Tax Court Sheds Light on Calculations IRS Should Use in Considering Offers in Compromise Alphson, TC Memo 2016-84 In concluding that IRS did not abuse its discretion in rejecting a taxpayer's offer in compromise (OIC), the Tax Court has shed light on various calculations that IRS should use when it considers OICs. Code Sec. 6321 imposes a lien on all property and property rights of a taxpayer liable for taxes after a demand for the payment of the taxes has been made and the taxpayer fails to pay those taxes. The filing of a Notice of Federal Tax Lien (NFTL) ensures priority of the Federal tax lien over claims of most competing creditors. ( Code Sec. 6323 ) When IRS pursues collection by lien, it must notify the affected taxpayer in writing of his right to a collection due process (CDP) hearing with an impartial officer from the IRS Office of Appeals. ( Code Sec. 6320(a) and Code Sec. 6320(b) ) Where a hearing is requested, the presiding Appeals officer must take into consideration, among other things, relevant issues raised by the taxpayer concerning the collection action. ( Code Sec. 6330(c)(3) ) Relevant issues may include challenges to the appropriateness of the collection actions and potential collection alternatives such as an installment agreement or an OIC. ( Code Sec. 6330(c)(2)(A) ) The Tax Court is empowered to review Appeals' determinations of nonliability issues for abuse of discretion. (Goza, (2000) 114 TC 176 ) An Appeals Office settlement officer abuses his discretion if his decision was grounded on an error of law or rested on a clearly erroneous finding of fact, or if he ruled irrationally. (Fargo, (CA 9 2006) 97 AFTR 2d 2006-2381 ) Code Sec. 7122(a) authorizes IRS to compromise a taxpayer's income tax liability. Code Sec. 7122(d)(1) gives IRS wide discretion to accept compromise offers and to prescribe guidelines "to determine whether an offer-in-compromise 1
is adequate and should be accepted." One of the grounds for the compromise of a tax liability is doubt as to collectibility ( Reg. 301.7122-1(b) ), which "exists in any case where the taxpayer's assets and income are less than the full amount of the liability." ( Reg. 301.7122-1(b)(2) ) IRS will accept an OIC based on doubt as to collectibility when it's unlikely that it can collect the unpaid tax liability in full and the offer reflects the taxpayer's reasonable collection potential (RCP). A taxpayer's RCP is the amount that IRS thinks it can get from the taxpayer's assets and income. (Internal Revenue Manual (IRM) pt. 5.8.4.3) Code Sec. 6502(a) provides that the statute of limitations for collection expires ten years after the date of assessment. For much of his professional career, up until 2008, the taxpayer, Mr. Alphson worked in the commercial real-estate industry. In 2008, he settled an ongoing legal dispute and received $1,195,000, payable partly in 2008, partly in 2009, and partly in 2010. As a result of the settlement, he was no longer able to work for the company he had previously worked for and he hadn't found work thereafter. His 2008-2010 returns showed tax due of over $200,000 which he never paid. He made an OIC of $2,400, payable over two years. IRS turned it down and later filed an NFTL against his property. He had a CDP hearing in which he challenged the lien, but the settlement officer agreed with the filing of the lien, and so he sought review by the Tax Court. The sole issue was whether the settlement officer abused his discretion by not accepting Alphson's OIC. There was no abuse of discretion. The Court rejected Alphson's argument that the settlement officer erred in calculating his RCP and that he therefore abused his discretion when he rejected the taxpayer's offer. The Court said that it was aware of the longstanding rule that the IRM doesn't have the force of law, but, because Code Sec. 7122 gives such wide discretion 2
to IRS to establish guidelines for evaluating OICs, it has generally upheld a settlement officer's determination rejecting an OIC as reasonable when he follows the IRM. (Atchison, TC Memo 2009-8 ) And even if the officer makes some errors in calculating the RCP, the Court has upheld a determination when the taxpayer's OIC was far less than the correct RCP. (Carter, TC Memo 2007-2 ) The Court said that the main components of a taxpayer's RCP are his realizable net equity in his assets and his net future income. It then analyzed both components....net equity in assets. The settlement officer determined that Alphson had net realizable equity in assets of more than $1.5 million, even though Alphson said on his Form 433-A, Collection Information Statement, that he had only $501 in total available assets. The bulk of the difference between these two figures was the $1,195,000 Alphson collected as a result of his settlement. The parties agreed that Alphson received the $1,195,000 and that he no longer had any of this money because he spent it. The disagreement was whether all or some of it should still be included in Alphson's RCP. This was a dispute, in other words, about whether or not the settlement proceeds are a "dissipated asset." A dissipated asset is any asset (liquid or illiquid) that has been "sold, transferred, or spent on non-priority items or debts and that is no longer available to pay the tax liability." (Johnson, (2011) 136 TC 475 ) The IRM provides specific guidance on how to calculate and when to include dissipated assets in a taxpayer's RCP, but the parties disagreed about what version of the IRM to apply. IRS revised the relevant portion of the IRM effective September 2013. That date was after the settlement officer completed his work on Alphson's case; the Court indicated that the earlier version was the appropriate version of the IRM for it to consider. That earlier version provides that, while dissipated assets shouldn't automatically be included in calculating RCP, if a taxpayer used assets on 3
