IRS Abused Its Discretion in Rejecting Taxpayer's Offer in Compromise

(Parker Tax Publishing February 2019)

The Tax Court held that an IRS Appeals officer abused her discretion in a collections due process hearing by rejecting a taxpayer's offer in compromise. The court found that the Appeals officer improperly included assets held by an irrevocable grantor trust in the taxpayer's reasonable collection potential and failed to consider relevant facts in determining that the taxpayer wasted his wealth in investments in an effort to deprive the government of funds. Campbell v. Comm'r, T.C. Memo. 2019-4.

Background

For 2001, John Campbell reported approximately $201,500 of taxable income and a tax liability of around $59,300 on his tax return and received a refund of approximately $17,400. In 2001, Campbell invested in a tax shelter called a CARDS transaction. In 2002, the IRS issued Notice 2002-21, requiring taxpayers to report any involvement in CARDS transactions. In May 2004, the IRS notified Campbell that his 2001 tax return was being submitted for examination.

Campbell and his family had moved to the U.S Virgin Islands in 2002. That year, Campbell decided to set up a family trust. In April 2004, Campbell established the First Aeolian Islands Trust (Trust), an irrevocable grantor trust. Campbell and his family were the named beneficiaries of the trust, but Campbell anticipated receiving no benefit from it. Campbell funded the Trust with a $5 million contribution. The initial contribution was the only contribution to the Trust. A trustee was appointed but Campbell maintained no control over the trustee to make distributions or investments. A Trust Protector was also appointed. Through the Trust Protector, Campbell could request that the trustee be changed, but could not force such action. The Trust Protector changed the trustee after Campbell requested the change based on his belief the original trustee was overbilling the Trust.

Campbell moved back to the United States in 2006 to pursue real estate investment opportunities in the Gulf Coast region. He invested $27 million in the Gulf Opportunity Zone (GO Zone) Initiative, which resulted in a net operating loss (NOL) of approximately $10.4 million. Campbell set up limited liability companies (LLCs) to purchase the real estate assets. In addition to his personal cash investment, Campbell personally guaranteed all of the LLCs' loans to purchase the assets. At the time he made the Go Zone investments, Campbell estimated his net worth at $19 million, consisting of cash and liquid investments. Campbell had approximately $6.5 million remaining in liquid assets after making the GO Zone investments.

In 2009, Campbell learned that some of the GO Zone properties contained Chinese drywall which made them uninhabitable. The lender foreclosed on the properties in 2011, when the outstanding loan balance was around $4.5 million, and later sold the properties. Campbell sued the buyer of the properties and won the right to repurchase them for $1.5 million. Campbell then sold the assets to Clairise Court, another LLC he owned, for $1.5 million. Clairise Court borrowed the funds for the purchase from Antilles Master Fund (Antilles), which was created by Campbell in 2012. Antilles had two investors: Campbell and Liberty Mountain Corp. (Liberty), which was wholly owned by the Trust. Campbell made Liberty aware of his conflicts of interest regarding the transaction. Campbell personally guaranteed a $4.5 million loan for Clairise Court. He continued to have an interest in only one other LLC formed to purchase property through the GO Zone, as the remaining properties were sold or foreclosed on by lenders. Campbell personally guaranteed all of the other LLCs' loans and remained personally liable on them for around $700,000.

In 2007, the IRS issued a notice of deficiency to Campbell for 2001, adjusting his income from $201,500 to approximately $13.8 million. Campbell challenged the notice in the Tax Court. The parties settled and Campbell was allowed to deduct his NOL carryback from his GO Zone investment against his 2001 tax liability. The Tax Court determined that for 2001, Campbell was liable for a deficiency of approximately $1.1 million and a penalty of $113,000. The IRS assessed the additional tax and penalty in 2010.

