AN OVERVIEW OF TAX ADMINISTRATION AND TAX LIENS

by Jeff Wong
Greene & Markley, PC

Tax laws are complicated and boring. Taxing agencies are powerful, unreasonable, intractable, and nasty. Most attorneys avoid tax issues like the plague.

But taxes and tax problems are everywhere. The majority of clients who have debt troubles owe taxes. Taxes play a major role in every business and household. There are tax considerations with most financial transactions and many lawsuits. Regardless of your area of practice, you can enhance the quality of your services by developing a better understanding of taxation.

This article attempts to describe the basic processes of tax administration as simply as possible, with an eye towards areas where lawyers often err. It also identifies the primary relief mechanisms the Internal Revenue Code (Title 26, US Code) provides taxpayers and third parties when the IRS errs or pursues a taxpayer with excess vigor. Part Two of this article (Summer 1999 issue) will provide an overview of the federal tax lien priority rules. The federal lien priority rules are notoriously complex. The frequency, however, with which federal tax lien notices are filed and the traps the federal priority rules create warrant at least a brief glance at this area.

I. Tax Administration

Tax administration must meet two conflicting goals. First, the taxing agencies must compute, record, and collect taxes from millions of taxpayers economically and promptly. Second, they must manage this mammoth inventory, scrutinize it, and enforce collection in ways that provide each citizen with due process. The common solution in most systems of American taxation is establishment of strict, regular, sequential processes that allow assembly-line processing of millions of returns, and that allow complaints and appeals only at designated points on the conveyor belt, and only under specific conditions. Taxation is cruel and agencies do err; administrative and judicial appeal rights must be allowed. But complaints made at the wrong time or through the wrong process often will be summarily and lawfully rebuffed. The unpleasantness of taxation gives rise to thousands of complaints, and addressing them in a disorderly fashion imperils the smooth workings of the overall machine.

For the past 33 years, the Anti-Injunction Act (26 USC §7421) has served as the IRS's shield against untimely complaints and challenges. The statute provides that unless one of eleven specified statutory rights of suit applies, "no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person." The Internal Revenue Code provides a similar number of instances where taxpayers have formal rights of administrative appeal. Solving a tax problem begins with understanding the stage in the tax administration process the client is in, and which administrative and judicial review rights are available for correction. Timeliness can be critical, and the taxpayer who misses his designated interval may get run over by the truck.

Most collection controversies each year involve either income or employment taxes. For brevity's sake, this article is limited to these two types of tax. America's most beloved agency, the IRS, has regulatory authority in the federal system. The Oregon Department of Revenue is its state counterpart.

A. Tax Determination

The tax administration process at both the federal and state levels starts with tax determination. Taxpayers are required to file returns. If a taxpayer fails to file a return, the IRS and ODR can compel production of information from the taxpayer and third parties to compute the tax due in the absence of the taxpayer's cooperation. The IRS enforces discovery with a summons, the ODR uses a subpoena. Those discovery powers also can be used to determine if a taxpayer has failed, inadvertently or deliberately, to report the correct amount of tax on a filed return. Auditors will typically propose excessive amounts of tax if the taxpayer fails to cooperate in the audit. The notorious habit of taxing agencies to "overdetermine" the tax theoretically provides incentive for the taxpayer to appear and produce records, and insures that the agency eventually recovers at least the correct amount due.

Oregon, like most states that collect income taxes, has adopted a "mirror tax code." The Oregon income tax laws largely employ the same definitions of income and the same system of deductions that have been adopted at the federal level in the Internal Revenue Code. It simplifies the process of reporting income tax for taxpayers, and makes tax determination simpler for ODR auditors. If a taxpayer underreports his or her taxable income for federal purposes, he or she will almost always have underreported taxable income for state purposes. Note that the IRS and ODR have established numerous information sharing programs; when the IRS succeeds in proving that a taxpayer has cheated on federal taxes, it will reveal that information to the ODR and the ODR will subsequently pursue enforcement for state taxes. The ODR reciprocally provides its audit information to the IRS. If a client tells you he or she has state but not federal tax problems, you can generally anticipate a knock at the door by the feds at some point down the road.

