Lesson From The Tax Court: The Overlooked Power Of Offset

Last week the Tax Court issued an opinion in Williams v. Commissioner, T.C. Memo 2017-182.  Although it involves small amounts, the opinion teaches a big lesson about the IRS power of offset

Mr. Williams filed his 2013 return reporting $503 of taxable income and withholding of $1,214.  So he claimed an overpayment of $711.  The IRS accepted his return as filed but did not refund the $711.  Instead, it used its offset powers under section 6402(a) to credit that supposed $711 overpayment against Mr. Williams' unpaid tax liabilities from 2011.  Later, the IRS audited Mr. Williams' return and proposed a deficiency of $1,403.  Mr. Williams' protest to Tax Court was not the usual one.  He agreed with the amount of the deficiency, but he thought that since there was not actually an overpayment, per the audit, then the IRS should not have credited that $711 to his 2011 liability but should instead apply it to his 2013 liability.  After all, it was part of the wage withholding for 2013.  Note that it was to Mr. Williams' benefit to pay off the most recent tax liabilities to increase the chances that the older ones would age out.

The Tax Court held it could not review the IRS offset because the offset had occurred prior to the audit of the 2013 return.  "Thus, of the $1,369 withheld from petitioner's 2013 income, only $658 ($1,369 - $711) was available at the time respondent examined petitioner's 2013 return."

Taxpayers often overlook the brutal fact that the IRS can take overpayments and apply them to old tax liabilities.  One common trap is when taxpayers attempt to designate an overpayment as a payment of estimated income tax for the subsequent year.  Treas. Reg. 301.6402-3(a)(5) permits taxpayers to do that and says the IRS will honor such designations.  That is consistent with the general rule that taxpayers may designate voluntary payments to any liability.  See, e.g. Muntwyler v. U.S., 703 F.2d 1030 (7th Cir. 1983).  Ahhhh, but then Treas. Reg. 301.6402-3(a)(6) says, in effect, "but we don't have to honor the designation if you owe us other taxes; we can apply the overpayment to any outstanding tax liability."  

Bottom line: if your taxpayer owes back taxes, your taxpayer will not be able to designate his or her way out of the IRS's power to take those overpayments and apply them to whatever liability serves the best interest of the government.