In late 2010, the IRS issued a final notice of intent to levy and notified Campbell of his right to a collections due process (CDP) hearing. The IRS filed three notices of federal tax liens (NFTLs) in September 2010. Campbell requested a CDP hearing. After submitting Campbell's 2001 return for examination, the IRS opened examinations of Campbell's subsequent years' returns. In 2012, the IRS upheld the proposed levy action. Campbell filed a Tax Court petition; the Tax Court remanded the case to the IRS Appeals Office (Appeals).

In 2014, Campbell submitted an offer in compromise (OIC) on the basis of doubt as to collectability, offering to compromise all outstanding tax liabilities for approximately $12,600. After a supplemental CDP hearing, the IRS calculated that Campbell's reasonable collection potential (RCP) was approximately $1.5 million, which included the "net realizable equity" in the Trust of around $1.4 million. As a result, the IRS rejected Campbell's OIC because of the disparity between the offer and his RCP and for issues related to transferee, nominee, and alter ego theories.

Campbell moved to remand his case to Appeals for another CDP hearing and the Tax Court granted his motion. Following another supplemental CDP hearing, an Appeals officer again rejected Campbell's OIC. She recommended that Campbell increase his offer to $1.5 million and increased his RCP to over $19.5 million due to the inclusion as dissipated assets of funds Campbell used for investments between 2006 and 2010. In June 2018, the IRS formally rejected Campbell's OIC and sustained the proposed levy. Campbell again took his case to the Tax Court, arguing that the Appeals officer abused her discretion.

Analysis

Reg. Sec. 301.7122-1(b) sets forth three grounds on which the IRS may compromise a tax liability: (1) doubt as to liability, (2) doubt as to collectability, and (3) promotion of effective tax administration. Doubt as to collectability exists where the taxpayer's assets and income are less than the full amount of the tax liability. Generally, the IRS will accept an OIC based on doubt as to collectability only if the offer reflects the taxpayer's RCP. Under the Internal Revenue Manual (IRM), a taxpayer's RCP includes (1) assets, including dissipated assets; (2) future income; (3) amounts collectible from third parties; and assets available to the taxpayer but beyond the reach of the federal government. Dissipated assets are includable in the RCP if the assets were disposed of to avoid paying the tax liability. The IRM instructs Appeals officers to look back three years from the date of the OIC to determine whether dissipated assets should be included. However, an Appeals officer may look beyond the three year period if the transfer of assets occurred within six months before or after the assessment of the tax liability. Under Code Sec. 6331(a), the IRS can levy third parties to collect a tax liability if the third party holds property as a nominee or alter ego of the taxpayer.

The Tax Court sided with Campbell, holding that the Appeals officer abused her discretion by including Trust assets and funds Campbell used for GO Zone investments in the RCP and by determining that Campbell had control over the Trust's assets.

The court noted that Campbell submitted his OIC in March 2014; therefore, the Appeals officer should have looked back only to 2012 for dissipated assets, and that the earliest she could look back was 2010 if there was a transfer of assets within six months of assessment. The court found that Campbell's $5 million contribution to the Trust in 2004 was not such a transfer, as it was made at a time when he was unaware of a potential audit of his 2001 return or any increased tax liability that might arise. The court further reasoned that, even if Campbell was aware of a potential tax liability, his net worth after making the contribution to the Trust exceeded any potential liability arising from the examination of his 2001 tax return, because Campbell established during the CDP proceedings that his net worth was $19 million in 2006.

The court also rejected the IRS's assertion that, in addition to the Trust assets, the funds Campbell used for the production of income between 2006 and 2010 should be included in the RCP as dissipated assets. The court noted that by 2010 Campbell had $3.5 million of negative equity in his investments. The court also found that Campbell did not waste his wealth in an effort to deprive the government of funds. After making his GO Zone investments, the court observed, Campbell still had cash on hand of over $6 million. The court also found that Campbell was unaware of the Chinese drywall issue and the looming financial crisis at that time, but the Appeals officer provided no consideration of these issues in the second supplemental determination. In the court's view, there was no indication that Campbell invested in the GO Zone in an attempt to avoid paying his 2001 tax liability.

For a discussion of offers in compromise, see Parker Tax ¶263,165.

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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