Third Circuit rejects IRS’s mootness claims

The IRS cannot render as moot a taxpayer’s claim in Tax Court for a refund of estimated taxes paid by applying the taxpayer’s refunds for later years as setoffs against the taxpayer’s outstanding liability for the year in question until the liability is eliminated.

Background

On Sept. 12, 2012, Jennifer Zuch and Patrick Gennardo, a married couple, untimely filed tax returns for the 2010 tax year, using the married filing separately status. Zuch’s tax return showed adjusted gross income (AGI) of $74,493 and an overpayment of tax of $731. Gennardo’s tax return showed AGI of $1,077,213 and tax due of $385,393. On that same day, Gennardo filed an offer in compromise (OIC) with the IRS for the 2007 to 2011 tax years.

In June 2010, the couple had sent in an estimated payment for 2010 of $20,000, and, in January 2011, Gennardo sent a second 2010 estimated tax payment of $30,000. The couple did not specify how these payments should be allocated between them, and Zuch’s late-filed 2010 tax return did not mention the estimated payments. The IRS allocated the full $50,000 amount to Gennardo’s return.

In November 2012, Zuch filed an amended 2010 tax return to report additional income of $71,000 and additional tax owed of $27,682, due to a retirement account distribution. On that return, she claimed the benefit of the same $50,000 in estimated payments and requested a refund of $21,918.

The IRS assessed the additional tax Zuch reported, but the Service did not credit her the $50,000 in estimated payments and did not pay her the refund. It also allegedly sent her a notice and demand for payment of her additional tax due, but Zuch disputed that the IRS sent her this notice.

In March 2013, Gennardo filed an amended tax return for the 2010 tax year. He included a statement with the return that he was amending it in part to notify the IRS that the $50,000 of 2010 estimated payments the couple made should be allocated to Zuch. However, 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 the next month. As part of accepting the offer, the IRS gave him a document showing it had credited the $50,000 of 2010 estimated payments to his outstanding tax liability.

On Aug. 31, 2013, because, in the IRS’s view, Zuch still had an outstanding liability for 2010, the Service sent her a levy notice that informed her she had 30 days to appeal the levy against Her property by requesting a Collection Due Process (CDP) hearing. Zuch timely requested a CDP hearing. Having not received a notice of deficiency or otherwise had an opportunity to dispute her tax liability, she exercised her right to challenge the underlying tax liability in the CDP proceedings. Specifically, she claimed her tax liability should be zero because she should have been credited the $50,000 of estimated payments she and Gennardo had made. Prior to the CDP hearing, Zuch’s counsel submitted a signed declaration from Gennardo directing the IRS to apply the $50,000 to Zuch’s personal tax liability.

In the CDP 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 the payments had already been credited to Gennardo’s account as part of his OIC. After the hearing, the IRS Office of Appeals sent Zuch a Notice of Determination sustaining the IRS’s proposed levy, stating it was “not in a position” to move credits from Gennardo’s account to hers.

Zuch timely petitioned the Tax Court for relief. After considerable legal wrangling, the parties eventually agreed to forgo trial and proceed on a stipulated factual record. However, during both the pendency of the original CDP hearing and the Tax Court proceedings, the IRS did not stand pat with respect to the liability it claimed Zuch owed. On six occasions — in 2013, 2014, 2015, twice in 2016, and in 2019 — the IRS used a refund Zuch was due to set off the remainder of her 2010 unpaid tax. After the IRS’s 2019 setoff, Zuch’s balance due for 2010 was $0.

Zuch was still ready to dispute the application of the estimated tax payments and her liability for 2010, but the IRS made a motion in Tax Court to dismiss Zuch’s CDP proceeding review as moot because she had no more unpaid tax liability. Zuch opposed this motion, but the Tax Court granted it and dismissed her case anyway, stating there was “no unpaid liability … upon which a levy could be based” and the IRS was “no longer pursuing the proposed collection action” (Zuch, No. 25125-14L (T.C. 4/6/22) (order of dismissal)). Further, the Tax Court reasoned that it was not the proper forum to determine whether Zuch had overpaid her tax liability because it lacked jurisdiction to determine an overpayment or to order a refund or credit of tax paid in a CDP proceeding.