Due process, for the most part, is meted out in the processes of tax determination rather than tax collection. Taxpayers are armed with both administrative and judicial challenge rights over the amount of tax due. Taxpayers are earnestly encouraged to participate in the audit process, where agency suspicions of unreported tax are confirmed or rebutted. Both the federal and state tax determination systems allow at least one opportunity to appeal an auditor's or revenue agent's initial determinations at a higher level within the administration. Taxpayers who are still unsatisfied with the agency's determinations of tax due are then allowed a single shot at judicial review. Most controversies involving federal income, estate and gift, and certain excise tax liabilities are heard in the US Tax Court. The IRS issues a document called a notice of deficiency, that serves as a time-sensitive ticket to the Tax Court and stays the assessment of the tax. The remainder of federal amount-due controversies are heard in the US District or Claims Courts, after the IRS has made an assessment and at least a small portion of the tax has been collected. The Oregon state income tax system marches through roughly the same sequence of administrative and judicial appeal, with collection stayed in most cases until the taxpayer has exhausted (or defaulted upon) his or her appeal rights.

B. Tax Assessment

In both the federal and state systems, the tax determination process culminates in the making of an assessment. This is where the tax collection process begins. An assessment is nothing more than the taxing agency's physical recordation of the tax. But the federal and state tax codes breathe magic into a tax assessment: assessed taxes can be forcibly collected. The administrative and judicial rights of review built into the tax determination process are intended to produce correct tax determinations in any instance where the taxpayer has meaningfully participated in the process. Incorrect assessments should occur only when the taxpayer has been inattentive, and since such errors are the fault of the taxpayer rather than the agency, due process will have been met even if an excessive tax is collected. It is thus deemed constitutional to cloak assessments with a presumption of correctness, and allow the taxing authority to collect too much tax in some instances before allowing the taxpayer a second bite at judicial review. Only an assessed tax can be collected, but once a tax has been assessed, it can often be collected without interference from the courts.

C. Tax Collection

It is really the power to collect a tax that is the power to destroy. The hardships generated by enforced collection are the events about which taxpayers are most likely to complain, but because of concerns of administrative efficiency, they are ironically the instances where complaining has historically been most ineffective. Persons other than the taxpayer who owes the tax are assured the right to prompt administrative and judicial challenge when the wrong property is inadvertently liened or seized. Until 1998, however, the persons who owed the tax in both the federal and state systems had virtually no rights of judicial appeal during the collection process. The Supreme Court carved out a judicial exception to the Anti-Injunction Act in Enochs v. Williams Packing, 370 US 1 (1962): a taxpayer may obtain injunctive relief against an IRS collection action if he or she can establish that the IRS's act was so clearly illegal that the government will never prevail on the merits. A taxpayer's only protection from lawful acts of extreme hardship or arguable inhumanity has been the discretion of tax administration field officers and management.

With both federal and state taxes, the power of the taxing agencies waxes supreme in circumstances of collection jeopardy. If the IRS or ODR comes to believe that a taxpayer is willfully attempting to evade collection of a tax by concealing assets or placing them out of reach, it can immediately assess and enforce collection through seizure with no advance notice: it's collect now, consider explanations later. The jeopardy power is used as sparingly as one might hope with such a dramatic and destructive tool. It is also subject in most instances to prompt judicial review.

We live in an era when significant questions are being asked about the balance between tax agency efficiency and due process. The IRS hearings over the last several years convinced Congress that the federal system needs to be more humane and oriented towards customer service. Strict tax compliance enforcement (never a politically popular slogan), is now clearly passé. Over a dozen new administrative and judicial complaint and damage provisions were added during 1998 to the Internal Revenue Code.

The remedies offered to taxpayers and third parties in the tax collection process cannot be fully appreciated without a basic understanding of the tax authority's primary collection tool, the tax lien. A brief discussion of the tax lien below is followed by a discussion of the various administrative and judicial appeal rights available to taxpayers with tax collection.

D. Tax Liens

With both federal and state income and employment taxes, the making of the assessment gives rise to the tax lien. The federal statute is Internal Revenue Code §6321; the mirror Oregon provision is ORS 314.417. These statutes provide that the federal and state tax liens come into existence upon the occurrence of three events: (1) a tax has been assessed, (2) the taxing agency has given the taxpayer notice of the liability and made demand for payment, and (3) the taxpayer has neglected or refused to pay. Virtually any failure to pay the tax after notice of issuance and demand is deemed a neglect or refusal to pay.

