Litigating Trust Fund Recovery Penalties -- the Flora Rule, Divisible Taxes and Unfairness (10/11/13)

UPDATE, most of the discussion below is still good, but Judge Wheeler of the Court of Federal Claims issued a new opinion going the opposite way and finding jurisdiction.  I posted a blog entry on the new opinion on 1/29/14.  See Revised Opinion in TFRP Case Involving Flora Full Payment Requirement (Federal Tax Procedure Blog 1/29/14), here.

Tax procedure enthusiasts will know the venerable Flora Rule, sometimes referred to as the Flora rule, after the case of Flora v. United States, 362 U.S. 145 (1960).  The following is a cut and paste of my explanation of this rule in my Federal Tax Procedure book (footnotes omitted):

In order to file a claim for refund and then sue for refund, the taxpayer must be able to assert that he or she overpaid taxes.  The critical question has been how much the taxpayer must pay in order to assert an overpayment.  The historical answer was that the taxpayer must have fully paid the assessment (which includes penalties and interest) in order to bring a refund suit.  This is referred to as the prepayment requirement which tax practitioners sometimes refer to as the Flora rule, after the Supreme Court case, Flora v. United States, 362 U.S. 145 (1960). 

Why is a prepayment rule important?  As the Supreme Court in Flora viewed the history and fabric of the procedures Congress adopted for tax litigation, any other rule would be counterproductive to those procedures.  Congress created the Tax Court as the forum for litigating most tax controversies.  The Tax Court is a prepayment judicial forum, and is the only prepayment judicial forum we have for resolving the merits of tax liabilities (excepting of course collection suits in the district courts).  If the IRS could assert a deficiency of, say, $100,000 and the taxpayer could get a prepayment remedy simply by paying $1 against the assessment that follows, the taxpayer could effectively turn the district courts into a prepayment forum. 

Of course, this highlights one of the problems with the prepayment rule.  A taxpayer who does not have the money to pay (the $100,000 assessed amount in the above example) doesn't really have a choice.  He or she must pursue the prepayment remedy in the Tax Court.  Is that fair?  Do citizens get better choices solely because they have substantial resources?  That is a policy question, and of course the answer is yes (just as substantial resources open up better and more choices throughout the law and life). 

Many authorities and commentators felt that Flora required full payment of not only the principal amount of tax liability, but also any penalties and interest assessed by the IRS.  This, of course, makes the cost of entry to refund litigation more expensive, particularly if distant years are involved where the interest can be more than the tax or penalties.  It is not unusual in tax cases involving old years to have the interest alone, because of the passage of time, cause the total bill with interest to triple or quadruple the principal amount involved.  With this “cost” of refund litigation, many taxpayers are forced to pursue the Tax Court route if it is available to them, as it is when income tax, estate and gift tax and certain types of miscellaneous tax liabilities are in dispute. 

As you can see, one of the issues is whether it is fair to force litigation into the Tax Court simply because the taxpayer is not rich.  (OK, that is a bit of hyperbole, but makes the point.)  And, some taxes and penalties like the TFRP cannot even get to the Tax Court (except late in the process via a CDP hearing, which is a relatively recent development). Accordingly, as I note in the book, the Courts have developed the divisible tax concept to mitigate some unfairness in the Flora rule.  The divisible tax concept (again from my book with only one footnote quoted) is:

The full payment rule even as to principal only can still be daunting and courts have found other ways to avoid the harshness of the full payment rule.  Perhaps the area of most interest in terms of the quantum of cases you are likely to encounter are the special formal and informal rules that apply to so-called divisible taxes.  A divisible tax has been described as follows: 

Where a tax is considered a “divisible tax,” the taxpayer need only pay a portion of the tax before instituting suit (assuming other jurisdictional prerequisites are met). A divisible tax is one that represents the aggregate of taxes due on multiple transactions (e.g., sale of items subject to excise taxes).   It is a tax the assessment of which reflects the accumulation of several separable assessments based on separate transactions.