Zuch appealed the decision to the Third Circuit. The Third Circuit determined that the question at issue in the appeal was: During litigation over a contested tax liability, is the IRS free to deprive the Tax Court of jurisdiction by the expedient of taking the taxpayer’s tax refunds and applying them to that liability?

The Third Circuit’s decision

The Third Circuit held that Zuch’s claim was not moot and remanded the case to the Tax Court to determine whether Zuch was entitled to receive credit for any amount of the estimated tax payments. The court stated, “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 by relevant statute, common law (incorporated into statute), or mootness principles.”

Characterization of Zuch’s claim

The IRS first argued that, rather than as it had originally maintained, Zuch’s challenge to the allocation of the estimated payments was not a challenge to her underlying liability under Sec. 6330(c)(2)(B) but was rather a challenge “relating to the unpaid tax” under Sec. 6330(c)(2)(A). Thus, Zuch’s challenge to the proper allocation of the estimated payments was extinguished when there was no unpaid tax.

The Third Circuit gave no credence to this argument. The court stated:

A dispute over whether the IRS appropriately credited a taxpayer’s account with estimated tax payments is, at bottom, a dispute over the taxpayer’s underlying tax liability. The point is one of plain English. Therefore, Zuch’s argument that her estimated tax payments were erroneously allocated to her ex-husband is a challenge to her underlying tax liability under §6330(c) (2) (B).

Zuch’s claim not moot because IRS setoffs were invalid

The Third Circuit held that Zuch’s claims were not moot because the Tax Court retained jurisdiction to review the IRS’s setoffs against her 2010 liability, and the setoffs were invalid because they violated setoff common law and constitutional mootness principles.

Jurisdiction to review setoffs: Sec. 6402(a) allows the IRS to apply any refund amount a taxpayer is entitled to as a setoff against the taxpayer’s unpaid tax debts, thereby reducing or eliminating the amount of the refund. The IRS argued that Congress had stripped the Tax Court of Its jurisdiction to review setoffs in Sec. 6512(b)(4) and by not explicitly granting the court that power in CDP cases.

The Third Circuit concluded that, as the Tax Court has recognized, Sec. 6402(a) contains a statutory counterpart to the common law right of setoff, and because that section does not disallow the Tax Court offset review, “it follows that the [Tax] Court has the power to review setoffs in a CDP proceeding to determine whether there was a pre-existing, valid debt that was owed to the IRS.”

Setoffs as violations of common law and Article III mootness principles: The court next noted that under common law as it applies to setoffs, the right to apply mutual debts to offset each other does not apply when the debts are disputed. Furthermore, Sec. 6402(a) did not rescind the common law governing setoffs. Thus, the court determined that since Zuch disputed whether she had any liability at all, the IRS’s setoffs of her refunds against the liability the IRS alleged she owed were a violation of common law.

As the Third Circuit explained, Article III of the Constitution restricts the power of federal courts to “Cases” and “Controversies.” Although the Tax Court, as an Article I tribunal, is not fully constrained by this rule, the court applies the rule to itself. Under Article III, a case becomes moot only when there is no longer a live case or controversy between the litigants. The Third Circuit found that, as a general matter, when an avenue of relief remains for a plaintiff, a defendant cannot render a case moot by unilaterally completing a challenged practice. Because Zuch challenged the IRS setoffs against her alleged liability, the court determined the setoffs also violated Article III mootness principles as well as common law.

Having found that the IRS’s setoffs were invalid and without legal effect under common law or Article III mootness principles, the court concluded that Zuch’s claims were not moot, although “Zuch’s money is, at least for the time being, in the government’s pocket.” Accordingly, it remanded the case to the Tax Court for it to determine whether Zuch was entitled to credit for any of the estimated payments she and Gennardo made.

Reflections

In a pointed opening to its opinion, the Third Circuit stated, “When Congress grants taxpayers the right to challenge what the Internal Revenue Service says is owed to the government, Congress’s will prevails. The IRS cannot say that such a right exists only under the circumstances it prescribes. That ought to go without saying, but this case requires us to say it.”

Zuch, No. 22-2244 (3d Cir. 3/22/24)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.