Retirement Assets In A CDP Hearing

 

Let’s talk about a Collection Due Process (CDP) hearing, how CDPs came about and a great way to flub one.

Think of filing taxes as having two phases:

·      The assessment of tax

 For most of us, this means filing the return. It shows total tax due, from which is subtracted tax withholdings and other payments. In general, processing the return is tantamount to assessing the total tax due shown on the return. Assessment in turn begins the statute of limitations. 

·      The collection of tax 

If you are overpaid, you are normally done with the process right here. 

Go the other way and the IRS may send notice and demand for payment. If the taxpayer fails to pay, a tax lien is created automatically retroactive to the date of assessment (Sec. 6321). 

This lien is a quiet lien and does not take priority over other competing claims. The lien we fear - the publicly-recorded lien which does take priority – requires a second step. 

The lien establishes a pathway for the IRS to take property to satisfy that unpaid assessment. The IRS could, for example, bring suit to enforce the lien. More commonly, the IRS will take collection action without seeking court approval. 

That ability to take property – a bank account, a garnishment on a paycheck – is generally referred to as a power to levy.

The CDP hearing takes place here – at the point where the IRS wants to formally file its lien and/or engage its Collection division.  Code section 6330 provides for CDP hearings. Congress wanted to protect taxpayers from arbitrary or abusive IRS actions (there was history) as well as provide procedural guardrails for taxpayers.

Section 6330 requires the IRS to notify a taxpayer at least 30 days in advance of his/her right to an administrative hearing (the CDP hearing) before the IRS Office of Appeals. After the Office issues its determination, the taxpayer may then petition the Tax Court for judicial review. This review is very limited and concerns abuse of discretion by the IRS.

It may come as a surprise to a nonpractitioner, but a taxpayer is generally not allowed to dispute a tax liability at a CDP hearing. The reasoning is that the taxpayer had earlier opportunities to dispute a liability. The CDP is instead a collection hearing. To the extent review of an underlying liability is permitted, it is as a remedy against abusive collection and as protection for taxpayers who would fall through the cracks (for example, a taxpayer who was never notified that they were in Collections).

Let’s talk about a CDP case in Scanlon and Fairweather v Commissioner.

“The only issue for decision is whether the Internal Revenue Service (IRS) Office of Appeals (Appeals) abused its discretion in sustaining” collection actions against the taxpayers.

The Court’s involvement is limited: it will not reopen the matter (nerd term is “de novo”), but it will review to determine if the IRS abused its authority, perhaps by not following its own rules. This limit is intentional. CDP cases constitute approximately 15% of Tax Court cases annually, even with this limited reach.

Lawrence Scanlon was an associate professor of English at Rutgers University, and his wife (Aline Fairweather) was an attorney with Pepper Hamilton. For the years 2011 through 2013 their taxable income ranged from $345,603 to $441,185. The tax issue was their failure to pay estimated taxes against that income, resulting in a considerable tax bill.

Here is a timeline:

10/21/14      IRS sent Notice of Federal Tax Lien for 2011 and 2012.

11/27/14        Taxpayers sent Form 12153 (Request for CDP or Equivalent Hearing). Taxpayers did not challenge the underlying liabilities.

1/12/15        IRS Settlement Officer (SO) requested financial information (Form 433-A), collection alternatives, a copy of the 2013 return, and a scheduled follow-up call for 2/4/15.

1/13/15        IRS sent a second lien notice for 2013.

1/31/15        Taxpayers’ representative (Markham) sent the SO Form 433-A and proposed monthly payments of $3,000.

2/4/15          The SO tried but failed to contact Markham.

2/4/15          Later that day Markham faxed the SO saying that a follow-up was not necessary, that taxpayers had submitted financial information, and reiterated the monthly $3,000 proposal.

2/10/15        IRS sent Final Notice of Intent to Levy for 2013, which liability exceeded $117 grand.

2/20/15        Taxpayers submitted another 12153 (for a second CDP hearing). Taxpayers also resubmitted the 433-A from 1/31/15 proposing a monthly $3,000 payment.

3/16/15        The SO determined that taxpayers had enough retirement assets (one account at TIAA-CREF and a second at Vanguard, both totaling $645,538) to pay the IRS ($271,941) and scheduled a telephone conference for 7/24/15.

7/24/15        Taxpayers objected to the retirement proposal, arguing tax implications. The SO had another call. She was to return the call by end of day, but she could not reach Markham. The SO scheduled another conference call for 9/23/15.

9/23/15        Markham told the SO that taxpayers could not reach the retirement funds; the SO asked how Mrs Fairweather had managed to borrow $30,000 against her Vanguard account. The SO wanted some verification that no further borrowings or withdrawals were available from Vanguard or TIAA-CREF. She requested a response date of 9/30/15.