Hence, on rehearing, in Flora, the Court said excise taxes "may be divisible into a tax on each transaction or event, so that the full-payment rule would probably require no more than payment of a small amount.” 

The most frequently encountered divisible tax is the trust fund tax penalty (“TFRP”) imposed under § 6672 upon persons who are responsible to collect and pay over the employees share of withholding taxes and FICA but who fail to do so.  These taxes are reported and taxed on a quarterly basis.  Although these withholdings are accounted for, in the aggregate, quarterly for all employees, they are separate liabilities for each employee (so the theory goes).  A taxpayer wishing to contest the IRS’ assertion of responsible person penalty tax liability need only pay for one taxpayer for the quarter.   I discuss the responsible person penalty litigation in a subsequent portion of this book.  Although I discuss the TFRP in some detail, many of the principles may apply to other divisible taxes. 

In divisible tax cases, the refund litigation from the payment of the divisible portion of the tax and denial of the claim for refund proceeds as follows: (i) the taxpayer sues for refund of the divisible taxes paid, putting in play his or her liability for the taxes paid and, by operation of principles of res judicata or collateral estoppel, his or her liability for the taxes not paid; and (ii) the Government will then counterclaim for the unpaid taxes.  For example, in the TFRP situation, a  party against whom the TFRP may pay the penalty for a single employee for a single quarter regardless of how many quarters were assessed to start this process [from current footnote: See Todd v. United States, 2009 U.S. Dist. LEXIS 90096 (S. D. Georgia, Sept. 29, 2009) (held a taxpayer need only pay the withholding tax of one employee for one quarter to meet the jurisdictional requirements for all quarters at issue for that employer).]

In TFRP cases, the divisible tax concept is critical.  The putative responsible person has no access to the Tax Court for a prepayment remedy and the amounts involved can and often are quite beyond the person's ability to pay.  So, again to quote my book:

The TFRP is generally litigated in refund suits in either the district court or Court of Federal Claims.  There is no “ticket to the Tax Court” (notice of deficiency) in TFRP cases. Denial of access to the Tax Court -- which is a prepayment forum for litigating liability -- can have a harsh effect.  The Flora rule requires in tax refund suits that the tax must be fully paid before the taxpayer may file a refund suit.  It is not unusual for trust fund penalties to be quite large and thus prohibitive if the Flora rule were to apply full bore.  Fortunately, the due process issues – and certainly general fairness issues – that might otherwise inhere in the full bore application of the Flora rule are avoided by two procedural techniques -- one statutory and the other non-statutory -- that permit the putative responsible person to litigate the liability without payment of the entire amount. 

The key to these techniques is the divisible tax concept which was discussed earlier beginning on p. 519.  Recall that the Flora rule requires full prepayment of the tax liability.  The concept for the TFRP is that it is the same as the underlying tax liability for withholding (both the income tax withholding and the employee's share of FICA withholding).  These tax liabilities are, in tax concept, divisible taxes – individual liabilities for each employee for each quarter.  They are not aggregated for all employees for the quarter.  Accordingly, under this concept, Flora only requires that the putative responsible person prepay the tax liability for one person for the quarter in order to contest whether the putative responsible person was a responsible person for that quarter.  In many cases, this amount will be less than $100.  Where the records are available to the putative responsible person, the actual minimum liability for the quarter can be determined precisely.  However, because it is often difficult for the putative responsible person to know precisely the amount for the lowest paid employee, an estimate will suffice but, since the prepayment of at least one minimal amount is jurisdictional the estimate should err on the side of caution (i.e., ramp up the amount to be certain that at least one employee’s divisible tax will be covered).  It is important in making the payment to designate the payment as completely as possible (e.g., trust fund FICA for one named employee, if possible – unnamed employee if not possible – for the 1st quarter of 2005).

