent's notice of intent to levy did not include Mr. Salazar's employment tax liabilities. On December 16, 2003, petitioners submitted a Form 12153, Request for a Collection Due Process Hearing. Notwithstanding the fact the final notice of intent to levy pertained only to petitioners' income tax liabilities, petitioners indicated they were seeking collection review with respect to both their income and employment tax liabilities. Petitioners stated: "We declared Chapter 7 bankruptcy in January 2001. Discharge was July 2001 [sic] --there were assets --the bankruptcy is still open pending filing of final accounting report by the trustee. Calls to IRS and IRS bankruptcy Department have gone unanswered." Despite the request for a collection review hearing, respondent issued the levy. Upon realizing that he should have suspended the proposed levy action until after the hearing and any appeals, respondent released the levy. See sec. 6330(e)(1); Grover v. Commissioner, T.C. Memo. 2007-176.
Petitioners' file was forwarded to Appeals Settlement Officer Bruce Conte. On May 14, 2004, Mr. Conte contacted petitioners to schedule a conference. At the same time, Mr. Conte contacted respondent's internal bankruptcy specialists. Mr. Conte received a fax from a specialist outlining petitioners' bankruptcy file and noting that "secured claims get paid first and then priority." Mr. Conte noted in his case record that there were also outstanding employment tax liabilities for petitioners and that final collection notices had not yet been issued with respect to those liabilities.
On or about May 24, 2004, petitioners submitted a completed Form 656, Offer in Compromise, to respondent seeking to resolve their outstanding employment and income tax liabilities for $9,024.25, to be paid within 90 days from notice of acceptance of the offer. Upon receipt of the offer-in-compromise, Mr. Conte contacted petitioners to seek additional financial information. Over the course of several months, Mr. Conte and petitioners corresponded on multiple occasions with respect to additional documents Mr. Conte needed in evaluating petitioners' offer-in-compromise. In one letter to Mr. Conte dated August 13, 2004, petitioners requested that "given that the Bankruptcy Court has failed to render a final accounting to date, the penalties attributable to the principal balance outstanding should be waived."
While he was attempting to obtain additional information about petitioners' economic situation, Mr. Conte was also attempting to determine what amount would be paid to respondent from petitioners' bankruptcy estate. Mr. Conte contacted respondent's internal bankruptcy specialists on numerous occasions. Following one such contact, Mr. Conte received an e-mail informing him that "Mr. Salazar owes: IMF $13,977.92 and BMF $62,786.01 for a total of $76,763.93. The amount that will come to IRS from the trustee's office * * * [$25,000 less trustee expenses] will not full-pay the account (less than 1/3 of balance due). Collection will not be withheld."2
According to his case record, Mr. Conte was concerned that accepting an offer-in-compromise while awaiting a final distribution from the bankruptcy might jeopardize respondent's claims to that distribution. Mr. Conte performed research, including reviewing the Internal Revenue Manual (IRM), to assist with his consideration of petitioners' offer-in-compromise. Mr. Conte noted the IRM's caution on accepting an offer-in-compromise while awaiting a distribution of assets from a bankruptcy. Mr. Conte also sought and received legal advice on the effect an offer-in-compromise would have on the pending bankruptcy distribution. Counsel from within the Internal Revenue Service (IRS) advised Mr. Conte that acceptance of the offer-in-compromise risked respondent's claim to the distribution and that the offer-in-compromise should be increased by the amount respondent expected to receive from the bankruptcy.
After receiving counsel's advice, on November 8, 2004, Mr. Conte sent petitioners a letter informing them that --
I have received guidance from our Counsel regarding the acceptance of an Offer in Compromise in an instance where the distribution of the assets of the bankruptcy has not been completed. This, as you may recall, was the primary issue surrounding your * * * request for an offer.
It is Counsel's opinion, as it is mine, that if the Service were to accept an offer in this instance, the Service would at that point no longer have a claim to any distribution of the bankruptcy proceeds.
It is also our opinion that the only way that an offer could be accepted under these circumstances, is for the Service to attempt to determine how much of the distribution we would be entitled to and add that to the amount of the offer.
Mr. Conte went on to reason that respondent would likely receive approximately $20,000 from the pending distribution. Accordingly, Mr. Conte informed petitioners that their offer-in-compromise would have to be increased by $20,000 before it could be accepted.
By letter dated November 22, 2004, petitioners responded that they could not pay the estimated $20,000 to respondent that was pending distribution without first receiving the distribution. As an alternative, petitioners offered to relinquish any rights they might have to the distribution for the benefit of respondent. Mr. Conte determined that this offer-in-compromise still risked respondent's forthcoming distribution and thus could not be accepted before receipt of the distribution from the bankruptcy estate. As part of his analysis in his closing memorandum, Mr. Conte noted that if the offer-in-compromise were accepted, any funds remaining after the bankruptcy trustee discharged petitioners' debts would go to other creditors or to petitioners. Mr. Conte concluded: "Based upon informal advice from Counsel and the taxpayer's response, it is Appeals' decision to reject the offer-in-compromise of $9,024.25 as insufficient due to the fact that a larger amount appears to be collectible."
On January 4, 2005, respondent's Appeals Office issued a Notice of Determination Concerning Collection Action(s) Under Section 6320 and/or 6330 sustaining the proposed levy action with respect to petitioners' 1997, 1998, and 1999 income tax liabilities. In a separate letter addressed only to Mr. Salazar, Mr. Conte indicated that the offer-in-compromise had also been rejected with respect to his outstanding employment tax liabilities.
On February 3, 2005, petitioners filed a petition with this Court seeking review of respondent's determination under docket No. 2203-05L. Petitioners allege that respondent's rejection of their offer to compromise both their outstanding income tax liabilities and Mr. Salazar's employment tax liabilities was an abuse of discretion. Petitioners' petition for docket No. 2203-05L did not seek to challenge the underlying income tax liabilities that respondent was seeking to collect.
Respondent moved to dismiss for lack of jurisdiction as to Mr. Salazar's employment tax liabilities on the grounds that respondent had never issued a notice of determination concerning a collection action under section 6330 with respect to the employment tax liabilities. In a Salazar v. Commissioner, T.C. Memo. 2006-7, filed January 18, 2006, we found that no notice of determination for purposes of section 6330 had been issued with respect to petitioners' employment tax liabilities and granted respondent's motion to dismiss for lack of jurisdiction with respect to Mr. Salazar's employment tax liabilities.3
In the interim, on June 20, 2005, the bankruptcy trustee submitted to the bankruptcy court a Trustee's Final Report and Application for Compensation and Reimbursement (the final report). In the final report, payment on respondent's secured claim of $19,915.40 was not allowed. Instead, payment on respondent's priority claim of $43,673.45 was allowed. On August 22, 2005, the bankruptcy trustee disbursed $17,834.51 to respondent.
On August 25, 2005, respondent applied the proceeds of the bankruptcy distribution to Mr. Salazar's outstanding employment tax liabilities for the taxable periods ending December 31, 1998, March 31, 1999, and June 30, 1999. However, the amounts that respondent applied to these taxable periods exceeded the priority claims for those periods. On April 24, 2007, respondent adjusted the application of the bankruptcy proceeds to also include partial payments for the taxable periods ending September 30, 1999, as well as December 31, 1999.
As of June 30, 2005, Mr. Salazar still had unpaid employment tax liabilities that included:
Period Ending Unpaid Balance
12/31/98 $2,636.81
3/31/99 5,281.02
6/30/99 4,067.44
9/30/99 5,904.60
12/31/99 5,158.55
3/31/00 4,219.10
6/30/00 4,729.82
9/30/00 5,522.11
12/31/00 4,670.33
3/31/01 4,097.97
6/30/01 1,752.20
On February 22, 2006, respondent issued a Final Notice of Intent to Levy and Notice of Your Right to a Hearing with respect to Mr. Salazar's employment tax liabilities.4 In response, Mr. Salazar submitted a second Form 12153 with respect to the proposed collection action on the employment tax liabilities. The new request for collection review was assigned to Appeals Settlement Officer Thomas Conley. In his initial correspondence with Mr. Conley, Mr. Salazar indicated that he did not intend to submit a new offer-in-compromise but instead sought reconsideration of petitioners' original offer-in-compromise of $9,024.25. Mr. Salazar also attempted to challenge the assessment of penalties and interest during the pendency of petitioners' bankruptcy as well as the manner in which respondent applied the bankruptcy proceeds.
