Tax Collections: The Basics and Beyond
My purpose in writing this article is not to debate the constitutionality of the tax laws or the legitimacy of the Internal Revenue Code (IRC).1 Many individuals and groups have chosen to protest and to litigate the validity of tax laws over the years. This is not the place. I begin this article with a set of clear assumptions. I assume the 16th amendment to the U.S. Constitution allowing for direct taxation of individuals was validly ratified. I assume the IRC is valid law. All the federal courts, including the U.S. Supreme Court, have upheld these assumptions. I assume the vast majority of citizens do their best to comply with the requirements of the tax laws.
IRC Sec. 1 states a tax is imposed on all taxable income according to the tables included in Sec. 1. IRC Sec. 61 defines gross income as being all income from whatever source derived. IRC Sec. 63 defines the deductions allowable against gross income to arrive at taxable income. Other code sections impose requirements to keep records of income and expenses and to file tax returns with the secretary of the treasury or his delegate, the commissioner of Internal Revenue. Further, other sections of the code and the related regulations include the requirements on when, where, and how to pay the taxes.
Most taxpayers have income taxes withheld from their wages or file and pay estimated taxes on time and in full. In an ideal world, the exact amount is properly withheld or paid in and no refunds would be due, or no amounts would be owed on April 15. Unfortunately, we do not live in an ideal world.
A few practical "nuts and bolts" administrative housekeeping details are relevant here. When a tax return is filed, the document is mailed to one of the service centers located at various places around the country. The line-by-line items are keypunched or scanned into the IRS computer systems. The assessment of income tax used to be done manually on a Form 23C (Assessment Certificate- Summary Record of Assessments). With the advent of modern computer systems, these functions have largely been automated. Items of income and allowed deductions are entered along with the tax liability. Credits and payments are entered and subtracted. The net tax due or tax refund is calculated.
What happens when a tax return is filed, or a tax liability is established, but an individual or company cannot pay the taxes in full when they are due?
The balance of this article will discuss the history and legal basis for tax collections and some of the practical aspects of tax delinquencies.
A “Brief” History
Taxes have been an unwelcome part of human civilization almost from our beginnings. Our legal system in the United States has its background and basis in English common law. Our tax system is no different. In common law, in any insolvency, the "Crown" or the government was paid its taxes first, and any other creditors would have to fight over the remaining assets. Over the centuries our laws have diverged and many insolvency cases are now resolved under the U.S. bankruptcy code. Under the IRC, certain classes of creditors are now afforded priority over the government's claim by action of law.
Modern taxation began around World War I with the IRC of 1916. Major rewrites of the code were made in 1928, 1939, 1954, and 1986. Various amendments to the code are passed each year. Some tax laws are written separately and some provisions are included in other measures. The current code stands in excess of 10,000 pages and was amended approximately 850 times in the 1990s. Current income tax regulations are published in a five-volume set. These do not cover other taxes such as Social Security and Medicare, or taxes administered by the Bureau of Alcohol, Tobacco, and Firearms (ATF). The administrative procedures relating to the regulations are further published in instructional volumes referred to as Internal Revenue Manuals (IRMs). These contain the day-to-day instructions to IRS employees on how to carry out their responsibilities.
Under the early revisions of the code deputy collectors, the forerunners of our modern revenue agents and revenue officers, were given the tasks of both assessing and collecting taxes. Lists of tax delinquencies were assigned to the deputy collectors. In essence, those delinquencies became the liabilities of the deputy collectors. The collectors had to account for (add) all taxes assessed and subtract all taxes collected, a system that followed very different legal and procedural "theories" than the one we operate under today.
In our history of taxation, there has been an ongoing process of revision and amendment. All of U.S. tax law and all the related regulations in 1928 (including all the changes from the 1916 Code) could fit in one book. I know. I bought one at a garage sale for $0.50!
Collection Basics I: Liens
But, what is the government's tax claim? The government's claim on a taxpayer's equity in assets is referred to as a statutory federal tax lien. IRC Sec. 6321 (and the following sections) state that when 1) a tax is assessed, 2) notice and demand are properly made, and 3) a taxpayer neglects or refuses to pay within the appropriate legal time period (generally ten days), a statutory federal tax lien comes into existence. This statutory lien is the primary legal basis for all further collection actions. If an individual subsequently does make payment in full, then one of the three necessary legal components of the establishment of the statutory tax lien (non-payment) is removed, and the statutory lien is rendered void or moot.
The statutory federal tax lien, which arises by action of law, is distinguished from the notice of federal tax lien which is a paper document. This notice is filed with the county recorder's office, or whichever equivalent office may be required in each of the fifty states. This document is placed in the public records to establish the government's claim in relation to other third-party creditors who may have claims against a taxpayer's assets. Generally, a filed notice of federal tax lien has the same status as a filed judgment lien as established through the local state or county Court of Common Pleas. Federal taxation would be much simpler if things ended there, and the "Crown" could take a priority position over all other creditors. Again, we do not live in an ideal or simple world.
