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First Circuit Court of Appeals Threatens Integrity of CDP Process

In September 2010, the United States Tax Court issued its opinion in the case of Dalton v. Commissioner. I wrote an article about that case in the December 2010 issue of Pilla Talks Taxes. See: “TAX COURT CLARIFIES ‘NOMINIEE OWNERSHIP:’ IRS Loses Issue in CDP Case.”

I will not reiterate the entire fact background of the Dalton case here since I addressed it in detail in that previous article. But for the purposes of discussing the next phase of the Dalton saga, it is important to review some of the basic facts of the case.

The Daltons submitted an Offer in Compromise (OIC) as a collection alternative that was presented in connection with their Collection Due Process (CDP) hearing. They presented an OIC as the means of resolving a longstanding delinquent employment tax debt that grew from a failed business several years prior.

The IRS’s settlement officer (SO) that worked the CDP appeal rejected the OIC, claiming that the offer failed to present an amount equal to the Dalton’s full collection potential. At issue was some property that the Dalton’s conveyed into a trust for the benefit of their children some thirteen years prior to IRS’s assessment of taxes. Mr. Dalton’s parents lived in the home that was held by the trust until the Dalton’s lost everything due to the failure of their business. The Dalton’s moved into the home and lived there with Mr. Dalton’s parents at the time the OIC was presented to the IRS.

The SO’s position in rejecting the OIC was that the property held in trust really belonged to the Dalton’s and that the trust was merely a “nominee” of the Dalton’s. A nominee relationship exits when one party (in this case, the trust) holds legal title to property that in reality is completely controlled by and all benefits flow to another (in this case, the Daltons). The party of benefits from the property is considered the legal owner, despite how title is held.

Let me give you an example. Suppose you have $200 cash in your pocket. You wish to save yourself from spending the cash over the weekend. To do so, you hand the cash to your brother, telling him, “Hold this cash for me. Give it back to me sometime next week, when I ask for it.”

Your brother takes possession of the cash. In essence, the cash is “in his name” because it’s now in his possession and care. (Of course, in this example, there’s no legal “title” to the cash.) However, you made it clear to your brother that the transfer of the cash was not a gift. He had no right to take “ownership” of the cash because you told him that he was just to hold it for you until you gave further instructions for him to return it. He has no right to dispose of the cash in any way he sees fit. You made it clear that you want the money back “sometime next week.” Thus, you maintain total control over the cash.

In this case, your brother is your “nominee” as to the cash. He holds it but you remain the equitable owner of the cash because you maintain control over it. In this example, the IRS could reach the $200 held by your brother in order to satisfy your tax debt.

In its decision, the Tax Court thoroughly analyzed the appropriate state law and, where necessary, the federal law to determine whether the “nominee” decision reached by the SO was correct. The Tax Court ruled that the IRS’s settlement officer misapplied the applicable law and thus reached an erroneous decision on the issue. Because of that, the Tax Court held that the SO abused his discretion in rejecting the OIC presented by the Dalton’s.

The IRS appealed the Tax Court’s decision to the United States Court of Appeals for the First Circuit. The First Circuit issued a decision reversing the Tax Court, holding that the SO’s decision to reject the OIC was not an abuse of discretion. See: Dalton v. Commissioner, 682 F.3d 149 (1st Cir. 2012). I analyze the First Circuit’s decision and its implications below.

What is an Abuse of Discretion?

“Abuse of discretion” is the standard of review the Tax Court uses in most CDP judicial appeals. In deciding whether or not to grant relief to a taxpayer in a CDP case, the IRS’s SO has wide discretion in the matter. There is no one size fits all application, particularly in light of the wide variation of the facts and circumstances in taxpayers’ individual cases. There literally is a countless variety of different fact scenarios that can present themselves in CDP cases.

