Debt Forgiveness - Reducing or Eliminating the Tax Impact of the Forgiven Debt

What are the tax implications when someone forgives debt that you legally owe? Is the amount forgiven taxable income to you? It really depends on a variety of facts. In this article, we will briefly address some of the things every taxpayer should know about debt forgiveness. If you have been, or expect to be, the recipient of debt forgiveness, for example, you have sold your house in a short sale or are in negotiations with your bank to receive a discount in the amount of your mortgage, you should work closely with your accountant or tax planner to make sure you properly report the transaction and qualify to exclude the debt forgiven from taxable income.

General Rule. If a debt for which a taxpayer is personally liable, recourse debt, is canceled or forgiven, other than as a gift or bequest, the taxpayer must include the canceled amount in income. However, this realized income may be excluded from taxable income if it meets certain requirements.

Examples of Forgiveness of Indebtedness.

CHANGE IN METHOD OF ACCOUNTING

One of the many decisions a business owner must make during the first year of operating is what accounting method is most appropriate for the company. While the Internal Revenue Service (IRS) requires that some taxpayers use the accrual method, for example, retail companies, some business taxpayers can elect to use either the cash or accrual method. If the taxpayer uses an improper method of accounting, the IRS can force the taxpayer to change his or her method of accounting.

In general, a “change in method of accounting” occurs when a taxpayer changes his or her overall method of accounting, changes treatment of a “material” item, or fails to properly account for “material” items. “Material” items include any item that involves the proper time for the inclusion of the item in income or the taking of a deduction, such as inventory. Treas. Reg. § 1.446-1(e)(2)(ii)(a).

Section 446 of the Internal Revenue Code (Code) allows the IRS to change a taxpayer’s method of accounting when the taxpayer’s overall method of accounting or treatment of a material item does not clearly reflect its income. The IRS has broad discretion in determining a new method.

The key feature of any change in method of accounting is the IRS’s ability to force the taxpayer to recognize income omitted in previous years. Code Section 481 allows the IRS to make an adjustment to account for any omissions or duplications of income or deductions in the years in which the taxpayer used the improper method of accounting. The Section 481 adjustment is generally taken into account entirely in the “year of change,” which is usually the year in which the change in method of accounting occurred.

To calculate a Section 481 adjustment, the IRS will first look at the taxpayer’s income as reported under the “old” method of accounting. Then, the IRS will impose its “new” method of accounting and recalculate the taxpayer’s income for each year in which the old method was used. The cumulative amount of any omitted income for all corrected years is taken into account, in general, entirely in the year of change. This can result in an addition to income in the year of change (positive Section 481 adjustment) or reduced income in the year of change (negative Section 481 adjustment).

The most crippling feature of a Section 481 adjustment is the IRS’s ability to look back to any series of consecutive years prior to the year of change in which the taxpayer used an improper method of accounting. Unlike the statute of limitations for assessment, where the IRS generally can look back up to 3 years to calculate an adjustment to income, there is no limit to how many years the IRS can look back when the taxpayer used an improper accounting method. The effects of 10 or 15 years of omitted income, all taken into account in one year, can be devastating to the business.

An IRS change in accounting method has a strong presumption of correctness. This means that the most important time to contact a tax practitioner when the IRS proposes a change in method of accounting is during the audit. If the practitioner is involved in the early stages, he or she may be able to convince the auditor that no change in method of accounting is appropriate, or, work with the auditor to minimize the impact of a Section 481 adjustment before any presumption is in place.

PREVENTING THE FILING OF A FEDERAL TAX LIEN

A Notice of Federal Tax Lien (NFTL) can cause irreversible harm to an individual or a business. The NFTL is usually filed with the County recorder and/or the Secretary of State at exactly the wrong time, that being when the individual or business has the greatest need for good credit. The NFTL will damage a good credit rating and possibly prevent creditors and vendors from continuing or starting to do business with the individual or business. Sometimes, the taxpayer’s real concern does not involve their credit, but rather, the damage to their good reputation.

We are often asked how to stop the IRS from filing a NFTL. Other than paying the obligation in full or filing a petition in bankruptcy, stopping the filing of the lien is dependent on convincing the IRS that not filing the lien is in its best interests. We understand from recent conversations with IRS representatives that while it has been difficult in the past, stopping the lien filing is about to become even more difficult.

The IRS’s primary goals in filing a NFTL are to:

1. Prevent the taxpayer from selling property and using the proceeds to pay other creditors ahead of the IRS. 
2. Protect the IRS’s position ahead of other creditors who may also be pursuing or intend to pursue the taxpayer and could obtain a security interest, a mechanic’s lien, or judgment.

The IRS is required to try to contact the taxpayer prior to filing the federal tax lien. Internal Revenue Manual (I.R.M.) 5.12.2.3. Usually, this contact is in the form of a field visit, telephone call, or mailed notice. I.R.M. 5.12.2.1. The IRS will usually proceed with filing the federal tax lien approximately 10 days after making contact with the taxpayer. I.R.M. 5.12.2.4. So, the keys to preventing the filing are to make a timely demonstration to the IRS that it does not need to worry about these issues and that it will be in a better position if it does not file the lien. This is difficult, but it can be done in the right circumstances.

