Court: IRS Cannot Apply New Law Based on Conduct Predating the Law

In Rafizadeah v. Commissioner, 150 T.C. No. 1 (2018), the court concluded that the IRS made a late assessment of tax and penalties. The case turns on whether the IRS can benefit from the longer six-year assessment period based on an information return filing that the law did not obligate the taxpayer to make at the time. The case may be helpful in analyzing other cases involving IRS assessments based on past conduct pre-dating a change in the law.

The Facts & Procedural History

Rafizadeah filed income tax returns for 2006-2009 that failed to report income earned on a foreign account. The IRS assessed tax and penalties for this income by issuing a notice of deficiency in December of 2014. The question for the court was whether the notice was invalid as it was issued after the three year assessment period had expired.

The Time Limit on the IRS’s Power to Assess Taxes

Section 6501 sets out the general rule that the IRS has to make an assessment before the later of three years from the date the tax return was filed or three years from the date the return was actually filed.

There are several exceptions to this general rule, including the six year exception. For foreign income, this exception allows the IRS to make an assessment within six years of the return filing if the taxpayer omits gross income in excess of $5,000 and the income is from a foreign asset that has to be reported under Sec. 6038D. Sec. 6038D requires reporting of additional information relating to “specified foreign financial assets” and says that there is no six year exception under Sec. 6501 if the foreign assets do not exceed $50,000.

Sec. 6038D was added to the Tax Code in 2010, prior to the 2006-2009 tax years at issue here. Because Sec. 6038D did not apply to these earlier years, the Taxpayer here was not required to report information about his foreign financial asset and, as he argued, the six year exception could not apply based on pre-2010 conduct. Put another way, the Taxpayer was arguing that this 2010 tax law change could not apply given that it imposed a requirement that did not apply prior to 2010.

The court agreed with the taxpayer. It reasoned that the the language of the six year limitation requires there to have been a Sec. 6038B reporting requirement in the prior year, which there was not in this case as the law did not impose a reporting requirement in the prior years.

Application to Other New Tax Laws

The Rafizadeah case is one that tax practitioners may want to keep handy as there are other instances where the IRS applies new laws based on the taxpayer’s conduct that pre-dated the new law. The IRS’s practice of assessing and collecting interest on criminal restitution assessments under Sec. 6201(a)(4) provides an example.

Section 6201 allows the IRS to collect criminal restitution that is ordered by the courts for certain tax crimes as if the restitution was a tax. This has been interpreted to mean that the IRS can assess and collect interest on the restitution as if the restitution was a tax. Interest on a tax is retractive back to the date the tax was originally due and payable, i.e., for income taxes, the original due date for the filing of the income tax return for the year in question. The IRS interprets this to mean that it can assess and collect interest on criminal restitution assessments from the tax year of the tax crime.

Section 6201(a)(4) was enacted in 2010 and applies to restitution orders entered on or after Aug. 2010. It is the IRS’s position that it can assess and collect interest retroactively back for crimes involving pre-2010 tax as long as the restitution order was not entered until after Aug. of 2010. This comes up quite often given the amount of time it takes to prosecute tax crimes. It is not uncommon for the courts to enter a restitution order for a tax crime year that is five, ten, or more years prior to the order. These individuals are often surprised to find that the IRS will assess a large amount of interest retractive back to the date of the tax crime year. Depending on the time that has elapsed between the tax crime year and the date the restitution order is entered, the amount of the interest assessed can be nearly as large as the restitution that has to be paid.

If the logic in the Rafizadeah case applies to this type of interest assessment, this retroactive interest should not be assessed. Like in Rafizadeah, taxpayers were not obligated to pay interest to the IRS on criminal restitution assessments prior to Aug. 2010. Absent an obligation to pay interest to the IRS prior to this date, it would seem that the interest could not start accruing until this date. It isn’t clear how the courts would decide this issue, especially given that there isn’t as clear of statutory language that can be read and interpreted as the six-year limitation in this particular case.