Last week’s lesson was about “self-assessment.” The idea was that even though it’s the IRS’s job to assess taxes, our system nonetheless depends upon taxpayers truthfully reporting the substance of their financial affairs.
Undergirding that idea is another idea: that for every taxpayer there exists a correct tax liability. The goal of tax administration is to get to the substance of taxpayer’s transactions to determine that correct amount of taxes due. For those interested, I explore this idea in my article Tax Administration as Inquisitorial Process ..., 56 Fla. L. Rev. 1 (2004).
The process of getting to that truth involves many forms, and not just the famous 1040. In 2016 the IRS processed over 244 million tax returns of various sorts. 2016 IRS Data Book Table 2, And that figure does not include all the other Forms that are important to tax administration.
This week’s lesson is about one of those other Forms. The case of Craig K. Potts and Kristen H. Potts v. Commissioner, T.C. Memo. 2017-228 (Nov. 20, 2017), teaches the importance the Form 870-AD, both to taxpayers and to tax administrators. The Form has a purpose and that purpose can, as it did in this case, trump substance. More below the fold.
Mr. and Mrs. Potts filed their 2005 return in late 2007, self-reporting over $30.7 million of taxable income (which appears to have come from sales of stock) and a tax liability of $2.1 million (just under 7%). The IRS selected the return for examination and, eventually, proposed a deficiency. The taxpayers protested to the Office of Appeals and reached a settlement with that office. The settlement increased their tax liability from $2.1 to $4.9 million. The taxpayers and the Service memorialized that settlement agreement using a Form 870-AD, signed by the taxpayers in February 2013 and by the IRS in March 2013.
Form 870-AD is used when the taxpayers and the IRS choose certainty over accuracy. The purpose of the form is to allow the Service to immediately assess the agreed-upon deficiency without having to send an Notice of Deficiency (NOD) to the taxpayers. Form 870-AD states that the taxpayers who sign it “consent to the immediate assessment and collection of any deficiencies...plus any interest provided by law.” The importance of the NOD, of course, is that it allows taxpayers to petition the Tax Court to contest a proposed deficiency.
By signing Form 870-AD, then, the Pottses gave up their “ticket to the Tax Court” as the NOD is often called. In exchange, the IRS promised not to reopen the year at issue (unless the IRS could prove fraud). The Pottses, however, retained the right to reopen the year at issue by asking for a refund after paying the liability. See e.g. Whitney v. United States, 826 F.2d 896 (9th Cir.1987). But their access to Tax Court was foreclosed. The Form says that in this language, just above the Taxpayer’s signature line: “I understand that by signing this waiver, I will not be able to contest these years in the United States Tax Court, unless additional deficiencies are determined for these years.”
The 870-AD does not give as much certainty as other forms of settlement, such as closing agreements. Both the IRS and the taxpayers can ask later courts to ignore the Form 870-AD for what are generally equitable reasons. The IRS can hold the taxpayer to a duty of consistency and taxpayers may be able to raise equitable estoppel. The IRS Office of Chief Counsel has this nice legal memo that explains how the Form 870-AD generally works and how the IRS might argue against it. Jack Townsend has this good blog post about the difficulties taxpayers face in raising equitable estoppel.
You may be wondering how the Pottses got to Tax Court if they waived their right to an NOD. The answer is found in §6330, which requires the IRS to give taxpayers a “Collection Due Process” (CDP) hearing---complete with the right of appeal to the Tax Court---before it may actually start collecting assessed taxes. So even though the IRS assessed $4.9 million in tax, the Pottses did not pay a dime of it but instead waited for the IRS to try and collect it. They then invoked their CDP rights and, hey presto!, got to Tax Court.
Section 6330 allows taxpayers to contest the underlying tax liability whenever “the person did not received any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.” The Pottses made a half-hearted effort to argue that they could now contest their 2005 liability because they indeed had not received an NOD. Judge Lauber made quick work of that argument by noting that they themselves had made the choice not to receive the NOD. Thus, they “had, but elected to forgo, a prior opportunity to challenge that liability.”
The Pottses sought to avoid the effect of the 870-AD by asking the Court to ignore the Form for equitable reasons. Basically, they argued that their former return preparer had turned over critical documents to the IRS and those documents showed that the Pottses had miscalculated their bases in the sold stock that produced much of their 2005 income. Judge Lauber rejected the argument. He basically said “nice try” but noted that three years before they signed the Form 870-AD the Justice Department had, in response to their request, sent back what it said were all the documents the Pottses had given up. It was difficult to see how the taxpayers here were lured or mislead into signing the 870-AD.
In sum, by signing the Form 870-AD, Mr. and Mrs. Potts chose certainty over accuracy. They chose the Form over substance.