One option is to request a hearing with an Appeals Officer under the Collection Appeals Program (CAP), prior to the filing of the lien. Filing a CAP hearing allows the taxpayer to raise any grievances and ensure IRS rules and regulations are followed. Unfortunately, the CAP procedures do not give the Appeals Officer much authority beyond reviewing the administrative handling of the taxpayer’s case. Processing these hearings can take between 14 and 60 days, depending on the backlog. There are no appeal rights that accompany these hearings, so the hearing officer’s decision is final.

You may also receive a notice of a right to Collection Due Process (CDP) hearing prior to the filing of the lien. Again, this allows you to ask an Appeals Officer to consider delaying or preventing the lien by showing him or her that it is the best interests of the IRS to not file the lien. The advantage of a CDP hearing is that the Appeals Officer has much more authority and can consider delaying the lien if it is in the best interests of the IRS. You may negotiate a collateral agreement, post a bond to guarantee the IRS’s interest, or prove that filing a federal tax lien will hamper the IRS’s ability to collect the obligation.

If the NFTL has already been filed, you may still have an option. You may submit an Application for Withdrawal of a Federal Tax Lien. The IRS will withdraw the federal tax lien if it was filed prematurely or incorrectly. The withdrawal has the advantage of removing the lien as if it had never been filed.

FILING A CLAIM FOR REFUND FOR FEDERAL TAXES

Sometimes a situation arises when a taxpayer overpays his or her taxes for a particular year. When a taxpayer overpays his or her taxes, he or she can file a Claim for Refund to recover the amount of the overpayment. One common example of a Claim for Refund is when a taxpayer files his or her annual income tax return for a year in which too much tax was withheld. The IRS will then issue the taxpayer a refund for the amount of the overpayment.

Timing is critical when asking the IRS to refund any tax overpayment. A taxpayer must file a Claim for Refund with the IRS within 3 years of the actual filing date of the tax return or within 2 years of the actual tax payment, whichever is later. Any refunds sought after these time periods are considered time barred, unless special circumstances exist.

The IRS requires different procedures for filing a Claim for Refund. These procedures are based on the underlying reason for the overpayment. One way is to amend an original tax return to reflect the recalculated amounts and show the IRS the amount of the overpayment. A common example where a taxpayer would file an amended return to recover a refund is when a business taxpayer incurs a net operating loss in the current year. By operation of the law, the taxpayer is entitled to carry that net operating loss back, up to two years. Depending on the circumstances, the amended returns showing the loss carryback may entitle the taxpayer to a refund.

Another way to submit a Claim for Refund is to file Form 843, Claim for Refund and Request for Abatement. When completing this form, the taxpayer must be certain to clearly identify the legal grounds on which her or she is relying to recover the overpayment. The Form 843 is typically used when the taxpayer is seeking a refund of any amount paid to the IRS as result of an IRS audit examination. A taxpayer should also use this form when seeking to recover amounts paid pursuant to an installment payment plan. If a taxpayer has made many payments toward a tax obligation, he or she may be required to file more than one Form 843 for each payment. When making claims for refund for installment payments, the IRS will not consider the merits of the claim until the obligation is paid in full.

In most cases, the IRS will also accept an “informal” Claim for Refund. An informal Claim for Refund is simply a letter to the IRS stating that the taxpayer is seeking a refund of a particular amount for the specified reason. Taxpayers must be careful when submitting an informal Claim for Refund as the IRS will only accept an informal Claim for Refund if the letter sufficiently notifies the IRS of the basis for the claim and the amount of the claim. These types of Claims for Refund are not appropriate in most circumstances and are reserved for very specific situations.

Sometimes future events or contingencies, like proposed changes in the tax law, may affect whether a taxpayer overpaid his or her taxes for a particular year. If the time limit for filing a Claim for Refund is approaching, the taxpayer may file a protective Claim for Refund to preserve the right to recover the specified amount. The protective Claim for Refund puts the IRS on notice that the taxpayer may have a right to make a Claim for Refund when the future event or contingency occurs.

Due to the large number of frivolous Claims for Refund the IRS receives each year, Congress enacted a provision that penalizes taxpayers who file a Claim for Refund for an excessive amount. I.R.C. § 6676. The penalty is equal to 20% of the amount of the claim that is considered excessive. To avoid having a claimed amount be considered excessive, the taxpayer must present a reasonable basis for the Claim for Refund amount. Taxpayers should consider consulting with a tax professional before making a Claim for Refund to ensure that their claim is not for an excessive amount.

If a taxpayer files a Claim for Refund, and the IRS denies the refund, then the taxpayer may appeal that denial to the IRS Appeals Office. If the taxpayer does not appeal the Claim for Refund or the Appeals Office rejects the claim, the IRS will issue a statutory notice of claim disallowance. The taxpayer then has 2 years from the date of the statutory notice of claim disallowance to file a suit for refund with the either the United States Court of Federal Claims or the United States District Court retaining jurisdiction.

One trap practitioners must be aware of when filing a Claim for Refund on behalf of a taxpayer is that the United States Court of Federal Claims and the United State District Court are limited to the evidence provided to the IRS when reviewing the merits of any particular Claim for Refund. Thus, the practitioner must be sure to put the IRS on notice of all possible arguments for recovering the overpayment, or when the taxpayer files suit, he or she will be deemed to have waived any arguments or evidence that were not presented to the IRS in the initial Claim for Refund.

