The IRS assesses a tax penalty against you or your business. The audit closes and the IRS assesses the penalty. So how do you get a judge to look at it?
For most tax disputes, the answer is the U.S. Tax Court. You can go there without first pre-paying the tax. But for certain types of penalties, the IRS can assess and collect without ever giving the taxpayer a pre-payment right to go to tax court.
These are called assessable penalties—penalties the IRS can impose and demand without issuing a notice of deficiency first. There are situations where assessable penalties are truly problematic. The IRS employs thousands of people, most of whom are diligent professionals doing their best within a large and imperfect bureaucracy. But like any large organization, the IRS is not immune to errors in judgment. Penalties sometimes get assessed based on incorrect assumptions, incomplete knowledge of the law, or simply the momentum of an examination that has gone on too long. When that happens with an assessable penalty, the taxpayer’s options for pushing back are limited from the start.
Once assessed, the taxpayer has to pay the full balance and sue for a refund to have any right to judicial review. For a penalty in the tens of millions of dollars, that path is simply not available to most taxpayers.
The collection due process framework, however, offers an alternative. Under the right circumstances, a taxpayer can challenge an assessable penalty’s validity through a CDP hearing and ultimately before the U.S. Tax Court—without paying first. But that right also isn’t always available.
The Diversified Group, Inc. v. Commissioner, 166 T.C. No. 2, addresses this fact pattern. The case gets into the question of whether a prior opportunity for an administrative appeals conference precludes tax court review, leaving taxpayers who are unable to pay the penalty in full with no avenue for judicial review.
Facts & Procedural History
The taxpayers in this case were a tax planner and his business entity. The IRS asserted that they sold tax avoidance strategies to clients. This included tax shelters that generated tax losses. The transactions were not registered as tax shelters with the IRS, which taxpayers can do to avoid some penalties.
The IRS started a tax promoter penalty audit for the taxpayers in 2002. The audit went on for more than eleven years. In 2013, the IRS issued Notices of Proposed Adjustment proposing penalties of approximately $41.2 million under Section 6707 of the tax code for failure to register the transactions. Section 6707 can apply to certain “organizers” of reportable transactions who fail to comply with the disclosure requirements under Section 6111.
This is where the taxpayers made a deliberate strategic choice. In 2013, the taxpayers sent a letter to the IRS Examination team purporting to waive all IRS Appeals rights “in connection with NOPAs relating to the proposed section 6707 penalties.” Their stated rationale was that “IRS Appeals consideration is not a meaningful option and might arguably foreclose any judicial review.”
The IRS sent a letter saying that the taxpayers were formally offered an Appeals conference. The letters stated that “If you do not agree to the IRC §6707 penalties, you can request a post-assessment conference with the IRS Appeals Office.” A follow-up letter in 2014, stated: “If you believe you have reasonable cause why this penalty should not be imposed, or if you otherwise believe you are not liable for this penalty, you may request consideration by our Appeals Office.”
The taxpayers did not take the IRS up on either offer. The IRS assessed penalties of approximately $24.9 million. Shortly before assessment, the taxpayers paid what they believed to be divisible portions of the penalties and filed refund claims, then sued for a refund in the Court of Federal Claims. That court dismissed the case for lack of jurisdiction, holding that the penalty was not divisible—meaning the taxpayers had not fully paid their liability, which is a prerequisite for a refund suit. The Federal Circuit affirmed.
After that avenue closed, the IRS issued collection notices, and the taxpayers requested CDP hearings. At the hearings, they argued that because they had consistently refused any pre-collection conference with Appeals, they had never had an “opportunity to dispute” their liabilities, and therefore the door to challenging those liabilities was still open. The IRS settlement officer disagreed and issued Notices of Determination holding the taxpayers precluded from challenging their penalty liabilities. The taxpayers then petitioned the U.S. Tax Court, which resulted in this court opinion.
The Collection Due Process Framework
We have covered the CDP process at length on this website. It is a framework intended to give taxpayers a meaningful check on the IRS’s collection power before the collection actions take place.
As part of this, before the IRS can levy on a taxpayer’s property to collect unpaid tax debts, it must give the taxpayer notice and an opportunity to request a collection hearing with IRS Appeals. Similarly, when the IRS files a tax lien, taxpayers have the right to request a CDP hearing to contest that collection action.
The CDP hearing is not simply a formality. At the hearing, Appeals is supposed to verify that all legal and procedural requirements have been met, and must consider any relevant issue the taxpayer raises, including collection alternatives like installment agreements or an offer in compromise.
One of the most powerful rights available in a CDP hearing is the right to challenge the existence or amount of the underlying tax liability. This is a big deal in assessable penalty cases like this one.
With these assessable penalties, the IRS can assess the penalty without giving the taxpayer a pre-payment right to go to the U.S. Tax Court. The IRS can simply say that the amount is due, and it is due. To dispute the penalty determination, the taxpayer has to pay the balance and only then can sue in court–which the taxpayers tried to do in this case.