The job of the settlement officer is to consider all the unique facts and circumstances, along with the applicable law and regulations, as well as the IRS administrative procedures (such as Internal Revenue Manual requirements) in order to come up with a ruling on the taxpayer’s CDP appeal. In reviewing an SO’s determination in a judicial appeal, the Tax Court does not necessarily ask the question, “was the SO correct in her determination?” That is to say, the Tax Court will not substitute its judgment for that of the SO’s. If it is true that the SO considered all the facts, considered all the arguments presented, and properly applied the law, regulations and procedures, the Tax Court will not overturn an SO’s decision, even if the Court might have come to a different conclusion based upon the same information.

In this sense, the SO’s determination is given deferential treatment precisely because the IRS has broad discretion to grant or not grant relief based upon the facts of a given case and the applicable law. Only in cases where an SO abused her discretion will the Tax Court rule that the SO’s determination is invalid. Even then, the Court generally does not impose its will in the matter. Rather, it usually remands the case to the IRS’s Appeals Office for another hearing, this time with orders to the SO to properly consider that which was ignored or mishandled the first time around.

Since the Collection Due Process procedures were added to the tax code in 1998 as part of the IRS Restructuring and Reform Act, there has been a mountain of litigation on the question of what constitutes an abuse of discretion. Of course, the idea of abuse of discretion as a standard of review is not new. Both federal and state courts have used this standard in various cases for decades.

In the context of CDP cases, the Tax Court has repeatedly held that an abuse of discretion exists when the SO’s decision is arbitrary or capricious. That is, where it is not grounded in any evidence that was presented in the case. Likewise, an abuse arises when the decision fails to consider the taxpayer’s specific facts and circumstances or fails to consider and rule on issues legitimately presented by the taxpayer. See: Woodral v. Commissioner, 112 T.C. 19 (1999); Murphy v. Commissioner, 125 T.C. 301 (2005); Sampson v. Commissioner, T.C. Summary Op. 2006-75 (2006); Fowler v. Commissioner, T.C. Memo. 2004-263 (2004).

It is also true that an abuse of discretion arises when the SO’s decision lacks sound basis in law or fact. See: Freije v. Commissioner, 125 T.C. 14 (2005); Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367 (1995). As to matters of law addressed by the SO, the Tax Court has ruled repeatedly that when an SO’s decision is erroneous “as a matter of law,” such decision constitutes “an abuse of discretion.” Freije v. Commissioner, supra.         

A good example is the case of Alessio Azzari, Inc. v. Commissioner, 136 T.C. 178 (2011). In that case, the Tax Court reviewed the determination of a Settlement Officer who refused to subordinate a lien that was filed against the corporation. The SO’s determination was based upon the erroneous legal conclusion that the Internal Revenue code precluded the subordination under the circumstances. The Tax Court reviewed the law and facts and found that the SO’s decision to rule against the corporation “was based on an error of law.” In its next breadth, the Tax Court repeated the longstanding rule that “to the extent that [the decision] was based upon an error of law, his determination constitutes an abuse of discretion.” I discussed this case at length in the July 2011 issue of PTT.

In Swanson v. Commissioner, 121 T.C. 111 (2003), the Tax Court reviewed the determination of a settlement officer in a situation where the taxpayer claimed his tax liabilities where discharged in a bankruptcy action and therefore, not legally collectible by the IRS. The SO ruled that the tax debts were not discharged in the bankruptcy because they fell under one of the bankruptcy code’s statutory exceptions to discharge. In reviewing the decision, the Tax Court stated:

In this case, respondent’s [IRS’s] determination regarding whether petitioner’s [taxpayer’s] unpaid liabilities were discharged in bankruptcy required the interpretation and application of bankruptcy law. If respondent’s determination was based on erroneous views of the law and petitioner’s unpaid liabilities were discharged in bankruptcy, then we must reject respondent’s views and find that there was an abuse of discretion. See, e.g., Cooter & Gell v. Hartmarx Corp., 496 U.S. 384, 405 (1990) (abuse of discretion occurs if ruling was based on erroneous view of the law); Abrams v. Interco, Inc., 719 F.2d 23, 28 (2d Cir. 1983) (stating that it is not inconsistent with the abuse of discretion standard to decline to honor a purported exercise of discretion that is infected by an error of law).