Taxpayers who believe they overpaid their taxes in a particular year should consult a tax practitioner to discuss whether it is appropriate to file a Claim for Refund.

INNOCENT SPOUSE RELIEF: RECENT TAX COURT DECISIONS ON EQUITABLE RELIEF FROM JOINT & SEVERAL TAX LIABILITIES¹

The United States Tax Court (hereinafter, “Tax Court”) recently issued three seminal opinions regarding innocent spouse relief pursuant to Section 6015 of the Internal Revenue Code (hereinafter, “Code”). Each decision helped clarify relief under Code Section 6015(f), commonly referred to as “equitable relief.”

Background

When married taxpayers file a joint Form 1040 income tax return, they are jointly and severally liable for any amount owing.² However, Section 6015 of the Internal Revenue Code provides three different forms of relief from joint and several liability, Section 6015(b), (c), and (f). To qualify for relief under Section 6015(b) and (c), a taxpayer must meet each of the listed statutory requirements. In contrast, the Internal Revenue Service (hereinafter, “IRS”) grants Section 6015(f) relief to a taxpayer if, under its prescribed procedures, it is inequitable when considering all of the facts and circumstances to hold the taxpayer jointly and severally liable for the tax owed.³

Lantz v. Comm’r, 132 T.C. ____, No. 25078-06, 2009 WL 928241 (February 12, 2009).

One of the requirements to qualify for relief from joint and several liability under Sections 6015(b) and (c) is that the taxpayer must request relief within the two-year period following the first IRS collection activity (hereinafter, “limitation period”). Section 6015(f) does not include this limitation period restriction. However, when the IRS established procedures for determining when a taxpayer qualifies for relief under 6015(f), it adopted Treasury Regulations Section 1.6015-5(b)(1). Section 1.6015-5(b)(1) required a taxpayer to request equitable relief within the limitation period. The IRS incorporated this requirement into Revenue Procedure 2003-61.⁴

In Lantz v. Comm’r, the Tax Court addressed the validity of the limitation period for equitable relief. Petitioner filed her request for equitable relief after the limitation period passed. The IRS denied her equitable relief solely because she did not make her claim within that period. She appealed the IRS’s decision to the Tax Court, arguing that Treasury Regulation Section 1.6015-5(b)(1) was invalid on its face.

In Chevron, the Supreme Court announced a two-prong test for determining the validity of treasury regulations.⁵ If Congress has directly spoken to the question at issue, the courts must give effect to the unambiguously expressed intent of Congress.⁶ If Congress has not directly spoken, then the court asks whether the treasury regulation is a permissible construction of the statute.⁷

The Lantz court, in an en banc decision, decided 12-5 in favor of invalidating Treasury Regulations Section 1.6015-5(b)(1) under the Chevron test. The majority opinion held that the regulation was invalid because Congress had directly spoken on the limitation period issue when it passed Section 6015(f). The court reasoned that because Congress explicitly included the limitation period in Sections 6015(b) and (c), and it did not include the requirement in Section 6015(f), that Congress “spoke through its audible silence.”⁸ Furthermore, because the language in Section 6015(f) is very broad, Congress intended relief to be more broadly available.⁹ Thus, the court invalidated the regulation requiring that a taxpayer request relief within the limitation period because Treasury Regulations Section 1.6015-5(b)(1) did not meet the first prong of the Chevron test .¹⁰

The court also held that it would invalidate the limitation period requirement under the second prong of Chevron. In arguing that the regulation is an impermissible construction of Section 6015(f), the court pointed out that the regulations for Section 66 of the Code, the counterpart to Section 6015 for taxpayers in community property states, prescribe a longer limitation period for taxpayers seeking “equitable relief” instead of “traditional relief.”¹¹ In contrast, the IRS only created one length of time, two-years, for all three types of relief under Section 6015, which is inconsistent with Congress’s intent to make equitable relief more broadly available. The court also highlighted the fact that it was contrary to the intent of Congress to allow the IRS to avoid consideration of all facts and circumstances by imposing a limitation period.¹² The court held that the taxpayer’s delay in applying for relief under section 6015(f) should only be one of the factors considered when examining all facts and circumstances.¹³

Four judges issued a dissenting opinion.¹⁴ The dissent argued that the distinctive quality allowing the IRS to prescribe a limitation period is that Congress expressly granted the IRS discretion to grant equitable relief, and did not do so for relief under Section 6015(b) or (c).¹⁵ The relevant language of Section 6015(f) states, “Under procedures prescribed by the Secretary… the Secretary may relieve such individual….” However, the dissent pointed out, Section 6015(b) and (c) state that the Secretary shall grant relief when such individual meets the specified conditions.¹⁶ This difference, the dissent argued, granted the IRS the authority to promulgate rules for deciding when to grant equitable relief. Furthermore, the dissent argued that Congress’s silence as to the limitation period in Section 6015(f) supports that it intended to delegate the procedural requirements for obtaining relief to the IRS.¹⁷ Therefore, the regulation was valid under the first prong of Chevron because Congress did not directly speak to the limitation period.