11/20/15      Taxpayers had not responded. The SO checked 2014 (not enough tax payments to cover the liability) and 2015 (no payments at all). She left a message for taxpayers that she was proceeding with collection action.

And … we are in Tax Court.

I could predict how this would go when I got to 7/24/15.

Through that date, the SO was behaving with restraint. The taxpayers were repeating a pattern (not paying) and the taxes due were adding up. The taxpayers however appeared to be acting in good faith, even though one had to wonder where the household income was going.  

Then we reached the two retirement accounts. Mrs Fairweather argued that one (Vanguard) was beyond her reach. We know next to nothing about the second. We do know that Markham (taxpayers’ representative) objected “because of its tax implications.” Really? If you are this deep into IRS machinery, I doubt the SO is overly concerned about your tax implications. I might, if pressed, request the SO to allow withdrawal and payment over two calendar years - to lessen some of the tax pressure.

And here is decades of tax practice speaking: you cannot - CANNOT - blow-off a response date. If there is a problem obtaining paperwork, let the IRS know as soon as possible. If life makes you unavailable that day, have someone in the office contact the IRS, preferably ahead of any scheduled call. There are … companies … out there that will use CDPs (and similar) to delay and obstruct collection activity. I know this. The IRS knows this. Do NOT give the SO reason to think you are one of those people. 

NOTE:  I have found that failure to make current estimated tax payments will generally doom a taxpayer’s request for a payment plan. I understand the issue: how can I pay this year when I cannot afford to pay the back years? Pay something toward the current year. Extend the return and continue paying on the year until you file on the last day of extension. Cut out some expenses and redirect the money. The IRS wants to see you stop digging the hole you are in.

Here is the Court:

Petitioners do not challenge the validity of their underlying Federal income tax liabilities for 2011, 2012, and 2013."

As discussed, a CDP is not the place for this anyway.

… petitioner’s underlying liabilities are not properly before the Court, and we will review Appeal’s determination for abuse of discretion…”

We do not conduct an independent review and substitute our own judgement for that of the appeals officer.”

What is the Court going to look at?

The only issue petitioners raise is whether Appeals determination to reject their proposed installment agreement and sustain the lien filings for 2011, 2012, and 2013, and the proposed levy for 2013 was an abuse of discretion.”

The first issue is the failure to make current estimated tax payments.

But …

No surprise. I have butted heads here too many times to count.

The second issue involves burning the retirement account(s).

I see that Mr Scanlon was 60 years old and Mrs Fairweather was 55. How about an economic hardship argument - only so many years to restore the monies otherwise drained from the retirement account and such?

Here you see an instance of hard procedure. There are areas in tax where “turn right” is not the same as “turn left, then left, then left.” This is one of them.

The IRS won. The IRS almost always wins a CDP case. The Court is reviewing for abuse of discretion and not for commendable application of common sense. It is a very high bar to overcome.

Our case this time was Scanlon and Fairweather v Commissioner, T.C. Memo 2018-51.

A Cannabis Business Offer In Compromise

 

Let’s talk reasonable collection potential (RCP).

If the conversation turns to RCP, chances are good that you owe the IRS and are hoping to settle for less than the full amount. A couple of programs come immediately to mind:

• Offer in Compromise

• Partial Payment Installment Agreement

 As you might guess, the IRS requires paperwork before agreeing to this. The IRS wants to look at your:

• Income

• Expenses

• Assets

• Liabilities

• Future Income Potential

Yes, the process is intrusive. I have had clients balk at the amount of disclosure involved, but in truth it is not much different from what a bank would request. I rarely work with OICs or partial pays these days. Some of it is the client base, but some also reflects past frustration. I have started this process too many times with a client and the first wave of documentation comes in quickly enough; the second wave takes longer. The last wave may take long enough that we must start the first wave over again, and sometimes we never even receive the last wave. It has happened enough that I am now reluctant to get involved, unless it is a client I have known for a while and am confident will follow instructions. The IRS is going reject a partially completed application anyway, so there is no upside to submitting one.

COMMENT: This is a repetitive tactic of the reduce-your-tax-debt mills. They will assemble and file whatever, knowing (or at least should know) that the application will be rejected. That does not matter to them, as they are paid in advance.

The IRS is trying to pin down how much you can pay: the RCP.

And it is not what you may think.

Assets are relatively easy: you must list and value all your assets. You may not want to disclose that restored Corvette or gun collection, but you really should.

Liabilities are tricky. You will submit all your liabilities, but the IRS may not allow them. Credit card debt comes to mind. Let’s just say that the IRS is not overly concerned whether you fail to repay your credit card balances.