Over the last eighty years or so, the tax laws have changed to allow more and more amendments, exceptions, exclusions, priorities, and super-priorities over the primacy of the federal tax lien. Priority is given to whole classes of creditors in some cases. Priority is given to very specific creditors in other cases. We now recognize that if a bank loans an individual or a couple money to buy a house and the bank properly files the mortgage, then that mortgage has a priority over a later established federal tax lien. This was not always the case. Under the old laws, if a federal tax lien were filed, it amounted to a financial death sentence for a business or an individual. No one would loan them money or advance any credit. These days it seems as though a filed notice of federal tax lien is merely regarded as a black mark on someone's credit score.
IRC Sec. 6322 states that the lien lasts until such time as the taxes are paid or until the taxes become unenforceable by reason of lapse of time. The general statute of limitations is now set at ten years. This may be extended by agreement, bankruptcy, a filed offer in compromise, and some appeals.
IRC Sec. 6323 and the following sections lay out many of the creditors who may have a priority over the federal tax lien. These include purchasers of security interests, property acquired at a casual sale, mechanic's liens, and some very specific commercial transactions. Under IRC Sec. 6323(c)(2)(a), commercial lenders are afforded a priority, but it is limited in time. Once a notice of federal tax lien is filed, a bank or other creditor only retains its priority for a period of forty-five days. After the forty-fifth day, all new inventory or accounts receivable are then subject first to the federal tax lien.
Other provisions of the law cover the release, withdrawal, and/or revocation of the federal tax lien.
I reiterate that the government's tax lien attaches to equity in assets, not necessarily to the asset itself. Assets may be seized and sold even if they are encumbered by a prior creditor. The purchaser of that asset still owes the secured creditor the balance of their security interest. This brings us to the second major portion of tax collections.
Collection Basics II: Levies and Seizures
IRC Sec. 6331 (Levy & Distraint) grants broad authority to the secretary of the treasury (or his delegates) to collect taxes by levy upon all property or rights to property owned by a delinquent taxpayer. Direct attachment of assets from an individual is generally referred to as a levy or seizure. Collecting from a third party for cash or near cash items (such as bank deposits, accounts receivable, or wages) is normally done through a notice of levy. Again, there are exceptions to this as well. IRC Sec. 6334 provides that some items are exempt from levy. These include some common-sense items such as those necessary for food, clothing, amounts set aside for the benefit of minor children, some public assistance benefits, tools of the trade, medical care, etc. Beyond those items specifically exempt, any equity in any asset subject to the statutory federal tax lien may be attached by levy or seizure.
From an administrative standpoint, once a tax liability is assessed, a series of letters or notices are sent from the IRS. The assessment and notice and demand for payment are almost always timed to happen on the same day to meet the provisions of IRC Sec. 6321 regarding the establishment of the statutory federal tax lien. After the 10-day period to establish the statutory lien, a series of letters is sent out. These letters are designed to inform taxpayers of their rights and responsibilities. There are a number of required attached publications that must accompany these letters. These include both the collection process and information concerning the appeal rights an individual has.
Service personnel go to great lengths to provide numerous opportunities for a taxpayer to submit proposals for resolving the tax issues. When a resolution is not reached, or when an individual or business cannot or will not meet the agreed-upon requirements, enforced collection actions are appropriate.
During my career, I filed numerous notices of federal tax lien, served levies on taxpayers and third parties, and seized and sold real and personal property, and seized many different types of businesses. It was never a pleasant task, but it was necessary. Levy and seizure were never the first consideration. Service personnel find it advisable to allow taxpayers to solve their own problems.
Alternatives to Enforced Collection Actions
The publication on the collection process outlines the requirements for alternatives to enforced collection actions by the Service. These might include a request for an installment agreement under IRC Sec. 6159(a) or an offer in compromise under other sections. A taxpayer may file a claim as an innocent spouse. A person may offer to post a bond to guarantee payment of the taxes due.
Administrative procedures also allow revenue officers to report an account as currently not collectible due to hardship, death, or corporate liquidation.
The IRS Reform and Restructuring Act of 1998 also provided for expanded appeals in many areas, but primarily concerning collection issues. Now, if collection personnel turn down a request for an installment agreement, offer in compromise, or propose lien or levy actions, all of these disputes may be taken to the appeals office under the recently passed RRA-98 provisions. Such disputes may further be taken to the U.S. Tax Court if the administrative appeal fails to result in satisfactory resolution.
I look forward to discussing these alternatives, and more detailed background, including how the Service views these issues at the NTPI.
In this article all references are to the Internal Revenue Code of 1986 and its many amendments, unless otherwise specified.
Andy Okapal began a 35-year career with the IRS in 1972, ending with his retirement in 2008, spending the majority of his career as a field revenue officer in the Collection Division. In 2001, he was selected as a settlement officer and completed his career in the Appeals Office conducting administrative hearings on tax disputes. On a personal note, he is a pack rat and loves to haunt old book stores and garage sales.