IRS's Application Of Overpayment To Prior Years' Employment Tax Liabilities Upheld

Pacific West Financial & Insurance Co., TC Memo 2011-143

The Tax Court has held that IRS properly applied an insurance company's employment tax overpayment, for which the company had requested an abatement on its corrected Form 941C, to its prior years' liabilities. In so holding, the Court rejected the company's argument that IRS lacked authority to make the abatement that ultimately resulted in the overpayment, noting that it was the company itself that requested the abatement. Accordingly, IRS could proceed with collection of the company's outstanding liability, save for a Code Sec. 6656 penalty which the Court rejected based on reasonable cause.

Background. Under Code Sec. 6402, if a taxpayer has any outstanding open federal tax liabilities, IRS may credit a tax overpayment, and interest on it, against any outstanding tax liability of the taxpayer before refunding any portion of it to the taxpayer. IRS may apply an overpayment to any year's tax and interest deficiency that it chooses, provided that it has sent a deficiency notice for that earlier year to the taxpayer.

Code Sec. 6656 imposes a penalty for failing to timely make a required deposit of taxes in an authorized Government depository unless the failure was due to reasonable cause and not willful neglect.

IRS is authorized to take various collection actions in order to ensure the payment and collection of employment taxes, including filing a notice of federal tax lien (NFTL) and issuing federal tax levies. However, before starting collection actions, IRS must generally provide the taxpayer with notice and an opportunity for an administrative CDP hearing. At the CDP hearing, the settlement or appeals officer verifies that all legal and administrative requirements have been met, considers issues raised by the taxpayer, and determines whether the proposed collection activity is appropriate. The taxpayer then has 30 days to appeal this determination to the Tax Court.

Facts. Pacific West is a California corporation that, from the date it was organized and began conducting business in’98, incurred various employment tax liabilities that obligated it to file a Form 941, Employer's Quarterly Federal Tax Return, for each calendar quarter.

In connection with collecting employment tax liabilities for periods predating the one at issue (fourth quarter of 2003), an IRS revenue officer realized that almost every Form 941 had been incorrectly prepared due to a bookkeeper's error. The officer required Pacific West to file a Form 941C, Supporting Statement to Correct Information, for each incorrect Form 941.

Most of the Form 941Cs combined a request for abatement of a portion of the tax incorrectly shown and overstated with a report of additional tax liability that should have been shown. For some quarters, the abatement requests and increased liability offset each other, and for others, the result was a net abatement or net increase.

Pacific West's Form 941C for the first three quarters of 2003 showed an abatement request of $115,460.47 and an additional liability of $124,029.62 for the second quarter. IRS's processing of the 2003 Form 941C resulted in a net abatement of $100,080.80 for the second quarter of 2003 (the “disputed abatement”), which IRS computed by applying an unexplained $15,379.67 additional assessment offset against the $115,460.47 abatement request. (The additional $124,029.62 tax liability for the second quarter of 2003 reported on the 2003 Form 941C was not assessed at the time the form was processed.)

IRS's records showed that before the 2003 Form 941C was filed, Pacific West's employment tax liability shown on the incorrectly filed Form 941 for the second quarter of 2003 had been overpaid by the periodic deposits credited against that liability. The records further showed that the disputed abatement resulted in an overpayment in the same amount for that quarter, and that the overpayment was applied against Pacific West's employment tax liabilities for periods dating back to’99.

The disputed abatement resulted in a discrepancy between Pacific West's total employment tax liability for all quarters of 2003 of $1,670,166.69, an amount agreed on by the parties, and the lesser amount that IRS's records showed as having been assessed for those quarters. The amount of this discrepancy ultimately resulted in IRS making a supplemental assessment for the fourth quarter of 2003. IRS's determinations to uphold the filing of a NFTL and to collect this amount via levy were subsequently upheld, and Pacific West filed its Tax Court petition in response.

Parties' arguments. The parties agreed to the amount of the liability and that IRS appropriately assessed that amount, but Pacific West claimed that its liability had already been paid. Pacific West argued that none of the situations that allow for an abatement applied to the second quarter of 2003. Therefore, according to Pacific West, there was no “overpayment” for that period that would allow IRS to re-apply deposits that were originally applied to that quarter.

Tax Court largely sides with IRS. The Tax Court determined that Pacific West's argument failed to take into account its abatement request on its 2003 Form 941C. The $115,460.47 requested abatement, which when combined with the additional $15,379.67 assessment, resulted in a $100,080.80 abatement, was shown in IRS's records as an overpayment which IRS was free to apply to Pacific West's employment tax liabilities for previous quarters.

The Court also observed that a portion of the disputed underlying liability was attributable to IRS's imposition of a Code Sec. 6656 penalty, which was apparently imposed based on Pacific West's failure to have made sufficient deposits to satisfy its after-the-fact determined employment tax liability for the fourth quarter of 2003. The Court rejected the Code Sec. 6656 penalty based on reasonable cause, noting the “unusual and at least partially unexplained manner” in which Pacific West's fourth quarter liability came about. Accordingly, the portion of the underlying liability attributable to the penalty was abated.

Since Pacific West didn't raise any other arguments regarding IRS's compliance with the Code Sec. 6320 and Code Sec. 6330 requirements, and since IRS appeared to have satisfied these requirements, the Court determined that IRS could proceed with collection against Pacific West, subject to the Code Sec. 6656 penalty abatement.

References: For application of overpayments to other amounts owed by a taxpayer, see FTC 2d/FIN ¶T-6003; United States Tax Reporter ¶64,024; TaxDesk ¶803,014; TG ¶70801.