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Is A Claimed Refund the Taxpayer’s Property? Tax Court Holds Yes in the Estate Tax Context

Posted on Nov. 30, 2015

Earlier this month in Estate of Badgett v Commissioner, the Tax Court had occasion to consider whether over $400,000 in an unpaid refund attributable to a 2011 tax return was considered part of Russell Badgett’s estate when he died in March 2012, prior to the filing of Badgett’s 2011 individual income tax return. The case raises an important estate tax issue, and I will describe it below. However it caught my attention because of its possible implications when IRS holds refunds without notifying or explaining its actions, a practice we have heard about in past posts such as Freezing the Refunds of Our Guests. In this post I will describe the Badgett case and also explain why its rationale may have significance in areas removed from the estate tax context, including ensuring fair treatment for individuals who claim refunds.

In Badgett the taxpayer died in March 2012, prior to filing his 2011 individual return. When the executor filed the 2011 individual return, it reflected a substantial overpayment and requested a refund of over $400,000, and also applied a small amount of the overpayment to Badgett’s estimated individual income taxes for 2012. After the executor filed the 2011 individual return in May 2012, the IRS issued the $400,000 plus refund to the estate, and applied a small portion of the overpayment to the 2012 year. When the estate filed its estate tax return in December of 2012, it did not include the refund from Badgett’s 2011 1040 as part of the estate’s gross value, nor did the estate tax return reflect the small amount of refund attributable to Badgett’s 2012 1040. IRS examined the estate, and proposed a deficiency attributable to the estate’s not including the refunds in the gross estate.

The Tax Court decided that the estate should have included the refunds attributable to both the 2011 and 2012 individual returns as part of the estate’s gross estate. In so doing it worked its way through the thicket of Kentucky state law and some cases which on the surface appear to support the estate’s position that the refund should not be part of the gross estate.

The Issue: Estate Tax and Overpayments

To start the Tax Court framed the estate tax issue. It noted that Section 2031(a) provides that “[t]he value of the gross estate of the decedent shall be determined by including to the extent provided for in this part, the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.”

It then looked to Section 2033, which provides that “[t]he value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.”

This teed up the issue: was the claimed but unpaid refund part of Badgett’s property at the time of his death?

The estate looked to Kentucky law (Badgett’s residence), which provided that “property must be in existence on the tax assessment date to be subject to tax and cannot be a mere possibility or expectancy.” To that end, its view was that the “overpayment does not create a right to an income tax refund” and that “there is no property interest until the refund has been declared by the Government.”

As further support, the estate looked to cases that considered the issue in light of the offset powers of Section 6402, which provides as follows:

In the case of any overpayment, the Secretary, within the applicable period of limitations, may credit the amount of such overpayment, including any interest allowed thereon, against any liability in respect of an internal revenue tax on the part of the person who made the overpayment and shall, subject to [ offsets for past due child support, state tax and certain other federal debts] refund any balance to such person.

There were two cases that relied in part on Section 6402’s offset powers in finding that an overpayment did not constitute a property interest, one in the bankruptcy context and the other in the estate tax context. The bankruptcy case was In re Piggot, a bankruptcy case in which the “IRS sought to offset an unpaid dischargeable tax debt of the debtors (husband and wife) incurred in 1996 and 1998 against a “potential” tax overpayment they made in 2004.”

In that case, the bankruptcy court found that the debtors’ tax overpayment was not a property interest, stating: “[T]he court is convinced that the tax law that holds that an overpayment is not the same as a refund is correct. Since an overpayment is not credited to the debtor until after offsets have occurred, if the IRS chooses to make such offset, there is no property interest in a debtor until the refund has been declared.”

In the estate tax context there was a Third Circuit case affirming the Tax Court which likewise found that the overpayment was not property. Estate of Bender v. Commissioner, 827 F.2d 884 (3d Cir. 1987), aff’g in part, rev’g in part 86 T.C. 770 (1987):

[Bender] was an estate tax case in which the testator had unpaid Federal tax liabilities for years other than those involving the tax overpayments. The Court of Appeals for the Third Circuit concluded that the testator did not have a property interest in the tax overpayments for purposes of calculating his gross estate. The court held that the IRS’ discretionary power to offset the testator’s tax overpayments against his unpaid liabilities meant that the estate could not compel the IRS to issue a tax refund for the years for which the testator overpaid his taxes; therefore, the tax overpayments “never attained the status of independent assets for estate tax purposes.”

In Badgett the Tax Court distinguished Bender and Piggot because of the presence in those cases of “undisputed and unpaid tax liabilities.” This is where tax procedure enters the picture. Under Section 6402 IRS has discretion to apply the overpayment to satisfy the debt or issue a refund; absent the liabilities the statute says the IRS “shall” issue the refund. Looking to Section 6402 as the key to the case, the Tax Court noted it “reached a different conclusion in another case where a deceased taxpayer had no tax liabilities to which a tax overpayment could be offset. Estate of Chisolm v. Commissioner, 26 T.C. 253 (1956). As such, in Chisolm it found “that the full value of the deceased taxpayer’s viable but unasserted income tax refund claim was an asset of the estate”:

