Payroll tax disputes can be more difficult to resolve with the IRS than some other types of taxes. This is largely due to the IRS’s notice of deficiency process.
The IRS’s notice of deficiency is the final notice the IRS sends before it assesses or records a tax as being due. The notice is required for most taxes. It is not required for payroll taxes, however.
Absent a notice of deficiency, there is no direct way to get the dispute before the courts without first paying the tax and suing the government for a refund. Many taxpayers do not want to or have the resources to pay the disputed taxes up front.
Taxpayers may have no choice but to wait for the IRS to try to collect the disputed taxes and try to use their collection rights to have the court review the liability. This does not always work. The recent Patrick’s Payroll Services, Inc. v. Commissioner, No. 20-1772 (6th Cir. 2021) suggests that it is unlikely to work in most cases.
Facts & Procedural History
This case involved a payroll tax dispute. The taxpayer was an entity set up to process payroll for another business. According to the IRS, the taxpayer incurred a payroll tax liability and failed to pay the taxes to the IRS.
The IRS sent the taxpayer a “30-day” letter advising of the right for the IRS Office of Appeals to review the liability. The taxpayer did not respond to the 30-day letter and the case moved into the IRS’s collection function. The IRS sent a notice of intent to levy, which the taxpayer responded to. In its response, the taxpayer argued it was not liable for payroll taxes for tax periods before the time the business started operations.
The IRS’s settlement officer concluded that the IRS collection actions could proceed. This tax court litigation resulted from that decision.
The Collection Due Process Hearing
The Collection Due Process Hearing (“CDP Hearing”) is a legal requirement. It is intended to allow taxpayers and the IRS an opportunity to pause the IRS’s collection efforts and evaluate whether the IRS should continue.
The CDP Hearing was one of the reforms Congress imposed on the IRS in the late 1990s. The IRS is required to have the CDP Hearing. It is not required to treat the process as anything more than a formality.
The CDP Hearing itself is not really a hearing. The “hearing” is usually just a phone call. The phone call is often one-sided, meaning, the IRS settlement officer may use the call to merely state a conclusion reached before the “hearing” takes place.
For “due process,” the IRS may or may not stop its enforced collection actions while the taxpayer waits for the IRS’s phone call. There is no real remedy if the IRS continues to try to collect the tax. And the phone call often does not happen for three to nine months later. That assumes it ever happens. There are quite a few instances where the phone call never happens.
The CDP Hearing does have some benefits. Namely, it affords the taxpayer the right to challenge the IRS’s actions in the U.S. Tax Court and, in some cases, the underlying liability. This remedy has proven invaluable for some taxpayers.
Contesting the Liability
The IRS attorney argued that the taxpayer could not contest the liability during the CDP Hearing and, by extension, in court. This argument was based on the taxpayer not responding to the IRS’s 30-Day Letter. The IRS’s 30-Day Letter merely allows the taxpayer to ask the IRS Office of Appeals, an administrative function of the IRS, to review the collection action.
According to the IRS, the administrative review by the IRS Office of Appeals that was afforded by the 30-Day Letter precluded the later argument about the underlying payroll tax liability.
The rule parties are referring to can be found in Section 6330:
The person may also raise at the hearing challenges to the existence or amount of the underlying tax liability for any tax period if the person did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.
Given this language, the taxpayer argued that it did not have an opportunity to dispute the tax liability. More specifically, the taxpayer argued that the IRS’s administrative review does not count as an opportunity to dispute the liability. They had to be afforded the right to dispute the liability in court.
The U.S. Tax Court rejected this argument: “The Tax Court rejected the taxpayer’s argument, holding that a conference with the Appeals Office constitutes an opportunity to dispute, as it had already established in a 2007 opinion and as every court of appeals to consider the issue has since agreed.”
The IRS Notice of Deficiency
The taxpayer raised a second argument. The taxpayer argued that it could still challenge the liability given that it did not receive a notice of deficiency. The language quoted above does say that: “did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.”
A plain reading of the Code supports the taxpayers argument. The use of the word “or” suggests that a notice of deficiency is required.
What exactly is a notice of deficiency? The notice of deficiency is issued after or in lieu of the 30-Day Letter in many cases. It is the letter that allows the taxpayer to petition the U.S. Tax Court for the redetermination of their tax. This letter is often referred to as the “ticket to tax court.” It is important as the U.S. Tax Court affords a pre-payment remedy. Meaning, the taxpayer can have the court review the tax liability without having to pay the tax first and sue for a refund.
The IRS does not issue a notice of deficiency in all cases. Per Section 6212 only the taxes in Subtitle A or B or chapter 41, 42, 43, or 44 of the Tax Code require a notice of deficiency. Subtitle A and B provided our income and estate and gift taxes. Payroll or employment taxes are in Subtitle C. So there is no notice of deficiency for payroll taxes.
That is the problem the taxpayer confronted in this case. They probably wanted the court to review the liability but did not want to pay the tax first and sue for a refund. Since they were not issued a notice of deficiency, the CDP Hearing was the only way to get the pre-payment review by the court.
Is a Notice of Deficiency Required
That brings us back to this case. If the taxpayer was correct that a notice of deficiency is required first, that would mean that all payroll tax liabilities could be challenged by timely filing a CDP Hearing request. It would be a work around by allowing this type of challenge for taxes that are outside of Subtitle A or B, such as payroll taxes in Subtitle C.
The appeals court did not agree with the taxpayer. It concluded that the word “or” means “and”:
Here the word “or” does not create disjunctive qualifications. Instead, the phrase “or does not otherwise” identifies a single operative criterion: not having a prior opportunity to dispute. And the statute provides one of the most common examples of such an opportunity: receiving a notice of deficiency.
Thus, the appeals court held that a notice of deficiency is not required. The taxpayer cannot challenge the underlying liability in the CDP Hearing if it failed to respond to the IRS’s 30-Day Letter.
This case shows why it is important to respond to the IRS’s 30-Day Letter. Failing to respond can preclude a later challenge to the liability. There is no notice of deficiency issued in payroll tax cases. With these cases, one cannot get a pre-payment review of the liability by the courts if the 30-Day Letter is issued.
All hope is not lost, however. Those with payroll taxes should consult with a tax attorney. There may still be a position that the CDP Hearing can be used in this circumstance if the taxpayer did not receive the 30-Day Letter, if one was never issued, or if the notice was defective for some reason.