Trusts Can't Recover Underpayment Interest on $71 Million Deposit Not Used to Pay Tax

(Parker Tax Publishing December 2022)

The Court of Federal Claims held that three family trusts were not entitled to a refund of underpayment interest under Code Sec. 6603 after a deposit they made with the IRS in order to suspend the running of interest was not used by the IRS for taxes due and was eventually returned to the trusts. The court found that under Code Sec. 6603, a taxpayer has no statutory entitlement to a suspension of underpayment interest if the IRS does not actually use a deposit for a payment of tax and the IRS is not required to use deposits as tax payments. Dillon Trust Company LLC v. U.S., 2022 PTC 351 (Fed. Cl. 2022).

Background

By the end of August 2014, Humboldt Shelby Holding Corp. (HSHC) was subject to a federal income tax deficiency of $25,617,887, and a gross valuation misstatement penalty of $10,247,155, plus interest, which remained unpaid. In November 2014, the IRS sent letters to nine family trusts of the Dillon family (the original trusts) notifying them that they might be held liable as transferees under Code Sec. 6901 for HSHC's unpaid liabilities. Acting on behalf of the Dillon family trusts, Dillon Trust Company (DTC) informed the IRS that six of the original trusts had terminated and provided a list of successor trusts that would be liable for any assessments made against the terminated trusts.

In May 2015, while the IRS examination was still ongoing, DTC sent the IRS a single check for $71,741,583, which was marked as a "deposit." The letter enclosed with the check reiterated that the check was "designated a deposit and is not intended as a payment of tax." The stated purpose in "enclosing a deposit as provided under IRC Section 6603 and Rev. Proc. 2005-18" was to "stop the accrual of interest" on HSHC's underlying liabilities in the event that the original trusts were held liable as transferees.

Given the successor trusts' assumption of liabilities for the terminated original trusts, DTC intended the $71.7 million to be posted as separate deposits for 30 different taxpayer accounts (two original and 28 successor trusts) to cover each of their potential liabilities. DTC's letter therefore instructed the IRS to distribute the $71.7 million according to an attached allocation schedule. However, on May 8, 2015, the IRS posted the $71.7 million deposit to the general ledger account and not the individual taxpayer's account for each trust.

In October 2016, the IRS issued statutory notices of liability to each original trust, whereby each trust was assessed with a portion of HSHC's income tax deficiency, penalty, and underpayment interest that was still running. For terminated trusts, notices were issued to the original trust rather than its successor trusts. HSHC's underlying liabilities totaled $68,511,826 by then, $32,646,784 of which was in accrued interest. In addition to filing protests seeking a hearing with IRS Appeals, DTC sent the IRS a letter requesting on behalf of all Dillon family trusts that the IRS use portions of the Code Sec. 6603 deposits as payments for some of the assessed liabilities. The letter also clarified that the remaining amount of the deposit should continue to be treated as a deposit. The IRS, however, had not applied any of the deposits as payments for the original trusts' liabilities by March 2017. Upon DTC's query, an IRS agent stated that the IRS's procedures do not allow a person to direct it to apply a deposit to pay another person's liability. The agent advised DTC to make a written request for the return of the deposits so that the trusts could make payments with the returned money.

In March 2017, DTC sent a written request to the IRS for a return of the deposits. The IRS applied a portion of the deposits as payments for two the trusts' respective liabilities, but no other deposits were applied as payments. The IRS returned the remaining deposits with interest. DTC then paid in full for transferee liabilities assessed against the original trusts. However, because the IRS did not stop underpayment interest on HSHC's underlying liabilities as of the date the deposits were posted, the trusts claimed that they paid over $11 million in interest that they did not owe. The trusts therefore brought an action in the Court of Federal Claims for a refund of the overpayment.

Under Code Sec. 6601(a), the IRS is authorized to collect underpayment interest. However, the IRS may not collect underpayment interest in circumstances described in Code Sec. 6603. Code Sec. 6603(a) permits a taxpayer to make a deposit with the IRS for any tax that has not yet been assessed. Once a taxpayer has made such a deposit, Code Sec. 6603(b) provides that underpayment interest is suspended from the date a deposit is made "to the extent such deposit is used by the Secretary to pay tax." To the extent the IRS does not use a deposit as a tax payment, Code Sec. 6603(c) requires the IRS to return any amount of the deposit that the taxpayer requests in writing. Rev. Proc. 2005-18 provides that a deposit made pursuant to Code Sec. 6603 is not subject to a claim for credit or refund as an overpayment until the deposit is applied by the IRS as payment of an assessed tax of the taxpayer. Under the procedure, a taxpayer may request the return of all or part of a deposit at any time before the IRS has used the deposit for payment of a tax.

