Tax Court Case Highlights Growing Problem of IRS Collection Activity before Taxes are Properly Assessed and Administrative Appeal Rights Exhausted

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March 5, 2016

A growing problem with the IRS’s administration of tax disputes involves the IRS initiating collection activity before it has either properly assessed the tax or before taxpayers have exhausted their administrative remedies. Generally, the IRS must observe certain procedural requirements before a tax or addition to tax is assessed against a taxpayer. Increasingly, however, the IRS has initiated collections against taxpayers before completing the assessment procedures or before the taxpayer has had the opportunity to exhaust its administrative remedies. This is particularly true with respect to certain employment tax liabilities and penalty assessments. It is important for taxpayers to avail themselves of their appeal rights timely to prevent erroneous and unsupportable assessments, which happen far more often than one would expect including against large employers.

The Tax Court recently addressed this issue in Hampton Software Development, LLC v. Commissioner. The Tax Court denied the Commissioner’s motion for summary judgment holding that a preassessment IRS Appeals conference held after the IRS issued a 30-day letter at the end of an employment tax audit did not constitute a “prior opportunity” for the taxpayer to dispute its underlying tax liability with respect to a Notice of Determination of Worker Classification (NDWC) that the taxpayer did not receive. Instead, the court held that a taxpayer will only be considered to have had a prior opportunity to dispute the underlying liability when the taxpayer actually receives the NWDC. Though this case arose in the context of worker classification, the procedures for challenging an NDWC apply in the same manner as if the NDWC were a notice of deficiency. Similar to a standard notice of deficiency in an income tax audit (as opposed to an employment tax audit, which are not within the jurisdiction of the Tax Court), section 7436 also provides for a 90-day period to file a petition in Tax Court challenging the IRS’s determination of worker classification during an IRS audit.

In this case, the taxpayer treated a maintenance worker as an independent contractor and issued Forms 1099-MISC. The IRS concluded on audit that the taxpayer should have treated the worker as an employee, thus underpaying its employment taxes for two tax years. The IRS issued a 30-day letter to the taxpayer advising the taxpayer of its right to request an IRS Appeals conference, and the taxpayer timely protested the audit findings and requested a conference with IRS Appeals. The taxpayer and the IRS Appeals Officer did not resolve the worker classification dispute, and the IRS subsequently sent an NWDC to the taxpayer by certified mail that the Postal Service was unable to deliver and returned to the IRS. Because the taxpayer was unaware of the NWDC, the taxpayer did not petition the Tax Court for redetermination of the worker classification dispute, and the IRS subsequently assessed the employment taxes and initiated collection activity by issuing a notice of levy.

Upon receiving the notice of levy, the taxpayer timely requested a collection due process (CDP) hearing before IRS Appeals. Although CDP hearings are conducted under the direction of IRS Appeals, they are not conducted by regular IRS Appeals Officers. Rather, Settlement Officers conduct CDP hearings. Generally, Settlement Officers are promoted from the ranks of Revenue Officers working for IRS Collections. Consequently, taxpayers seeking to make substantive legal challenges to an assessment in a CDP hearing can face an uphill battle. However, a taxpayer may seek judicial review of the Settlement Officer’s determination in the Tax Court if the taxpayer timely requests the CDP hearing within 30 days of the issuance of the CDP notice.

When the Settlement Officer conducted the CDP hearing in Hampton Software, the taxpayer disputed the underlying employment tax liabilities arising from the asserted misclassification of the worker, but the Settlement Officer refused to allow the taxpayer to dispute the underlying liabilities because it had previously disputed the same liabilities in a preassessment IRS Appeals conference. Soon thereafter, the Settlement Officer issued a notice of determination permitting collection activity to continue, and the taxpayer filed a Tax Court petition seeking review of the underlying employment tax liabilities.

In its motion for summary judgment, the Commissioner asserted that the taxpayer was precluded from disputing the underlying tax liabilities in the CDP hearing because it previously had an “opportunity to dispute” the underlying tax liabilities with IRS Appeals and because the IRS had issued an NWDC to the taxpayer. The Tax Court denied the Commissioner’s motion for summary judgment on both theories. With respect to the former, the court identified that the Commissioner’s argument deviated from its own regulations. In particular, the Section 6330 regulations regarding CDP hearings draw a distinction between taxes subject to the deficiency procedures and taxes not subject to the deficiency procedures. Taxes not subject to the deficiency procedures may not be challenged in a CDP hearing if the taxpayer had an opportunity to dispute the underlying liability either before or after the assessment of the tax. Conversely, the regulations provide that taxes subject to the deficiency procedures may be challenged in a CDP hearing if the taxpayer had an opportunity for a conference with IRS Appeals prior to assessment (but not a postassessment Appeals conference), meaning that in Hampton Software Development, the preassessment conference with IRS Appeals was not a “prior opportunity” for the taxpayer to be heard so the underlying liability could be raised in the Appeals conference.

Consequently, the court found that an NDWC is generally subject to the deficiency procedures, so the taxpayer was not precluded from later challenging the underlying liability in a CDP hearing, provided it did not have “actual receipt” of the NDWC. Had the taxpayer actually received the NDWC, it would have been able to petition the Tax Court within 90 days, so it would have been barred in any subsequent CDP hearing from contesting the substantive basis for the underlying liability. Because the taxpayer did not receive the NDWC and its Appeals conference was a preassessment conference, the taxpayer was not barred from raising substantive issues in its CDP hearing. The importance of actual receipt of the notice of deficiency is underscored by the requirement that the IRS send the notice by certified or registered mail. Absent evidence that the taxpayer deliberately refused delivery of the NDWC, the taxpayer’s claim that it did not receive the NDWC was sufficient to overcome the IRS’s motion for summary judgment. The Tax Court did not remand the case to the IRS Settlement Officer for further consideration. At this time, the taxpayer’s challenge has survived the Commissioner’s motion for summary judgment and presumably the Tax Court will review and rule upon the underlying worker classification dispute.