About this time every year, my wonderful staff of attorney-advisors presents me with early drafts of the discussion of the ten most litigated issues in federal courts that are ultimately published in the National Taxpayer Advocate’s Annual Report to Congress. Editing these drafts is one of my favorite tasks, because I get to review in a concentrated fashion a significant swath of tax litigation. There are always one or two cases I have missed over the year that leap out at me during the editing process. Mescalero Apache Tribe v. Commissioner is one such case.
It is a basic canon of statutory construction that statutory language enacted by Congress is presumed to have meaning. Yet the IRS’s interpretation of the statutory language at issue in this case would, as a practical matter, render it virtually meaningless.
After an audit of the Mescalero Apache Tribe (the Tribe), the IRS asserted that some of its workers were misclassified as independent contractors. Under Internal Revenue Code (IRC) § 3402(a), an employer must withhold income taxes on the wages it pays to employees. Because the Tribe did not withhold on payments to the workers it classified as independent contractors, the IRS concluded that it was liable for their income tax withholding under IRC § 3403.
Even if an employer fails to withhold, however, IRC § 3402(d) provides that the IRS “shall not collect” the withholding tax liability from the employer (but can collect penalties) if the workers have paid their income taxes. To take advantage of this exception, the Tribe obtained statements from many (but not all) of its workers on IRS Form 4669, Statement of Payments Received, affirming that they paid their taxes. In Mescalero Apache Tribe v. Commissioner, the Tribe sought discovery of the IRS’s records to help establish that its workers had paid their taxes. However, the IRS raised a number of objections.
First, the IRS argued it was barred from disclosing the workers’ payment information. It said the information was confidential “return information” protected by IRC § 6103. The Tax Court did not agree. IRC § 6103(h)(4)(C) permits disclosure in “judicial or administrative” proceedings pertaining to tax administration if: the return information “directly relates” to a “transactional relationship” between a person who is a party to the proceeding and the taxpayer, and “directly affects” the resolution of an issue in the proceeding. The Tax Court concluded that: (1) the Tribe and its workers had a transactional relationship, (2) the worker’s tax payment information directly related to the relationship and (3) the information would directly affect resolution of the case. Thus, it could be disclosed.
Notably, IRC § 6103(h)(4)(C) permits disclosure in both “judicial” and “administrative” proceedings. Thus, in these types of cases the IRS could help employers by providing their worker’s tax payment information in examinations or appeals, at least to the extent the information would help resolve the cases. This approach might eliminate costly litigation.
Moreover, the IRS’s job is to “help” the Tribe and other employers to the full extent permitted by IRC § 6103. After all, Section 1002 of the Internal Revenue Service Restructuring and Reform Act of 1998 directed the IRS to “restate its mission to place a greater emphasis on serving the public and meeting taxpayers’ needs.” Today, its mission is to “[p]rovide America’s taxpayers top-quality service by helping them understand and meet their tax responsibilities…” In addition, the IRS adopted my proposal to adopt a Taxpayer Bill of Rights in 2014, and Congress codified it in 2016. Helping employers show they are not liable for withholding taxes by doing a search of the IRS’s records would further their rights to quality service, to a fair and just tax system, which includes the right to expect the IRS “to consider facts and circumstances that might affect their underlying liabilities,” and to pay no more than the correct amount of tax. However, the IRS resisted the Tribe’s discovery request on other grounds.
The IRS argued that even if the workers’ payment information could be disclosed, it was not discoverable because (1) the employer has the burden of proving its defense under IRC § 3402(d) and (2) allowing discovery would violate the rule that each party in civil litigation generally must bear the burden of financing his or her own suit. The Tax Court also rejected these arguments.
The court reasoned that Tax Court Rule 70(b) says relevant information is discoverable “regardless of the burden of proof involved.” The IRS did not cite Tax Court Rule 70(c), which limits discovery where it is unreasonably cumulative or unduly burdensome or where the information is more easily obtained from another source. However, the Tax Court said Rule 70(c) was inapplicable. It reasoned the Tribe had “already exhausted its own ability to find its workers, and a request for return information for about only 70 payees is not particularly voluminous.”
In addition, the Tax Court strongly suggested the IRS should have helped the Tribe. It focused on IRC § 3402(d), which says the withholding tax liability “shall not be collected from the employer” if paid by the employee. It said this language at least “implies that the Commissioner should have some responsibility for reviewing his own records for the proof that the Tribe may not be liable for withholding taxes.”