The trusts argued that underpayments on HSHC's tax deficiency should not have accrued beyond May 8, 2015, the date when the IRS posted their deposits. According to the trusts, the IRS erred when it issued notices of liabilities to the successor trusts rather than to the terminated original trusts and, had it not done so, there would have been no impediment to applying the deposits as payments. The trusts further contended that the IRS cannot be vested with discretion so broad as to allow it to reap a windfall from its own bureaucratic incompetence and/or intransigence. It was unlawful for the IRS to collect interest, the trusts asserted, while it delayed the return of the deposits they requested, and if the IRS had returned the money immediately when the request was made in March 2017, the trusts could have paid their liabilities earlier and thus stopped interest sooner than August 2017.

The government filed a motion for partial dismissal on the ground that the government had not waived sovereign immunity and the court therefore lacked jurisdiction. The government also filed an alternative motion for partial summary judgment, arguing that Code Sec. 6603 mandates interest suspension only when the IRS uses a deposit for payments of tax and that the trusts could not benefit from such a suspension given that their deposits were not applied as tax payments.

Analysis

The Court of Federal Claims denied the government's motion for partial dismissal for lack or jurisdiction, but it granted the government's motion for summary judgment after finding as a matter of law that the IRS's collection of interest for the period at issue did not violate the law.

The court explained that, in order for it to have subject matter jurisdiction over an illegal exaction claim, all that is required is that the taxpayer paid money over to the government and seeks its return by making a non-frivolous allegation that the government has, in obtaining the money, violated the Constitution, a statute, or a regulation. In the court's view, the trusts met this low threshold by making a non-frivolous allegation that they deposited over $71 million with the IRS in 2015, that the IRS held the deposits until their return in 2017, and that the IRS violated Code Sec. 6603 by failing to suspend underpayment interest as of the date the deposits were posted - resulting in an $11 million overpayment of interest. The court therefore denied the government's motion for dismissal for lack of jurisdiction.

The court granted the government's motion for partial summary judgment, however, after finding no violation of Code Sec. 6603 by the IRS. The court found that under Code Sec. 6603, (1) a deposit is not a tax payment until and unless the IRS uses the deposit for a payment; (2) a taxpayer has no statutory entitlement to a suspension of underpayment interest if the IRS does not actually use a deposit for a payment of tax; and (3) Code Sec. 6603 does not require the use of deposits as tax payments, whether as a result of the IRS making an assessment or a taxpayer requesting the deposit to be used. The court reached this conclusion based on the permissive language of Code Sec. 6603, which states that a taxpayer "may" make a deposit which "may" be used by the IRS to pay a tax which has not been assessed at the time of the deposit. The decision to use a deposit for a payment of tax, the court concluded, is thus subject to IRS discretion, and the statute does not limit such discretion with conditions or exceptions. In the court's view, Rev. Proc. 2005-18 cannot establish illegality on the part of the IRS for not using deposits as payment of tax since such the procedures in Rev. Proc. 2005-18 do not confer substantive rights on taxpayers.

The court found that the trusts' argument regarding the IRS's error in issuing notices to the terminated trusts was effectively an argument for the abatement of interest attributable to unreasonable errors and delays by the IRS, a claim over which the Court of Federal Claims lacks subject matter jurisdiction. The court also found that Code Sec. 6603 vests the IRS with broad discretion since it does not set forth any factors that constrain the IRS as to whether to use a taxpayer's deposit for a payment of tax. The same is true, the court found, of the IRS's discretion in the time it takes to return a deposit upon the taxpayer's request. The court said that it could not find that a delay of five months in returning the trusts' deposit was a violation of the law. According to the court, although Code Sec. 6603(c) makes it nondiscretionary for the IRS to return any deposit when a taxpayer makes a request in writing before the deposit is used for a tax payment, it does not prescribe a timeframe for the IRS in returning the deposits.

For a discussion of making deposits to suspend the running of underpayment interest, see Parker Tax ¶261,510.

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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