The dissenting judges also argued that the regulation is valid under the second prong of the Chevron test. They stated that including the limitation period requirement was a permissible construction of the statute because the regulation was consistent with the legislative grant of authority to the Secretary.¹⁸ The dissent relied upon the legislative history of Section 6015(f), arguing that the statute’s history suggests that Congress enacted it to grant a means for relief for taxpayers who underpaid taxes as opposed to understated taxes.¹⁹ The legislative history did not address the permissibility of a limitation period. The dissent stated, “[h]olding that the Secretary cannot exercise his discretion to set a common deadline isn’t a reasonable inference; it’s the usurpation of the authority that Congress delegated to the Secretary, not [the Tax Court].”²⁰ Therefore, the dissent would uphold the limitation period in Treasury Regulations Section 1.6015-5(b)(1).

The IRS has not announced whether it will appeal the Lantz decision.

Chief Counsel Notice CC-2009-012, (April 17, 2009).

The IRS Counsel addresses the holding in Lantz in Chief Counsel Notice CC-2009-012. It will continue to argue that relief is unavailable under Section 6015(f) when the taxpayer files the claim after the limitation period, but will no longer file summary judgment motions. The IRS will also now consider the merits of any cases where it denied relief solely based upon the limitation period.

Porter II: Porter v. Comm’r, 132 T.C. ____, No. 13558-06, 2009 WL 1098488, (April 23, 2009).

In Porter I, the Tax Court held that the scope of its review in Section 6015(f) cases is de novo, and, therefore, it will consider evidence introduced at trial that was not included in the administrative records.²¹ In Porter II, the Tax Court revisited its holding in Butler, where it held that the proper standard of review for an IRS determination under Section 6015(f) is for an abuse of discretion.²² In an en banc decision, the Porter II court decided 11-6 in favor of reviewing the IRS’s Section 6015(f) determinations de novo.²³

The majority opinion cited four reasons for applying a de novo standard of review for Section 6015(f) determinations. First, the court argued that Congress’s amendments to Section 6015(e), which grants the Tax Court jurisdiction to hear all Section 6015 claims, suggest that the proper standard of review is de novo.²⁴ The statute states, “the Court has jurisdiction to determine the appropriate relief available to the individual under [Section 6015(f)].”²⁵ The court argued that the use of the word “determine” indicates that Congress intended the Tax Court give no deference to the IRS when determining a taxpayer’s eligibility for equitable releif.²⁶

Second, Congress, in the past, had included language to limit the standard of review in similar statutes.²⁷ In 2002, Congress amended the statute for interest abatement claims, explicitly providing that the courts review for an abuse of discretion.²⁸ The majority opinion reasoned that, because Congress did not include language limiting the standard of review for equitable relief claims as it did for interest abatement claims, Congress intended the courts to apply a de novo standard of review.²⁹

Third, the court pointed out that Section 6015(f) cases cannot be remanded to the IRS for reconsideration. It was concerned about the IRS’s inability to consider changes in a taxpayer’s circumstances during the time between the IRS’s determination and a final disposition in court.³⁰

Finally, the court stated that it reviews Section 6015(b) and (c) cases de novo. Therefore, it is only fair and consistent to apply a de novo standard of review.³¹

Six judges dissented from the majority opinion, favoring an abuse of discretion standard in Section 6015(f) cases. The dissent contended that two distinctive features of the language in Section 6015(f) support an abuse of discretion standard. First, Section 6015(f) states, in part, “the Secretary may relieve such individual of such liability.”³² “May,” the dissent argued, is discretionary language.³³ Second, Section 6015(f) expressly names the decision-maker, the Secretary, which implies that the courts should give deference to that decision-maker.³⁴

The dissent, in addition, contrasted Congress’s use of the word “elect” in Sections 6015(b) and (c) with the word “request” in Section 6015(f). The dissent stated that “to elect” relief means to exercise a right to relief. In contrast, “to request” relief simply implies that the IRS may choose who is eligible for relief.³⁵

Like the majority, the dissent examined the language for equitable relief in Code Section 66, Section 6015’s counterpart for community property states. The dissent pointed out that the language for determining equitable relief in Section 66 is identical to the language in Section 6015(f). The courts review Section 66 equitable relief cases for abuse of discretion. Therefore, the dissent reasoned, it is inconsistent to apply a different standard for Section 6015(f) equitable relief cases.³⁶

The dissent also scrutinized the court’s reasons for abandoning the abuse of discretion standard. First, the majority placed great weight on Congress’s 2006 amendment to Section 6015(e), which expanded the Tax Court’s jurisdiction to hear equitable relief cases. The dissent noted that the language amended in the statute did not implicate a change in the proper standard of review.³⁷

Second, the use of the word “determine” does not necessarily implicate a de novo standard of review. The dissent mentioned that a form of “determine” appears in the Tax Court’s principal jurisdiction statute. Section 6015(e) grants the Tax Court the power to issue a “redetermination of the deficiency.” The dissent noted that even though it has the power to redetermine a deficiency, it still must apply different standards of review depending on the nature of the case.³⁸

Third, although Congress specified the standard of review in interest abatement cases, the dissent lists examples where the courts review for abuse of discretion even when the statute does not explicitly state the standard of review.³⁹

Fourth, the Tax Court’s decision not to remand equitable relief cases, coupled with an abuse of discretion standard of review, may not leave the Tax Court with the simplest system in application. But, the dissent argued, Congress could fix this inconsistency by giving the Tax Court the power to remand equitable relief cases to the IRS if it so chooses.⁴⁰

Last, the dissent again cited the language differences between Sections 6015(b) and (c) to combat the majority’s argument that it is inconsistent to apply a different standard of review for Section 6015(f) cases.⁴¹

The IRS has not announced whether it will appeal the decision in Porter II.

