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.

What Makes A Tax Extension Valid?

 

You file an extension on April 15th for your personal tax return.

Is the extension valid if you wind up owing money but entered zero (-0-) on line 6?

What if you entered a balance due on line 6 but entered zero (-0-) on line 7?

A couple of things come immediately to mind:

(1)  There are clients – numerous clients – who have no intention of fully paying their taxes by April 15^th. The best the CPA can do is get them to pay something - anything - to take the pressure off the tax due (plus interest and penalties) when they finally file. I have heard the scold many times over the decades: the tax should be fully paid-in by April 15; the extension is for time to file not time to pay; yada yada. This is not a classroom, folks. This is real life, and I cannot control people. I think that I do some good just by nudging clients closer to compliance with the tax law.

(2)  Are you trying to get me sued? What if I (i) enter a number on line 4 but (ii) file the extension with no payment due (line 6)? Will the IRS bounce the extension? This is where procedural consistency is critical. I need high confidence in how the IRS will process this extension.

Let’s look at Karp.

The Karps wanted the IRS to apply a 2016 tax overpayment (of $336,558) to a later tax year.

Problem: The Karps were not diligent about filing tax returns on time. They were counting on that huge overpayment/carryover to keep them out of trouble. While true, there are ways this can blow up.

The IRS told the Karps that the 2016 overpayment could not be applied to 2017 because they filed the 2016 return in April 2021.

COMMENT: That’s how it blows up: you have to get that return in within 3 years (plus the extension, if you obtained one). The 2016 return was due April 15, 2017. Three more years is April 15, 2020. The IRS did not receive the return until April 2021 - a year late.

The Karps responded with proof that the IRS received their 2016 return on October 15, 2020.

COMMENT: Good! That is why practitioners recommend certified mail (which is becoming a dinosaur as we move to electronic filing) with proof of mailing.

FURTHER: We are not told whether the Karps actually waited until the last day for filing or were instead impacted by IRS closures during COVID.

The IRS backed down when presented proof. The IRS refunded $154,720 and credited the remaining 2016 overpayment to 2022.

The IRS then changed its mind.

Huh?

The IRS argued that the 2016 extension was invalid.

Because it was invalid, there was no extension until October 15, 2017.

Which means that the 2016 return filed October 15, 2020 was outside the three-year window (without the extension, that date was now April 15, 2020). The IRS wanted its $154,720 back. Oh, the IRS also reversed the portion of the overpayment that was credited to 2022.

“No soup for you” snarled the IRS.

Let’s catch our breath.

First, what was the IRS’ reasoning to blow up the 2016 extension?

The IRS looked at Form 4868 and saw zero (-0-) on both lines 5 and 6.

Mind you, the Karps had a sizeable overpayment from 2015 to 2016 (in fact, the Karps had reported sizeable overpayments for years). There was enough there to pay a subsequent year’s tax and send the Karps a refund check for 2016.

The IRS was relying on a Tax Court case (Crocker) where the taxpayer did not appear to even try to estimate the tax due on the extension. When finally filed, the return showed significant additional income and tax (because: of course). The Court agreed with the IRS that the extension was void. The return was late. Penalties. Interest. Brussels sprouts and lima beans. It was catastrophic.

Second, how was the IRS to know?

The 2015 return had not been received or processed by the time the 2016 extension arrived. Maybe - if the Karps ever got around to filing a tax return on time - the IRS might have had a clue of knowing what they intended for 2016.

While I disagree, I do have some sympathy for the IRS.

First, the Court noted that the Karps had a track record of (a) huge overpayments that (b) they repetitively applied to the following tax year.

COMMENT: I personally think this was THE factor that saved the Karps here.

The Karps looked at that overpayment and said: we do not owe anything for 2016. They then put zeros all over that Form 4868. Technically, they should have put (1) estimated gross tax on line 4; (2) the overpayment on line 5: and the (resulting) negative amount on line 6. The Karps did not do that, explaining that they mistakenly thought that the tax estimate was the amount they would be required to pay upon filing. The Court considered it a ministerial error, and they had conflated gross tax with net tax.

The Court also pointed out – devastatingly, I think – that the IRS initially accepted the 2016 return, including the extension as filed. That is why the IRS now wanted the refund check back.