I actually think the Tax Court is being very generous to the IRS in its discussion here. To be clear, IRC § 3402(d) says that if an employer fails to deduct and withhold tax but the tax is thereafter paid by the recipient, that tax “shall not be collected from the employer.” That language imposes a blanket prohibition against collecting tax from an employer that has already been paid by the employee – an eminently reasonable provision that prevents the IRS from collecting the same tax amounts twice. Note that the statutory language is absolute and is not conditioned on whether the employer is able to substantiate employee payments. Indeed, such a requirement would make little sense. The IRS is the party that knows for certain whether and in what amount employee payments have been made. The employer does not have access to its workers’ tax returns or payment histories, so at best, it can know only what its employees voluntarily tell it – some of which may not be accurate. Thus, placing the burden of proving the amount of employee tax payments on the employer would sharply limit the scope of the provision.
Indeed, the Tax Court also cited Jones v. United States, where the U.S. Court of Appeals for the Ninth Circuit granted an employer’s request to be awarded attorneys’ fees by the IRS because the IRS failed to search its own records for proof that a taxpayer did not owe withholding taxes before making a counter-claim for them. In Jones, the Ninth Circuit stated that “[A]lthough the IRS had proof in its own records that Jones did not owe FICA and withholding taxes, it persisted in advancing a counterclaim [for FICA and withholding taxes] that was the epitome of a frivolous and unreasonable lawsuit.”
Notwithstanding the court’s suggestion that the IRS should help an employer in the Tribe’s situation, Chief Counsel Advice (CCA) 2017050511184404 recently recommended the IRS continue its practice of not providing employers with workers’ payment information during an exam or administrative appeal, even if doing so would help resolve the case. The CCA said the IRS was not required to help employers in exams or appeals because:
The opinion in Mescalero is limited to worker return information requested during the discovery process in a Tax Court proceeding, when the Tax Court has… balanced the relevancy of the requested information against the burden placed on the government in producing the information in accordance with Tax Court Rules 70(b) and 70(c).
The CCA does not address the Tax Court’s suggestion that IRC § 3402(d) requires the IRS to search its databases to avoid collecting amounts that “shall not be collected” from employers. Nor does it address the Ninth Circuit’s opinion in Jones v. United States, which says the IRS’s failure to do so before filing a claim makes the claim “frivolous and unreasonable.”
The IRS’s position in Mescalero and the ensuing CCA makes a mockery of the Taxpayer Bill of Rights. It is also shabby tax administration. I asked my research staff just how long it would take to identify the tax payments made by employees of a single employer in a given tax year. They advised me it generally would take about an hour to search IRS databases, two hours at most. In Fiscal Year 2016, the IRS assessed additional tax in the worker classification audits of about 500 firms. Each assessment addressed just over two tax years (resulting in about 1,100 firm tax year combinations). Even if the IRS conducts an average of two hours of research for each tax year involved, the IRS would only expend about 2,200 research hours or slightly more than one Full-Time Equivalent (FTE) to compute the amount of tax previously paid by the reclassified employees.
One final point: The expenditure of a mere hour or two of an IRS employee’s time pales in comparison to the significant resources the IRS has and will expend litigating this issue under the CCA guidance. In this case alone, the IRS at a minimum devoted Examination Resources to develop the case, Counsel resources to litigate the case, Counsel resources to decide whether to acquiesce in the decision, and Counsel resources to write the CCA. Instead, it could have assigned a lower graded employee to spend just one or two hours to identify the tax payments made by employees and then resolved the case in accordance with statutory requirement. The waste of taxpayer, IRS, Chief Counsel, and Tax Court resources is astounding.
Thus, to avoid the expenditure of infinitesimal resources, the IRS interpreted the law in a manner that undercuts its plain language, and violated the taxpayers’ rights to be informed and to pay no more than the correct amount of tax. Indeed, although the Tax Court did not explicitly say so in its opinion, its ruling enforced those taxpayer rights.
Hopefully, Mescalero will prompt the IRS to search its databases to ensure it only tries to collect withholding tax liabilities (in cases where IRC § 3402(d) applies) against employers for amounts not already paid by its workers. If it does not and these cases make it to court, employers may seek reimbursement for attorney fees incurred to defend against the IRS’s “frivolous and unreasonable” actions. They may also raise the IRS’s failure in Collection Due Process litigation, which applies an “abuse of discretion” standard of review to determine the appropriateness of collection actions. All of this further undermines taxpayers’ trust in the fair and just administration of the tax system.
My office will continue to advocate that the IRS reverse its practices and not follow the advice in CCA 2017050511184404. Employers who are unable to obtain this information from the IRS in worker classification cases should consider reaching out their Local Taxpayer Advocate for assistance.
The views expressed in this blog are solely those of the National Taxpayer Advocate. The National Taxpayer Advocate presents an independent taxpayer perspective that does not necessarily reflect the position of the IRS, the Treasury Department, or the Office of Management and Budget.
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