Third Circuit rules taxpayer’s claim is not moot

The Third Circuit held that a taxpayer’s claim related to prepaid tax was not moot, vacating the Tax Court’s dismissal of the case.

Facts: Before their September 2012 untimely filing of separate returns for tax year 2010, Jennifer Zuch and her then-husband, Patrick Gennardo, made two prepayments for their 2010 estimated tax liability of $20,000 and $30,000 in June 2010 and January 2011, respectively.  These prepayments, however, did not specify how they should be allocated between their separate tax liabilities.  The IRS applied the full $50,000 in prepayments to Gennardo’s return to offset his tax due. Zuch later filed an amended return for 2010 claiming additional income and the full $50,000 in prepayments, which resulted in a refund request.  The IRS accepted the additional tax due but did not refund or otherwise credit her for the $50,000 of prepayments.  In August 2013, after additional failed attempts by Gennardo to direct the IRS to allocate the prepayments to Zuch, the IRS issued a notice of intent to levy to Zuch.

In response to the notice, Zuch timely requested a Collection Due Process (CDP) hearing and exercised her right under Sec.  6330(c)(2)(B) to challenge the existence or amount of the underlying tax liability in the CDP proceeding because she had not received a notice of deficiency or otherwise had an opportunity to dispute her tax liability.  Following the CDP hearing, in September 2014, the IRS Office of Appeals issued a notice of determination sustaining the proposed levy and stated that it was not able to move the credits from Gennardo’s account to hers.

Zuch timely petitioned the Tax Court for relief, which then granted the IRS’s motion to remand the case to the IRS Office of Appeals.  In June 2017, the IRS issued a supplemental notice of determination sustaining the levy, noting it had not received any new information that would compel it to change its prior decision.  The case was returned to the Tax Court, where the parties agreed to proceed on a stipulated factual record.

During the years that Zuch was disputing her 2010 tax liability, the IRS took tax refunds owed to her for 2013 through 2016 and 2019 and applied them to what the IRS considered to be the amount of her 2010 tax liability.  In 2019, the cumulative effect of applying the refunds to her 2010 tax liability reduced the balance due to zero.  At this point, the IRS moved to dismiss the Tax Court proceedings as moot, given that there was no remaining unpaid tax.  The Tax Court agreed, finding that there was no longer a live controversy because there was no unpaid liability, and the IRS was no longer pursuing the proposed collection action (Zuch, No.  25125-14L (T.C. 4/6/22) (order of dismissal)). The court further explained that it “lacked ‘jurisdiction to determine an overpayment or to order a refund or credit of tax paid in a [CDP] proceeding.’ ” Zuch timely appealed the court’s ruling.

Issues: The Third Circuit noted that the dispute came down to “whether, in the midst of litigation over a contested tax liability, the IRS is free to deprive the Tax Court of jurisdiction by the expedient of taking the taxpayer’s tax refunds and applying them to that liability.” The court first analyzed the characterization of Zuch’s claim in relation to Sec.  6330(c)(2)(A), whether it was a challenge related to the unpaid tax or a claim under Sec.  6330(c)(2)(B), i.e., a challenge to the underlying liability.

The IRS argued that because there was not any remaining levy or unpaid tax, Zuch’s underlying tax liability was not in dispute; therefore, the question of the allocation of the prepayments was extinguished.  The court was not persuaded, finding that “Zuch’s argument that her estimated tax payments were erroneously allocated to her ex-husband is a challenge to her underlying tax liability under [Sec.] 6330(c)(2)(B).”

Turning to the question of whether Zuch’s claim was moot, the court first examined if the Tax Court had jurisdiction to review setoffs and whether the setoffs were valid. The IRS argued that Sec.  6512(b)(4) “affirmatively stripped the Tax Court of its jurisdiction to review setoffs.” Although the Third Circuit agreed that the Tax Court would be constrained in a deficiency proceeding, it noted that Sec.  6512(b)(4) does not refer to CDP proceedings.  Therefore, the Tax Court did have jurisdiction in Zuch’s case to review setoffs, the Third Circuit concluded.

Next, the court considered whether the IRS setoffs were invalid because they violated common law and mootness principles of Article III of the U.S. Constitution, which restricts the power of federal courts to “cases” and “controversies.” It began its analysis by noting that “the right to apply mutual debts to offset each other does not apply when the debts are disputed.” The court further reasoned that “although [Sec.] 6402(a) allows the IRS to credit overpayments to ‘any liability’ of the taxpayer, reading that provision to allow a disputed debt to be set off has the infirmity of presupposing that the taxpayer in fact has some liability.” Ultimately, the court concluded that Zuch’s claims were not moot, finding that the setoffs violated Article III mootness principles because they violated common law and “the clear legislative intent to preserve taxpayer rights in CDP hearings.”

In an alternative approach to addressing the validity of Zuch’s claim, the court examined whether her claim was live under Sec.  6330(c)(2)(B) because the Tax Court had jurisdiction. Warning that its discussion applied only to taxpayers who did not receive a notice of deficiency or otherwise have a previous opportunity to challenge their underlying tax liability, it concluded that Zuch’s claim remained a live issue for five reasons.

First, a plain reading of Sec.  6330 does not suggest that a taxpayer’s challenge under Sec.  6330(c)(2)(B) “can be rendered moot by the unilateral action of the IRS.” Second, properly read Tax Court precedent does not indicate that a taxpayer may challenge an underlying tax liability only if there remains an unpaid tax or proposed levy.  Third, a live dispute as to an underlying liability does not become moot based upon payment of the “unpaid” tax.  In other words, Sec. 6330 “grants the Tax Court jurisdiction to review a CDP determination regarding a taxpayer’s properly raised challenge to the existence or amount of her underlying tax liability, full stop. That jurisdiction does not change until the dispute is resolved” (citing Naftel, 85 T.C. 527, 530 (1985)).

Fourth, “because the Declaratory Judgment Act does not bar the Tax Court from declaring the rights to estimated payments at issue in a CDP hearing, there is a live case and controversy, and a Tax Court determination of Zuch’s tax liability would not be an improper declaratory judgment.” The Declaratory Judgment Act allows any U.S. court to adjudicate any case or controversy “except with respect to Federal taxes” (28 U.S.C. ˜2201(a)).

Fifth, the IRS did not meet its burden to show mootness because it did not prove that Zuch would have “no relief whatsoever if the Tax Court were to declare she has a right to the estimated tax payments.”

Holding: The Third Circuit held that the Tax Court’s dismissal for mootness was erroneous, vacated the dismissal, and remanded the issue to the Tax Court to determine whether Zuch is entitled to receive credit for any amount of the estimated tax payments at issue.  As the court stated, “The IRS’s arrogation to itself of the power to eliminate pre-deprivation judicial review of liability by seizing a taxpayer’s money to cover a disputed debt is not supported by relevant statute, common law (incorporated into statute), or mootness principles.”

■ Zuch, No.  22-2244 (3d Cir. 3/22/24)

—Matthew Geiszler, Ph.D., is a lecturer in accounting in the Brooks School of Public Policy; John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business; and Ayman Hashmi is a student in the Sloan MHA program in the Brooks School of Public Policy, all at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul Bonner, the JofA‘s tax editor.