Pollock v. Comm’r, 132 T.C. ____, No. 17755-07, 2009 WL 349743, (February 12, 2009).

In Pollock, the Tax Court clarified its jurisdictional boundaries in equitable relief cases. Petitioner filed for relief under Section 6015(f) from joint and several liability sometime before 2006. On April 27, 2006, the IRS denied Petitioner relief and mailed its statutory notice of deficiency. The notice stated that Petitioner had 90 days to file a petition in Tax Court. Only days later, the Eighth Circuit Court of Appeals held that the Tax Court did not have jurisdiction to hear cases under Section 6015(f) where a Petitioner is seeking relief from joint and several liability for an underpayment of tax (a special kind of equitable relief case referred to as “nondeficiency stand-alone” cases).⁴² The Tax Court, shortly thereafter, adopted the Eighth Circuit’s position, denying itself jurisdiction in nondeficiency stand-alone cases.⁴³ Therefore, Petitioner had no forum to bring her nondeficiency stand-alone case and did not file a petition in Tax Court within her 90-day period. Petitioner, instead, filed a claim in United States District Court challenging a lien-enforcement action and asked the District Court to consider her nondeficiency stand-alone claim.

On December 20, 2006, Congress amended Section 6015(e).⁴⁴ The amendment granted the Tax Court jurisdiction to hear nondeficiency stand-alone cases for tax liabilities “arising or remaining unpaid on or after the date of enactment” if the petitioner files his/her petition within 90 days of the statutory notice of deficiency.⁴⁵ In 2007, the District Court dismissed Petitioner’s nondeficiency stand-alone claim, but granted her 30 days to bring this claim in Tax Court, as Petitioner did not have a forum to bring her claim during her initial 90-day window. Petitioner filed her petition with the Tax Court during those 30 days. The issue facing the Tax Court was whether it had jurisdiction to hear Petitioner’s nondeficiency stand-alone claim after her 90-day period passed, and/or pursuant to the decision of the District Court.

The Pollock court held that it did not have jurisdiction to hear Petitioner’s case for four reasons. First, the majority ruled that the District Court’s order granting Petitioner 30 days to file a petition with the Tax Court violated the jurisdictional boundaries set by Congress. The court examined the “Law of the Case” doctrine, which states that a court may review the previous decision of another court on the same issue when the initial decision is “clearly erroneous and would work a manifest injustice.”⁴⁶ The court believed that expanding its jurisdiction in accordance with the District Court’s order would be contrary to public policy.⁴⁷

Second, as the 90-day limit for filing a petition in Tax Court is jurisdictional, and not a statute of limitations, the Tax Court could not apply the doctrine of “equitable tolling” to extend the 90-day deadline for Petitioner. Section 6015(e) states that the “individual may petition the Tax Court (and the Tax Court shall have jurisdiction) to determine appropriate relief…. “not later than the close of the 90th day after the [IRS’s final determination letter].”⁴⁸ Congress’s use of the word “jurisdiction” in the statute, the court explained, was evidence of its intent for this requirement to be jurisdictional and not a statute of limitations.⁴⁹ Because the doctrine of equitable tolling cannot apply to jurisdictional limitations, the court could not toll the statute to allow for Petitioner’s claim.⁵⁰

Third, the Tax Court could not construe the language of Section 6015(e), either before or after the Congressional amendment in 2006, to give itself jurisdiction. According to the court, the language of Section 6015 is unambiguous and not capable of more than one interpretation. It requires that a petitioner file his or her petition within the 90-day window.⁵¹

Finally, the Tax Court rejected Petitioner’s argument that her 90-day filing period did not commence until Congress granted the Tax Court jurisdiction to hear her case. The court reasoned that Congress had the power to amend the statute to allow for a grace period for taxpayers in the Petitioner’s position, but it chose not to include this Petitioner, and others in her same situation, within the group of taxpayers who may seek relief.⁵²

Based on these reasons, the Tax Court dismissed Petitioner’s case for lack of jurisdiction.

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CLASSIFYING YOUR ACCOUNT AS CURRENTLY NOT COLLECTIBLE (CNC)

Having an outstanding obligation with the Internal Revenue Service (IRS) and being unable to propose an acceptable resolution to satisfy that obligation is an intimidating scenario for any taxpayer. The IRS will entertain a variety of solutions to resolve an obligation, including Offers in Compromise and Installment Agreements, but, sometimes, the taxpayer simply cannot afford these options. What happens then?

The taxpayer should continue communicating with the IRS. Under the right circumstances, the IRS will determine that a taxpayer’s account is “currently not collectible.” This determination allows the IRS to “shelve” the taxpayer’s account for a limited period of time, often two years. While the IRS will most likely file or have already filed a lien before “shelving” the account, during the “not collectible” period, the IRS will not take any collection action, like levying bank accounts or wages. Unfortunately, this determination does not stop the addition of interest and penalties.