On May 17, 2006, petitioners had an in-person hearing with Mr. Conley. On June 20, 2006, Mr. Salazar submitted a new offer-in-compromise. The basis of the new offer-in-compromise was again doubt as to collectibility, and the new offer included updated financial information. Mr. Salazar offered to compromise petitioners' then-outstanding income and employment tax liabilities for $19,547.13. By this time, Mrs. Salazar was working as an attorney and Mr. Salazar as a manager of a restaurant. Mr. Salazar had also begun collecting monthly Social Security benefits. Mr. Conley determined that petitioners' reasonable collection potential exceeded the outstanding liabilities and thus rejected the offer-in-compromise. Mr. Conley's determination did not, however, address Mr. Salazar's claims that respondent was seeking to collect penalties and interest assessed for the period while petitioners' bankruptcy petition was pending.
On October 18, 2006, respondent issued a Notice of Determination and Collection Action Under Section 6320 and/or 6330 to Mr. Salazar regarding his employment tax liabilities. Mr. Salazar then filed a second petition to this Court claiming error in respondent's determination to proceed with collection in the case at docket No. 23547-06L. The second petition does not allege any error with respect to respondent's rejection of Mr. Salazar's second offer-in-compromise. Instead, Mr. Salazar again alleges that respondent abused his discretion in failing to revisit and accept petitioners' original 2004 offer-in-compromise. Mr. Salazar also alleges error by respondent in not abating the penalties and interest assessed for the period while petitioners' bankruptcy petition was pending. Finally, Mr. Salazar alleges that it was an error for respondent to apply the bankruptcy proceeds to his individual employment tax liabilities instead of petitioners' joint income tax liabilities. The two petitions have been consolidated for trial, briefing, and opinion.
OPINION
I. Introduction
While this matter has developed in a manner that has made it more complicated than necessary, in the end it is a collection review case in which petitioners principally sought to resolve their outstanding income and employment tax liabilities through an offer-in-compromise. Petitioners offered to settle all of their outstanding liabilities, including the income tax liabilities and the employment tax liabilities, for $9,024.25. Respondent rejected the offer-in-compromise because he was likely to receive more from the petitioners' pending bankruptcy. Petitioners want the Court to determine that respondent's rejection was an abuse of discretion and that respondent be compelled to accept the offer-in-compromise with respect to both the income taxes and the employment taxes. We find that respondent did not abuse his discretion.
Section 6330 provides that no levy may be made on any property or right to property of a person unless the Secretary first notifies him in writing of the right to a hearing before the Appeals Office. At the hearing, the taxpayer may raise any relevant issues relating to the unpaid tax or the proposed levy, including appropriate spousal defenses, challenges to the appropriateness of collection actions, and collection alternatives. Sec. 6330(c)(2)(A). A taxpayer may contest the existence or amount of the underlying tax liability if the taxpayer failed to receive a notice of deficiency for the tax liability in question or did not otherwise have an earlier opportunity to dispute the tax liability. Sec. 6330(c)(2)(B); see also Sego v. Commissioner, 114 T.C. 604, 609 (2000).
Following a hearing, the Appeals Office must make a determination whether the Secretary may proceed with the proposed collection action. We have jurisdiction to review the Appeals officer's determination. Sec. 6330(d)(1). Where the underlying tax liability is properly at issue, we review that determination de novo. Goza v. Commissioner, 114 T.C. 176, 181-182 (2000). Where the underlying tax liability is not at issue, we review the determination for an abuse of discretion. Id. at 182.
II. Offers-in-Compromise
Petitioners first seek to compel respondent's acceptance of their offer-in-compromise. Petitioners suggest that the failure to accept their original offer-in-compromise was an abuse of discretion.
We do not conduct an independent review of what would be an acceptable offer-in-compromise. Murphy v. Commissioner, 125 T.C. 301, 320 (2005), affd. 469 F.3d 27 (1st Cir. 2006); Fowler v. Commissioner, T.C. Memo. 2004-163. The extent of our review is to determine whether the Appeals officer's decision to reject the taxpayer's offer-in-compromise was arbitrary, capricious, or without sound basis in fact or law. Skrizowski v. Commissioner, T.C. Memo. 2004-229; Fowler v. Commissioner, supra.
Section 7122(a) authorizes the Commissioner to compromise any civil or criminal case arising under the internal revenue laws. See Fargo v. Commissioner, 447 F.3d 706, 712 (9th Cir. 2006) (noting that the authorization to compromise any civil or criminal case is discretionary), affg. T.C. Memo. 2004-13. Section 7122(c) provides that the Commissioner shall prescribe guidelines for evaluation of whether an offer-in-compromise should be accepted. See sec. 301.7122-1(c)(1), Proced. & Admin. Regs.
The section 7122 regulations set forth grounds for the compromise of a taxpayer's liability, including doubt as to collectibility. Sec. 301.7122-1(b), Proced. & Admin. Regs. Doubt as to collectibility exists in any case where the taxpayer's assets and income are less than the full amount of the liability. Sec. 301.7122-1(b)(2), Proced. & Admin. Regs. Generally, under the Commissioner's administrative pronouncements, an offer to compromise based on doubt as to collectibility will be acceptable only if it reflects the reasonable collection potential of the case; i.e., that amount, less than the full liability, that the IRS could collect through means such as administrative and judicial collection remedies. Rev. Proc. 2003-71, sec. 4.02(2), 2003-2 C.B. 517, 517. The offer-in-compromise must include all unpaid tax liabilities and periods for which the taxpayer is liable. 1 Administration, IRM (CCH), pt. 5.8.17, at 16,256.
If an offer-in-compromise is submitted where a taxpayer has also filed a bankruptcy petition, the Commissioner cautions against acceptance of the offer-in-compromise in the window between a taxpayer's discharge in bankruptcy and the time the final distribution is made because "it is uncertain whether the Service would still have a valid claim in bankruptcy if an offer is accepted." 1 Administration, IRM (CCH), pt. 5.8.10.2.3(2), at 16,368. Thus, the Internal Revenue Manual guidelines advise that "the amount acceptable for an offer should include the amount we reasonably expect to recover from the bankruptcy in addition to what can be collected from the taxpayer on non-discharged liabilities or from property outside the bankruptcy." Id.
It is clear from the administrative record that Mr. Conte was concerned that accepting petitioners' $9,024.25 offer-in-compromise would risk respondent's expected distribution from the bankruptcy. Mr. Conte had extended contact with respondent's bankruptcy specialists. He also performed his own research, including reviewing the IRM guidelines. Mr. Conte sought to determine the likely amount respondent would receive from the bankruptcy and the effect accepting a compromise would have on respondent's distribution. Ultimately, Mr. Conte concluded that respondent was likely to receive approximately $20,000 of the $25,000 remaining in the bankruptcy. Further, as advised by counsel, Mr. Conte concluded that accepting the offer-in-compromise risked respondent's claims in the bankruptcy estate. Thus, in accordance with the IRM and advice from counsel, Mr. Conte determined that petitioners' offer-in-compromise was inadequate because it was less than what respondent expected to receive from the bankruptcy trustee and because accepting that offer would place that distribution at risk.
Petitioners argue that respondent's rejection of the offer-in-compromise was based on an erroneous conclusion of law that the bankruptcy distribution was at risk. Petitioners argue that respondent's distribution from the bankruptcy was never at risk. If respondent's determination was based upon an erroneous conclusion of law, we must reject that view and find that respondent abused his discretion. See Swanson v. Commissioner, 121 T.C. 111, 119 (2003).
As respondent's counsel now explains, an offer-in-compromise must include all of the outstanding liabilities of the taxpayer. Further, section 6325(a) provides that the Commissioner "shall issue a certificate of release of any lien imposed with respect to any internal revenue tax" not later than 30 days after the liability for the amount has been fully satisfied. Thus respondent argues, if respondent were to accept an offer-in-compromise and the liabilities were thereby fully satisfied, he would jeopardize any secured claim to the bankruptcy distribution. Accordingly, as respondent's counsel argues, an offer-in-compromise will not be accepted while a bankruptcy is pending if the offer is less than the amount he reasonably stands to receive when the bankruptcy distribution occurs.
We believe, however, that respondent's risk, or at least his perceived risk, goes beyond simply the release of any secured claim he has to the bankruptcy distribution. If an offer-in-compromise must include all of the outstanding liabilities of the taxpayer, then acceptance and satisfaction of the offer would risk, if not extinguish, all claims the Commissioner had to the bankruptcy assets. The administrative record suggests it was this more generalized risk, to all of respondent's claims, that concerned Mr. Conte in evaluating petitioners' offer-incompromise. Nonetheless, petitioners fail to point to any authority to suggest that respondent's position that accepting an offer-in-compromise jeopardized the bankruptcy distribution was without legal basis, and the Court knows of none.
