Last week the Tax Court handed down its opinion in Melasky v. Comm’r, 151 T.C. 9 (Oct. 10, 2018). The important issue in Melasky relates to the application of the proceeds of a levy. Four days prior to the date the levy was made, the taxpayer hand-delivered a check to the IRS and properly designated how the check was to be applied. Had the IRS immediately cashed the check, it would have cleared and the payment would have been applied according to the taxpayers’ designation. Instead, the IRS held the check until after it levied the account four days later and then applied the proceeds of the levy in its own best interests on the basis that the funds were obtained through an involuntary payment – the levy. In a reviewed opinion, with two concurrences and one dissent, the Tax Court agreed with the the IRS.
Melasky was not on anyone’s radar prior to the date the opinion was issued, but the case is now drawing attention for its particularly harsh result. The result was probably justified based on the facts of the case, but the implications of the opinion are not so contained. To understand importance of the case, you need to understand the importance of designating voluntary payments made to the IRS.
When a taxpayer pays the IRS less than the total amount due for all periods, an issue arises as to how the payment should be applied. As a matter of policy, the IRS allows taxpayers to designate how voluntary payments will be applied between periods and among the tax, interest, and penalties attributable to each period.1 By strategically designating such payments between periods and among the tax, penalties, and interest due within a period, a taxpayer can significantly reduce or eliminate his or her liability. In the absence of a designation, or if the payment was involuntary, the IRS will apply the payment in the government’s best interest, which usually means applying the payment to tax, penalty, and interest, in that order, for the earliest period, then for the next succeeding period.2 The following examples illustrate the point:
- EXAMPLE 1: Taxpayer is president of Poor Co., Inc. (“Poor Co.”), a corporation that failed to withhold and pay employment taxes for the quarter ending 9/30/2009 and the quarter ending 9/30/2017. The IRS has assessed trust fund recovery penalties under IRC § 6672 against Taxpayer for both periods. As of 10/1/2018, the total of the tax, penalties, and interest due for the quarter ending 9/30/2009 was $100,000, of which $40,000 is attributable to trust fund taxes (i.e., income taxes and employee’s portion of FICA taxes), $30,000 is attributable to non-trust fund taxes (i.e., the employer’s portion of FICA taxes), $20,000 is attributable to penalties, and $10,000 is attributable to interest. As of 10/1/2018, the total of the tax, penalties, and interest due for quarter ending 9/30/2017 was $40,000, of which $20,000 is attributable to trust fund taxes, $10,000 is attributable to non-trust fund taxes, $5,000 is attributable to penalties, and $5,000 is attributable to interest. On 10/1/2018, Poor Co. has $60,000 in its bank account and the board of directors of Poor Co. votes to dissolve and liquidate the corporation. Under IRC § 6672, Taxpayer is personally liable for payment trust fund taxes due for each period, but not for non-trust fund taxes, penalties, or interest. If Poor Co. makes a voluntary payment of $60,000 on 10/1/2018 and designates $40,000 to be applied to the trust fund tax due for the quarter ending 9/30/2009 and $20,000 to be applied to the trust fund tax due for the quarter ending 9/30/2017, the payment would eliminate the trust fund portion of the unpaid tax, thereby relieving Taxpayer personal liability.
- EXAMPLE 2: The facts are the same as Example 1, except that on 10/1/2018, the IRS levies Poor Co.’ bank account. The proceeds of the levy are applied as follows: $10,000 to interest due for the quarter ending 9/30/2009, $20,000 to penalties due for the quarter ending 9/30/2009, and 30,000 to the non-trust fund tax due for the quarter ending 9/30/2009. As a result, the trust fund taxes remain unpaid and Taxpayer remains personally liable.
As the examples show, it often behooves taxpayers to designate payments to the most recent tax periods. Paying the debt in that order produces the most efficient result because it erodes the basis for calculating penalties and interest, and in some cases can eliminate the basis for the liability itself. In addition, there is a ten-year statute of limitations for most tax debts,3 and tax debts older than three years can possibly be discharged in bankruptcy.4
In Melasky, the taxpayers, David and Audrey Melasky, attempted to make a voluntary payment of tax due for 2009. On January 29, 2011, they hand-delivered a check to the IRS, which they designated to be applied to their 2009 liabilities. Four days later, on January 31, 2011, the IRS issued a notice of levy to the taxpayers’ bank with respect to their 1995, 1996, and 1999 – 2004 liabilities. As a result of this levy, a hold was placed on their account.
