UNITED STATES TAX COURT

 

RONALD J. SPELTZ                  )

JUNE M. SPELTZ,                   )

                                  )

                   Petitioners,  )

                                  )        

                                  )

                                  )  Docket No. 15382-03”L”

     v.                           )

                                  )

COMMISSIONER OF INTERNAL REVENUE, )

                                  )

                   Respondent.   )

 

 

PETITIONERS’ FURTHER SUPPLEMENTAL MOTION CURIA ADVISARI VULT OPPOSING

RESPONDENT’S MOTION FOR SUMMARY JUDGMENT

     PETITIONERS hereby submit this Further Supplemental Motion Curia Advisari Vult Opposing Respondent’s Motion for Summary Judgment (hereinafter, the “Supplemental Motion” or “Motion”).  Petitioners in this Supplemental Motion hereby incorporate by reference the factual and legal arguments made in Petitioners’ Opposition to the Motion for Summary Judgment and Supplements thereto (hereinafter, collectively, the “Initial Opposition”).  Attachments in this Supplemental Motion are numbered sequentially from the Attachments in the Initial Motion.  References to Attachments in this Supplemental Motion refer to Attachments to the Initial Motion or to this Motion per the applicable number.   

In this Supplemental Motion, Petitioners will show the following in the corresponding Sections in this Motion:

(Section 1) A proper statutory analysis of the three applicable statutes at play in the Speltz situation (hereinafter referred to herein as the “Three Statutes”), demonstrates that granting the Speltzes relief fulfills the literal language and the intent of  Section 7122 (the offer in compromise statute), fulfills the literal language and intent of Section 421-422 (the incentive stock option statute), and fulfills the intent of Section 56(b)(3) (the alternative minimum tax as applied to incentive stock options).  While granting relief compromises the tax liability imposed by the literal language of the AMT ISO Statute, that is precisely the role of Section 7122, when a tax liability arising under the substantive internal revenue laws creates hardship, or is inequitable/contrary to public policy.

(Section 2) A careful analysis of the language and intent of each of the Three Statutes, demonstrates that granting the Speltzes relief and accepting their offer in compromise is the only way to properly interpret and align the public policy goals of those Three Statutes.  Respondent itself recognizes that a rigid application of the literal language of the internal revenue laws does not always effect the intent of Congress; applying the same principles the IRS uses for “tax shelters” to the Speltz “tax trap” leads to the conclusion that OIC relief should be granted.

(Section 3) Section 7122 and corresponding regulations 26 CFR 301.7122 grant the Secretary of the Treasury and the Commissioner of the IRS discretion to consider the special circumstances raised by the Speltzes in their offer in compromise for their ISO AMT tax liability; the laws further provide that discretion must be exercised fairly and with careful consideration.

(Section 4) The IRS failed either to consider (or if it did consider it failed to properly consider), under the principles and processes laid out in Section 7122, corresponding regulations 26 CFR 301.7122, and the corresponding IRM provisions, the special circumstances raised by the Speltzes in their offer in compromise.

(Section 5) Proper consideration of the Speltzes’ special circumstances shows that, in the Speltzes’ exceptional situation, they are entitled to relief under both the Section 7122 hardship and the Section 7122 public policy/equity grounds (or alternatively - if the Speltzes are found to not have the ability to pay – under doubt as to collectibility with special circumstances).

 

Overview of Petitioners’ Argument

Petitioners first want to clarify an important and fundamental point; Petitioners do not argue or assert that the ISO AMT tax law is “unfair.”  Further, Petitioners have not asked the IRS, nor are Petitioners asking this Court, to ignore, undermine or circumvent the AMT ISO law or any other law.  Rather, the Speltzes contend that under their special circumstances the tax liability being imposed on them is unfair and inequitable, a situation for which Congress has fashioned a remedy in the law – Section 7122.   

     The unfairness and inequity of the Speltz tax liability is quickly seen on even a cursory review of the facts.  The Speltz tax liability for 2000 was over 220%; 11x that of a similarly situated taxpayer; based on money they never received and never will receive; requiring them to over-extend themselves to borrow immense sums of money to pay as much as possible such that their wages are now being garnished by one creditor; is so disproportional to any economic benefit they ever received that it has destroyed them financially and will destroy them financially for years to come; with interest and penalties the Speltzes liability has swelled to 257% of their 2000 taxable income, nearly 15x that of a similarly situated taxpayer; and ironically they already have accrued over $120,000 in tax overpayment “credits” and any additional tax payments they make will increase that overpayment credit amount.  See, Initial Opposition. 

