Tax Court Improperly Dismissed Taxpayer's CDP Challenge As Moot, Third Circuit Says

(Parker Tax Publishing April 2024)

The Third Circuit vacated the Tax Court's dismissal moot of a taxpayer's petition for review of a decision by the IRS Independent Office of Appeals to sustain a levy after the IRS withheld refunds owed to the taxpayer and applied them to the allegedly unpaid balance, satisfying it in full. The Third Circuit found that the IRS's setoffs were invalid and without legal effect because the right to offset mutual debts does not apply when the debts are disputed; the court also found that a taxpayer's right to challenge an underlying tax liability under Code Sec. 6330(c)(2)(B) does not become moot once the levy is no longer being enforced or the tax is satisfied. Zuch v. Comm'r, 2024 PTC 85 (3d Cir. 2024).

Background

Jennifer Zuch and Patrick Gennardo were married from 1993 to 2014. In September 2012, they filed separate, untimely tax returns for the 2010 tax year, each electing married-filing-separately status. Zuch's tax return showed an overpayment of tax of $731. Gennardo's tax return showed tax due of $385,393. Gennardo also filed an offer-in-compromise (OIC) to settle his tax debts for the 2007 to 2011 tax years.

All of this had been preceded in 2010 and 2011 by two prepayments of the couple's estimated tax liability for 2010. More specifically, in June of 2010, the couple submitted an estimated tax payment of $20,000 to the IRS for the 2010 tax year. Gennardo then, in January of 2011, sent an estimated tax payment of $30,000 for the 2010 tax year. When they made the payments, Zuch and Gennardo did not specify how they wanted to have the IRS allocate those payments to their respective tax liabilities, and Zuch's late-filed 2010 tax return did not mention the estimated payments. After processing Gennardo's return, the IRS applied the full $50,000 in estimated payments to offset the tax due on his individual 2010 return.

In November 2012, Zuch filed an amended 2010 tax return to report additional income from a retirement account distribution, causing additional tax due of $27,682. On that return, she claimed the benefit of the same $50,000 in estimated payments and requested a refund. The IRS assessed Zuch the additional tax she reported, but it did not refund or otherwise credit her for the $50,000 in estimated payments that she claimed. It also allegedly sent her a notice and demand for payment of her additional tax due, but she disputes ever having been sent such a notice.

In March 2013, Gennardo filed an amended tax return for the 2010 tax year. He included a statement that he was amending his return in part to notify the IRS that there were estimated payments of $50,000 that should be allocated to Zuch, apparently showing his approval of Zuch's previously filed amended return in which she claimed the benefit of the estimated payments. But the IRS did not adjust the allocation of the $50,000 from Gennardo to Zuch. In June 2013, Gennardo submitted an amended OIC to increase the amount of his offer, which the IRS accepted. Despite his earlier direction that the estimated payments should be allocated to Zuch, the IRS gave him a document showing it had credited the $50,000 in estimated payments to his outstanding tax liability.

In August 2013, the IRS sent Zuch a Final Notice of Intent to Levy and Notice of your Right to a Hearing. That notice informed her that the IRS intended to levy on her property for failing to pay her remaining 2010 tax liability of approximately $36,000 and that she had thirty days to appeal the levy by requesting a collection due process (CDP) hearing with the IRS Independent Office of Appeals (Appeals). Zuch timely requested a CDP hearing. Because she did not receive a notice of deficiency or otherwise have an opportunity to dispute her tax liability, she exercised her right to challenge "the existence or amount of the underlying tax liability" in the CDP proceedings under Code Sec. 6330(c)(2)(B). Specifically, Zuch alleged that the $50,000 of estimated tax payments credited to Gennardo should have been credited to her, making her underlying tax liability $0. Prior to the hearing, Zuch's counsel submitted a signed declaration from Gennardo directing the IRS to apply the $50,000 to Zuch's personal tax liability.

The CDP hearing was held in July 2014. During the hearing, an IRS officer told Zuch's counsel that he did not believe that the IRS could credit any of the estimated payments to Zuch's liability because they had already been credited to Gennardo's account. In September 2014, Appeals sustained the IRS's proposed levy, stating it was "not in a position" to move credits from Gennardo's account to Zuch's. Zuch petitioned the Tax Court for relief. She asked the court to review her underlying tax liability and conclude that the $50,000 in estimated tax payments should be applied to her individual account. The Tax Court then granted the IRS's unopposed motion to remand the case to Appeals. In June 2017, Appeals confirmed its prior determination to sustain the levy, and the case returned to the Tax Court.

Credit Setoffs

Throughout the several years Zuch was arguing with the IRS about her 2010 tax liability, including in the CDP hearing and in the Tax Court, the IRS was taking tax refunds that Zuch was owed in later tax years and applying them to what it calculated to be her 2010 tax liability. It did this six times - once each in 2013, 2014, 2015, and 2019, and twice in 2016. In 2019, the IRS used a refund to set off the remainder of Zuch's 2010 unpaid tax, reducing the balance due to $0. With no remaining unpaid tax on which to execute a levy, the IRS moved to dismiss the Tax Court proceeding as moot. Zuch opposed the motion, but the Tax Court granted it and dismissed the petition. The Tax Court found that there was no longer a live controversy because there was no unpaid liability upon which a levy could be based and the IRS was no longer pursuing the proposed collection action.

In reaching its conclusion, the Tax Court followed the reasoning of Greene-Thapedi v. Comm'r, 126 T.C. 1 (2006), a case with similar facts. There, a taxpayer challenged her tax liability in a CDP hearing after being notified by the IRS of its intent to levy her property. Appeals sustained the levy, and the taxpayer took her case to the Tax Court. After she filed her petition, the IRS used the taxpayer's overpayment in a later year to fully satisfy the disputed tax liability. The Tax Court then dismissed the taxpayer's proceeding as moot. The Tax Court reasoned that whatever right the taxpayer may have to challenge the existence and amount of her underlying tax liability arose only in connection with her challenge to the proposed collection action and, if the proposed levy was moot, then the taxpayer had no independent basis to challenge the existence or amount of her underlying tax liability in the Tax Court.

