Tax Liability Review by Tax Court Limited

The collection due process hearing law has provided taxpayers with another avenue for challenging their underlying tax liabilities.

With this option, taxpayers can let the IRS assess the additional tax or penalties and then wait for the IRS to attempt enforced collection for the balance. They can then file a collection due process hearing request to challenge the tax or penalty determination.

This was the case until recently. In Johnson v. Commissioner, 117 T.C. 204 (U.S.T.C. 2001), the court held that it would no longer allow these types of challenges in some cases. This is a significant change that limits the ability to use the collection due process hearing in some cases.

Facts & Procedural History

The taxpayers amended their tax returns to show that their Form W-2 wages were not taxable income. The IRS assessed a frivolous return penalty under Section 6702. The IRS then began enforced collection actions, including issuing a notice of levy and tax lien.

The taxpayers filed a collection due process hearing to challenge the IRS’s collection actions. As part of the CDP hearing, the taxpayers challenged the underlying liability for the penalties.

The court had to decide whether it had jurisdiction or the ability to consider the taxpayers challenge.

About CDP Hearing Requests

Congress created CDP hearings as a check on the IRS’s collections powers. They are intended to pause the IRS collection’s efforts and allow for an independent IRS employee to review that the IRS has followed the law before proceeding with collections.

CDP Hearings were established by the Restructuring and Reform Act of 1998 (“RRA98”). Prior to the passage of RRA98, taxpayers had limited rights to appeal IRS collection actions, and the IRS had broad discretion to seize property and assets without a meaningful opportunity for the taxpayer to challenge the action.

The CDP hearing process was designed to provide a fair and impartial forum for taxpayers to challenge IRS collection actions, including liens, levies, and wage garnishments. The CDP hearing process requires the IRS to provide the taxpayer with written notice of the collection action and the right to request a hearing within 30 days of the notice. The hearing is conducted by an independent IRS Appeals Officer who reviews the taxpayer’s case and the IRS’s collection action and makes a determination as to whether the collection action is appropriate.

The need for CDP hearings arose in part due to abuses by the IRS in its collection practices prior to the passage of RRA98. These abuses included the use of aggressive and abusive collection tactics, such as making repeated and harassing phone calls to taxpayers, seizing assets without proper notice or due process, and imposing excessive and unwarranted penalties.

For example, in the early 1990s, the IRS was accused of engaging in a pattern of abuse and harassment against taxpayers who owed back taxes. In one case, an IRS agent allegedly threatened to take a taxpayer’s home and put his family on the street if he did not pay his tax debt. In another case, an IRS agent allegedly told a taxpayer that he could have her arrested and jailed for tax evasion.

These abuses led to congressional hearings and investigations, culminating in the passage of RRA98. The CDP hearing process was one of the key reforms included in RRA98 to address these abuses and provide taxpayers with greater protections against IRS collection practices.

Challenging the Tax Liability in CDP Hearings

The statute for CDP hearing requests allows taxpayers to challenge the underlying tax liability:

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.

The requirement that the taxpayer did not receive a notice of deficiency or did not otherwise have an opportunity to dispute the liability is where the disputes often come in.

Under the tax code, taxpayers generally have the right to challenge their tax liability in a prepayment forum, such as a deficiency proceeding, before the IRS can take collection actions against them. However, if the taxpayer did not receive a notice of deficiency or did not otherwise have an opportunity to dispute the liability, they can raise a challenge to the underlying liability in a CDP hearing.

For example, if the IRS made an assessment of tax liability based on information that was not properly reported by the taxpayer, and the taxpayer did not receive a notice of deficiency or otherwise have an opportunity to dispute the liability, the taxpayer can raise a challenge to the underlying liability in a CDP hearing. Similarly, if the taxpayer was not properly notified of the assessment, they may be able to challenge the underlying liability in a CDP hearing.

The U.S. Tax Court’s Limited Jurisdiction

This brings us to the question in this case. The taxpayers did not receive a notice of deficiency or might not have had an opportunity to dispute the tax liability. The frivolous return penalty is an assessable penalty. An assessable penalty is one that the IRS can assess without giving taxpayers a statutory notice of deficiency or an opportunity to dispute the liability. So if that were the case, it would seem that the taxpayer can challenge the underlying penalty in U.S. Tax Court by way of the CDP hearing.

The U.S. Tax Court is in some ways, not a real court. It is tied to the executive branch as its judges are appointed by the President of the United States. This is important as the court can only hear those cases that Congress specifically authorized the court to hear.

Congress specifically authorized the U.S. Tax Court to hear disputes involving CDP hearings. Since the law also allows the taxpayer to dispute the tax liability in CDP hearings, one would think that the U.S. Tax Court could hear challenges to any liability that was in dispute in the CDP hearing.

The court in this case reached the opposite conclusion. It reasoned that the court can only consider challenges to the underlying liability if the court could consider challenges to the liability outside of the collection due process hearing. Put another way, if the taxpayer could not originally challenge the tax in the U.S. Tax Court, they cannot do so using the collection due process hearing rules.

The Takeaway

Given this case, the CDP hearing request is more narrow in scope. Taxpayers may not be able to use this process to challenge the underlying liability for taxes that the court would not have subject matter jurisdiction over. This includes assessable penalties, like the frivolous return penalty in this case.

Taxpayers who have balances for assessable penalties may have to pay the penalties and file refund claims and litigate the cases in district court. The same concept applies for other penalties too, such as the trust fund recovery penalty. This is less advantageous than being able to take advantage of the pre-payment remedy of a collection due process hearing and litigation in the U.S. Tax Court.