In furtherance of their argument that the bankruptcy distribution was not at risk, petitioners highlight their offer to relinquish any claim to the bankruptcy distribution for the benefit of respondent. While this offer would have reduced the risk that petitioners would receive a windfall from the bankruptcy by virtue of the offer-in-compromise, it did nothing to reduce respondent's risk with respect to other creditors. As Mr. Conte explained in his closing memorandum: if the offer-incompromise were accepted, any remaining funds in the bankruptcy "would go to other creditors or to the taxpayer." Petitioners again fail to present any authority to suggest that their other creditors would be precluded from objecting to any distribution to respondent after the acceptance of their offer-in-compromise.
Petitioners make two additional arguments on why respondent's determination was an abuse of discretion. First, petitioners suggest that respondent was announcing a bright-line rule and did not exercise discretion at all. Second, petitioners argue that respondent abused his discretion because he rejected the offer-in-compromise solely on the basis of the amount offered in contravention of section 7122(d)(3). We address each in turn.
Petitioners first take issue with Mr. Conte's requirement that their offer-in-compromise be increased by the amount of the expected distribution from the bankruptcy. The IRM guidelines instruct that an acceptable offer-in-compromise would have to include the amount that respondent expected to receive from the bankruptcy in addition to what respondent could collect from petitioners directly. Petitioners argue that by relying upon this provision of the IRM, the Appeals officer was not exercising discretion at all but instead enunciating a bright-line rule for all postdischarge bankruptcy cases where the Commissioner is waiting for a distribution. See Estate of Roski v. Commissioner, 128 T.C. 113 (2007) (holding that by requiring all estates to post a bond to make a section 6166 election regardless of the facts before him, the Commissioner was adopting a bright-line policy that trumped the exercise of his discretion).
Mr. Conte's use of the IRM was not, however, a de facto enunciation of a bright-line rule that trumped the exercise of discretion. In evaluating an offer-in-compromise under doubt as to collectibility, the Commissioner must first determine the reasonable collection potential on the amount owed. Rev. Proc. 2003-71, sec. 4.02(2). In the ordinary circumstance, the Commissioner calculates the reasonable collection potential by determining the excess of a taxpayer's assets and future income above certain allowances for basic living expenses. See Klein v. Commissioner, T.C. Memo. 2007-325. The guidelines aid the Commissioner in this endeavor. Id.; see also, e.g., McDonough v. Commissioner, T.C. Memo. 2006-234; Etkin v. Commissioner, T.C. Memo. 2005-245; Schulman v. Commissioner, T.C. Memo. 2002-129. A pending bankruptcy petition changes this collection analysis because the taxpayer has surrendered his assets to the bankruptcy court. Thus, where a taxpayer has filed for bankruptcy, the Commissioner stands to collect as a creditor in the bankruptcy proceeding in addition to possibly collecting from the taxpayer directly from future income and assets not subject to the bankruptcy.
Thus, at first, the IRM instructs a settlement officer to consider the Commissioner's standing as a creditor in the bankruptcy and advises that an acceptable offer-in-compromise include the amount the Commissioner reasonably expects to recover from the bankruptcy. 1 Administration, IRM (CCH), pt. 5.8.10.2.3(2). In other words, the Appeals officer should not accept an offer of $5 when doing so will risk the likely receipt of $10 down the road. Second, the IRM instructs that an acceptable offer-in-compromise should also include the amount that "can be collected from the taxpayer on non-discharged liabilities or from property outside the bankruptcy." Id. Thus, if the Commissioner stands to receive $10 as a creditor in the bankruptcy and, in addition, $5 can be collected directly from the taxpayer, then the reasonable collection potential is not $5 or even $10, but more like $15.
Mr. Conte did not have to reach the second part of this analysis --the amount respondent could collect from petitioners outside of the bankruptcy. The $9,024.25 offer-in-compromise from petitioners was less than the $20,000 Mr. Conte expected respondent would receive from the bankruptcy, and he determined that acceptance of the offer would risk the receipt of that $20,000. We find that Mr. Conte was not enunciating a bright-line rule for all cases. Mr. Conte was simply applying respondent's guidelines on evaluating offers-in-compromise, including the reasonable collection potential, to the specifics of petitioners' offer.
Finally, petitioners argue that respondent abused his discretion by rejecting petitioners' offer-in-compromise solely on the basis of the amount offered. Section 7122(d)(3)(A) provides: "an officer or employee of the Internal Revenue Service shall not reject an offer-in-compromise from a low-income taxpayer solely on the basis of the amount of the offer". The regulations expand on this by stating that "No offer to compromise may be rejected solely on the basis of the amount of the offer without evaluating that offer under the provisions of this section and the Secretary's policies and procedures regarding the compromise of cases." Sec. 301.7122-1(f)(3), Proced. & Admin. Regs.
The administrative record makes clear that Mr. Conte did not reject petitioners' offer-in-compromise solely on the basis of the amount offered, $9,024.25. Mr. Conte used respondent's policies and procedures --the guidelines of the IRM as well as advice received from counsel --to evaluate the specifics of petitioners' offer in the light of what respondent could reasonably expect to collect on petitioners' liabilities. Mr. Conte concluded that respondent was likely to receive more in the distribution from the bankruptcy than from petitioners' offer-incompromise. Further, Mr. Conte determined that accepting petitioners' offer would risk this expected greater distribution. We find petitioners' offer-in-compromise was not rejected solely on the basis of the amount offered.
We are not unsympathetic to petitioners' situation as they ultimately had no control over when any distribution from the bankruptcy would be made. Since then, petitioners' financial outlook has improved dramatically. Mr. Salazar is now employed as a manager of a restaurant and has begun receiving Social Security benefits. Mrs. Salazar completed law school and now works as an attorney. Thus, while the $9,024.25 offer-in-compromise may have been the limit of what petitioners could pay in 2004, when Mr. Salazar submitted a second offer-in-compromise during the second collection review hearing with respect to his employment tax liabilities, respondent determined that Mr. Salazar was then in a position to pay the entirety of his outstanding employment tax liabilities. Petitioners have not presented any argument or evidence to the Court to suggest that respondent's rejection of this second offer-in-compromise was an abuse of discretion.
In sum, we find that respondent did not abuse his discretion in rejecting petitioners' offers-in-compromise.
III. Underlying Liability
To the extent the Court does not compel respondent to accept their original offer-in-compromise, petitioners argue in the alternative that respondent's assessment of penalties and interest while their bankruptcy petition was pending was erroneous. Petitioners also argue that respondent erroneously applied the bankruptcy proceeds to the individual employment tax liabilities of Claude Salazar instead of their joint income tax liabilities.
In a collection review proceeding, a taxpayer may raise challenges to the existence or amount of the underlying 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 the underlying liability. Sec. 6330(c)(2)(B). Where a taxpayer has filed a bankruptcy action, and the Commissioner has submitted a proof of claim for unpaid Federal tax liabilities in a taxpayer's bankruptcy action, we have held that the taxpayer has had the opportunity to dispute the liabilities for purposes of section 6330(c)(2)(B). See Kendricks v. Commissioner, 124 T.C. 69 (2005); Sabath v. Commissioner, T.C. Memo. 2005-222. A bankruptcy court may consider the amount or legality of taxes, including penalties and interest. 11 U.S.C. sec. 505(a) (2000); Sabath v. Commissioner, supra.
In petitioners' bankruptcy proceeding, respondent submitted a proof of claim for petitioners' unpaid income tax and employment tax liabilities, including penalties and interest. Petitioners, while represented by counsel, did not file an objection to these tax liabilities. Accordingly, petitioners are precluded from challenging their underlying liabilities, including the penalties and interest. However, even if petitioners had raised the issue of whether respondent's assessment of penalties and interest during their bankruptcy proceeding was erroneous, to the extent that respondent has not conceded this issue, we would sustain his assessment of penalties and interest.
Section 6658(a) provides that "No addition to the tax shall be made under section 6651, 6654, or 6655 for failure to make timely payment of tax with respect to a period during which a case is pending under title 11 of the United States Code". Petitioners' bankruptcy was pending from the date they filed their petition until their case was closed on March 30, 2006. See Rev. Rul. 2005-9, 2005-1 C.B. 470.
Respondent admits having erroneously assessed a failure to pay penalty with respect to petitioners' 1997 income tax account on October 23, 2003, while petitioners' bankruptcy was pending. Respondent has agreed to correct this error. Petitioners did not present any evidence that respondent assessed penalties for their 1998 and 1999 income tax liabilities while their bankruptcy petition was pending. Further, a review of petitioners' income tax account transcripts for 1998 and 1999 confirms that respondent did not assess any additional penalty during the pendency of their bankruptcy.
With respect to the employment tax liabilities for Mr. Salazar under docket No. 23547-06L, petitioners again argue that additions to tax were sought for the period their bankruptcy was pending. However, section 6658 does not prevent respondent from assessing the additions to tax during the pendency of the bankruptcy related to employment taxes to the extent that they are withheld or collected from others. Sec. 6658(b); Kiesner v. IRS, 194 Bankr. 452, 458 (Bankr. E.D. Wis. 1996); see also S. Rept. 96-1035, at 51 (1980), 1980-2 C.B. 620, 646 ("These relief rules do not, however, apply with respect to liability for penalties for failure to timely pay or deposit any employment tax required to be withheld by the debtor or trustee."). Accordingly, we find no basis to suggest that the employment tax liabilities respondent seeks to collect include any erroneously assessed additions to tax.