The entire taxes on the income of Harvey [the deceased taxpayer] and his wife for 1950, as disclosed on the return filed for that year, were paid by Harvey. He was dead at the time the return was filed and of course did not join in filing it. However, the type of return that was filed for that period is immaterial as is the crediting of the overpayment as requested on that return. The fact is that Harvey had overpaid not only his own taxes but those of himself and his wife. The resulting overpayment was really his. It was valuable property and a part of his estate at the time he died. It was includible in his estate under section 811(a) [a precursor to the current section 2033], and incidently would have been includible in his estate even if it represented jointly held property since he had supplied the entire consideration therefor. * * *

There were a couple of other post-Chisolm Tax Court cases where there was no offsetting liability when the Tax Court also held that the refund was part of the gross estate. To the Tax Court, Chisolm and those cases controlled:

We believe it proper to herein follow the holdings in these cases. Simply stated, if no offsetting liability exists, section 6402(a) is clear: The statute mandates that the IRS “shall” refund any balance to the taxpayer. In the matter herein, there is no indication that decedent was subject to any liability or obligation against which the IRS could offset his overpayments. The status of the tax refund is more than a mere expectancy; the estate has the right to compel the IRS to issue a refund for the years for which decedent overpaid his tax. Thus, we hold that the overpayments in question attained the status of independent assets for estate tax purposes; they constitute decedent’s property for estate tax purposes.

When is an Overpayment Property of the Taxpayer? Other Contexts

The estate tax issue is interesting enough, and that alone would warrant a PT post. What tipped the scales for me, however, is the discussion in the opinion concerning the nature of the taxpayer’s interest in the overpayment. The estate argued that “a taxpayer has ‘no legal right’ to a tax refund unless and until the taxpayer files a successful suit within the permitted statutory periods against the IRS for that tax refund after meeting all conditions precedent.” The estate cited to a number of cases that it alleged supported its view, including the 1996 Lundy Supreme Court case where the Court held that the Tax Court lacks jurisdiction to award a refund of tax paid more than two years prior to the IRS mailing a taxpayer a deficiency notice where the taxpayer failed to file a  return. The Tax Court in Badgett was not persuaded that those cases supported the estate’s argument:

These cases do not support the estate’s contention. Rather, they merely discuss the requirements imposed on a taxpayer of prosecuting a tax refund action.

We therefore hold that decedent had property interests in the values of his 2011 and 2012 Federal income tax refunds and consequently the refunds are included in the value of decedent’s gross estate for Federal estate tax purposes.

In the International Taxpayer Rights Conference two weeks ago I gave a talk on a paper I am writing considering both legal on nonlegal ways to counter agency actions that deprive taxpayer rights. On the legal side, I pointed to three main areas, administrative law, constitutional law and organic agency statutes. Constitutional law and in particular procedural due process have at times been like the red-headed stepchild in this list, though perhaps that may change.  The presence of a property interest is essential when one considers what protections are due when the government takes actions that may deprive access to that property right. Procedural due process under the 5th Amendment generally requires that individuals receive adequate notice and the opportunity for a hearing prior to the deprivation of a protected interest. It is always an uphill struggle when arguing that IRS procedures may trigger a procedural due process challenge, in part because the Supreme Court in cases stemming from the 19th century has held that in certain exceptional areas (including tax) a postdeprivation hearing may be sufficient process when essential government needs must be satisfied. In addition, there is some uncertainty as to when a property interest arises in the context of applications for benefits in the nontax context, though recent cases suggest that applications for benefits where the government does not exercise meaningful discretion in determining eligibility may trigger a property inteterest worthy of constitutional protection. Those cases have bearing in considering procedural protections that should attach to returns claiming refundable credits.

The Badgett distinction between cases where the IRS knows about undisputed and unpaid liabilities and other scenarios may be important not just for the estate context in which it arises. Badgett suggests that absent undisputed liabilities to which the Service can use its offset powers, taxpayers have a property interest in the receipt of refunds claimed on returns. We have discussed in PT how on occasion IRS sits on refunds or fails to adequately explain why it chooses to not issue a refund. In addition, the National Taxpayer Advocate has on multiple occasions (such as here in a 2013 report) criticized IRS for failing to issue refunds when the taxpayer’s return preparer may have engaged in abusive and illegal behavior and altered a return to ensure that the preparer rather than the taxpayer gets funds that rightfully belong to the taxpayer. Relatedly I have criticized the lack of adequate explanation or defined standards and process to challenge the IRS’s imposing a ban on individuals who IRS has claimed have recklessly or fraudulently claimed an EITC, actions that may inhibit taxpayers from receiving and even claiming refunds to which they may be entitled to receive.

In past papers I have criticized the rationale in older Supreme Court cases that take a narrow view of procedural due process in the tax context, in part due to those cases’ overstatement of the government interest and failure to consider the individual interest in prompt payment and procedures to help ensure that the government does not erroneously deprive people of property. The individual interest is even more enhanced when Congress for better or worse uses the Code to deliver benefits in the form of refundable credits. I think recent examples of IRS sitting on refunds and freezing them without adequately explaining itself raise at a minimum fairness concerns and may in fact trigger a relook at some of the constitutional underpinnings of IRS procedures. While the IRS has a strong interest in ensuring integrity, minimizing overclaims and detecting fraud, framing as Badgett does overpayments as property of the taxpayer should remind the IRS in other contexts that it needs to more carefully consider individuals’ interests. If it does not the courts will likely force the issue.

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