Second, the Court noted that the IRS was put in a tough spot, as it did not have a 2015 return when processing the 2016 extension.

While it was easy for the Court to point out that the Karps had applied their prior overpayments, the IRS could not automatically predict that they would do so again. This dance was getting close to: heads you win, tails I lose for the IRS.

The Court pointed out that the Karps were still within procedural guardrails. They pushed it, but they got it done within three years.

Technically correct, but not an optimal real-world approach to tax filing.

The Court ordered summary judgement for the Karps and instructed both sides to sort the dollars involved and report the results back to for judgement.

I point out that this was not a Tax Court case. It was heard in the Court of Federal Claims, which hears civil claims against the federal government. While specialized (cases against the U.S. government), it is not the same specialization as the Tax Court (which hears only tax cases).

The cynical part of me wonders if the verdict would have been the same had the case gone to Tax Court. The Karps had an advantage: many cases go to Tax Court because one does not need to pay the tax before bring suit in Tax Court. Here, the Karps had already paid the tax (hence the huge overpayment), so filing outside the Tax Court was an option.

Our case this time was Karp v United States, U.S. Court of Federal Claims, No. 23-926, filed May 21, 2026.

A Penalty Against A Tax Preparer

 

Did you know that the IRS can assess penalties against a tax preparer as well as a taxpayer?

I am looking at an IRS Chief Counsel Memorandum recommending a preparer be penalized for a deduction on a client return.

You do not see that every day.

Let’s talk about it.

As is our way, we will streamline the issue so that it is something you might want to read and something I might want to write.

A taxpayer accrued expenses on its books for customer early payment discounts and estimated write-offs for disputed billing and shipping charges.

Sure, easy for a CPA to say.

Let’s clarify. The company sold stuff. It allowed discounts if a customer paid early. It also had routine billing disputes – for quantity, quality, price, damage and so on. As part of its general accounting, it estimated these charges and recorded them as expenses when the related sale was recorded.

Makes sense to me. Generally accepted accounting wants one to record all related expenses when the sale is recorded. This is called the “timing principle,” and the idea is to present net profit from a sales transaction as well as reasonably possible. What if all the expenses are not known at that precise moment - say, for example - the amount of product that will be returned because of damage in shipping? Generally accepted accounting will allow one to estimate that number, normally by statistical analysis of historical experience.

BTW you better do this if you expect to have your financial statements audited. Part of an audit is a review of your accounting method, and the “estimate that number” described above is considered a best-of-breed.

Generally accepted accounting might not work when you get to your tax return, however. Why? Well, generally accepted accounting is trying to get to the “best” number in an economic sense. Tax accounting is not trying to get to the “best” number; rather, it is trying to measure your ability to pay. Pay what? Taxes, of course.

Let’s go back to our taxpayer. They estimated a bunch of expenses when they recorded a sale. They included those numbers on their financial statements. They then wanted to deduct those same numbers on their tax return.

Problem:

The taxpayer utilized statistics to record the expenses for the two items. The courts held that statistics were not a valid method to record the amounts.”

Their CPA firm had to review the accounting method and decide whether it was acceptable for tax purposes.

There is even a Code section and Regulations:

           Reg § 1.461-1. General rules for taxable year of deduction

(a)(2) Taxpayer using an accrual method.

(i) In general. Under an accrual method of accounting, a liability (as defined in §1.446-1(c)(1)(ii)(B)) is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. 

 

You see that last sentence and its reference to “economic performance?”

 

For generally accepted accounting, one must:

        

·      Establish the fact of the liability.

·      Measure the amount of the liability with reasonable accuracy.

 

Tax then adds one more requirement:

        

·      Economic performance on the liability must have occurred.

 

That third requirement is what slows down the tax deduction.

 

What is an example of economic performance?

 

Say that you record expenses for services related to the sale. Economic performance wants to see those services performed before allowing the deduction. What if you know - because it has happened millions of times before and can be calculated with near-arithmetic certainty – that the services will occur? Tax doesn’t care.  

 

But the auditors signed-off on the financial statements, you say. Doesn’t that mean that experts agreed that the accounting method was valid?      

A taxpayer’s conformity with its accrual method used for financial accounting purposes does not create a presumption that its tax accrual method clearly reflects income.”