With this background we get to the recently decided case of Kaplan v. United States, 2013 U.S. Claims LEXIS 1530 (10/9/13) [NOTE THIS OPINION HAS BEEN REVISED WITH A DIFFERENT OUTCOME (SEE THE UPDATE AND LINK AT THE TOP OF THIS BLOG ENTRY; I LEAVE THE DISCUSSION HERE AS A WARNING TO STUDENTS AND PRACTITIONERS OF THE ISSUE WHICH I DON'T THINK IS FULLY RESOLVED BY THE REVISED OPINION.  In Kaplan, the taxpayer did not know that amounts involved for one taxpayer for the three quarters involved.  The taxpayer paid $100 per quarter.  I understand that this is a standard technique, although as noted above there was always the risk that it might not be sufficient.  But, my understanding was that DOJ Tax in prior cases would not fight about the issue.  Until Kaplan.  DOJ Tax argued that the taxpayer must show that $100 covers the tax for one employee for each quarter.  The Court agreed and dismissed for lack of jurisdiction.  The Court said:

In this case, the evidence in the record is insufficient for the Court to conclude that Mr. Kaplan has satisfied the full-payment requirement. The only direct evidence that he offers is one payroll report for one week of one quarter. See Pl.'s Resp. (Sep. 17, 2013), Ex. A. Of the 30 employees in the report, four had gross FICA and income tax withholding of $7.69 or less. See id. From that $7.69 figure, Mr. Kaplan extrapolates a total of $99.97 for a full thirteen-week quarter. Pl.'s Resp. at 5-6. Thus, he concludes, his payments of $100 must be enough to meet the divisible tax threshold for at least one employee. Id. The problem with this conclusion is that it assumes a certain level of consistency in work schedules without any reasonable basis for such an assumption. Indeed, a comparison with payroll reports from the fourth quarter of 2008 reveals tremendous variation in the number of hours worked. Given these circumstances, it would be unreasonable to extrapolate an entire quarter's worth of information from just one week's payroll report. Accordingly, Mr. Kaplan cannot meet his burden of showing this Court's subject matter jurisdiction.

There are unanswered questions.  Why could not the IRS / DOJ Tax have confirmed specifically whether the $100 covered one employee for one or more of the quarters involved?  Why did not the judge insist that the Government do that?

The following is from the IRM 8.25.1.7.4.2  (12-07-2012), Request for Refund Claim, here.

1. The TFRP imposed against a responsible person is divisible. Accordingly, unlike a refund suit for income taxes, a responsible person need not pay the full amount of the assessment in order to invoke the refund jurisdiction of the district court or the Court of Federal Claims. 

2. When seeking a refund of TFRPs, the taxpayer is required to pay the tax attributable to one individual for each period of liability, if the claim is based on employment taxes, or one transaction, if the claim relates to a TFRP for excise taxes. The government may then place the unpaid portion of the TFRP before the court by means of a counterclaim. 

Note: 

If the amount required cannot be accurately determined, the Service may accept a representative amount. 

3. According to IRC 6511 (a), the taxpayer must pay the proper portion of tax, and within two years, must submit a separate Form 843 for each quarter in question to retain the option of judicial review. 

4. If the aforementioned requirements for judicial review are met, the claim is considered a formal claim.

I call readers' attention specifically to the "Note" under paragraph 2.  The IRS will accept a representative amount.  Of course, the court in Kaplan could not find that it was a representative amount.

After this long exposition, for practitioners reading this blog, I would appreciate their experiences and thoughts either by comments available to the community of readers or by separate email to me at jack@tjtaxlaw.com.

I have also heard that, in addition to the minimal payment hurdle that DOJ Tax imposed in Kaplan, DOJ Tax may now also have the position that the minimal amount must be paid for each quarter.  This latter is just a rumor at this time, but it seems goofy to me.  But that is a subject for a later blog.

Thanks

For related blogs, see:

• TFRP Refund Suits - How Much Must be Paid (Federal Tax Procedure Blog 1/18/13), here, dealing with the number of quarters that have to be paid.
• Ah, the Flora Full Payment Rule Raises Its Ugly Head (Federal Tax Procedure Blog 1/16/13), here, dealing with a related subject.

Thanks to my partner, Larry Jones, for calling the IRM provision to my attention.