Income again is easy, unless you have unusual sources of income. In practice, I have found that the IRS also has difficulty with erratic (think gig) income, sometimes to the point that one cannot get a plan in place.

Expenses can break your heart. Just because you have an expense does not mean that the IRS will allow it. Examples? Think an expensive car lease, private school tuition, even veterinary expenses for an aging dog. For some expense categories, the IRS will look to tables listing normalized allowances for your region of the country. You supposedly can persuade the IRS that your situation is different and requires a larger number than the table. I wish you the best of luck with that.

Future income potential has disqualified many. Let me give an example:

·      A retiree has substantial health issues. It is unlikely that the retiree will (or can) return to work, meaning that current income (sources and amount) is likely all there is into the foreseeable future.

·      A young(er) nurse practitioner is bending under the weight of credit cards, car loan, day care, and aging parents.

The IRS is not going to view the retiree and nurse practitioner the same. One’s earning power is behind him/her, whereas the other likely has many years of above-average earning power remaining. Granted, both may be in difficult straits and both may receive relief, but it is unlikely that the relief will be the same. The retiree may receive an OIC, for example, whereas the nurse practitioner may receive a temporary partial-pay with a two-year revisit. Even then, I anticipate that getting a partial pay for the nurse practitioner is going to be … challenging.

Let’s talk about a recent RCP situation that irritates me. It involves a business.

Mission Organic Center (Mission) is a state legal marijuana dispensary in California.

COMMENT: Two things come into play here. The first is the federal Controlled Substances Act, which classifies cannabis as a Schedule 1 substance. The second is a Code section (Sec 280E) that prohibits businesses from deducting ordinary business expenses from their gross income if the business consists of trafficking in controlled substances. This gives us the odd result of a state-legal business that cannot deduct all its expenses on its federal tax return. Perhaps the state will allow those expenses on its return, but there is no federal equivalent. An accounting firm can deduct its payroll, rent and utilities, by contrast, but a cannabis business cannot (there is an exception for cost of goods sold, but let’s skip that for now).

This raises the question: what is the reasonable collection potential of that cannabis business?

Did you know that there are different accounting methods for different purposes?

Let’s say that you are auditing a Fortune 500 company.  You probably want to keep the accounting on the pavement, something the accounting profession refers to as “generally accepted accounting principles.” Leave the pavement too long or too far and you might have liability issues.

Switch this to the tax return for the Fortune 500, and it is a different matter. The IRS is likely telling you which bad debt – or inventory, or asset capitalization, or depreciation, or deferred compensation, or (on and on) - accounting method to use. The profession calls it “tax accounting,” and that is what I do. I am a tax CPA.

Here is the Supreme Court in Thor Power Tool distinguishing generally accepted accounting income from taxable income:

The primary goal of financial accounting is to provide useful information to management, shareholders, creditors, and others properly interested; the major responsibility of the accountant is to protect these parties from being misled. The primary goal of the income tax system, in contrast, is the equitable collection of revenue; the major responsibility of the Internal Revenue Service is to protect the public fisc. Consistently with its goals and responsibilities, financial accounting has as its foundation the principle of conservatism, with its corollary that "possible errors in measurement [should] be in the direction of understatement rather than overstatement of net income and net assets." In view of the Treasury's markedly different goals and responsibilities understatement of income is not destined to be its guiding light. Given this diversity, even contrariety, of objectives, any presumptive equivalency between tax and financial accounting would be unacceptable.”

Got it: financial accounting provides useful information to stakeholders and tax accounting funds the fisc. Both use the word “accounting,” but they are not the same thing.

Question: what does a business pay bills with?

With cash. Unless somebody is throwing in equity or loaning money, profit is the sole remaining source of cash.

Mission owed a lot of taxes. It submitted an OIC. An IRS Settlement Officer reviewed the OIC and disallowed the Section 280E expenses. The reasoning? The IRS has a policy of disregarding for RCP purposes those business expenses nondeductible under Code Sec. 280E.

I do not see this is an issue of discretion. I see it as a matter of economic reality. Mission needed cash to pay the IRS, and merely making something nondeductible does not create cash. The IRS missed a step here by conflating RCP (an economic measurement of cash) with taxable income (which might mirror cash by luck or accident but then only rarely).

Mission however had a history of filing tax returns without paying. We are not making friends and influencing people here, Mission.

The Tax Court looked at this and decided that the policy was within IRS discretion, and the Settlement Officer did not abuse her discretion by following that policy.

I disagree.

We now have a precedential case that Congressional tax-writing caprice will override an economic evaluation of a business’ ability to generate and retain the cash necessary to pay its tax obligations to the IRS. Let me restate this: Congress - via tax law - can bankrupt you.

Bad facts.

Bad law.

Our case this time was Mission Organic Center v Commissioner, 165 T.C. 13 (2025).