But the penalties were so large, that presumably the taxpayers were not able to pay them first. This effectively precluded any judicial review–leaving the CDP hearing as the only way to get judicial review. So you see, the CDP hearing provides a means to get these assessable penalties before the courts without having to first pay the balances.
Section 6330(c)(2)(B): The Gatekeeper
Section 6330(c)(2)(B) of the tax code provides that a taxpayer may raise challenges to the underlying tax liability at a CDP hearing only “if the person did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.”
These are necessary conditions, not just sufficient ones. A taxpayer who received a statutory notice of deficiency for the liability in question is barred from relitigating it in a CDP hearing, because that notice itself provides an avenue for U.S. Tax Court review. But as noted above, you don’t get this type of notice or right to tax court for assessable penalties.
Similarly, a taxpayer who “otherwise” had an opportunity to dispute the liability is equally barred. It is this opportunity to dispute the liability that is the issue in this case. This is where the Treasury Regulation and the body of case law interpreting Section 6330(c)(2)(B) come in.
What Counts as an “Opportunity to Dispute”?
Section 301.6330-1(e)(3), Q&A-E2, of the regulations defines “opportunity to dispute” by saying that it includes “a prior opportunity for a conference with Appeals that was offered either before or after the assessment of the liability.”
The U.S. Tax Court upheld this regulation in Lewis v. Commissioner, 128 T.C. 48 (2007). Multiple courts of appeals have since relied on it. The regulation explicitly covers offers made both before and after assessment, which is significant. It means a taxpayer cannot argue that a pre-assessment offer does not count because the liability had not yet been formally assessed.
These cases do not really address whether an administrative appeal is an truly an opportunity for review. The IRS Office of Appeals has changed dramatically over time–and will no doubt continue to do so. There was a time when appeals focused on being independent and acting impartial like a court. As of late, this “walk a mile in the taxpayers shoes” mantra is gone. Appeals has adopted the “One IRS” approach as of late. Many tax practitioners and taxpayers these days prefer to skip appeals for certain types of cases as it is well known that the appeals process is a waste of time for the particular types of cases. We as tax practitioners know this, as do some taxpayers, but it is something that the courts haven’t ever taken up.
To the courts, as it was in this case, the court only saw the question as whether either of the IRS letters constituted offers of an Appeals conference for purposes of CDP hearing rights. Each letter explained that the taxpayers could request Appeals consideration by filing a protest—exactly the kind of invitation the regulation describes. Given this, the court concluded that the taxpayers here could not dispute the liability in the CDP hearing as they had a prior opportunity.
The court also focused on the question as to whether the taxpayers had an opportunity when they failed to exercise or use that opportunity. The statute bars liability challenges when the taxpayer had an opportunity to dispute — not when the taxpayer exercised that opportunity. Multiple courts of appeals have addressed this directly.
As noted by the court here, even the U.S. Tax Court itself has held consistently that a taxpayer who declines an offered conference with IRS Appeals loses the right to challenge the underlying liability in a subsequent CDP hearing.
Is a Hollow Gesture Enough?
The taxpayers argued at length in this case that the offer of an administrative review with IRS Appeals would have been a hollow gesture.
They pointed to the fact that Appeals had allegedly sustained Examination’s Section 6707 penalty determinations 100% of the time, that the issue was designated as an Appeals coordinated issue, and that the Examination team and Appeals were essentially working in tandem to guarantee an unfavorable outcome. In short, they argued the offer was a hollow gesture designed to foreclose judicial review rather than provide a genuine dispute resolution opportunity.
The court was skeptical of this characterization. But more importantly, the court said it did not matter—because the taxpayers had declined to participate, no conference record ever developed. Without that record, the court had no basis to evaluate how the conference would have actually played out. The court’s reasoning was straightforward: a party cannot refuse to show up to a proceeding and then demand a trial on whether that proceeding would have been fair. By declining the offer, the taxpayers made it impossible for the court to assess the very argument they were making.
Given that it was a promoter penalty for a tax shelter, one can understand the skepticism about whether Appeals would have provided a genuinely independent review. But the court’s point was that the argument needed a record to support it, and the taxpayers’ own conduct prevented that record from ever existing.
The outcome is that the taxpayers were likely denied any judicial review. The penalties here are large. The taxpayer’s attempt to pay part of the penalty to get to court in a refund action suggests that they cannot fully pay the tax liability to be able to sue outside of tax court. So the taxpayers never got their day in court and, based on this ruling, likely never will. While one can understand the need to conserve resources, this has to be balanced against the full loss of the right to court–parituclarly due to the offer of an administrative appeal when that offer might really have been a hollow gesture.
The Takeaway
The collection due process framework provides a means to get issues before the U.S. Tax Court without first having to fully pay the balance. This is a remedy that protects the fundamental right to have your day in court. As this case shows, even the CDP hearing right is not absolute. A mere offer of an administrative appeal hearing can result in the loss of the right to judicial review. This is true even for assessable penalties where no prior court review was possible, limiting judicial review to those who can afford to pay the full balance first and sue for a refund. Even a hollow gesture offer of an appeal is enough to preclude judicial review. The IRS can simply offer an administrative appeal and take away the taxpayer’s right to court.
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