On Feb. 9, 2011, the taxpayers submitted a request for a Collection Due Process hearing with respect to their unpaid income tax liabilities for the periods in question. Among other things, the taxpayers argued that the period of limitations on collection had expired with respect to their 1995 and 1996 liabilities. The taxpayers also noted that the 2011 check had not been deposited as of January 31, 2011, and that their bank placed a hold on their checking account. They requested that the bank account levy proceeds be applied against their 2009 liability.
On Feb. 28, 2011, the IRS applied the proceeds of the bank account levy to the taxpayers’ 1995 liability. The IRS then attempted to deposit the 2011 check but it didn’t clear, either because of the hold on the bank account or because the funds had already been transferred to the IRS as a result of the levy.
On Apr. 20, 2012, the IRS issued a notice of determination sustaining the notice of intent to levy, concluding that the period of limitations for collection of the taxpayers’ ’95 and ’96 income tax liabilities had not expired, denying their request to apply the proceeds of the levy on their bank account against their 2009 income tax liability, and rejecting their proposed installment agreement.
The IRS reasoned that it didn’t have to apply the bank levy proceeds against the taxpayers’ 2009 liability as they requested because the levy was an involuntary payment. The IRS also explained that it rejected the installment agreement on the basis that the taxpayers didn’t pay over the equity in all of their assets and because of “Mrs. Melasky’s unwillingness to take any distributions” from a trust established for her own support and maintenance.
The taxpayers timely filed a Tax Court petition, and both sides sought summary judgment.
The issues before the Tax Court were whether the IRS abused its discretion in (1) deciding not to apply the bank account levy proceeds against the taxpayers’ 2009 liability as they requested, and (2) rejecting their proposed installment agreement.
In a reviewed opinion, a majority of the Tax Court found that the IRS didn’t abuse its discretion in refusing to apply the bank account levy proceeds as the taxpayers requested, because the proceeds were an involuntary payment and as such could be applied as the IRS saw fit.
The taxpayers argued that their 2011 check should be treated as a voluntary payment toward their 2009 liability because that check was written and accepted before the levy. The Tax Court, however, rejected this argument on the ground that the check was a conditional payment-subject to the condition subsequent that it be paid upon presentation to the drawee. The Tax Court reasoned that there was no payment in this case until the check was presented for payment, and because the check wasn’t honored when it was presented, there was no payment for the taxpayers to designate. Of course, the only reason the check was dishonored was because the IRS had levied the taxpayers’ account. The Tax Court, however, was not sympathetic to this fact. The Tax Court also rejected the taxpayers’ argument for an equitable exception, finding no case law or other support for this argument, and further finding that the IRS did not cause the check to bounce but such was rather the result of the taxpayers’ chronic failure to pay their taxes.
There were two concurring opinions. The first concurrence strenuously disagreed with the dissent, and the second generally emphasized the limited scope of the majority opinion. The dissent would have held that the taxpayers’ payment was made on January 27, 2011 and thus voluntary, on the ground that there were sufficient funds in the account at that time and that the check bounced on account of the IRS’ later actions.
In the end, Melasky could be chalked up to a bad facts case. The Melasky’s were not sympathetic taxpayers by any means. The fact that they were chronically delinquent and that Mrs. Melasky refused to make distributions from her trust fund did not help their case. As a reviewed case, however, it is considered binding precedent under the Tax Court’s rules of procedure. In the context of voluntary payments, the decision creates uncertainty regarding any payment made by check. Until a check is presented for payment and the check is honored, the IRS can take the position that no payment has been made. There is nothing to discourage or prevent a revenue officer from creating an involuntary payment by holding the check and levying the account. The decision, however, could have implications far beyond the context of the case. Whether that will happen is not clear, but the IRS will undoubtedly cite this case anytime its actions cause an inequitable result. In the interim, it may be beneficial for taxpayers to opt to make payment via wire transfers or a cashier’s check in lieu of personal check payments if there is a chance for a levy.
Footnotes
- See Dixon v. Comm’r, 141 T.C. 173, 185-187 (2013); Rev. Proc. 2002-26, § 3.01, 2002-1 C.B. 746, 746.
- Rev. Proc. 2002-26 at § 3.02.
- IRC § 6502; see also § 6503 (providing for circumstances under which statute of limitations under IRC §§ 6501 and 6502 are suspended).
- 11 U.S.C. ⸹ 523(a)(1)(A) (2012); see 11 U.S.C. ⸹ 507(a)(8) (2012); Severo v. Comm’r, 129 T.C. 160, 165 (2007), aff’d, 586 F.3d 1213 (9th Cir. 2009)