IRS Maintains Legality of Revenue Ruling on Refund Offsets in Letter to Law Professor

This is in response to your letter dated September 20, 2007, to Congressman Rangel and Senator Baucus, in which you express some concerns with Revenue Ruling 2007-51, 2007-37 I.R.B. 573. The revenue ruling addresses, in part, the ability of the Internal Revenue Service to offset overpayments against unassessed internal revenue tax liabilities determined in a notice of deficiency under section 6402(a) of the Internal Revenue Code. Specifically, you question whether the revenue ruling is in violation of law or inconsistent with the nature of the Tax Court as a prepayment forum. You also express concern that the revenue ruling applies to lower income taxpayers and will result in the delay or denial of refunds attributable to over-withheld income taxes, the earned income tax credit, and the refundable portion of the child tax credit.

The revenue ruling is neither in violation of law nor inconsistent with the nature of the Tax Court as a prepayment forum. Rev. Rul. 2007-51 was published to provide guidance concerning when the right to offset under section 6402(a) legally exists. It holds, in relevant part, that pursuant to section 6402(a), the Service may credit an overpayment against unassessed internal revenue tax liabilities that have been determined in a notice of deficiency sent to the taxpayer. It does not address, nor was it intended to change, the Service's current practice as to when the Service will exercise that right. For example, the revenue ruling will not deprive taxpayers of a prepayment forum nor does it require the Service to offset every refund against every unassessed liability determined in a notice of deficiency. Moreover, the Service has not implemented any new procedures or attempted in any way to change the processes that have been in place for many years. Any delay or denial in a refund to a lower income taxpayer will not be because of this revenue ruling.

Authority

The Internal Revenue Code has long provided the authority for the position taken in Rev. Rul. 2007-51. The Service may credit an overpayment against an unagreed deficiency if the Service has issued a notice of deficiency, even though the deficiency has not been formally assessed. While not precedential, GCM 38480, A-612564 (August 21, 1980), sets forth the legal justification for this interpretation.¹See also Rev. Rul. 54-378, 1954-2 C.B. 246, clarified by Rev. Rul. 2007-51. The position taken in GCM 38480 with respect to the crediting of overpayments under section 6402 has never been modified.

The Service's position is supported by cases decided under the predecessors to current section 6402. In each of the cases that follow, the Service had credited an overpayment for one year against an unagreed deficiency for another year. The courts held that crediting the overpayment was proper if the taxpayer's liability for the year of the underpayment was "then due." The underpayment was considered to be "then due" if the Service had issued a notice of deficiency to the taxpayer even though no actual assessment of the deficiency had been made. See McCarl v. United States, 42 F.2d 346 (D.C. Cir. 1930), cert, denied, 284 U.S. 839 (1930) (interpreting section 284(a) of the Revenue Act of 1926), Cole v. Helvering, 78 F.2d 852 (D.C. Cir. 1934) (interpreting section 322(a) of the Revenue Act of 1928), and Standard Oil Co. v. United States, 5 F. Supp. 976 (Ct. CI. 1934), cert. denied, 293 U.S. 599 (1934). See also Smith v. Director of Internal Revenue, 77-2 USTC ¶ 9599, 40 AFTR 2d 77-5553 (S.D. Fla. 1977) (taxpayer's suit for a refund of 1975 tax that had been credited to deficiencies pending before the Tax Court was dismissed without prejudice).

When an offset may occur

A tax liability legally exists independent of any action on the part of the Service, such as the assessment of the liability. See Goldston v. United States, 104 F.3d 1198, 1199-1200 (10th Cir. 1997) (tax liability arises from statutory duty to pay tax, not assessment of liability), and United States v. Latham, 754 F.2d 747, 750 (7th Cir. 1985) (assessment is an administrative determination that is not a prerequisite to tax liability). Rev. Rul. 2007-51 breaks no new legal ground, holding only that the Service will treat a tax liability determined in a notice of deficiency as an outstanding liability for offset purposes under section 6402 at the time the notice of deficiency is issued. The Commissioner's determination in the notice of deficiency is presumed correct, and the taxpayer has the burden of proof to show that the determination is invalid. See Helverinq v. Taylor, 293 U.S. 507, 515, 55 S. Ct. 287, 79 L Ed. 623 (1935).