This relief from IRS enforcement gives the taxpayer time to reorganize his or her financial matters, reduce expenses, and increase income, to better position themselves for an Offer in Compromise or an Installment Agreement when the case is sent back to the field. Unfortunately, even this additional time may not be enough to make a difference. In those cases, when the IRS checks back with the taxpayer after two years, it may again determine that the account is currently not collectible. These follow-up determinations will continue until the expiration of the statute of limitations on collection, that being 10 years from the date the taxes were originally assessed, subject to extension. When the statute of limitations expires, the taxpayer will be relieved from all collection activity.

Another benefit of an account being classified as currently not collectible is that it may provide sufficient time for taxes to become dischargable in bankruptcy. For more information about discharging taxes in bankruptcy, see our earlier article on the topic.

There are a variety of situations that will encourage the IRS to classify a taxpayer’s account as currently not collectible. One of these situations is when IRS enforcement action would cause an undue hardship the taxpayer’s household. To prove an undue hardship, the taxpayer must demonstrate to the IRS that a monthly payment to the IRS will make him or her unable to meet reasonable and necessary living expenses. The IRS will determine whether a hardship exists by conducting a financial analysis of his or her situation. Even though the taxpayer may believe he or she does not have any excess income, the IRS’s financial analysis may show otherwise.

No matter what grounds the IRS uses to determine that a taxpayer’s account is currently not collectible, this determination can be helpful. Even though it is a temporary remedy, it can facilitate a long-term resolution. With this determination, the taxpayer will have the time he or she needs to find an appropriate solution to their outstanding obligations.

TAKING YOUR CASE TO THE UNITED STATES TAX COURT

While most taxpayers can resolve their situation with the Internal Revenue Service (IRS) without asking for the assistance of the courts, filing a petition with United States Tax Court (Tax Court) can be the taxpayer’s best option. Some reasons a taxpayer may decide to file a petition with the Tax Court include: the law is unsettled on an issue, the IRS issues an unfavorable determination that can only be appealed to the Tax Court, or negotiations with the IRS employee working on the case have reached a standstill.

For the Tax Court to have jurisdiction to hear income, gift, or estate tax cases, the IRS must first issue a Statutory Notice of Deficiency. This notice allows the taxpayer 90 days from the date of the notice to file a petition in Tax Court. The Tax Court also has jurisdiction to hear certain other tax-related cases, such as innocent spouse cases, excise tax cases, or levy and lien cases. Please review the Tax Court’s Rules of Practice and Procedure for more information. The technical requirements for filing a petition are in Rules 30 through 41 of the Tax Court’s Rules of Practice and Procedure. IRS Area Counsel must file an answer to the petition within 60 days from the date of the service of the petition. It can often take more than one year after the petition is filed before the Tax Court schedules the case for trial.

The discovery process in Tax Court is less formal than other litigation arenas. Tax Court Rule 70(a) provides that the Tax Court expects the petitioner (the taxpayer) and the respondent (the IRS) to attempt to achieve the objectives of discovery through informal communications before utilizing formal discovery procedures, such as interrogatories, subpoenas, and depositions. Informal conferences between the IRS Counsel and the petitioner for discovery purposes are typically called “Branerton conferences.” Branerton Corp. v. Comm’r, 61 T.C. 691 (1974). The Court expects both sides to at least offer the opportunity for a meeting to each other before allowing formal discovery.

Another unique aspect of practicing in Tax Court is the Court’s heavy reliance on the parties agreeing to stipulate to all undisputed facts. The Court treats each stipulation as a conclusive admission. The Court expects the parties to stipulate to all documentary evidence unless either party is questioning the authenticity of the evidence or using it for impeachment. The IRS Counsel typically prepares the stipulations and the taxpayer has the opportunity to accept or object to some or all of the stipulations. The petitioner should work with IRS Counsel to make sure the language of each stipulation accurately represents the facts of the case before signing the stipulations.

A few months prior to trial, the Tax Court will issue a Standing Pretrial Order. This order will include a template for a Pretrial Memorandum, which functions as a report of the status of the case and a synopsis of the factual and legal issues to prepare the Court for trial. The petitioner and respondent must serve a Pretrial Memorandum on each other 14 days prior to trial. The Standing Pretrial Order also includes a Final Status Report, which the petitioner must complete and send to the Tax Court if the status of the case changes after the filing of the Pretrial Memorandum.

Trial in Tax Court is conducted like any other trial under the Federal Rules of Evidence. The parties will have a chance to make opening and closing statements, examine and cross-examine witnesses, and introduce documents. The Court may ask the parties to submit written post-trial briefs outlining the factual and legal issues in the case. The Court will then issue a judgment.

Taxpayers should talk with an experienced attorney to help them weigh the benefits and costs before filing a petition with the Tax Court.

INCOME TAXES CAN BE DISCHARGED IN BANKRUPTCY

The bankruptcy laws were created, in part, to give a fresh start to individuals struggling through a difficult financial situation. This includes relieving taxpayers of the overwhelming burden of old tax, penalty, and interest obligations. Taxpayers who are looking at their options for resolving their outstanding tax obligations, like an Installment Agreement or an Offer in Compromise, should consider bankruptcy and talk with an experienced bankruptcy attorney. It will not be appropriate for all situations, but for some, it will clearly be the best choice. This article is intended to give you some background to begin your analysis.