Like other liens, a tax lien is an encumbrance that clouds title to property and restricts the ability to sell it or use it for security. The lien also empowers the taxing agency to take property belonging to the taxpayer for payment of the tax. If the property is cash, like money in a bank account or an account receivable, the taxing agency can levy or garnish it and apply the funds to the tax debt. If the property isn't cash (e.g., real property, a car, securities, etc.), the agency seizes the property and reduces it to cash through a public auction.

The federal and state lien statutes (IRC §6321 and ORS 314.417) define the scope of the lien in the same way: the lien attaches to all property and rights to property, both real and personal, that belong to the taxpayer. Virtually everything that the taxpayer owns at the time the lien comes into existence, and all property he or she acquires until the collection limitations period expires, is snagged by the lien. The federal tax lien is actually broader in scope than the state tax lien. Under ORS 314.423, a lien for income or employment taxes gives the ODR the same rights against real property as a judgment lien, and the same rights against personal property as a UCC interest. Oregon law establishes a variety of exemptions from the reach of nonconsensual encumbrances, and those exemptions are good against the state tax lien as well. A taxpayer's homestead exemption is valid against a state tax lien on a taxpayer's residence. Anti-alienation and spendthrift provisions protect a taxpayer's pension or beneficial interests in a trust against a state tax lien.

The federal tax lien, in comparison, is a super-lien. The federal tax lien pierces state homestead exemptions on real property both within and outside of bankruptcy. It also pierces anti-alienation and spendthrift provisions in pension plans and trusts, and all other exemptions that state law establishes on other personal property. It's a cruel joke, but true, that federal law provides for only one exemption from a federal tax lien: the "interest in unrestricted land held in trust by the United States for an individual noncompetent Indian (and not a tribe)." Treas. Reg. §301.6321-1. Section 6334 of the Internal Revenue Code makes a dozen different property interests exempt from a federal levy. The fact, however, that the IRS is precluded from administratively seizing certain types of property should not be confused with the fact that the property is still attached. The attachment of the tax lien, of itself, gives a taxing authority certain rights, even if it cannot levy. The IRS can, for example, still foreclose judicially on property that's exempt from levy, and property exempt from levy is still considered in the computation of the IRS's lien claim in a bankruptcy case.

II. Relief Provisions

Both taxpayers and persons who don't owe tax can be injured in the collection process. Third parties, as one might expect, are better protected from collection injuries than taxpayers under the Internal Revenue Code. As discussed above, taxpayers have largely been left to grapple one-on-one with the IRS without the benefit of a black-robed referee. Over the last fifteen years, growing concern over IRS errors and instances of hardship have provoked the enactment of several Taxpayer Bills of Rights. Some provisions restrict the IRS's collection discretion. Others provide for administrative and judicial review, and the recovery of damages.

Administrative relief is cheaper and easier to obtain. It is generally effective in well-run IRS Districts like Oregon. Under pressures from Congress over the last few years, IRS employees are now being encouraged to review claims of hardship or error more quickly and carefully, even in instances where the Code does not specifically require the administration to do so.

A. Remedies from Tax Lien Notices

Due to the breadth of the federal tax lien and the priorities it is granted, the filing of a federal tax lien notice can do serious damage. The cloud created by a filed tax lien notice can prevent a taxpayer from selling property. Sophisticated lenders will not grant new loans or make further advances once a tax lien notice has been filed. Third parties who hold common or joint interests in property subject to the tax lien unfortunately get swept up in the taxpayer's problems. Occasionally, the IRS errs and files a lien notice when it actually has no lien, or misspells a name and clouds an innocent bystander's property.

Screw-ups are addressed initially by IRC §6326. This statute allows both taxpayers and third parties to appeal administratively erroneous lien notice filings. If the administration fails timely to act or refuses to admit error, both taxpayers and third parties can seek judicial review under the quiet title provisions of 28 USC §2410. Persons damaged by the erroneous filing of a notice of tax lien can recover any actual damages they sustain under IRC §7432. Exhaustion of the administrative appeal process is a requirement for recovery. Section 7430 of Title 26 allows taxpayers and third parties to recover attorney fees in screw-up cases, if the government fails to respond reasonably in the review process. There are, however, many conditions imposed and limitations upon the fees recovered.