Petitioners also argue for abatement of interest on both their income tax and employment tax liabilities. The Commissioner is not prevented from seeking interest for the period a taxpayer's bankruptcy proceeding is pending. Sec. 6658(a); see also, e.g., Woodward v. United States, 113 Bankr. 680, 684 (Bankr. D. Or. 1990). Under section 6404(a), the Commissioner is granted the discretion to abate the assessment of any tax or liability that is excessive in amount, assessed after the expiration of the period of limitation, or erroneously assessed. But see sec. 6404(b) ("No claim for abatement shall be filed by a taxpayer in respect of an assessment of any tax imposed under subtitle A or B."). Section 6404(e) authorizes the Commissioner to abate interest assessments that are attributable to errors or delays by the IRS.
Petitioners do not argue that the interest is excessive or was erroneously assessed under section 6404(a). Instead, petitioners argue for abatement of interest because of the delay in the distribution of funds from the bankruptcy. While in certain circumstances interest may be abated because of an unreasonable delay of the Commissioner, respondent was no more in control over the distribution of the bankruptcy proceeds than were petitioners. We find that the delay in the distribution of proceeds by the bankruptcy trustee is not grounds for the abatement of interest under section 6404 or for otherwise relieving petitioners from liability for the interest.
Finally, under docket No. 23547-06L,5 petitioners challenge respondent's application of the bankruptcy proceeds to the employment tax liabilities of Mr. Salazar instead of the joint tax liabilities of both petitioners. Because the distribution occurred after the bankruptcy proceeding was closed, and Mr. Salazar raised it during the hearing, we may review this issue.
At the time of the bankruptcy trustee's final report, respondent possessed: (1) A secured claim of $19,915.40 for petitioners' 1997 and 1998 tax liabilities; (2) an unsecured priority claim of $43,673.45 for petitioners' 1999 income tax liabilities and Mr. Salazar's 1998, 1999, 2000, and 2001 employment tax liabilities; and (3) an unsecured general claim of $8,850.74. However, only payment on respondent's $43,673.45 priority claim was allowed by the bankruptcy trustee.
Respondent applied the $17,834.51 that was ultimately disbursed by the bankruptcy trustee on August 22, 2005, to the employment tax liabilities of Mr. Salazar that made up part of respondent's priority claim. At first respondent applied the disbursement to the employment tax periods ending December 31, 1998, March 31, 1999, and June 30, 1999, in amounts that exceeded respondent's priority claims for those periods. Eventually, respondent corrected this application of the proceeds to also include partial payments on the priority claims for the periods ending September 30, 1999, and December 31, 1999.
Petitioners claim that respondent should have applied the disbursement to petitioners' joint income tax liabilities first instead of just Mr. Salazar's employment tax liabilities. Where a taxpayer makes voluntary payments to the IRS, he does have the right to direct the application of payments to whatever type of liability he chooses. See, e.g., Estate of Wilson v. Commissioner, T.C. Memo. 1999-221. However, where a taxpayer makes an involuntary payment, the IRS may allocate or reallocate the payment as it sees fit, regardless of a taxpayer's designation. As we have stated: "An involuntary payment of Federal taxes means any payment received by agents of the United States as a result of distraint or levy or from a legal proceeding in which the Government is seeking to collect its delinquent taxes or file a claim therefor." Amos v. Commissioner, 47 T.C. 65, 69 (1966); see also United States v. Pepperman, 976 F.2d 123, 127 (3d Cir. 1992) (noting that most courts to have considered the issue have concluded that payments made in the bankruptcy context are involuntary). In the light of the involuntary nature of the bankruptcy distribution, we find no error in respondent's application of the proceeds to the employment tax liabilities of Mr. Salazar before the joint income tax liabilities of both petitioners. In any event, there is no evidence that petitioners specified in writing that the proceeds be applied to their income tax liability instead.
On the basis of the record before the Court, and with the exception of the failure to pay penalty for income tax year 1997 which respondent concedes, petitioners are liable for the taxes, additions to tax, and interest as determined by respondent. We further find that respondent did not abuse his discretion in rejecting petitioners' offers-in-compromise. Thus, respondent's determination that the Federal tax levies were appropriate in these cases is sustained.
To reflect the foregoing,
Decision in docket No. 2203-05L will be entered under Rule 155.
Decision in docket No. 23547-06L will be entered for respondent.
1 Unless otherwise indicated, all section references are to the Internal Revenue Code, as amended, and all Rule references are to the Tax Court Rules of Practice and Procedure.
2 "IMF" refers to respondent's Individual Master File for petitioners' income tax liabilities. "BMF" refers to respondent's Business Master File for Mr. Salazar's employment tax liabilities.
3 Respondent also moved to dismiss on the grounds that the Court lacked jurisdiction to hear any challenge to Mr. Salazar's employment tax liabilities. However, because respondent issued a notice of determination with respect to Mr. Salazar's employment tax liabilities on Oct. 18, 2006, respondent admits that we now have jurisdiction to review his determination under sec. 6330(d)(1). See Callahan v. Commissioner, 130 T.C. __ (2008).
4 Respondent's notice of intent to levy did not include the periods ending Dec. 31, 1998, or Mar. 31, 1999.
5 The trustee had not filed his final report nor had any disbursements been made at the time of petitioners' collection review hearing with respect to their joint liabilities.
In a collection review proceeding, a taxpayer may raise challenges to the existence or amount of the underlying 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 the underlying liability. Sec. 6330(c)(2)(B). Where a taxpayer has filed a bankruptcy action, and the Commissioner has submitted a proof of claim for unpaid Federal tax liabilities in a taxpayer's bankruptcy action, we have held that the taxpayer has had the opportunity to dispute the liabilities for purposes of section 6330(c)(2)(B). See Kendricks v. Commissioner, 124 T.C. 69 (2005); Sabath v. Commissioner, T.C. Memo. 2005-222. A bankruptcy court may consider the amount or legality of taxes, including penalties and interest. 11 U.S.C. sec. 505(a) (2000)
Claude E. and Dana L. Salazar v. Commissioner.
Dkt. Nos. 2203-05L ; 23547-06L , TC Memo. 2008-38, February 25, 2008.
[Code Sec. 7122]
The IRS's rejection of married taxpayers' two offers-in-compromise with respect to both income and employment taxes was not an abuse of discretion. The taxpayers had already filed for bankruptcy when they submitted their first offer-in-compromise (OIC), and the Appeals officer rejected the offer after determining that it was less than what the IRS expected to receive from the bankruptcy distribution and because accepting that offer would risk, if not extinguish, all claims the IRS had to the bankruptcy estate's assets. The IRS also did not abuse its discretion when rejecting the taxpayers' second OIC with respect to the husband's employment tax liabilities because the taxpayers' financial situation had improved by the time the second OIC was submitted and the IRS determined that the taxpayers could pay such liabilities in their entirety. In addition, the taxpayers did not present any argument or evidence to suggest that the rejection of the second OIC was an abuse of discretion.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: These consolidated cases arise from petitions for judicial review of two notices of determination concerning collection action(s) under section 6320 and/or 6330.1 In response to a notice of intent to levy issued by respondent with respect to outstanding income tax liabilities, petitioners Claude and Dana Salazar (Mr. and Mrs. Salazar) submitted an offer-incompromise for all of their outstanding tax liabilities, which also included employment tax liabilities of Mr. Salazar. Petitioners also sought abatement of penalties for the period their bankruptcy petition was pending. After Mr. Salazar individually received a notice of intent to levy with respect to his employment tax liabilities, Mr. Salazar submitted a second offer-in-compromise and again challenged the assessment of penalties and interest during the pendency of petitioners' bankruptcy petition. Respondent issued separate notices of determination rejecting both offers-in-compromise and sustaining the proposed collection actions.
We have jurisdiction to review respondent's collection determination relating to the employment tax liabilities as well as the income tax liabilities under amended section 6330(d)(1) because respondent made his determination more than 60 days after August 17, 2006. See Callahan v. Commissioner, 130 T.C. __ (2008). Respondent has now admitted to assessing a penalty erroneously for petitioners' 1997 income tax year while their bankruptcy petition was pending and has agreed to correct this error. Because we find respondent did not abuse his discretion in rejecting petitioners' offers-in-compromise, and because we find that respondent did not otherwise erroneously assess penalties and interest, we sustain respondent's determinations.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of facts and related exhibits are incorporated herein by this reference. At the time the petitions were filed, petitioners, husband and wife, resided in New York.
