IRS may not use offset doctrine to increase balance due.

It is well settled that' a taxpayer must establish that he has overpaid his tax liability to obtain a refund. A corollary to this rule is that, in determining the extent to which an overpayment exists, the IRS is entitled under the so-called "offset doctrine" to offset any adjustment otherwise barred by the statute of limitations (SOL) on assessment against the amount claimed by the taxpayer as a refund. One question left unanswered until recently was whether the Service could use the offset doctrine outside of the refund setting. In a significant case of first impression, the Fourth Circuit has held that the IRS cannot reopen a tax liability agreed to in an estate closing letter and attempt to collect additional taxes after the SOL has expired by offsetting a time-barred adjustment against an otherwise available foreign death tax credit.

Est. of Michael

In Est. of Michael v. Lullo (4th Cir. 4/2/99), the taxpayer's estate timely filed an estate tax return reflecting a tax due of $175,487. On audit, the Service determined an estate tax deficiency of $85,776, to which the taxpayer agreed in a 1992 closing letter. The IRS thereafter gave the taxpayer credit for foreign death taxes paid of $228,939, and the taxpayer remitted the assessed balance plus interest, in 1993.

After the SOL on assessment had run, the IRS determined that the deficiency should have been $139,134 greater than that originally computed (due to an error by the examiner that failed to take into account the value of certain assets reported on the estate tax return). The IRS reopened the case in 1994, and sent the estate a letter indicating that it would offset the computational error against the agreed credit, resulting in an unpaid estate tax liability. The IRS then sought to collect this amount from the estate.

The estate refused to pay, arguing that the IRS was required by law to allow the full credit and filed a district court action seeking to obtain a writ of mandamus under 28 USC Section 1361 (the Mandamus Act) to compel the IRS district director to allow the credit. (28 USC Section 1361 grants jurisdiction to a Federal district court to compel a Federal official or employee to perform a ministerial duty owed to the plaintiff.) The district court rejected the estate's contention on jurisdictional grounds, observing that a writ of mandamus is proper only if the plaintiff has a clear right to relief, the government official has a clear duty to act, and no other adequate remedy is available to the plaintiff. The court found that a refund suit was an adequate remedy. In addition, the court noted that it was not convinced that the estate had a clear right to any relief. Citing Lewis, 284 US 281 (1932), it suggested that, in its view, there was no substantive difference between the offset of a time-barred adjustment against a refund and the offset of a time-barred adjustment against a payment or credit.

On appeal, the Fourth Circuit, in a two-to-one decision, reversed. At the outset, the court was confronted with the IRS's argument that the Anti-Injunction Act (codified as Sec. 7421) overrides the Mandamus Act. (Sec. 7421(a) forbids any suit to restrain the assessment or collection of tax by the Service.) While the court did not disagree with the IRS's thesis, it found that the taxpayer fell within the narrow exception to the Anti-Injunction Act articulated in Enochs v. Williams Packing & Navig. Co., 370 US 1 (1962). (The Supreme Court in Enochs ruled that the statutory prohibition on injunctive suits does not apply if the taxpayer shows that (1) it is certain to succeed on the merits and (2) it will suffer "irreparable injury" (i.e., the lack of an adequate remedy at law).)

Addressing the "certainty of success" factor, the court flatly rejected the Service's reliance on Lewis. According to the court, Lewis merely provided the IRS with a "shield" that it could use to fend off refund suits; it did not "forge a `sword' with which the IRS could assess or collect additional taxes in violation of Sec. 6501(a)." The court concluded that Lewis merely authorized the IRS to keep tax payments in the face of a refund suit, if, based on its calculations at the time of audit, it determined that the taxpayer did not actually overpay its properly calculated tax burden. Thus, the Service could not collect an additional amount from the estate after the limitations period expired. To allow otherwise, the court noted, would "nullify" the SOL. (The court similarly concluded that the IRS would not obtain a better result if the estate paid the alleged deficiency and filed a refund suit, as any payments would constitute overpayments under Sec. 6401, regardless of whether the Service relied on the 1992 closing letter or 1994 reopening letter as a basis for its "assessment.")

Addressing the issue of whether the estate would suffer irreparable injury if it were not granted relief, the court disagreed with the IRS's assertion that an adequate remedy at law existed in the present case in the form of a refund suit. (Had it succeeded in compelling the taxpayer to pay the tax supposedly due and sue for a refund, the Service would presumably have re-invoked Lewis in the refund suit to prevent any recovery.) Observing that the IRS had maintained its "baseless" position that the estate should pay it more money for more than five years, the court noted that"[s]uch actions can have one of two possible causes: the IRS's shocking ignorance of the laws it administers, or its utter disregard for the limits of those laws. Whatever the cause, the effect on the Estate is to force it to either pay the amount demanded or continue fighting the IRS." The court then concluded that it would not continue to require the estate to continue in yet another forum (i.e., a refund suit)--a "waste of private, agency, and judicial resources." The court explained that forcing such a suit would not advance the purposes of the Anti-Injunction Act, which is designed to promote efficient and timely tax collection; rather, it would require taxpayers to file pointless lawsuits to recover taxes that were unquestionably time-barred. (The court also noted that through its offset strategy, the Service had denied the taxpayer the usual prepayment remedy before the Tax Court, because it never issued a deficiency notice for the additional amount.)