nonpriority items, the officer should determine what portion of the value of the asset is appropriate to include in the taxpayer's RCP. The determination should analyze facts such as when the assets were dissipated in relation to the tax liability and the OIC, with a general rule of considering only assets dissipated within five years of the offer. The officer shouldn't include assets that were used to fund necessary living expenses. (IRM pt. 5.8.5.16 (Oct. 22, 2010) Notably absent from this version of the IRM is a presumption against including dissipated assets where the officer doesn't show an attempt to avoid paying the tax. Alphson cited the September 2013 IRM for the principle that "inclusion of dissipated assets in...rcp is no longer applicable, except in situations where it can be shown the taxpayer has sold, transferred, encumbered, or otherwise disposed of assets in an attempt to avoid the payment of the tax liability." (IRM pt. 5.8.5.18(1) (Sept. 30, 2013)) The Court held that the settlement officer did not abuse his discretion under the guidance in either of the two versions of the IRM. Looking first to the 2010 IRM, the Court noted that Alphson provided the settlement officer with a chart of his expenses during the 2-1/4 year period from the time he received the first settlement check until the settlement officer made his decision. The chart showed a total of almost $1.3 million, but almost $1.1 million of that amount was labelled only as either "credit card" expenses or "living expenses." The Court said that the table alone wasn't adequate substantiation-it didn't prove he actually spent those amounts or spent them on what he claimed. He did provide pages and pages of photocopies of checks, but he didn't sort or organize them by type of expense or purpose. Some seemed to be for clearly unnecessary expenses-for example, there were many to various country clubs. Electronic withdrawal records similarly showed payments to businesses such as American Express, Chase, or Bank of America, but not what the underlying charges were for. The Court acknowledged that Alphson obviously spent some money over the 2-1/4 years, but there was no evidence that he spent anywhere 4
near the entire amount of settlement on necessities. The Court also found no abuse under the September 2013 IRM. It noted that the taxpayer's argument omitted a relevant portion of that IRM which says to include dissipated assets used for unnecessary items after the tax has been assessed or within six months before assessment. (IRM pt. 5.8.5.18(1) (Sept. 30, 2013)) The Court looked at the dates of the assessments and concluded that, without even looking at whether the first two settlement amounts should be considered for this purpose, clearly the third settlement, which greatly exceeded Alphson's $2,400 offer, should be so considered because it was received well after the 2008 taxes were assessed....net future income. The Court did find clear error with certain aspects of the settlement officer's determination of future income. The settlement officer included several calculations in that determination, one of which involved determining a monthly amount by dividing Alphson's adjusted gross income for the 2-1/4 years by the 27 months during that period, and then multiplying that by the 10-year (i.e., 120-month) collection period under Code Sec. 6502. Alphson was unemployed through most or all of the 2-1/4 years. He claimed to be unemployed despite his "herculean efforts to obtain suitable employment," and he blamed this on his age, his low credit rating, and the fact that the real estate market was severely depressed after the Great Recession began. The Court said that the settlement officer didn't abuse his discretion by finding that Alphson would earn some future income. There is a difference between "unemployed" and "permanently unemployable," and, in the past, the Tax Court has found IRS didn't abuse its discretion when deciding that, on the basis of a taxpayer's health, education, skills, prior earnings, and professional background, the taxpayer could earn future income despite being unemployed at the moment. But, the Court said that the IRM provides that, when a taxpayer has been unemployed for a long time, his current income should be used, and the officer shouldn't average income, and shouldn't use anticipated future income if the 5
taxpayer's future employment is uncertain. (IRM pt. 5.8.5.18(4)) The settlement officer's calculation averaged Alphson's income over 2-1/4 years. That calculation would seem to violate the IRM's direction not to average when the taxpayer is unemployed. Moreover, Alphson's AGI from 2008-2010, when he claimed to be unemployed, might not have been a good indicator of what he would make when employed in the future. For example, in 2010, most of his reported AGI came from a capital gain related to an entity he appeared to have sold an interest in. There was nothing to indicate that Alphson could continue to have such high capital gains in the future. The settlement officer made one more error: multiplying Alphson's net monthly income by 120 months to calculate his future income. An older version of the IRM instructed a settlement officer to multiply monthly income by the number of months remaining in the statutory collection period. (IRM pt. 5.8.5.6.6 (Sept. 23, 2008)) However, this IRM rule changed in 2010, and the IRM then told settlement officers to multiply monthly income by 60 months or the remaining statutory period, whichever is less, for OICs payable between more than five months and 24 months. (IRM pt. 5.8.5.23) Alphson had expressed his intent to pay the $2,400 in 24 months, so IRS should have used 60 months. 6