IRS Can Sidestep Taxpayers’ CDP Rights by Applying Overpayments

Imagine that Congress sets out a remedy to curb IRS abuses. And further consider that after the taxpayer pursues the remedy, the rules allow the IRS to simply sidestep the remedy. So the remedy is no remedy at all.

That is what we have in the Zuck v. Commissioner, No. 25125-14L (U.S.T.C. Apr. 6, 2022) case. The case involves a collection due process hearing request that was denied because the IRS applied an overpayment from another period to eliminate the tax balance. The taxpayer sought out the remedy, and the court did not resolve the dispute.

Facts & Procedural History

This case involved a taxpayer who filed her 2010 income tax return showing a balance due. In November 2012, she filed an amended 2010 return reporting additional tax due of $27,682, along with an estimated tax penalty, for a total balance of $32,002.

On July 3, 2013, the IRS sent the taxpayer a notice indicating its intent to levy to collect the unpaid 2010 liability and informing her of the right to request a collection due process hearing (“CDP Hearing”). The taxpayer timely requested a CDP Hearing, asserting that the estimated tax payments reported on her amended return should be credited to her account and any penalties abated for reasonable cause.

The Appeals Officer conducting the CDP hearing rejected these arguments and issued a notice of determination sustaining the levy action. The taxpayer then timely petitioned the U.S. Tax Court for review.

While the Tax Court case was pending, the IRS offset a $14,883 overpayment from the taxpayer’s 2018 income tax return against the 2010 balance. This eliminated the entire 2010 liability. As a result, the IRS filed a motion to dismiss the Tax Court case as moot. The IRS argued that because there was no longer any unpaid 2010 tax to collect, the case was moot and should be dismissed for lack of jurisdiction.

The taxpayer objected to the motion, arguing that (1) the offset was improper because the IRS failed to properly assess the 2010 liability, and (2) the Tax Court still had jurisdiction to determine she had overpaid her 2010 taxes and was due a refund.

About Collection Due Process Hearings

The Collection Due Process Hearing statutes were enacted to help prevent IRS abuses. They are part of the taxpayer’s Constitutional due process rights. This was a key provision in the legislation that came out of the Congressional hearings on IRS abuses in the late 1990s.

Under Sections 6320 and 6330, the IRS has to provide taxpayers with written notice before filing a Notice of Federal Tax Lien (“NFTL”) or initiating a levy action. The notice gives the taxpayer the right to request a CDP Hearing with the IRS Office of Appeals. Once requested, the IRS has to pause its collection actions while the CDP Hearing request is being considered.

There are two different reasons for pursuing CDP Hearing requests, depending on what issues the taxpayer raises:

1. Collection Alternative Hearings: The taxpayer can propose collection alternatives, such as an installment agreement, offer in compromise, or currently not collectible status. With these requests, the Appeals Officer must consider whether any proposed alternative balances the need for efficient tax collection with the legitimate concern that the collection action be no more intrusive than necessary.
2. Underlying Liability Hearings: The taxpayer can challenge the existence or amount of the underlying tax liability, but only if they did not have a prior opportunity to dispute it (such as previously receiving a statutory notice of deficiency). With these hearings, the Appeals Officer makes a de novo determination of the liability.

There are times when the IRS Appeals Office does not get to the correct decision in CDP Hearing cases. Congress anticipated this and provided a process to have the U.S. Tax Court review the IRS Office of Appeals determinations in CDP Hearing cases.

The U.S. Tax Court’s Limited Jurisdiction

The U.S. Tax Court is often quick to point out that it is a court of limited jurisdiction. It is not a full court that can hear just about any tax controversy, as many other Federal Courts can. The U.S. Tax Court has to have a specific statute authorizing it to hear a case.

This type of jurisdiction issue has often been at issue with CDP Hearing cases as the court grapples with exactly what its jurisdictional limit is for the statute that allows it to review CDP Hearing requests.

The current understanding is that the U.S. Tax Court can determine whether the IRS followed proper procedures, consider the issues raised at the hearing, and decide whether the proposed collection action may proceed. However, it cannot consider issues outside the scope of the hearing, such as the merits of a liability that was not properly raised by the taxpayer, etc.

This brings us to the U.S. Tax Court’s jurisdiction over refunds or credits from other years in CDP Hearing cases.