Previously, petitioners were residents of Nevada, where they owned and operated a retail art gallery named Artistic Nature. While operated by both petitioners, the gallery was organized as a sole proprietorship in the name of Mr. Salazar. The operation, and ultimately the failure, of Artistic Nature has led to the current proceedings. Respondent seeks collection of petitioners' outstanding Federal income taxes, penalties, and interest for taxable years 1997, 1998, and 1999. Respondent also seeks to collect the outstanding employment tax liabilities of Mr. Salazar related to Artistic Nature from 1998 through 2001.
On January 23, 2001, when Artistic Nature was failing, petitioners filed for chapter 13 bankruptcy protection in the U.S. Bankruptcy Court for the District of Nevada. Petitioners captioned their bankruptcy petition as "Claude E. Salazar dba Artistic Nature and Dana Salazar dba Artistic Nature." The petition was later converted to a chapter 7 proceeding.
On February 1, 2001, respondent filed a proof of claim with the bankruptcy court, which respondent later amended. On respondent's last amendment to the proof of claim, filed on September 27, 2003, respondent listed a secured claim of $19,915.40, an unsecured priority claim of $43,673.45, and an unsecured general claim of $8,850.74. The secured claim related to a lien respondent had previously filed with respect to petitioners' 1997 and 1998 income tax liabilities, and it included penalties and interest. The unsecured priority claim also included interest. Petitioners, while represented by counsel, did not file an objection to respondent's claims. On July 25, 2002, petitioners received a discharge of debtor from all dischargeable debts. On August 22, 2005, the bankruptcy trustee disbursed $17,834.51 to respondent. The bankruptcy case was closed on March 30, 2006.
During the 2000, 2001, and 2002 tax years, petitioners allowed withholdings from income to exceed their income tax liabilities, which created overpayments totaling $15,814.91. On October 2, 2003, respondent applied these overpayments to petitioners' 1997 income tax liabilities. On October 6, 2003, respondent assessed $3,192.34 in interest and an additional $1,216.52 failure to file penalty for petitioners' taxable period ending December 31, 1997.
After petitioners received the discharge of debtor, respondent initiated collection on petitioners' liabilities. On October 27, 2003, respondent sent petitioners a separate letter for each of the outstanding liabilities stating that he intended to seek collection by levy. Respondent's notification of intent to levy indicated the following liabilities, including penalties and interest:
Tax From Form Period Ending Unpaid Balance
1040 12/31/1997 $437.21
1040 12/31/1998 5,923.33
1040 12/31/1999 6,923.71
941 12/31/1998 3,970.30
941 3/31/1998 6,248.92
941 6/30/1999 5,658.56
941 9/30/1999 7,000.45
941 12/31/1999 6,122.27
941 3/31/2000 5,006.08
941 6/30/2000 5,626.37
941 9/30/2000 6,575.15
941 12/31/2000 5,855.57
941 3/31/2001 5,118.99
941 6/30/2001 2,210.01
On or about December 6, 2003, respondent issued a final notice of intent to levy related to the income tax liabilities for 1997, 1998, and 1999. Respondent's notice of intent to levy did not include Mr. Salazar's employment tax liabilities. On December 16, 2003, petitioners submitted a Form 12153, Request for a Collection Due Process Hearing. Notwithstanding the fact the final notice of intent to levy pertained only to petitioners' income tax liabilities, petitioners indicated they were seeking collection review with respect to both their income and employment tax liabilities. Petitioners stated: "We declared Chapter 7 bankruptcy in January 2001. Discharge was July 2001 [sic] --there were assets --the bankruptcy is still open pending filing of final accounting report by the trustee. Calls to IRS and IRS bankruptcy Department have gone unanswered." Despite the request for a collection review hearing, respondent issued the levy. Upon realizing that he should have suspended the proposed levy action until after the hearing and any appeals, respondent released the levy. See sec. 6330(e)(1); Grover v. Commissioner, T.C. Memo. 2007-176.
Petitioners' file was forwarded to Appeals Settlement Officer Bruce Conte. On May 14, 2004, Mr. Conte contacted petitioners to schedule a conference. At the same time, Mr. Conte contacted respondent's internal bankruptcy specialists. Mr. Conte received a fax from a specialist outlining petitioners' bankruptcy file and noting that "secured claims get paid first and then priority." Mr. Conte noted in his case record that there were also outstanding employment tax liabilities for petitioners and that final collection notices had not yet been issued with respect to those liabilities.
On or about May 24, 2004, petitioners submitted a completed Form 656, Offer in Compromise, to respondent seeking to resolve their outstanding employment and income tax liabilities for $9,024.25, to be paid within 90 days from notice of acceptance of the offer. Upon receipt of the offer-in-compromise, Mr. Conte contacted petitioners to seek additional financial information. Over the course of several months, Mr. Conte and petitioners corresponded on multiple occasions with respect to additional documents Mr. Conte needed in evaluating petitioners' offer-in-compromise. In one letter to Mr. Conte dated August 13, 2004, petitioners requested that "given that the Bankruptcy Court has failed to render a final accounting to date, the penalties attributable to the principal balance outstanding should be waived."
While he was attempting to obtain additional information about petitioners' economic situation, Mr. Conte was also attempting to determine what amount would be paid to respondent from petitioners' bankruptcy estate. Mr. Conte contacted respondent's internal bankruptcy specialists on numerous occasions. Following one such contact, Mr. Conte received an e-mail informing him that "Mr. Salazar owes: IMF $13,977.92 and BMF $62,786.01 for a total of $76,763.93. The amount that will come to IRS from the trustee's office * * * [$25,000 less trustee expenses] will not full-pay the account (less than 1/3 of balance due). Collection will not be withheld."2
According to his case record, Mr. Conte was concerned that accepting an offer-in-compromise while awaiting a final distribution from the bankruptcy might jeopardize respondent's claims to that distribution. Mr. Conte performed research, including reviewing the Internal Revenue Manual (IRM), to assist with his consideration of petitioners' offer-in-compromise. Mr. Conte noted the IRM's caution on accepting an offer-in-compromise while awaiting a distribution of assets from a bankruptcy. Mr. Conte also sought and received legal advice on the effect an offer-in-compromise would have on the pending bankruptcy distribution. Counsel from within the Internal Revenue Service (IRS) advised Mr. Conte that acceptance of the offer-in-compromise risked respondent's claim to the distribution and that the offer-in-compromise should be increased by the amount respondent expected to receive from the bankruptcy.
After receiving counsel's advice, on November 8, 2004, Mr. Conte sent petitioners a letter informing them that --
I have received guidance from our Counsel regarding the acceptance of an Offer in Compromise in an instance where the distribution of the assets of the bankruptcy has not been completed. This, as you may recall, was the primary issue surrounding your * * * request for an offer.
It is Counsel's opinion, as it is mine, that if the Service were to accept an offer in this instance, the Service would at that point no longer have a claim to any distribution of the bankruptcy proceeds.
It is also our opinion that the only way that an offer could be accepted under these circumstances, is for the Service to attempt to determine how much of the distribution we would be entitled to and add that to the amount of the offer.
Mr. Conte went on to reason that respondent would likely receive approximately $20,000 from the pending distribution. Accordingly, Mr. Conte informed petitioners that their offer-in-compromise would have to be increased by $20,000 before it could be accepted.
By letter dated November 22, 2004, petitioners responded that they could not pay the estimated $20,000 to respondent that was pending distribution without first receiving the distribution. As an alternative, petitioners offered to relinquish any rights they might have to the distribution for the benefit of respondent. Mr. Conte determined that this offer-in-compromise still risked respondent's forthcoming distribution and thus could not be accepted before receipt of the distribution from the bankruptcy estate. As part of his analysis in his closing memorandum, Mr. Conte noted that if the offer-in-compromise were accepted, any funds remaining after the bankruptcy trustee discharged petitioners' debts would go to other creditors or to petitioners. Mr. Conte concluded: "Based upon informal advice from Counsel and the taxpayer's response, it is Appeals' decision to reject the offer-in-compromise of $9,024.25 as insufficient due to the fact that a larger amount appears to be collectible."
On January 4, 2005, respondent's Appeals Office issued a Notice of Determination Concerning Collection Action(s) Under Section 6320 and/or 6330 sustaining the proposed levy action with respect to petitioners' 1997, 1998, and 1999 income tax liabilities. In a separate letter addressed only to Mr. Salazar, Mr. Conte indicated that the offer-in-compromise had also been rejected with respect to his outstanding employment tax liabilities.