Whether income taxes can be eliminated through a bankruptcy is primarily an issue of the age of the tax obligation. Income taxes are dischargeable in bankruptcy if the petition in bankruptcy is filed more than three years after the due date for the return, more than two years after the date the return was filed, and more than 240 days after the taxes were assessed. There are additional considerations, but this is the starting point.

The Due Date. The due date of the return is either April 15 or, if the taxpayer filed a request for an extension of time to file, the extension date. Prior to January 1, 2006, the filing date could be extended to August 15 or October 15. For extensions requested after December 31, 2005, the extension date is automatically October 15. For example, the due date for a 2005 Form 1040, where a request for an extension was filed on or before April 15, 2006, will be October 15, 2006. Taxes from this 2005 Form 1040 will satisfy the “three year” test for dischargeability after October 15, 2009, that being three years after the due date.

The Filing Date. The filing date is a key element in those situations when a taxpayer files his or her returns after the due date. For example, three years after the due date for a 2001 Form 1040 may be long gone, but if the return was not filed until December 1, 2008, the obligation will not be dischargeable until December 2, 2010, more than two years after the date the return was filed.

You should take special notice that this test requires the return to be the taxpayer’s return, not an IRS Substitute For Return (SFR) under IRC Section 6020(b). If the taxpayer does not file his or her own return, the IRS may prepare an SFR. The taxes owing on the SFR are usually higher than the amount the taxpayer really owes. To correct this, the taxpayer must file amended returns. If the amended return does not make a significant change from the SFR, and it appears it was filed only to start the running of the two year period for dischargeability, the IRS and the Bankruptcy Court may reject the return and treat the SFR as the original and only return. This would make the obligation non dischargeable. An example of this is a single wage earner who has no other income and no deductions other than personal exemptions and the standard deduction. The SFR will usually be fairly accurate and the taxpayer’s amended return will be perceived as nothing more than an attempt to make the taxes dischargeable, not an honest and genuine effort to comply with the tax laws. This taxpayer will be stuck with the SFR and unable to discharge the obligations in bankruptcy.

The Assessment Date. The law gives the IRS 240 days from the date the taxes were assessed to file a lien to protect its interests before the taxpayer files a bankruptcy. By filing a lien, the IRS will protect itself to the extent its lien attaches to equity in the taxpayer’s assets.The taxpayer must be careful not to inadvertently give the IRS more than this 240 days. If a taxpayer files an Offer in Compromise within this 240 days, the running of the 240 days stops until the offer is withdrawn or rejected, plus 30 days. For example, on the 239^th day after the assessment of taxes from an audit, the taxpayer files an Offer in Compromise and that Offer is finally rejected or withdrawn one year later. The taxpayer was one day away from having dischargeable taxes and now, one year later, he must wait an additional 31 days.

Federal Tax Lien. While the bankruptcy can discharge the income taxes, it does not eliminate the federal tax lien. For example, if the taxpayer has equity in real estate and the lien is properly filed to encumber that real estate, the lien will survive the bankruptcy. Thus, if a taxpayer owes $100,000 in dischargeable taxes, but he or she also owns equity in real estate of $200,000, and the IRS has a properly filed priority lien, the bankruptcy may stop the IRS from levying wages and bank accounts, but it will do very little to relieve the taxpayer of the liability. After the bankruptcy, the IRS will try to collect the taxes from the equity in the real estate.Before a taxpayer starts negotiations with the IRS for an installment agreement or an Offer in Compromise, he or she should contact an attorney to review bankruptcy as an option. Bankruptcy will not be appropriate for everyone, but for some it may be the best way to start fresh and build a new life.

A BASIC UNDERSTANDING OF THE PROCESS OF APPEALING AN IRS AUDIT

Appealing an IRS audit determination gives the taxpayer a second chance to demonstrate his or her position, although this time, to an Appeals Officer (Officer). The IRS’s goal in appeals is to reach a disposition of the case which reflects the probable result of litigation. The Officer will work with both the evidence provided to the Revenue Agent (Agent) and any additional information the taxpayer provides. Unlike the Agent, the Officer’s authority to consider evidence is broad. The Officer will consider the hazards of litigation, the credibility of the parties involved, the burden of proof, the probative value of the evidence, and relevant legal authorities.

To appeal an audit determination, the practitioner must send a written appeal within 30 days of the Agent’s 30-day letter. This written appeal should include:

1. A request for a conference with an Appeals Officer;
2. The name, address, and Tax Identification Number of the taxpayer;
3. Date and symbols contained in the 30-day letter;
4. A schedule of the disputed adjustments;
5. The factual background for the appeal;
6. The legal basis for the appeal; and,
7. Signatures, under penalty of perjury, of the taxpayer and/or the practitioner.

The practitioner should prepare the written appeal as if preparing for trial. It is important to submit an appeal that is thought-out, documented, and supported with legal authority. Cite legal positions from case law; statutes and regulations; revenue rulings or procedures; private letter rulings; or technical advice memoranda. Also, be sure to include copies of any documents which support the taxpayer’s position.