According to the U.S. Tax Court, its jurisdiction in CDP Hearing cases is limited with respect to refunds and credits. The court agrees that the law says that it cannot order the IRS to issue a refund or credit an overpayment from another tax year with this type of case.

This differs from the court’s jurisdiction in deficiency cases. Deficiency cases are cases where the IRS has conducted an audit or otherwise determined that the taxpayer owes an additional amount and has made an assessment to record the balance due on the IRS’s books. The court has determined that the statutes allow it to determine an overpayment and order a refund with respect to this type of case. In fact, this is the most common type of dispute that the tax court hears.

The IRS’s Use of the Court’s Jurisdiction Limit

This brings us back to the Zuch case. The taxpayer petitioned the U.S. Tax Court for review of an IRS notice of determination sustaining a proposed levy for her 1992 taxes. Among other things, she argued the IRS failed to properly assess the deficiency and interest.

After the U.S. Tax Court petition was filed, the IRS offset an overpayment from the taxpayer’s 1999 return against the 1992 balance, eliminating the liability. The IRS then filed a motion to dismiss the case as moot, arguing there was no longer any unpaid 1992 tax for the IRS to collect.

The court agreed with the IRS and dismissed the case. Citing its prior precedent, the court held it lacked jurisdiction to determine an overpayment or order a refund in a CDP case, even though part of the taxpayer’s argument involved a claim she had overpaid the 1992 liability.

It should be noted that this did not resolve the taxpayer’s underlying concerns about not owing the tax for 1992. Thus, the taxpayer was not afforded any remedy by way of the CDP Hearing process.

As this case demonstrates, by applying an overpayment from another year, the IRS can unilaterally eliminate a liability that is the subject of a CDP Hearing request. This can basically void the taxpayer’s CDP rights and force the taxpayer to pursue any refund claim separately, either administratively with the IRS or through a refund lawsuit in district court or the Court of Federal Claims.

Preserving the Right to Contest the Liability

Taxpayers may have some other remedies in this type of situation. Specifically, if a taxpayer believes they have overpaid their tax liability, they can file a refund claim with the IRS. This process allows the taxpayer to argue the merits of the liability and potentially recover any overpayment.

However, pursuing a refund claim comes with its own set of challenges and limitations. First and foremost, the taxpayer must have fully paid the assessed tax for the period at issue. This is known as the “full payment” rule, established by Flora v. United States, 362 U.S. 145 (1960). The rule applies even if the taxpayer believes the assessment is erroneous or illegal. Second, there are strict deadlines for filing a refund claim under Section 6511. In general, a claim must be filed within two years of the date the tax was paid or three years from the date the return was filed, whichever is later. If the claim is filed after the three-year mark, the amount of tax recoverable is limited.

While a refund action provides an alternative forum for contesting the liability, it is not a perfect substitute for a CDP Hearing or U.S. Tax Court review. Refund litigation can be time-consuming and expensive, and it may not provide the same level of procedural protections as the CDP process. For example, in a refund suit, the taxpayer generally bears the burden of proof to demonstrate an overpayment, whereas in a CDP case, the IRS bears the initial burden of showing that the liability was properly assessed.

Despite these drawbacks, filing a refund claim may be the only option left for taxpayers seeking to challenge a liability after their CDP rights have been curtailed.

The Takeaway

This case demonstrates how the IRS can use this jurisdictional limitation to its advantage.

By applying an overpayment from another tax year, known as an “offset,” the IRS can unilaterally extinguish a liability that is the subject of a CDP hearing request or Tax Court petition. This offset “maneuver” can significantly prejudice taxpayers by depriving them of a pre-collection judicial forum to argue the merits of the liability and propose collection alternatives. It also forces taxpayers to incur additional time and expense of pursuing a refund action in a different court.

The takeaway from this case is that taxpayers should not overpay the IRS during the pending CDP Hearing process or litigation on the matter. Any overpayment, even if the payments are for a different tax year, can void CDP Hearing rights.

The key is the term “overpay.” As long as at least $1 is still owed after the overpayment, this may not be an issue. Taxpayers seeking to reduce the accrual of penalties and interest may also consider making deposits rather than payments to the IRS pending CDP Hearings.