Fifth Circuit Affirms Tax Court's Holdings on Closing Agreement and Offer In Compromise

(Parker Tax Publishing June 2018)

The Fifth Circuit held that, where the IRS entered a closing agreement showing zero tax liability but later found that its calculations were incorrect and assessed a liability of approximately $2 million, the Tax Court did not exceed its jurisdiction in holding that the assessments were not barred by the closing agreement because the agreement was not a legal impediment to assessment and did not fix the taxpayer's liability for any particular year. The Fifth Circuit also found no error in the denial by the IRS Office of Appeals of an offer in compromise of $40,000 where the taxpayer's own estimate of net worth and expected future income was approximately $545,000. Estate of Duncan v. Comm'r, 2018 PTC 134 (5th Cir. 2018).

Jannette and Robert Duncan held partnership interests through RCD Investments, Inc. (RCD). The Duncans used RCD to participate in a Son-of-BOSS (SOB) transaction which reduced their individual income tax liability for 1999 and 2000. RCD also claimed bad debt deductions resulting in a net operating loss (NOL) for 2001. The Duncans carried the NOL back to claim a large refund for 1996.

Robert Duncan died in 2003. His estate was valued at over $8 million. The IRS informed Mrs. Duncan and Mr. Duncan's estate (the Duncans) that it would audit RCD's tax returns shortly before the estate's inventory was prepared. Months later, Mrs. Duncan agreed to participate in an IRS initiative offering reduced penalties to taxpayers who conceded the benefits of SOB transactions. Mrs. Duncan also agreed to the disallowance of a bad debt deduction taken by RCD in 2001. To formalize these agreements, Mrs. Duncan signed two Forms 4549, Income Tax Discrepancy Adjustments, specifying the tax liability for 1996 and 2000. These forms reflected that the Duncans owed taxes, but attributed the deficiencies to the disallowance of the bad debt deduction from 2001, not the SOB transaction.

The parties also entered a closing agreement on Form 906, Closing Agreement On Final Determination Covering Specific Matters, which required the Duncans to concede all claimed benefits and attributes from the SOB and pay a 10 percent penalty on any deficiency related to the transaction. The agreement stated that the Duncans would make full payment of their tax, penalties and interest resulting from the application of the terms of the agreement. At the time, the IRS's calculations (reflected on the Form 4549) showed the cancellation of the SOB related deductions, but no tax deficiency. The IRS countersigned the Form 906 without requiring payment.

The IRS later determined that its initial calculations were incorrect. Updated Forms 4549 were sent reflecting that the Duncans owed approximately $82,000 for 1996 and $2 million for 2000, including $739,000 from the cancelled SOB deduction and a 10 percent penalty. Mrs. Duncan signed the new Forms 4549 in July 2006, waiving the right to appeal or contest the liability and consenting to immediate collection.

When the IRS attempted to collect the tax, the Duncans disputed their tax liability in two collections due process (CDP) hearings. In the hearing for 1996, the Duncans submitted an offer in compromise (OIC) premised on doubt as to liability. The Duncans argued that they never agreed to the assessment and that the IRS failed to send them a notice of deficiency. In the 2000 hearing, the Duncans disputed the underlying liability. The IRS Office of Appeals (Appeals) concluded that by signing the Form 4549 for 1996, the Duncans had agreed to the 1996 liability and waived assessment restrictions. For 2000, Appeals determined that the Duncans had waived challenges to their underlying liability by signing the closing agreement and Form 4549 for that year. Notices of determination were issued sustaining the levies for both years.

The Duncans appealed to the Tax Court, which remanded the case to Appeals to consider the Duncans' new OIC based on doubt as to collectability. The Duncans offered $40,000 when their liability was approximately $3.47 million. They asserted that Mrs. Duncan had $545,000 in net assets and expected future income, but special circumstances justified the offer, including her advanced age (91), a life insurance loan obligation, and losses on an office building.

Appeals rejected the offer. It did not compute the Duncans' precise reasonable collection potential (RCP), but estimated that the Duncans owned $3.2 million in assets and had dissipated about $3.4 million from Mr. Duncan's estate, which the government would likely be able to recover though a lawsuit against the estate trustee. Appeals determined that calculating an exact RCP would be impossible due to the Duncans' interconnected web of family partnerships and trusts. Based on its estimate of the Duncans' assets, the likelihood of a full recovery by suing the trustee, and the large gap between the $40,000 offer and the Duncans' own RCP estimate of $545,000, Appeals rejected the OIC and issued a notice of determination requiring full payment.

Returning to the Tax Court, the Duncans argued that Appeals had abused its discretion in failing to verify that the IRS had complied with applicable law and procedures. The Duncans also attempted to challenge their underlying tax liabilities, but the Tax Court held that they had waived that right by signing the Forms 4549 agreeing to the liability. The Duncans also argued that the closing agreement barred the assessments because, by executing the closing agreement without requiring payment, the IRS had implicitly represented that no tax related to the SOB transaction would ever be due.

The Tax Court held that Appeals did not abuse its discretion by deciding that the closing agreement did not bar assessment. In the Tax Court's view, the closing agreement did not purport to fix the tax liability for a specific year, but rather to memorialize that the Duncans would relinquish all benefits from the SOB transaction. The Tax Court also concluded that Appeals properly rejected the Duncans' $40,000 OIC and did not err in basing the rejection on an inexact RCP estimate. The Duncans appealed to the Court of Appeals for the Fifth Circuit.

On appeal, the Duncans argued that by interpreting the closing agreement in the course of considering their argument that the closing agreement barred the assessments, the Tax Court erroneously rendered a decision on the merits of the underlying tax liabilities in excess of its jurisdiction. The Duncans also said that Appeals abused its discretion by failing to follow procedures required by the Internal Revenue Manual (IRM) including calculating the exact RCP.

The Fifth Circuit affirmed the Tax Court's holding that Appeals did not abuse its discretion by concluding that the IRS properly assessed the Duncans' tax liabilities. The Fifth Circuit also agreed with the Tax Court that the closing agreement did not fix the Duncans' liability, but only acknowledged that the Duncans would pay the correct taxes and penalties arising from the disallowed SOB transaction. The Fifth Circuit found that although the agreement required payment upon execution, it did not purport to settle the Duncans' liability. In the Fifth Circuit's view, the agreement allowed the IRS to recalculate the liability, and the IRS's failure to require payment on execution did not change the plain terms of the agreement.

The Fifth Circuit rejected the Duncans' argument that Appeals abused its discretion by failing to follow the applicable IRM procedures. In the court's view, Appeals was not required to calculate the Duncans' exact RCP. Given the disparity between the Duncans' $40,000 offer and their own $545,000 RCP, Appeals had ample justification to reject the OIC, the Fifth Circuit reasoned. The Fifth Circuit also concluded that Appeals correctly considered assets dissipated from Mr. Duncan's $8 million estate.

For a discussion of closing agreements, see Parker Tax ¶263,160. 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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