A tax liability determined in a notice of deficiency is an outstanding liability for purposes of section 6402, notwithstanding a taxpayer's subsequent right to challenge the underlying liability itself, e.g., in a Tax Court proceeding. This is not a change in interpretation or Service position. It is entirely consistent with the Internal Revenue Code, case law, and the Service's historical practice.

Section 6402 provides that the Service may credit the amount of any overpayment of tax against any tax liabilities on the part of the person who made the overpayment and shall, subject to subsections (c), (d), and (e) (certain other offsets), refund the balance of the overpayment to such person. The authority provided for tax offsets is discretionary and is not subject to review. See section 6402(f). There are Service procedures in place to address hardship situations and to minimize tax offset errors.

The application of a tax overpayment against any outstanding Federal tax liability, child support (section 6402(c)), Federal agency non-tax debts (section 6402(d)), or State income tax obligations (section 6402(e)) is known within Service processing as a "refund offset." Internal Revenue Manual 21.4.6 sets forth internal guidance to be used by Service personnel to address refund offset processing inquiries.

A taxpayer may notify the Service that the failure to receive a refund will create a hardship situation. Under those circumstances, the Service may be able to use Offset Bypass Refund (OBR) procedures to manually refund an overpayment without first satisfying an outstanding tax liability balance. To qualify for OBR treatment, a taxpayer must meet the criteria set forth in IRM 21.4.6.5.12. The OBR procedures are only available to bypass a federal tax offset; they will not prevent an offset under section 6402 (c), (d), or (e). See IRM 21.4.6.5.12. The revenue ruling does not affect these normal processes.

When an overpayment is determined, the Service will look for other outstanding tax liabilities and certain other offsets before refunding an overpayment to the taxpayer. As a practical matter, although a taxpayer's liability for a tax is independent of the assessment thereof, the Service's procedures are not designed to setoff an overpayment against a liability prior to the time the liability is assessed.

There are Service procedures intended to prevent the premature assessment of an amount reflected in a notice of deficiency. The actual process used will depend on which part of the Service issues the notice of deficiency. For example, if the notice of deficiency originates at a Service campus in connection with the underreporter program, the taxpayer's account will be noted with a transaction code (TC 922) associated with the appropriate Underreporter Processing Code (found in section 8.19 of Document 6209, IRS Processing Codes and Information (Rev. 01-2007)).

If the notice of deficiency originates in Compliance, the Service enters status code 24 into the Audit Information Management System database that is used by both Compliance and Appeals. See IRM 4.14.1, generally. This status code indicates that a notice of deficiency has been issued. Office and Field Examination cases are then controlled in a suspense unit for 105 days (165 days for taxpayers outside the United States) to await taxpayer correspondence, agreement, or notification of a petition filed with the Tax Court. IRM 4.14.1.17. After that time has passed with no action by the taxpayer, the file is forwarded to the Technical Services Field Review Staff for assessment.

If the notice of deficiency originates in Appeals, the Appeals Centralized Database System, the system used to monitor Appeal's inventory, is updated to indicate that a notice of deficiency has been issued. See IRM 8.17.4, generally. The taxpayer's file is controlled in a suspense unit to await taxpayer correspondence, agreement, or notification of a petition with the Tax Court. After that time has passed, the file is forwarded to the Appeals Processing Service unit for assessment. Notably, in both Compliance and Appeals, the actual assessment is done by a different Service unit. A deliberate action must be taken to make an assessment, which the system requires in order for an offset to occur.

If a petition is filed with the Tax Court, the Service places a transaction code (TC 520) on the taxpayer's account indicating that the tax period is in litigation. This prevents an assessment from being made before the decision of the Tax Court becomes final. See section 6213(a).

Prepayment forum

The revenue ruling specifically states that it does not address the question of the Service's crediting rights prior to the issuance of a notice of deficiency. While silent on the subject, the ruling also does not address the Service's crediting rights after a notice of deficiency is issued while the amount determined therein is being challenged in the Tax Court.