In Crawford v. United States, Docket No. 03:05-CV-0022 (DC Nev. 2006), the federal court ruled it an abuse of discretion for the SO to summarily reject the taxpayer’s proposed collection alternative since the SO had the legal authority to consider the collection alternative. The Court noted that the SO did not have the duty to actually accept the proposed alternative. However, rejecting it “without proper consideration” when there was no statutory authority barring the requested relief, constituted an abuse of discretion.

The Tax Court’s decision in the case of Vinatieri v. Commissioner, 133 T.C. 392 (2009), had a very profound impact on taxpayers’ rights and IRS collection defense. Vinatieri filed a CDP appeal to challenge an IRS levy notice. She provided information to the SO showing that, given her modest income and necessary living expenses, she could not make a payment to the IRS and that levy action would cause a serious financial hardship by making it impossible for her to pay her living expenses. Vinatieri was not current with her tax return filing requirements at the time of her CDP Hearing.

The SO considered all the financial facts and circumstances presented by Vinatieri and agreed that collection would indeed cause a hardship and that she was otherwise entitled to have her case closed as “currently not collectible.” That is the status afforded a case when the IRS recognizes that you cannot get blood from a stone and there’s no point in pressing the issue. However, having come to that conclusion regarding Vinatieri’s finances, the SO made the final decision that the case could not be closed as uncollectible because Vinatieri was not current with her filing requirements. The SO therefore ruled that levy action may proceed.

On appeal, the Tax Court carefully reviewed the tax code and regulations regarding the IRS’s right to levy and the circumstances under which a levy would cause hardship. The Court noted that under code section 6343, a levy causing hardship must be released without regard to whether a taxpayer is current with her filing requirements or not. The Court concluded that given Vinatieri’s financial condition, the law and regulations would require that any subsequent levy would have be released since it would cause hardship by making it impossible for Vinatieri to pay her necessary living expenses. The Tax Court correctly stated:

Proceeding with the levy would be unreasonable because section 6343 would require its immediate release, and the determination to do so was arbitrary. The determination to proceed with the levy was wrong as a matter of law and, therefore, was an abuse of discretion. 

This decision had a profound impact on taxpayers’ rights because prior to this decision, the IRS would routinely deny uncollectible status to any taxpayer who had unfiled tax returns. After the Vinatieri decision the IRS changed (as you would hope) its procedural manuals to reflect the fact that a taxpayer facing financial hardship is entitled to have his case closed as uncollectible even if he has unfiled returns.

It is true that the IRS fully acquiesced to the Vinatieri decision. This is not always the case. When the IRS disagrees with a Court ruling, it will often continue to litigate the issue in other courts and continue to enforce its administrative policies that are contrary to the decision. That is not at all the situation with Vinatieri. While the IRS was slow to implement the policy mandated by Vinatieri, the agency did eventually do so completely. Moreover, the IRS never appealed the Vinatieri decision and did not continue to litigate the issue in other cases.

Along Comes Dalton

The Tax Court’s decision in Dalton was not remarkably different than other CDP cases in which the Court reviewed the legal analysis and decisions reached by settlement officers. The Tax Court looked at the facts of the case, analyzed the law as it applies to the facts and came to the conclusion that the settlement officer’s decision on the law was wrong. Specifically, the Court determined that the SO in Dalton misapplied state law in coming to the conclusion that the IRS’s lien attached to the property held in trust and the Dalton’s should have included the value of that property in their OIC.