Having determined that the district court had jurisdiction to decide the merits of the estate's request for mandamus relief, the court concluded that the estate was entitled to relief because it had a clear right to the full credit amount, and that the IRS had a clear duty to act as the estate requested. Observing that Sec. 2014(a) requires that a credit against the estate be allowed for foreign death taxes paid, the court held that the Service erred in disallowing the credit and that the district court, in turn, erred in dismissing the estate's mandamus suit.

Critique

In dispelling the notion that the offset doctrine is something more than a creature of refund jurisprudence, the Fourth Circuit clearly reached the right result. (Taxpayers can also take comfort in the court's pragmatic other-adequate-remedy analysis, which may pave the way for injunctive relief in similar future situations.) The doctrine owes its existence entirely to the peculiar nature of a refund suit, which the Supreme Court has likened to a common-law suit for money had and received. The practical effect of such a characterization is to require a taxpayer to show that the government has money that, in equity and good conscience, belongs to him. It also means that the IRS can re-audit the return and "retain payments already received when they do not exceed the amount which might have been properly assessed and demanded." Outside of the refund context, nothing in the tax statutes authorizes this sort of offsetting. (For example, Sec. 6404 only permits the Service to credit an overpayment against any liability of the taxpayer.) Simply stated, the IRS has no other statutory power or right to increase the balance due from the taxpayer after the SOL has run. To allow this would largely obliterate the SOL.

The Fourth Circuit is also correct in pointing out that an expansion of the offset doctrine in the manner sought by the Service would subvert the Code's deficiency scheme; a taxpayer would never be able to contest otherwise-barred income, estate or gift tax adjustments in Tax Court, because the tax on these adjustments would have been "paid" by offset. No deficiency would exist--only an unpaid, properly assessed balance.

Example: A taxpayer reports tax due on his income tax return of $100 for year X, which the IRS assesses and the taxpayer pays. After the SOL on assessment runs, the Service asserts a time-barred deficiency of $50 for the same year. Under the IRS's offset theory, $50 of the $100 payment is offset by the barred deficiency, leaving an unpaid assessed balance of $50.

It is unclear whether, despite its loss in Est. of Michael, the IRS will seek to expand the offset doctrine in other circuits. It may be encouraged by the vigorous dissent filed in the case, which argues for a broad (but very questionable) interpretation of Lewis that does not link the offset doctrine to refunds.

Abbreviations Commonly Used in The Tax Adviser

TTA             The Tax Adviser
aff'g           affirming
AFTR2d          American Federal Tax Reports,
                second series (RIA)
Ann.            IRS Announcement
CB              Cumulative Bulletin
Cir.            Court of Appeals
Cl. Ct.         Claims Court
COBRA           Consolidated Omnibus Budget
                Reconciliation Act of 1985
Ct. Fed. Cls.   Court of Federal Claims
DC              District Court
ERISA           Employee Retirement Income
                Security Act of 1974
ERTA            Economic Recovery Tax Act of 1981
Fed. Cir.       Court of Appeals for the Federal Circuit
Fed. Reg.       Federal Register
F2d             Federal Reports, second series
F3d             Federal Reports, third series
F Supp          Federal Supplement
GCM             General Counsel Memorandum
HIPAA           Health Insurance Portability and
                Accountability Act of 1996
H. Rep.         House Ways and Means Committee Report
IR              Internal Revenue News Release
IRB             Internal Revenue Bulletin
IRSRRA '98      Internal Revenue Service Restructuring
                and Reform Act of 1998
Regs. Sec.      Treasury Regulation
Rev. Proc.      Revenue Procedure
Rev. Rul.       Revenue Ruling
rev'g           reversing
RRA             Revenue Reconciliation Act of 1993
SBJPA           Small Business Job Protection Act of 1996
Sec.            Section (refers to the Internal Revenue
                Code of 1986 unless otherwise indicated)
S. Rep.         Senate Finance Committee Report
Sup. Ct.        Supreme Court
TAM             Technical Advice Memorandum
TBOR2           Taxpayer Bill of Rights 2
TC              Tax Court (regular decision)
TC Memo         Tax Court (memorandum decision)
TD              Treasury Decision
TRA '86         Tax Reform Act of 1986
TRA '97         Taxpayer Relief Act of 1997
USTC            United States Tax Cases (Commerce
                Clearing House)

RONALD A. STEIN, LL.M., CPA, ARTHUR ANDERSEN LLP, CHICAGO, IL3