Nothing in Rev. Rul. 2007-51 changes or eliminates the prepayment forum as an option to taxpayers. A notice of deficiency is a jurisdictional prerequisite to the Tax Court. Once a taxpayer has timely filed a petition with the Tax Court, payment of the amount determined in that notice of deficiency will not deprive the court of jurisdiction. In Smith v. Director of Internal Revenue, supra, the Service issued a notice of deficiency for tax years 1973 and 1974. Following a petition to the Tax Court to challenge the determinations for those years, the Service applied a 1975 overpayment against plaintiff's tax deficiencies for 1973 and 1974 pursuant to its authority under section 6402(a). In dismissing the taxpayer's claim for refund of the 1975 offset amount pending a taxpayer favorable disposition for 1973 and 1974 years in the Tax Court, the district court recognized the Service's statutory right to act as it had. Notably, the offset did not deprive the Tax Court of jurisdiction over the 1973 and 1974 years. Accordingly, even if the Service were to offset a taxpayer's refund against an amount determined in a notice of deficiency, that offset would not deprive the Tax Court of jurisdiction over the taxpayer's case.

Further, although the revenue ruling provides that the Service is authorized to offset a taxpayer's refund against an amount determined in a notice of deficiency, the revenue ruling does not require the offset as a prerequisite for Tax Court jurisdiction. This is distinguishable from the requirement in Flora v. United States, 362 U.S. 145, 158-163 (1960), which requires a taxpayer to make full payment before filing a claim for refund and suing for refund in a U.S. district court or the U.S. Court of Federal Claims.

Refunds to lower income taxpayers

Your letter appears to suggest that the revenue ruling requires the Service to effectuate offsets in all cases, thereby depriving or denying well-needed refunds to taxpayers and violating the prohibition against assessment and collection under section 6213(a). Neither suggestion is correct.

The revenue ruling does not affect in anyway the rights and responsibilities otherwise available to, and required of, taxpayers. The Service's offset rights under section 6402 have always applied to individuals, including lower income taxpayers. Further, the offset of an overpayment against an outstanding liability is not a collection activity within the meaning of section 6213(a).

The earned income credit and additional child tax credit are included in the definition of a statutory deficiency under section 6211. Thus, any adjustments to these credits would be included in a notice of deficiency. The Tax Court has jurisdiction over adjustments to these credits.

In Sorenson v. Secretary of the Treasury, 475 U.S. 851 (1986), the Supreme Court held that a federal income tax refund for earned income credit was subject to interception for overdue child support pursuant to section 6402(c). The opinion states that an individual can receive the amount by which his entitlement to an earned income credit exceeds his tax liability only because section 6401(b) defines that amount as an "overpayment," and section 6402 provides a mechanism for disbursing overpayments, namely, the income tax refund process. The refundability of the earned income credit is thus inseparable from its classification as an overpayment of tax. If it were not, the Secretary would lack authorization for refunding it.

It follows that the Supreme Court's opinion supports a tax offset against a refund resulting from the EIC, if done by the Service under appropriate circumstances. Further, a refund resulting from any other refundable credit would not warrant a different result. The revenue ruling has no affect on these preexisting principles.

Application to all taxpayers

Although the fact patterns in the revenue ruling describe a corporate taxpayer, the Service's offset rights under section 6402 are not limited to corporations. As a result, the analysis and holdings of Rev. Rul. 2007-51 apply to all taxpayers, including individual taxpayers. All taxpayers, however, have protections available. See, for example, the discussion regarding Offset Bypass Refunds on page 3. The Service may authorize this OBR even though the taxpayer owes unpaid taxes against which the refund may be offset. The OBR process is available only when an overpayment exists.

Eligibility for Offers in Compromise and Installment Agreements

As discussed above, the revenue ruling does not affect in any way the options available to a taxpayer to challenge the tax liability determined in a notice of deficiency. Similarly, the ruling does not affect the ability of low-income taxpayers to negotiate Offers in Compromise or Installment Agreements.

If you have any questions or require further assistance, please contact Cynthia McGreevy of my office at (202) 622-4910.