July 5, 2018

The Last Filed Rule Overruled? IRS Collections Now Uncertain

Tax Relief Articles

Houston Tax Attorney

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Taxpayers will often file tax returns that do not report all of their allowable deductions and credits, with the intent of going back and filing amended returns once they are able to determine the correct deductions and credits.  Can the IRS base its collection analysis on the originally-filed but incorrect tax returns?  The court recently addressed this question in Rosendale v. Commissioner, T.C. Memo. 2018-99.  The holding is surprising, as the court seems to have overturned its last filed rule.

The Facts & Procedural History

The taxpayers came forward and voluntarily filed their then-unfiled tax returns for 2008, 2009, and 2012-2014 years and a timely-filed 2015 return.  They did not pay the $200,000+ tax reported on these returns.  The IRS responded by filing a notice of intent to levy, and the taxpayers submitted a timely collection due process hearing (“CDP hearing”) request.

In advance of the CDP hearing, the taxpayers submitted copies of amended returns for 2014 and 2015 that had been filed with the IRS service center.  As part of the CDP hearing, the IRS settlement officer noted that the IRS had not yet processed the 2014 and 2015 amended returns. The IRS settlement officer used the originally-filed 2015 return in her collection analysis.  This caused the IRS to determine that the taxpayers could pay more than they would have had to if the amended return was used.

The case does not provide the details as to why the originally-filed 2015 tax return resulted in a higher amount of tax the taxpayers could afford to pay.  It is likely that the IRS used the originally-filed 2015 tax return to compute the taxpayer’s future income potential.

In computing future income, the IRS is to reduce the income by deductible and creditable expenses.  The IRS looks to the taxpayer’s current and past tax returns to determine these amounts.  Thus, if the IRS used an originally-filed tax return that did not have all of the allowable deductions or credits reported on it, the IRS may have concluded that the taxpayer’s future income potential was higher than what it really is.

Litigation ensued.

The Last-Filed Tax Return

The question for the court was whether the IRS settlement officer abused her discretion by using the originally-filed tax return for 2015 rather than the amended tax return for 2015.

In considering this question, the court in Rosendale cites Lloyd v. Commissioner, T.C. Memo. 2017-60.  The Lloyd case provides the last filed rule.

The Lloyd case did not involve a question about an amended return vs. an originally-filed return for the same tax year.  The Lloyd case was one where the IRS used a 2013 tax return to determine the number of household members to use in its collection analysis.  Apparently the taxpayer had additional dependents that would be included on its 2014 return, and wanted the IRS to include the additional dependents even though the 2014 return was not yet filed.

The court in Lloyd concluded that the IRS could use the last filed tax return for this purpose, i.e., the 2013 tax return (as a side note, the Lloyd case does not address the language in section 5.8.5.22.1 of the IRS’s policy manual which says that “the taxpayer’s current year income tax return” is to be used in determining the allowable dependents, not the last filed tax return–the two concepts may not always describe the same tax return).

The Last Processed Tax Return

One would think that Lloyd stands for the proposition that the last filed tax return is to be considered.  In the Rosendale case, the last filed return would have been the 2015 amended return–the amended tax return was filed with the IRS 11 days prior to the CDP hearing.

The court in Rosendale did not reach this conclusion.  Instead, even though it cites Lloyd, it seems to reject the Lloyd holding by saying that the IRS can use the last processed tax return, not the last filed tax return.  The court case does not provide any substantive discussion of these change in its position.

If Rosedale is good law, this means that the IRS may not have to factor in the most recent numbers when performing its collection analysis.  The IRS may not have to properly account for the taxpayer’s future income potential in its analysis, which is troubling.

The holding also means that the IRS, which is notorious for not processing amended returns timely or even failing to ever process them, may benefit from being dilatory and even negligent in processing amended returns (and imposing freeze codes so that amended returns are not processed timely when there are collections issues, CDP hearing cases, etc.).

The Takeaway

As in this case, a tax return that does not include all tax deductions and credits could result in the IRS basing its collection analysis off of incorrect information and, thereby, result in the IRS insisting on an incorrect and unreasonable collection alternative.  Taxpayers should be careful as to what tax returns are filed if they are not able to full pay the balance.  Tax returns should report all known and allowable deductions and credits where possible in collection cases.

It should also be noted that the taxpayers in Rosendale did not contest the underlying liability for 2015 as part of the CDP hearing.  Had they done so, the IRS settlement officer would have to have evaluated the merits of the amended tax return and a decision would have had to be made on the return before the CDP hearing was closed.  This case serves as a reminder of the importance of contesting the underlying liability in the CDP hearing when there is any doubt as to the correctness of the liability.

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