On February 3, 2005, petitioners filed a petition with this Court seeking review of respondent's determination under docket No. 2203-05L. Petitioners allege that respondent's rejection of their offer to compromise both their outstanding income tax liabilities and Mr. Salazar's employment tax liabilities was an abuse of discretion. Petitioners' petition for docket No. 2203-05L did not seek to challenge the underlying income tax liabilities that respondent was seeking to collect.
Respondent moved to dismiss for lack of jurisdiction as to Mr. Salazar's employment tax liabilities on the grounds that respondent had never issued a notice of determination concerning a collection action under section 6330 with respect to the employment tax liabilities. In a Salazar v. Commissioner, T.C. Memo. 2006-7, filed January 18, 2006, we found that no notice of determination for purposes of section 6330 had been issued with respect to petitioners' employment tax liabilities and granted respondent's motion to dismiss for lack of jurisdiction with respect to Mr. Salazar's employment tax liabilities.3
In the interim, on June 20, 2005, the bankruptcy trustee submitted to the bankruptcy court a Trustee's Final Report and Application for Compensation and Reimbursement (the final report). In the final report, payment on respondent's secured claim of $19,915.40 was not allowed. Instead, payment on respondent's priority claim of $43,673.45 was allowed. On August 22, 2005, the bankruptcy trustee disbursed $17,834.51 to respondent.
On August 25, 2005, respondent applied the proceeds of the bankruptcy distribution to Mr. Salazar's outstanding employment tax liabilities for the taxable periods ending December 31, 1998, March 31, 1999, and June 30, 1999. However, the amounts that respondent applied to these taxable periods exceeded the priority claims for those periods. On April 24, 2007, respondent adjusted the application of the bankruptcy proceeds to also include partial payments for the taxable periods ending September 30, 1999, as well as December 31, 1999.
As of June 30, 2005, Mr. Salazar still had unpaid employment tax liabilities that included:
Period Ending Unpaid Balance
12/31/98 $2,636.81
3/31/99 5,281.02
6/30/99 4,067.44
9/30/99 5,904.60
12/31/99 5,158.55
3/31/00 4,219.10
6/30/00 4,729.82
9/30/00 5,522.11
12/31/00 4,670.33
3/31/01 4,097.97
6/30/01 1,752.20
On February 22, 2006, respondent issued a Final Notice of Intent to Levy and Notice of Your Right to a Hearing with respect to Mr. Salazar's employment tax liabilities.4 In response, Mr. Salazar submitted a second Form 12153 with respect to the proposed collection action on the employment tax liabilities. The new request for collection review was assigned to Appeals Settlement Officer Thomas Conley. In his initial correspondence with Mr. Conley, Mr. Salazar indicated that he did not intend to submit a new offer-in-compromise but instead sought reconsideration of petitioners' original offer-in-compromise of $9,024.25. Mr. Salazar also attempted to challenge the assessment of penalties and interest during the pendency of petitioners' bankruptcy as well as the manner in which respondent applied the bankruptcy proceeds.
On May 17, 2006, petitioners had an in-person hearing with Mr. Conley. On June 20, 2006, Mr. Salazar submitted a new offer-in-compromise. The basis of the new offer-in-compromise was again doubt as to collectibility, and the new offer included updated financial information. Mr. Salazar offered to compromise petitioners' then-outstanding income and employment tax liabilities for $19,547.13. By this time, Mrs. Salazar was working as an attorney and Mr. Salazar as a manager of a restaurant. Mr. Salazar had also begun collecting monthly Social Security benefits. Mr. Conley determined that petitioners' reasonable collection potential exceeded the outstanding liabilities and thus rejected the offer-in-compromise. Mr. Conley's determination did not, however, address Mr. Salazar's claims that respondent was seeking to collect penalties and interest assessed for the period while petitioners' bankruptcy petition was pending.
On October 18, 2006, respondent issued a Notice of Determination and Collection Action Under Section 6320 and/or 6330 to Mr. Salazar regarding his employment tax liabilities. Mr. Salazar then filed a second petition to this Court claiming error in respondent's determination to proceed with collection in the case at docket No. 23547-06L. The second petition does not allege any error with respect to respondent's rejection of Mr. Salazar's second offer-in-compromise. Instead, Mr. Salazar again alleges that respondent abused his discretion in failing to revisit and accept petitioners' original 2004 offer-in-compromise. Mr. Salazar also alleges error by respondent in not abating the penalties and interest assessed for the period while petitioners' bankruptcy petition was pending. Finally, Mr. Salazar alleges that it was an error for respondent to apply the bankruptcy proceeds to his individual employment tax liabilities instead of petitioners' joint income tax liabilities. The two petitions have been consolidated for trial, briefing, and opinion.
OPINION
I. Introduction
While this matter has developed in a manner that has made it more complicated than necessary, in the end it is a collection review case in which petitioners principally sought to resolve their outstanding income and employment tax liabilities through an offer-in-compromise. Petitioners offered to settle all of their outstanding liabilities, including the income tax liabilities and the employment tax liabilities, for $9,024.25. Respondent rejected the offer-in-compromise because he was likely to receive more from the petitioners' pending bankruptcy. Petitioners want the Court to determine that respondent's rejection was an abuse of discretion and that respondent be compelled to accept the offer-in-compromise with respect to both the income taxes and the employment taxes. We find that respondent did not abuse his discretion.
Section 6330 provides that no levy may be made on any property or right to property of a person unless the Secretary first notifies him in writing of the right to a hearing before the Appeals Office. At the hearing, the taxpayer may raise any relevant issues relating to the unpaid tax or the proposed levy, including appropriate spousal defenses, challenges to the appropriateness of collection actions, and collection alternatives. Sec. 6330(c)(2)(A). A taxpayer may contest the existence or amount of the underlying tax liability if the taxpayer failed to receive a notice of deficiency for the tax liability in question or did not otherwise have an earlier opportunity to dispute the tax liability. Sec. 6330(c)(2)(B); see also Sego v. Commissioner, 114 T.C. 604, 609 (2000).
Following a hearing, the Appeals Office must make a determination whether the Secretary may proceed with the proposed collection action. We have jurisdiction to review the Appeals officer's determination. Sec. 6330(d)(1). Where the underlying tax liability is properly at issue, we review that determination de novo. Goza v. Commissioner, 114 T.C. 176, 181-182 (2000). Where the underlying tax liability is not at issue, we review the determination for an abuse of discretion. Id. at 182.
II. Offers-in-Compromise
Petitioners first seek to compel respondent's acceptance of their offer-in-compromise. Petitioners suggest that the failure to accept their original offer-in-compromise was an abuse of discretion.
We do not conduct an independent review of what would be an acceptable offer-in-compromise. Murphy v. Commissioner, 125 T.C. 301, 320 (2005), affd. 469 F.3d 27 (1st Cir. 2006); Fowler v. Commissioner, T.C. Memo. 2004-163. The extent of our review is to determine whether the Appeals officer's decision to reject the taxpayer's offer-in-compromise was arbitrary, capricious, or without sound basis in fact or law. Skrizowski v. Commissioner, T.C. Memo. 2004-229; Fowler v. Commissioner, supra.
Section 7122(a) authorizes the Commissioner to compromise any civil or criminal case arising under the internal revenue laws. See Fargo v. Commissioner, 447 F.3d 706, 712 (9th Cir. 2006) (noting that the authorization to compromise any civil or criminal case is discretionary), affg. T.C. Memo. 2004-13. Section 7122(c) provides that the Commissioner shall prescribe guidelines for evaluation of whether an offer-in-compromise should be accepted. See sec. 301.7122-1(c)(1), Proced. & Admin. Regs.
The section 7122 regulations set forth grounds for the compromise of a taxpayer's liability, including doubt as to collectibility. Sec. 301.7122-1(b), Proced. & Admin. Regs. Doubt as to collectibility exists in any case where the taxpayer's assets and income are less than the full amount of the liability. Sec. 301.7122-1(b)(2), Proced. & Admin. Regs. Generally, under the Commissioner's administrative pronouncements, an offer to compromise based on doubt as to collectibility will be acceptable only if it reflects the reasonable collection potential of the case; i.e., that amount, less than the full liability, that the IRS could collect through means such as administrative and judicial collection remedies. Rev. Proc. 2003-71, sec. 4.02(2), 2003-2 C.B. 517, 517. The offer-in-compromise must include all unpaid tax liabilities and periods for which the taxpayer is liable. 1 Administration, IRM (CCH), pt. 5.8.17, at 16,256.
If an offer-in-compromise is submitted where a taxpayer has also filed a bankruptcy petition, the Commissioner cautions against acceptance of the offer-in-compromise in the window between a taxpayer's discharge in bankruptcy and the time the final distribution is made because "it is uncertain whether the Service would still have a valid claim in bankruptcy if an offer is accepted." 1 Administration, IRM (CCH), pt. 5.8.10.2.3(2), at 16,368. Thus, the Internal Revenue Manual guidelines advise that "the amount acceptable for an offer should include the amount we reasonably expect to recover from the bankruptcy in addition to what can be collected from the taxpayer on non-discharged liabilities or from property outside the bankruptcy." Id.