And there you have a brief introduction to why a company’s financial statements and its tax return might show different numbers. Financial statement accounting and tax accounting serve different purposes, and those differences have real-world consequences.

 

In this situation, I side with the IRS. Work in a CPA firm for any meaningful period and you will see tax people repetitively “tweak” the audit people’s numbers. It happens so often it has a term: “M-1.” Schedule M-1 is a tax schedule that reconciles the profit per the financial statements to the profit per the tax return. The possible list of differences is near endless:

 

·      Entertainment

·      Depreciation

·      Allowance for uncollectible receivables

·      Accrued bonuses

·      Reserve for warranties

·      Deferred rent

·      Controlled foreign corporation income

·      Opportunity zone income

 

And on and on. Knowing these differences is part of being a tax pro.

 

The Chief Counsel wanted to know why the tax pros at this particular CPA firm did not know that this generally accepted accounting method would not work for purposes of the tax return.

 

To be fair, methinks, because it is complicated …?

 

No dice, said the Counsel’s office. The preparer should have known.

 

The items deducted constituted a substantial part of the return. 

TRANSLATION: It was a big deduction.

And therefore the preparer penalty is appropriate.  

TRANSLATION: Someone has to pay.

Mind you, a Chief Counsel memorandum is internal to the IRS. The taxpayer – and by extension, its CPA firm – might appeal the matter to the Tax Court. I would expect them to, frankly. The memorandum is just the IRS’ side.

For the home gamers, today we have been discussing Chief Counsel Memorandum 20223301F.

 

A Failure To Keep Records

You have to keep records.

Depending upon, this can be easy. Say that you have a job and a money market account – two sources of income. At year-end you receive a W-2 and a 1099-INT. File them with your individual tax return and you have kept records.

Dial this up to business level and the recordkeeping requirement can be more substantial.

Maybe you do not need a bookkeeper or accountant, but you can open a separate business bank account, running all deposit and disbursements through it. You can buy an expanding file – one with a pocket for each month – and keep invoices and receipts throughout the year. That might not be sufficient were you a regional contractor, with equipment and employees and whatnot, but it may be more than enough for what you do.

Why do this?

Because of taxes.

There is a repetitive phrase in tax cases - I have read it a thousand times:

Deductions are a matter of legislative grace, and the taxpayer must prove his or her entitlement to deductions.”

To phrase it another way:

Everything is taxable and nothing is deductible unless we say it is deductible.

One of the things the IRS says is that you must keep records. You can extrapolate what the IRS can do to you concerning deductions if you do not.

“But they can’t eat me, right, CTG?” you ask.

No, but here is what they can do.

Sam Fagenboym was a 50% owner of Alcor Electric, which provided electrical installation for midsize commercial projects. Alcor was a sub to a general contractor. Alcor in turn had suppliers and its own subs.

With the possible exception of the second round of subs, this is pretty routine stuff.

Alcor was an S corporation. It allocated Fagenboym a loss of approximately $110,000 on his 2015 Schedule K-1.

The IRS examined Alcor’s 2015 business return.

Alcor could not document over a quarter million dollars of purchases from a supplier.

Half of that audit adjustment went to Fagenboym, as he was a 50% owner.

The IRS next looked at Fagenboym’s personal return.

So much for the loss he had claimed from Alcor.

Fagenboym went to Tax Court. He went pro se, generally meaning that he was without tax representation.  As we have discussed before, that technically is not correct, as I could represent someone in Tax Court and they would be considered pro se.

Fagenboym argued for Cohan treatment of Alcor’s business expenses.

COMMENT: I would have expected Alcor to fight this issue during its business audit, but here is Fagenboym doing the fighting during his individual audit.    

Cohan is old tax case, going back to 1930 and involving someone who was known for entertaining but not for keeping receipts and records. The Court considered his situation, reasoning there was no doubt that Cohan had incurred expenses. It would be inequitable to disallow all expenses, so the question became: how much to allow?

Cohan has triggered tax changes ever since. It was responsible for the hyper-technical rules concerning meals and entertainment, for example, as well as business use of a vehicle.

Fagenboym wanted some of that Cohan.

I presume there truly were no records. There is no way that I would lead with Cohan if I had any other argument.