Third Circuit's Analysis

In the view of the Third Circuit, this dispute came down to whether, in the midst of litigation over a contested tax liability, the IRS is free to deprive the Tax Court of jurisdiction by the expedient of taking the taxpayer's refunds and applying them to that liability. The Third Circuit concluded that the answer is no -- the IRS's arrogation to itself of the power to eliminate pre-deprivation judicial review of liability by seizing a taxpayer's money to cover a disputed debt is not supported the law.

The Third Circuit found that Zuch's claim was not moot because the IRS's setoffs were invalid. The court explained that under the common law rule, the right to apply mutual debts to offset each does not apply when the debts are disputed. Accordingly, a creditor cannot set off a disputed debt with an undisputed one. The court further found that Code Sec. 6402, which codifies the IRS's right to credit overpayments to any liability of a taxpayer, does not rescind the common law regarding setoffs. The court also reasoned that the purpose of CDP hearings is to give taxpayers protections in dealing with the IRS that are similar to those they would have in dealing with any other creditor. Allowing offsets such as the one here, the court said, would be an affront to the entire purpose of CDP hearings.

Observation: In a footnote, the court observed that Reg. Sec. 301.6330-1(g)(2), Q&A (G)(3) provides that the IRS may offset overpayments against the unpaid tax in a CDP proceeding during the pendency of the CDP hearing and appeals process. The court said that, to the extent the regulation provides that the IRS can take an undisputed debt (i.e., an overpayment of taxes, giving rise to an obligation by the government to issue a refund) and apply it against a disputed one (like the alleged liability in this case), such an interpretation of the statute is untenable. According to the court nothing in the plain text of Code Sec. 6402 allows for such a meaning.

The Third Circuit reached the same conclusion by viewing Zuch's claim as a challenge to liability under Code Sec. 6330(c)(2)(B). In the court's view, Zuch's underlying tax liability was very much in dispute when the IRS withdrew its levy because it had already taken her money without her consent. The court found that the rights provided by Code Sec. 6330(c)(2)(B) are not restricted by any requirement that the challenge relates to an unpaid tax or proposed levy. Consequently, the court said that there is nothing in Code Sec. 6330(c)(2)(B) to suggest that a taxpayer's right to challenge the existence or amount of her underlying tax becomes moot once the levy is no longer being enforced or the tax is satisfied.

In interpreting Code Sec. 6330(c)(2)(B) this way, the Third Circuit parted ways with the Fourth and D.C. Circuits. In McLane v. Comm'r, 2022 PTC 19 (4th Cir. 2022), the Fourth Circuit held that the phrase "underlying tax liability" in Code Sec. 6330(c)(2)(B) must be read in the "specific context of the IRS's attempt to collet via lien or levy." With that limitation in mind, it reasoned that the Tax Court does not have jurisdiction "over independent overpayment claims when the collection action no longer exists." Similarly, in Willson v. Comm'r, 2015 PTC 399 (D.C. Cir. 2015), the D.C. Circuit reasoned that the only relief Code Sec. 6330 authorizes the Tax Court to grant is relief from levy and that, consequently, there is "no appropriate course of action for the Tax Court to take but to dismiss [a case] as moot" when the IRS withdraws its proposed levy. The Third Circuit did not read "underlying tax liability" so narrowly. On the contrary, the court found that by its terms Code Sec. 6330 provides a forum to challenge a lien or levy and accounts for different circumstances in which that need may raise - including the circumstance in which the taxpayer had no opportunity to challenge her underlying liability.

The Third Circuit also found that the Tax Court's reasoning in Greene-Thapedi was faulty. In that case, the Tax Court relied on two non-precedential cases, Chocollo v. Comm'r, T.C. Memo. 2004-152, and Gerakios v. Comm'r, T.C. Memo. 2004-203. The Third Circuit noted that in both of those cases, the taxpayer was not asserting any ongoing challenge to the tax liability underlying the CDP proceeding when the Tax Court declared the matter moot. Further, the Third Circuit found that the Tax Court's own precedent since Greene-Thapedi suggests that the case was wrongly decided. In Vigon v. Comm'r, 149 T.C. 97 (2017), the Tax Court held that the IRS cannot unilaterally moot a case by withdrawing its proposed collection activity if the Tax Court has already "obtained jurisdiction of a liability challenge when the petition was filed." Although a footnote in Vigon distinguished it from Greene-Thapedi because Greene-Thapedi involved a liability that had been satisfied and not merely abated, the Third Circuit found that there is nothing in Code Sec. 6330 to suggest that distinction. The Third Circuit concluded that, once the Tax Court has jurisdiction to resolve a disputed tax liability, it does not lose that jurisdiction simply because the IRS decides to satisfy the asserted liability with the taxpayer's own funds.

The court noted that in a 2003 Chief Counsel Notice (CC-2003-016), the Office of Chief Counsel explained that "a motion to dismiss for mootness is inappropriate if petitioner is disputing the existence or amount of the liability. Even if the liability has been paid, may still dispute the liability." The Third Circuit said that is the correct view, and the IRS should have stuck with it. The court concluded that the holding in Greene-Thapedi that a taxpayer may only challenge her underlying tax liability if there remains an unpaid tax or a proposed levy is erroneous.

For a discussion of CDP hearings, see Parker Tax ¶260,540. For a discussion of offsetting overpayments against unpaid taxes, see Parker Tax ¶260,520.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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