It is clear from the administrative record that Mr. Conte was concerned that accepting petitioners' $9,024.25 offer-in-compromise would risk respondent's expected distribution from the bankruptcy. Mr. Conte had extended contact with respondent's bankruptcy specialists. He also performed his own research, including reviewing the IRM guidelines. Mr. Conte sought to determine the likely amount respondent would receive from the bankruptcy and the effect accepting a compromise would have on respondent's distribution. Ultimately, Mr. Conte concluded that respondent was likely to receive approximately $20,000 of the $25,000 remaining in the bankruptcy. Further, as advised by counsel, Mr. Conte concluded that accepting the offer-in-compromise risked respondent's claims in the bankruptcy estate. Thus, in accordance with the IRM and advice from counsel, Mr. Conte determined that petitioners' offer-in-compromise was inadequate because it was less than what respondent expected to receive from the bankruptcy trustee and because accepting that offer would place that distribution at risk.
Petitioners argue that respondent's rejection of the offer-in-compromise was based on an erroneous conclusion of law that the bankruptcy distribution was at risk. Petitioners argue that respondent's distribution from the bankruptcy was never at risk. If respondent's determination was based upon an erroneous conclusion of law, we must reject that view and find that respondent abused his discretion. See Swanson v. Commissioner, 121 T.C. 111, 119 (2003).
As respondent's counsel now explains, an offer-in-compromise must include all of the outstanding liabilities of the taxpayer. Further, section 6325(a) provides that the Commissioner "shall issue a certificate of release of any lien imposed with respect to any internal revenue tax" not later than 30 days after the liability for the amount has been fully satisfied. Thus respondent argues, if respondent were to accept an offer-in-compromise and the liabilities were thereby fully satisfied, he would jeopardize any secured claim to the bankruptcy distribution. Accordingly, as respondent's counsel argues, an offer-in-compromise will not be accepted while a bankruptcy is pending if the offer is less than the amount he reasonably stands to receive when the bankruptcy distribution occurs.
We believe, however, that respondent's risk, or at least his perceived risk, goes beyond simply the release of any secured claim he has to the bankruptcy distribution. If an offer-in-compromise must include all of the outstanding liabilities of the taxpayer, then acceptance and satisfaction of the offer would risk, if not extinguish, all claims the Commissioner had to the bankruptcy assets. The administrative record suggests it was this more generalized risk, to all of respondent's claims, that concerned Mr. Conte in evaluating petitioners' offer-incompromise. Nonetheless, petitioners fail to point to any authority to suggest that respondent's position that accepting an offer-in-compromise jeopardized the bankruptcy distribution was without legal basis, and the Court knows of none.
In furtherance of their argument that the bankruptcy distribution was not at risk, petitioners highlight their offer to relinquish any claim to the bankruptcy distribution for the benefit of respondent. While this offer would have reduced the risk that petitioners would receive a windfall from the bankruptcy by virtue of the offer-in-compromise, it did nothing to reduce respondent's risk with respect to other creditors. As Mr. Conte explained in his closing memorandum: if the offer-incompromise were accepted, any remaining funds in the bankruptcy "would go to other creditors or to the taxpayer." Petitioners again fail to present any authority to suggest that their other creditors would be precluded from objecting to any distribution to respondent after the acceptance of their offer-in-compromise.
Petitioners make two additional arguments on why respondent's determination was an abuse of discretion. First, petitioners suggest that respondent was announcing a bright-line rule and did not exercise discretion at all. Second, petitioners argue that respondent abused his discretion because he rejected the offer-in-compromise solely on the basis of the amount offered in contravention of section 7122(d)(3). We address each in turn.
Petitioners first take issue with Mr. Conte's requirement that their offer-in-compromise be increased by the amount of the expected distribution from the bankruptcy. The IRM guidelines instruct that an acceptable offer-in-compromise would have to include the amount that respondent expected to receive from the bankruptcy in addition to what respondent could collect from petitioners directly. Petitioners argue that by relying upon this provision of the IRM, the Appeals officer was not exercising discretion at all but instead enunciating a bright-line rule for all postdischarge bankruptcy cases where the Commissioner is waiting for a distribution. See Estate of Roski v. Commissioner, 128 T.C. 113 (2007) (holding that by requiring all estates to post a bond to make a section 6166 election regardless of the facts before him, the Commissioner was adopting a bright-line policy that trumped the exercise of his discretion).
Mr. Conte's use of the IRM was not, however, a de facto enunciation of a bright-line rule that trumped the exercise of discretion. In evaluating an offer-in-compromise under doubt as to collectibility, the Commissioner must first determine the reasonable collection potential on the amount owed. Rev. Proc. 2003-71, sec. 4.02(2). In the ordinary circumstance, the Commissioner calculates the reasonable collection potential by determining the excess of a taxpayer's assets and future income above certain allowances for basic living expenses. See Klein v. Commissioner, T.C. Memo. 2007-325. The guidelines aid the Commissioner in this endeavor. Id.; see also, e.g., McDonough v. Commissioner, T.C. Memo. 2006-234; Etkin v. Commissioner, T.C. Memo. 2005-245; Schulman v. Commissioner, T.C. Memo. 2002-129. A pending bankruptcy petition changes this collection analysis because the taxpayer has surrendered his assets to the bankruptcy court. Thus, where a taxpayer has filed for bankruptcy, the Commissioner stands to collect as a creditor in the bankruptcy proceeding in addition to possibly collecting from the taxpayer directly from future income and assets not subject to the bankruptcy.
Thus, at first, the IRM instructs a settlement officer to consider the Commissioner's standing as a creditor in the bankruptcy and advises that an acceptable offer-in-compromise include the amount the Commissioner reasonably expects to recover from the bankruptcy. 1 Administration, IRM (CCH), pt. 5.8.10.2.3(2). In other words, the Appeals officer should not accept an offer of $5 when doing so will risk the likely receipt of $10 down the road. Second, the IRM instructs that an acceptable offer-in-compromise should also include the amount that "can be collected from the taxpayer on non-discharged liabilities or from property outside the bankruptcy." Id. Thus, if the Commissioner stands to receive $10 as a creditor in the bankruptcy and, in addition, $5 can be collected directly from the taxpayer, then the reasonable collection potential is not $5 or even $10, but more like $15.
Mr. Conte did not have to reach the second part of this analysis --the amount respondent could collect from petitioners outside of the bankruptcy. The $9,024.25 offer-in-compromise from petitioners was less than the $20,000 Mr. Conte expected respondent would receive from the bankruptcy, and he determined that acceptance of the offer would risk the receipt of that $20,000. We find that Mr. Conte was not enunciating a bright-line rule for all cases. Mr. Conte was simply applying respondent's guidelines on evaluating offers-in-compromise, including the reasonable collection potential, to the specifics of petitioners' offer.
Finally, petitioners argue that respondent abused his discretion by rejecting petitioners' offer-in-compromise solely on the basis of the amount offered. Section 7122(d)(3)(A) provides: "an officer or employee of the Internal Revenue Service shall not reject an offer-in-compromise from a low-income taxpayer solely on the basis of the amount of the offer". The regulations expand on this by stating that "No offer to compromise may be rejected solely on the basis of the amount of the offer without evaluating that offer under the provisions of this section and the Secretary's policies and procedures regarding the compromise of cases." Sec. 301.7122-1(f)(3), Proced. & Admin. Regs.
The administrative record makes clear that Mr. Conte did not reject petitioners' offer-in-compromise solely on the basis of the amount offered, $9,024.25. Mr. Conte used respondent's policies and procedures --the guidelines of the IRM as well as advice received from counsel --to evaluate the specifics of petitioners' offer in the light of what respondent could reasonably expect to collect on petitioners' liabilities. Mr. Conte concluded that respondent was likely to receive more in the distribution from the bankruptcy than from petitioners' offer-incompromise. Further, Mr. Conte determined that accepting petitioners' offer would risk this expected greater distribution. We find petitioners' offer-in-compromise was not rejected solely on the basis of the amount offered.
We are not unsympathetic to petitioners' situation as they ultimately had no control over when any distribution from the bankruptcy would be made. Since then, petitioners' financial outlook has improved dramatically. Mr. Salazar is now employed as a manager of a restaurant and has begun receiving Social Security benefits. Mrs. Salazar completed law school and now works as an attorney. Thus, while the $9,024.25 offer-in-compromise may have been the limit of what petitioners could pay in 2004, when Mr. Salazar submitted a second offer-in-compromise during the second collection review hearing with respect to his employment tax liabilities, respondent determined that Mr. Salazar was then in a position to pay the entirety of his outstanding employment tax liabilities. Petitioners have not presented any argument or evidence to the Court to suggest that respondent's rejection of this second offer-in-compromise was an abuse of discretion.