Situations in which the IRS is lawfully entitled to the lien it has noticed are more difficult. New in 1998 is 26 USC §6220, which provides a right of administrative review when the IRS files a notice of federal tax lien. The statute envisions a forum for claims of undue hardship or lack of necessity for lien notice filing. Sometimes the filing of a tax lien notice impairs rather than improves the IRS's ability to collect. There is, however, still no right of judicial review to a lawful lien notice. No court can soften the IRS's heart if it is lawfully entitled to cast a pox on a taxpayer's property.

Third parties who hold competing security interests or judgments on property encumbered by a tax lien bear similar rights to foreclose, redeem, or sell as they do under state law with nontax encumbrances. Junior lienholders can foreclose and sell the property subject to a senior federal tax lien. The federal tax lien can be stripped off property by the foreclosure sale of a senior interest. There are, however, some traps. Both judicial and nonjudicial foreclosures of tax-liened property are subject to special joinder and notice requirements. See 26 USC §7425 (with judicial foreclosures, also 28 USC §2410), and the associated Treasury Regulations. Dozens of attorneys blow the notice requirements every year, and unwittingly pass property to a purchaser while it is still encumbered with a tax lien.

Section 6325 of the Internal Revenue Code grants the IRS authority to issue three forms of relief from a tax lien. Subsection (a) of the statute compels the IRS to issue a certificate of release when a tax lien has been satisfied or is unenforceable. This statute largely takes care of instances where the IRS forgets to release a tax lien after it has received full payment or the taxpayer has received a bankruptcy discharge. Equate the word "release" with "extinguishment." When a tax lien is released, the tax lien disappears. This is a different form of relief than the "discharge" of property from a lien that the IRS can (rather than must) grant under IRC §6325(b). If the IRS is assured of receiving the value of its lien in an item of property from other property offered by the taxpayer or a third party, the IRS can "discharge" the property from the lien. Relief is discretionary (it pays to be polite to Revenue Officers); the Collection Division in Oregon has traditionally administered its discharge authority in a reasonable and business-like way. Offer the Revenue Officer the same or a larger amount than it could receive through seizure and sale from an item of property, and it will generally cut you a certificate of discharge.

Section 6325(c) provides for discretionary subordination of the tax lien to other interests. In substance, the IRS can agree to accept second place to a security interest that would otherwise be junior to the tax lien, if it believes that collection prospects will ultimately be enhanced. The typical scenario for subordination is a business that relies upon an open credit line for operations. The tax lien notice cuts off the lender's ability to make further advances (see discussion on lien priorities in the next issue), and without new money, the business will die. Lender and Taxpayer must convince the IRS that Taxpayer will be able to make installment payments only if the IRS will let Lender keep Taxpayer alive.

B. Relief From Seizures and Levies

For the past thirty years, 26 USC §7426(a) has provided relief from IRS seizures to persons other than the taxpayer. Section 7426(a)(1) provides for both administrative and judicial appeals of a "wrongful levy." Nontaxpayers holding ownership, lien, security interest, leasehold, and other interests are all protected under the statute's umbrella. Thus, if the IRS seizes the funds in a married couple's joint bank account for taxes due only from Husband, Wife can administratively appeal or sue to recover any funds that belonged to her rather than Husband. A senior security interest holder can administratively appeal or sue to recover funds the IRS levied under a junior tax lien. If the IRS has not yet sold the property, the third party can recover it. If the IRS has sold the property, the third party can recover the amount recovered by the IRS in the sale or the fair market value of the property, whichever is greater, plus interest. The statute also allows the third party to seek an injunction to preclude a sale, and recover excess proceeds after a seizure sale. As noted above, taxpayers (in contrast to nontaxpayers) had no statutory right of judicial review with lawful but arguably unnecessary seizures until last year. Section 7433 of the Internal Revenue Code provided taxpayers with a right to recover damages if the IRS executed an unlawful levy or seizure recklessly or intentionally. If, however, the levy or seizure was lawful, the taxpayer was stuck. New IRC §7330 grants taxpayers rights of both administrative and judicial appeal under a standard of "appropriateness," rather than legality or illegality. The provision is too new for predictions of how the IRS Appeals Office and the federal courts will define "inappropriateness." In a questionable effort to check the tide of judicial suits that may be filed over levies, the statute limits each taxpayer to one suit per tax period that the IRS has levied for. The IRS could, theoretically, levy inappropriately for the 1996 tax year once and lose in court; then levy inappropriately for the 1996 year a dozen more times with impunity. Further, the taxpayer who accrues taxes for three tax years may get more appeals than the less irresponsible taxpayer who only defaulted for one year. As poorly conceived as this aspect of the statute might be, §7330 constitutes the most significant breach in the Anti-Injunction Act in the last 22 years.