The Officer will generally schedule a hearing within a few months after he or she receives the written appeal request. The practitioner’s chief advantage is knowing the case in much greater detail than the Officer. If the taxpayer’s credibility is important to the issue, and assuming the taxpayer is credible, then the taxpayer should attend the hearing. The taxpayer can provide the answers to odd questions which will help bring the case to life and make it believable. The practitioner should also formulate a settlement proposal in advance of the hearing.

During the hearing, the practitioner should emphasize the taxpayer’s strongest points and explain how the Agent misinterpreted the facts or law. Admit the weak points of the case, but explain why these points are not relevant or how other factors outweigh them. Address all of the Officer’s concerns. Show the Officer that it will be risky for the IRS to proceed to trial. One of the greatest hazards for the IRS is the precedential effect of the taxpayer’s success. Most importantly, ask the Officer why he or she disagrees with the taxpayer’s position. Ask for the legal authority on which the IRS is relying. It is very effective to give the Officer as much ammunition as possible to decide in the taxpayer’s favor.

If the Officer decides against the taxpayer, then the Officer will issue a Statutory Notice of Deficiency. The taxpayer must then weigh the benefits and costs of filing a petition in Tax Court.

REPRESENTING TAXPAYERS IN AN IRS AUDIT EXAMINATION

The audit examination process is one of the procedural safeguards the IRS uses to ensure taxpayers are complying with our voluntary tax system. Being selected for an Internal Revenue Service (IRS) audit examination does not, however, necessarily mean that the taxpayer did not comply, filed his or her return incorrectly, or abused the system. In some cases, an audit examination may even end in a refund to the taxpayer. A practitioner can often help a taxpayer provide the information the IRS needs to substantiate the taxpayer’s position on the tax return.

The IRS conducts audit examinations in two different ways: a “letter” audit or a “field” audit. In a letter audit, the IRS informs a taxpayer, by letter, that the IRS has identified errors in a taxpayer’s return. The letter may ask for more information or propose adjustments to the tax return. As most letter audits are a result of simple mathematical errors or errors matching Form W-2 or Form 1099 information with the information reported on the return, a taxpayer may not need the assistance of a practitioner when handling a letter audit. Even in a letter audit, the taxpayer must make sure he or she communicates in a timely manner to all IRS requests for information.

In a field audit, the IRS assigns a local representative, called a Revenue Agent (Agent), to conduct a thorough examination of a tax return. Taxpayers may choose to hire a practitioner to help with an audit examination if they are feeling pressured or the audit involves complex factual or legal issues. To represent a taxpayer before the IRS, the practitioner must first complete and submit Form 2848, Power of Attorney and Declaration of Representative to the IRS.

When resolving a case in an field audit, the practitioner must be aware that the Agent is the initial finder of facts. This is the Agent’s greatest power. A good presentation of the facts can eliminate an issue at the earliest stages. The Agent will likely ask to conduct an in-person interview with the taxpayer to collect information. In most circumstances, this interview is helpful as it gives the practitioner the chance to stress the important facts and eliminate any misunderstandings. The practitioner should accompany the taxpayer to this interview and supply the Agent with all of the factual and legal information to persuade the Agent to make a favorable determination. The Agent may ask the taxpayer to provide additional information. If this happens, the practitioner should ask the Agent to issue a written information request to both track the course of the examination and verify that the taxpayer is complying with these requests.

If there is a dispute over a legal issue, the practitioner should provide any relevant legal authority which supports the taxpayer’s position. The Agent, however, does not have the authority to act contrary to a stated IRS position. Thus, even if the practitioner presents strong legal arguments, the Agent may still choose to propose an assessment.

In most cases, the statute of limitations for the IRS to assess additional taxes is three years from the date when the taxpayer filed the tax return. Sometimes, during the course of an audit, the time for assessing additional taxes is close to expiring. If the Agent believes he or she will not complete the audit with enough time for the taxpayer to appeal the determination, he or she may ask the taxpayer to voluntarily extend the statute of limitations for assessment. If the taxpayer does not extend the statute of limitations, the Agent will usually issue a final report and assess any additional taxes and penalties based on the information the Agent collected to that point.

Whether to extend the statute of limitations for assessment is a judgment call. If the practitioner is making progress with the Agent in a timely manner, extending the period will most likely be the best decision as it leaves the period open for later adjustments in the taxpayer’s favor. If the Agent is delaying, searching for more adjustments, or simply harassing the taxpayer, the practitioner should ask the Agent to complete the final report so the taxpayer can file an appeal. A practitioner must examine all implications, good and bad, before refusing to sign an extension.

At the end of an examination, the Agent will issue a final report. This final report will show all of the adjustments, and any proposed refund or additional tax and penalty. The Agent should send the “30-day” letter with the final report. The 30-day letter provides a taxpayer 30 days to accept an Agent’s final report or request an appeals hearing, in writing, with the IRS Appeals Office. If the statute of limitations for assessment is about to expire, instead of issuing the 30-day letter, the Agent will issue a Statutory Notice of Deficiency. The Statutory Notice of Deficiency allows the taxpayer to file a petition in United States Tax Court if he or she does not agree with the Agent’s determination.