The analysis of state law is vital in a case like Dalton. The reason is that code section 6321 provides that the IRS’s lien attaches to “all property and rights to property, whether real or personal,” owned by the taxpayer. But federal law does not define or dictate what constitutes “property or rights to property.” That question is now and always has been a matter of state law. The Supreme Court in 1960 stated very clearly that state law alone determines whether a property right exists to which the federal tax lien can attach. See: Aquilino v. United States, 363 U.S. 509 (Sup. Ct. 1960). This rule has become so axiomatic in federal tax law as to be, in every way, set in stone.

So in the context of an Offer in Compromise, which the Daltons presented as their collection alternative, they had an obligation to offer an amount equal to their reasonable collection potential. To the extent that they owned equity in any asset, such as real estate, stocks, insurance policies, etc., the net realizable equity in those assets had to be included in their offer amount. The Daltons excluded the value of the real estate held by the trust for the simple reason that the trust owned the real estate not the Daltons.

In coming to a contrary conclusion, the settlement officer determined that under state law, the trust was in fact the nominee of the Daltons and therefore, the Daltons were the equitable owners of the property despite the fact that the property was titled to the trust. The Tax Court found this conclusion to be erroneous as a matter of law. The Court stated:

We conclude that petitioners [Daltons] do not have an interest in the Poland property that constitutes property or rights to property to which the Federal tax levy could attach under Maine law or a Federal factors analysis. See: Dalton v. Commissioner, 135 T.C. 393 (2010).

The Court declared that it was an abuse of discretion to require the Dalton’s OIC to include the trust property because of the erroneous legal conclusion of the SO. The Tax Court even cited the Vinatieri case as support for its conclusion.

The key difference between the Dalton decision and the Vinatieri decision is that the IRS appealed the Dalton decision.


The First Circuit’s Reasoning

The First Circuit’s decision in the Dalton appeal might be the most bizarre court opinion I’ve ever read. In the first place, the Court of Appeals did not decide whether the Tax Court’s analysis of state law was correct. Rather, the Court noted that a judicial review of an IRS decision in a CDP case should be limited to “ensuring that the IRS’s determinations, whether of law or fact, are not arbitrary.” So far, so good, as an arbitrary determination—that is, one that disregards the law or the facts—is the essence of an abuse of discretion.

But keep in mind that the Tax Court’s decision in Dalton was that the SO came to an erroneous conclusion of law. How can a decision be reasonable if it’s poisoned by erroneous legal conclusions? The Court of Appeals did answer that question, and this is where it gets bizarre. The Court of Appeals stated:

* * * After all, the question is not the correctness vel non [or not] of the IRS’s determination that the taxpayers actually own the Property. Rather, the question is whether the IRS’s determination, correct or not, falls within the wide universe of reasonable outcomes. Because the evidence before the IRS was ample to justify its conclusion that the taxpayers’ valuable ownership interest in the Property had to be considered when evaluating their $10,000 offer in compromise, the IRS acted within its discretion in refusing to accept that offer. * * *

The SO’s determination on the law was wrong but according to the Court of Appeals, that doesn’t matter. Rather, the only thing that matters is whether the decision falls within “the wide universe of reasonable outcomes” based on the facts and law of the case. What does that mean? What is the “wide universe of reasonable outcomes” when we are talking about settled principles of law?

The Court of Appeals clarified what it believes the IRS’s role is in deciding legal issues in a CDP case. The Court stated:

It is not our role, as a court reviewing findings made in the course of a CDP hearing, to determine whether the IRS applied the correct rule of law. In the last analysis, we need only determine whether the IRS applied a reasonable view of what the law is or might be. 

The Court is saying that is makes no difference whether the IRS is right or wrong in its legal analysis, as long as the conclusion reflected some “reasonable view.” The problem with this should be clear. I can express my opinion all I want on various legal issues but in the final analysis, my view is meaningless. The statutes, regulations and court opinions dictate what the law is, not my subjective “view” of the matter.