C. Offers In Compromise

Section 7122 of the Internal Revenue Code allows the IRS, in its discretion, to forgive administratively a tax liability. By regulation, the IRS's discretion is limited to two circumstances: when there are doubts either about the taxpayer's liability for the tax, or about whether the tax will ever be collected. The compromise authority regarding doubts as to liability empowers the IRS Appeals and Problem Resolution Offices to reduce or eliminate taxes when they conclude the taxes were overassessed. The authority regarding doubts as to collectibility empowers the IRS to be humane in situations where an unpayable tax liability has been accrued.

Lots of people owe unpayable tax liabilities, but the compromise authority saw sparse use during the first fifteen years after enactment in 1977. Forgiving a tax debt due the public was deemed extraordinary relief, and the IRS's general policy was to wait out the statute of limitations in the hopes that some day, the taxpayer would have something to pay. Compromise philosophy changed radically in the early 1990s under a program called Compliance 2000. At the urging of Congress, the IRS put its power to forgive unpayable tax debts to work. The administration recognized that many people who accrue unpayable tax liabilities drop out of the system. They do odd jobs or work out of their homes rather than earn salaries upon which the IRS can levy. They avoid holding title to assets and use cash rather than bank accounts. Many people who drop out of the system never come back in, and thus, never pay another voluntary dollar of tax.

Compliance 2000 offers wayward taxpayers a feasible way to re-enter the system. The IRS began accepting, and even inviting, offers of relatively small sums towards large liabilities, in exchange for a promise of strict compliance with the return filing and payment requirements for five years. It is, in substance, the IRS's version of chapter 13, only payment must be up front rather than over time. If a debtor's problems are largely or exclusively tax-related, offers are better than chapter 13 because they: (a) can eliminate or reduce tax liabilities that are not dischargeable in bankruptcy; (b) resolve an unpayable tax situation in one fell swoop, assuming the taxpayer can acquire the necessary funds; and (c) resolve the taxpayer's tax problems without a general disruption of finances.

The program has been an enormous success. Thousands of taxpayers in Oregon rejoin the flock and rid themselves of tax albatrosses every year through offers in compromise. Most IRS field offices have at least one "Offer Specialist" on staff. Review and acceptance criteria are streamlined and consistent from office to office. There must always be some form of payment. There must always be a promise of five years of tax compliance, and the penalty for default is revival of all the taxes that otherwise would have been forgotten. Technically, the taxpayer must offer an amount towards the old liabilities that is at least the sum of: (a) the taxpayer's net equity in property at the time of the offer; plus (b) the amount the taxpayer could conceivably pay towards taxes with his or her current income after subtraction of all necessary living expenses. In actuality, the IRS often accepts sums that are less than the target figure. Offer Specialists typically apply for their jobs because they like the humanitarian aspects of it. The Specialists' beliefs about the sincerity of the taxpayer's intent to rehabilitate are critical. The taxpayer must typically borrow money from a relative, since the offered sum usually must approximate or exceed the value of the property he or she owns. The IRS will generally agree to release its liens when an offer is accepted, subject to refiling if a default occurs.

(Part Two of this article, Federal Tax Lien Priorities, will appear in the Summer 1999 issue of the Newsletter.)

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should not act upon this information without seeking competent legal counsel for their specific situation.