What happens if the IRS enters into a settlement agreement for your tax liability and then, later, it takes a position that is inconsistent with the agreement?
For example, can the IRS agree that an expense is deductible by your business only to say that the same is expense is taxable income to you as the business owner?
The IRS did just that in Padda v. Commissioner, T.C. Memo. 2020-154. This case provides an opportunity to consider how to contest an IRS settlement agreement.
Facts & Procedural History
The taxpayers were doctors. The husband operated a successful medical practice. The medical practice was a corporation and subject to tax as a C corporation.
The taxpayers also owned five restaurants and a brewery. The husband spent a considerable amount of time managing these businesses. The businesses were taxed as partnerships.
The IRS audited the medical practice return and questioned $81K that was spent for travel, meals and event tickets. The IRS settled the issue by allowing some portion of the expenses as tax deductions for the business.
The IRS audited the taxpayers individual income tax return too. The IRS concluded that the $81K was a constructive dividend for the taxpayers.
The taxpayers filed a petition with the U.S. Tax Court to challenge the constructive dividend.
About Constructive Dividends
There are several methods an owner can use to take money out of their C corporation. This includes wages and other compensation paid to the owner, loans to the owner, interest on or repayment of loans from the owner to the business, a gift to the owners, or dividends paid to the owner. Each transfer is treated differently for income tax purposes.
The last option, dividends, are usually not preferred by taxpayers. Dividends are profits paid out of the earnings of the corporation. As earnings, the dividend is subject to income tax at the C corporation level. As distributions to the owner, the dividend is subject to income tax again at the shareholder level. Many taxpayers structure their affairs to avoid this double tax.
One way to do this is to change the accounting for the expenses. Personal expenses can be memorialized in a loan agreement and recorded in the business accounting records as such. Personal expenses can be structured as a repayment of a shareholder loan if the owner had put any funds into the business.
Even with these steps, on audit by the IRS, it is common for the IRS to identify any personal expenses paid by the corporation and assert that the expenses are constructive dividends. This allows the IRS to impose income tax on the dividend at the corporate and shareholder level.
That is what the IRS proposed in this case. It concluded that the $81K was for personal expenses or for expenses that benefited the taxpayer’s other businesses.
The IRS’s Inconsistent Position
In this case, the IRS apparently allowed part of the $81K as a deduction for the C corporation. It also asserted that the $81K was a constructive dividend. This position seems inconsistent. That is what the taxpayers argued.
The court noted this argument in a footnote in the case:
Padda and Kane also argue that the IRS is bound by a duty of consistency to treat the reimbursements as other than distributions. The duty of consistency is an obligation by which a representation made by a taxpayer to the IRS may be binding on the taxpayer if the IRS relies on the representation to its detriment. See, e.g., Beltzer v. United States, 495 F.2d 211, 212 (8th Cir. 1974). Even if the duty of consistency governs the IRS (as opposed to taxpayers), the record does not show that the IRS made a representation to Padda and Kane on which they detrimentally relied.
The court does not explain why the settlement agreement itself is not a representation. The very existence of the agreement shows that the intent was to have some of the expenses not be treated as dividends.
The court also addressed the taxpayer’s argument that the IRS was barred from taking an inconsistent position given the IRS settlement agreement. The court had this to say about the settlement agreement:
First, the settlement expressly governed only the question of whether Interventional Center [the C corporation] was entitled to deductions. The settlement did not purport to address the question of what amounts are includable in Padda and Kane’s income. Second, Interventional Center was a party to the settlement agreement, and Padda and Kane were not.
Based on this, the court concluded that the IRS can maintain an inconsistent position and that the $81K was a constructive dividend.
Settling IRS Tax Disputes
This case shows the difficulties that can arise when working with the IRS when a taxpayer has multiple entities and interests.
In this case, the result would have been different had the settlement agreement encompassed both the corporate and the individual income tax returns.
This may not have been possible in this case given the way the IRS handles cases. The IRS Office of Appeals likely settled the corporate deduction issue. The appeals office may or may not had the individual income tax return assigned to them. If they did not, they would not have the ability to settle the individual income tax return (and the taxpayer should have requested the individual income tax case be forwarded to the same appeals officer and/or that appeals hold the case pending the other case being assigned to appeals). If they did, they settled the corporate but not the individual income tax liability. The result is a settlement agreement that does not really settle the matter.
Since the settlement agreement did not settle the matter, the taxpayers did not get what they bargained for in the settlement. The taxpayers may still have a remedy. They may be able to contest the IRS settlement agreement.
Contesting IRS Settlement Agreements
The IRS often settles cases without documenting the terms of the settlement in anything that is signed by the taxpayer. The IRS Appeals Officer will simply keep an Appeals Case Memorandum or ACM in the appeals records.
In other cases, the IRS will use one of several forms to record the results of its settlement agreements. This includes the Form 870, Forms 870-AD, or Form 906.
The IRS is authorized to renegotiate settlements that were not documented on a Form 870 and those that are recorded on the Form 870. Convincing the IRS Office of Appeals to do so can be challenging. And the IRS takes the position that it will not renegotiate settlements on Form 870-AD, even though the courts have said that the Form 870-AD is not final.
The Form 906 is a formal closing agreement and is binding and final. This is the general rule. Section 7121 authorizes the IRS to reopen and renegotiate the closing agreement and it allows the taxpayer to bring suit on the agreement when there is a “showing of fraud or malfeasance, or misrepresentation of a material fact.”
If the IRS will not voluntarily reopen or renegotiate a settlement agreement, the taxpayer is usually able to file refund claims after entering into the agreement if the statute of limitations is still open. This can force the IRS to reopen and reconsider the matter. It can also afford the taxpayer the ability to litigate the issue in court.
These options should allow the taxpayers in this case to rectify the IRS’s inconsistent position. These options should be explored in cases like this one, where the taxpayers do not get the full benefit of their settlement agreements.