In Vinatieri, for example, the SO’s “view” of the law was that the taxpayer had to be current with her filing requirements in order to have her case closed as uncollectible. He was wrong. There was no such legal requirement, as the Tax Court pointed out. But under the First Circuit’s reasoning, it doesn’t matter that the SO was wrong. However, since the IRS will not consider an installment agreement or Offer in Compromise unless a taxpayer is current with their filing requirements, it could be argued that the SO’s “view” that the same rule also must (or should) apply to uncollectible status was therefore “reasonable.” The First Circuit might have said that such a conclusion was within the “wide universe of reasonable outcomes.” Never mind that such a decision flew in the face of the plain language of the code section involved.

Even worse is the idea that an SO might legitimately ground his opinion in his view of what the law “might be.” That is, not only does the SO not have to understand the law and conform his ruling to what the law is, apparently he can just guess at the law, as long as his guess falls somewhere within the “wide universe of reasonable outcomes.” How can such a process possibly be referred to as a “due process” hearing?

The First Circuit uses even more bizarre language later in its opinion, when it talks about the role of a reviewing court in CDP cases. The court states that the implication of its opinion (that the IRS does not have to be correct as to the law) goes beyond just legal questions. The Court states that its logic applies also to “a purely factual question,” and even “a mixed question of law and fact.” In all such cases, the First Circuit states that the reviewing court’s mission is merely to evaluate the “reasonableness of the IRS’s subsidiary determination.” The First Circuit concluded:

* * * The CDP process presents no occasion for a reviewing court to demand incontrovertibly correct answers to subsidiary questions, whatever their nature. Rather, the IRS acts within its discretion as long as it makes a reasonable prediction of what the facts and/or the law will eventually show. (The Court’s footnote 6 is found here, which I discuss later in this article; emphasis added.) 

Thus, the Court of Appeals has devolved the CDP process into one of guessing and predicting what the law and facts might turn out to be in a given case.

It should be noted that the IRS’s settlement officers are not judges. They are not appointed to function in any formal judicial capacity. They are not administrative law magistrates. The vast majority of SOs are not even attorneys. They have little or no formal legal training. Most of the SOs serving in the IRS today are former revenue officers (tax collectors) who were appointed to the position of settlement officer and given training by the IRS to function as such. These are IRS employees, working for the IRS. If these people are given the kind of latitude the First Circuit claims they have, what do you believe will be the likely outcome in any given CDP appeal?

This all begs the question: why is it that the First Circuit believes the Tax Court and other courts have no basis for second guessing the legal decisions of settlement officers? The Court itself answers that question by saying:

Any more intrusive standard of review would result in the courts “inevitably becom[ing] involved on a daily basis with tax enforcement details that judges are neither qualified, nor have the time, to administer.” Citations omitted.

This explanation defies the intent of Congress as written in the plan language of code section 6330, the statute that creates CDP rights in the first place. Section 6330(d) explains the right of judicial review and gives the Tax Court jurisdiction over any CDP determination. Very clearly Congress intended the Tax Court to be involved with tax enforcement details for the sole purpose of keeping the agency in check and preventing IRS abuse. The Tax Court has stated innumerable times that the very purpose of code section 6330 and the CDP rights encompassed there is to provide taxpayers with protection from the IRS. That promise is meaningless if the IRS’s determinations will be considered valid so long as they fall somewhere within the “wide universe of reasonable outcomes.”

But even more staggering is the First Circuit’s idea that the judges are somehow not “qualified” to make decisions regarding matters of tax law enforcement. The First Circuit would have us believe that the IRS’s settlement officers—who are not judges, the vast majority of whom are not attorneys and none of whom have any background or training in functioning in a judicial capacity—are more qualified than United States Tax Court judges to decide matters of tax law. If that’s the case, why have the Tax Court at all? If Congress believed for a moment that IRS officials were more qualified than Tax Court judges to determine matters of tax law, why would Congress build a Tax Court appeal right into code section 6330?