In sum, we find that respondent did not abuse his discretion in rejecting petitioners' offers-in-compromise.
III. Underlying Liability
To the extent the Court does not compel respondent to accept their original offer-in-compromise, petitioners argue in the alternative that respondent's assessment of penalties and interest while their bankruptcy petition was pending was erroneous. Petitioners also argue that respondent erroneously applied the bankruptcy proceeds to the individual employment tax liabilities of Claude Salazar instead of their joint income tax liabilities.
In a collection review proceeding, a taxpayer may raise challenges to the existence or amount of the underlying 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 the underlying liability. Sec. 6330(c)(2)(B). Where a taxpayer has filed a bankruptcy action, and the Commissioner has submitted a proof of claim for unpaid Federal tax liabilities in a taxpayer's bankruptcy action, we have held that the taxpayer has had the opportunity to dispute the liabilities for purposes of section 6330(c)(2)(B). See Kendricks v. Commissioner, 124 T.C. 69 (2005); Sabath v. Commissioner, T.C. Memo. 2005-222. A bankruptcy court may consider the amount or legality of taxes, including penalties and interest. 11 U.S.C. sec. 505(a) (2000); Sabath v. Commissioner, supra.
In petitioners' bankruptcy proceeding, respondent submitted a proof of claim for petitioners' unpaid income tax and employment tax liabilities, including penalties and interest. Petitioners, while represented by counsel, did not file an objection to these tax liabilities. Accordingly, petitioners are precluded from challenging their underlying liabilities, including the penalties and interest. However, even if petitioners had raised the issue of whether respondent's assessment of penalties and interest during their bankruptcy proceeding was erroneous, to the extent that respondent has not conceded this issue, we would sustain his assessment of penalties and interest.
Section 6658(a) provides that "No addition to the tax shall be made under section 6651, 6654, or 6655 for failure to make timely payment of tax with respect to a period during which a case is pending under title 11 of the United States Code". Petitioners' bankruptcy was pending from the date they filed their petition until their case was closed on March 30, 2006. See Rev. Rul. 2005-9, 2005-1 C.B. 470.
Respondent admits having erroneously assessed a failure to pay penalty with respect to petitioners' 1997 income tax account on October 23, 2003, while petitioners' bankruptcy was pending. Respondent has agreed to correct this error. Petitioners did not present any evidence that respondent assessed penalties for their 1998 and 1999 income tax liabilities while their bankruptcy petition was pending. Further, a review of petitioners' income tax account transcripts for 1998 and 1999 confirms that respondent did not assess any additional penalty during the pendency of their bankruptcy.
With respect to the employment tax liabilities for Mr. Salazar under docket No. 23547-06L, petitioners again argue that additions to tax were sought for the period their bankruptcy was pending. However, section 6658 does not prevent respondent from assessing the additions to tax during the pendency of the bankruptcy related to employment taxes to the extent that they are withheld or collected from others. Sec. 6658(b); Kiesner v. IRS, 194 Bankr. 452, 458 (Bankr. E.D. Wis. 1996); see also S. Rept. 96-1035, at 51 (1980), 1980-2 C.B. 620, 646 ("These relief rules do not, however, apply with respect to liability for penalties for failure to timely pay or deposit any employment tax required to be withheld by the debtor or trustee."). Accordingly, we find no basis to suggest that the employment tax liabilities respondent seeks to collect include any erroneously assessed additions to tax.
Petitioners also argue for abatement of interest on both their income tax and employment tax liabilities. The Commissioner is not prevented from seeking interest for the period a taxpayer's bankruptcy proceeding is pending. Sec. 6658(a); see also, e.g., Woodward v. United States, 113 Bankr. 680, 684 (Bankr. D. Or. 1990). Under section 6404(a), the Commissioner is granted the discretion to abate the assessment of any tax or liability that is excessive in amount, assessed after the expiration of the period of limitation, or erroneously assessed. But see sec. 6404(b) ("No claim for abatement shall be filed by a taxpayer in respect of an assessment of any tax imposed under subtitle A or B."). Section 6404(e) authorizes the Commissioner to abate interest assessments that are attributable to errors or delays by the IRS.
Petitioners do not argue that the interest is excessive or was erroneously assessed under section 6404(a). Instead, petitioners argue for abatement of interest because of the delay in the distribution of funds from the bankruptcy. While in certain circumstances interest may be abated because of an unreasonable delay of the Commissioner, respondent was no more in control over the distribution of the bankruptcy proceeds than were petitioners. We find that the delay in the distribution of proceeds by the bankruptcy trustee is not grounds for the abatement of interest under section 6404 or for otherwise relieving petitioners from liability for the interest.
Finally, under docket No. 23547-06L,5 petitioners challenge respondent's application of the bankruptcy proceeds to the employment tax liabilities of Mr. Salazar instead of the joint tax liabilities of both petitioners. Because the distribution occurred after the bankruptcy proceeding was closed, and Mr. Salazar raised it during the hearing, we may review this issue.
At the time of the bankruptcy trustee's final report, respondent possessed: (1) A secured claim of $19,915.40 for petitioners' 1997 and 1998 tax liabilities; (2) an unsecured priority claim of $43,673.45 for petitioners' 1999 income tax liabilities and Mr. Salazar's 1998, 1999, 2000, and 2001 employment tax liabilities; and (3) an unsecured general claim of $8,850.74. However, only payment on respondent's $43,673.45 priority claim was allowed by the bankruptcy trustee.
Respondent applied the $17,834.51 that was ultimately disbursed by the bankruptcy trustee on August 22, 2005, to the employment tax liabilities of Mr. Salazar that made up part of respondent's priority claim. At first respondent applied the disbursement to the employment tax periods ending December 31, 1998, March 31, 1999, and June 30, 1999, in amounts that exceeded respondent's priority claims for those periods. Eventually, respondent corrected this application of the proceeds to also include partial payments on the priority claims for the periods ending September 30, 1999, and December 31, 1999.
Petitioners claim that respondent should have applied the disbursement to petitioners' joint income tax liabilities first instead of just Mr. Salazar's employment tax liabilities. Where a taxpayer makes voluntary payments to the IRS, he does have the right to direct the application of payments to whatever type of liability he chooses. See, e.g., Estate of Wilson v. Commissioner, T.C. Memo. 1999-221. However, where a taxpayer makes an involuntary payment, the IRS may allocate or reallocate the payment as it sees fit, regardless of a taxpayer's designation. As we have stated: "An involuntary payment of Federal taxes means any payment received by agents of the United States as a result of distraint or levy or from a legal proceeding in which the Government is seeking to collect its delinquent taxes or file a claim therefor." Amos v. Commissioner, 47 T.C. 65, 69 (1966); see also United States v. Pepperman, 976 F.2d 123, 127 (3d Cir. 1992) (noting that most courts to have considered the issue have concluded that payments made in the bankruptcy context are involuntary). In the light of the involuntary nature of the bankruptcy distribution, we find no error in respondent's application of the proceeds to the employment tax liabilities of Mr. Salazar before the joint income tax liabilities of both petitioners. In any event, there is no evidence that petitioners specified in writing that the proceeds be applied to their income tax liability instead.
On the basis of the record before the Court, and with the exception of the failure to pay penalty for income tax year 1997 which respondent concedes, petitioners are liable for the taxes, additions to tax, and interest as determined by respondent. We further find that respondent did not abuse his discretion in rejecting petitioners' offers-in-compromise. Thus, respondent's determination that the Federal tax levies were appropriate in these cases is sustained.
To reflect the foregoing,
Decision in docket No. 2203-05L will be entered under Rule 155.
Decision in docket No. 23547-06L will be entered for respondent.
1 Unless otherwise indicated, all section references are to the Internal Revenue Code, as amended, and all Rule references are to the Tax Court Rules of Practice and Procedure.
2 "IMF" refers to respondent's Individual Master File for petitioners' income tax liabilities. "BMF" refers to respondent's Business Master File for Mr. Salazar's employment tax liabilities.
3 Respondent also moved to dismiss on the grounds that the Court lacked jurisdiction to hear any challenge to Mr. Salazar's employment tax liabilities. However, because respondent issued a notice of determination with respect to Mr. Salazar's employment tax liabilities on Oct. 18, 2006, respondent admits that we now have jurisdiction to review his determination under sec. 6330(d)(1). See Callahan v. Commissioner, 130 T.C. __ (2008).
4 Respondent's notice of intent to levy did not include the periods ending Dec. 31, 1998, or Mar. 31, 1999.
5 The trustee had not filed his final report nor had any disbursements been made at the time of petitioners' collection review hearing with respect to their joint liabilities.
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