Why?

Think about it from the Court’s perspective.

(1) The Court will require a rational basis to estimate the expenses, and

(2)  The Court will consider the taxpayer’s culpability in creating this situation.

Perhaps if there were extenuating circumstances: illness of a key employee, a data loss, a pandemic, something that compromised the taxpayer.  The more one is responsible for causing the mess, the less likely the Court will be to clean-up the mess.

Fagenboym tried. He presented the Court with estimates of job profitability. He then subtracted labor and other known expenses to arrive at what the missing purchases should have been. He submitted four pages of handwritten analysis, but he did not or could not support it with business bank statements or other records, such as an accounts payable history for the supplier in question. Despite how earnest he seemed and how well he understood the business, there were no records backing him up.

Fagenboym could not overcome the two factors above. Even if the Court allowed some leniency on his culpability, it decided it could not independently arrive at a reasonable estimate of the costs involved.

No Cohan. No tax deduction. Bad day in Court for Fagenboym.

Estimated Taxes Matter

Sometimes I read a case and I wonder if the most interesting part was not included.

There is a couple – a doctor and a financial consultant - who are not keen on paying their taxes. Here is a quick recap:

          Year            Tax           Withheld         Due

          2014         $70,018      $24,148         $45,870

          2015         $58,293      $11,677         $45,995

          2016         $52,474      $20,230         $32,244

          2017         $37,001      $11,720         $25,281

This is not rocket science. Chances are that one person has withholdings and the other person is supposed to pay estimated taxes. No estimated taxes were paid. The solution? Simple: (1) pay estimated taxes, or (2) increase the other spouse’s withholdings to compensate for the lack of estimated taxes.

On November, 2016 the IRS sent a Notice of Intent to Levy.

COMMENT: This tells you the taxpayers had been in the system for a while.

The taxpayers requested for a Collection Due Process Hearing.

COMMENT: Good step. The CDP is a chance to halt the IRS automated machinery and allow the taxpayers an opportunity to speak with an Appeals Officer about their specific situation.

The taxpayers were interested in collection alternatives, including:

(a)  an installment agreement

(b)  an offer in compromise

(c)  a “cannot pay balance” status

Seems to me they covered the bases.

They did not submit financial data with the CDP request, but they did later when the Appeals Officer requested. Their information showed monthly income of $25,317 and monthly living expenses of $17,217, leaving a monthly net of $8,100.

The IRS wanted the $8,100.

Surprise factor: zero.

The taxpayers balked, arguing that it was beyond their means.

COMMENT: How can the $8,100 be beyond their means, if that is the amount they calculated? The likely reason is that the IRS has tables for certain expense categories, such as transportation. Say that you have an expensive monthly car payment. You will bump up against that limit, and good luck getting the IRS to spot you more. Mind you, the IRS says that it will consider specific circumstances, but they do not consider them for long. You may find yourself having to trade-down on your car or pulling your kid from private school.

The taxpayers indicated they were going to file an offer in compromise.

They did – eight months later.

COMMENT: Folks, seriously, do not do this. If you are hip deep in a CDP hearing with the IRS, it is a very poor decision to stall.

The Appeals Officer – not willing to wait the better part of a year – sustained the proposed levy.

Next stop: Tax Court.

From the Court we learn that the taxpayers withdrew the offer in compromise because they were “unable” to make estimated tax payments.

Huh?

Folks, this act is fatal. Here is a requirement for an offer:

“Proof of sufficient withholding or estimated tax payments”

The Tax Court’s purview can be broad or narrow, depending on the issue. If there is an issue of tax law, the Court generally has broad powers. This case was not an issue of tax law; rather it was an issue of IRS procedure. Did the IRS follow its own rules? To phrase it another way, did the IRS abuse its authority?

This narrows the Court’s reach – a lot.

It means the Court is not reviewing whether the taxpayers should have received an installment plan, an offer in compromise or whatnot. Rather, the Court is reviewing whether the IRS abused its authority by not allowing said installment plan, offer in compromise or whatnot.

The Court decided the IRS had not.

Why?

“Proof of sufficient withholding or estimated tax payments”

To me, the take-away question is: what are these people doing with their money?

Our case this time was Reid v Commissioner.