Equally troubling is the First Circuit’s suggestion that Tax Court judges don’t have the time to administer tax enforcement matters. If Tax Court judges don’t have the time to deal with tax cases, what are they doing? The sole and express purpose of the United States Tax Court is to hear and resolve tax disputes. The idea of creating the Tax Court and staffing the court with specially trained judges was to set up a judicial tribunal with the expertise to hear and decide complicated tax cases exclusively. That’s the sole purpose of the Tax Court and that’s what the Court does. The Tax Court has no authority to hear any other kind of case. The Court’s jurisdiction is very limited expressly to prevent the Court from getting bogged down with cases outside the scope of the expertise of its judges. So how can it be that reviewing the determinations of settlement officers is too much of a burden for Tax Court judges when that’s exactly what Congress intended them to do?

The First Circuit leaves us with one final thought in its opinion, which is found it its footnote 6 (the last footnote in the opinion). The Court mollified its “reasonable prediction” language with this footnote:

6 Of course, an absurd factual determination or a legal determination that flies in the face of settled precedent will never be reasonable and, thus, will always constitute an abuse of the IRS’s discretion.

So is this the new standard for the First Circuit? Apparently, the SO’s opinion must not simply be incorrect but it must constitute “an absurd factual determination” or if a matter of law is at issue, the SO’s decision must “fly in the face of settled precedent.” How will a reviewing court possibly apply such a standard, especially when reviewing a factual analysis? What constitutes an absurd factual determination as opposed to one which is merely erroneous and without basis?

Moreover, a legal determination which is dead wrong might not fly in the face of “settled precedent” if there is no settled precedent on the topic. For example, in both Vinatieri and Alessio Azzari, there was no “settled precedent” that guided the Tax Court’s analysis. In both cases, the Court merely reviewed the law and regulations to find that the respective SOs erred in their application of the law to the facts of the case. If the First Circuit is correct, neither taxpayer should have won their case despite the plain error of the SO.

The First Circuit states in footnote 4 of its opinion that the standard of review it adopts “by no means leaves a taxpayer at the mercy of the IRS.” The Court states that “there are almost always other legal channels through which a taxpayer may develop a complete record and secure a definitive legal ruling on a contested point of law or fact.” But the Court is wrong on both counts. 

First, if a settlement officer is free to make any ruling that falls within some undefined “wide universe of reasonable outcomes,” how is a taxpayer supposed to challenge such a ruling? If an SO’s determination on the law need not be correct, how does that do anything but put a taxpayer at the mercy of the IRS? The fact is such a standard strips the Tax Court of any meaningful right to force the IRS to follow the law in collection matters. In turn, this gives the IRS license to turn the dogs loose on taxpayers who would have no meaningful way to protect themselves.

What’s worse, taxpayers rarely if ever have an opportunity to seek other judicial remedies in which they can “secure a definitive legal ruling on a contested point of law or fact.” The reason for this is a “settled precedent” of law with which the First Circuit should be well familiar. The precedent I speak of is the so-called Anti-injunction Act found at code section 7421. That section reads in key part as follows: 

. . . no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed.

This statute effectively deprives any federal court of jurisdiction (with narrow exceptions) to entertain lawsuits against the IRS. The idea is that the IRS must operate largely without judicial interference if it is to collect the revenue in any meaningfully efficient manner. Thus, a taxpayer with a dispute over the amount of tax owed or the manner in which it is being collected will not find refuge in any federal court.

However, code section 7421(a) states that one of the exceptions to this rule is in fact code section 6330. Recall that section 6330 establishes the right of judicial appeal to the Tax Court in CDP cases. Thus, the CDP appeal is one of the precious few meaningful ways a taxpayer has to challenge IRS collection actions. The First Circuit’s reference to “other legal channels” a taxpayer might have is purely illusory. There are no other legal channels to question the IRS’s collection actions in the common tax delinquency case. And if the IRS and the First Circuit Court of Appeals have their way, taxpayers won’t have that option either.

The First Circuit’s opinion in Dalton is nothing short of bizarre. And ironically, it “flies in the face of settled legal precedent” regarding the abuse of discretion. 


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