     The Speltzes contend that Section 7122 is, in applicable part, designed and intended by Congress to address situations where a tax liability accurately imposed under the literal language of the internal revenue laws, nonetheless creates hardship or is inequitable and against public policy.  This relief will only be appropriate in exceptional circumstances, as the tax laws operate fairly and equitably in the great majority of situations.  The Speltz situation is, in fact, a stark example of just such exceptional circumstance that qualifies for relief under Congress’s Section 7122 OIC “safety net.” Proper application of the compromise principles of Section 7122 to an unintended and inequitable tax liability arising under special circumstances, does not undermine or circumvent the normal operation of the tax law imposing that unintended and inequitable tax in that special circumstance.

 

SECTION 1.  A proper statutory analysis of the Three Statutes at play in the Speltz situation, demonstrates that granting the Speltzes relief fulfills the letter and the intent of  Section 7122 (the Offer in Compromise Statute), fulfills the letter and intent of Section 421-422 (the Incentive Stock Option Statute), and fulfills the intent of Section 56(b)(3) (the Alternative Minimum Tax as Applied to Incentive Stock Options).  While granting relief compromises the tax liability imposed by the literal language of the AMT ISO Statute, that is precisely the role of Section 7122, when a tax liability arising under the internal revenue laws is creating hardship, or is inequitable and contrary to public policy.

 

     Determining whether the Speltzes should be entitled to relief requires analysis and understanding of the following three Statutes involved and intertwined in this case:  the incentive stock option (ISO) statute Sections 421 and 422 (hereinafter referred to as the “Incentive Statute”), under which Congress intended to provide an incentive and reward for employees to invest in their companies; the AMT statute as applied to ISOs  Section 56(b)(3) (hereinafter referred to as the “AMT ISO Statute”), under which Congress intended to ensure that taxpayers could not totally avoid paying some tax on economic benefit received after exercising incentive stock options; and the OIC statute Section 7122 (hereinafter referred to as the “OIC Statute”), under which Congress provided, inter alia, protections to taxpayers whose tax liabilities are creating hardship or are contrary to equity and public policy.

     Petitioners will show in this Motion, that providing relief to the Speltzes fulfills the literal language and intent of Congress as to the OIC Statute, fulfills the literal language and intent of Congress as to the Incentive Statute, and fulfills the intent of Congress as applied to the AMT ISO Statute. Providing relief does indeed compromise the tax liability imposed by the literal language of the AMT ISO Statute.  However, it is important to recognize that under the Congressionally mandated compromise policies, appropriately compromising an inequitable  liability arising under the internal revenue laws is not undermining or circumventing the revenue laws, but in fact is supporting the overall public policy and intent of the internal revenue laws.  When in exceptional situations the internal revenue laws are not operating fairly and equitably, enforcing the unfair and inequitable liability not only is against public policy, but undermines taxpayer confidence and compliance.  

    

A.  The application of the literal language of a statute does not always effect the public policy for that statute, either individually or within the context of other applicable statutes.

 

     The Speltz situation involving the AMT ISO Statute is not the first time that the literal language of a Statute, in a particular situation, failed to effect the intent of Congress for that Statute, both individually and within the necessary context of other applicable Statutes.  The Supreme Court has recognized that a rote application of the literal words of the statute may not, in all situations, bring about the purposes Congress intended for that statute.  In such cases, it is necessary to look beyond the words of the statute to understand its purpose.

There is, of course, no more persuasive  evidence of the  purpose of a statute than the words by which the legislature undertook to give expression to its wishes.  Often these words are sufficient in and of themselves to determine the purpose of the legislation.  In such cases we have followed their plain meaning. When that meaning has led to absurd or futile results, however, this Court has looked beyond the words to the purpose of the act. Frequently, however, even when the plain meaning did not produce absurd results but merely an unreasonable one "plainly at variance with the policy of the legislation as a whole" this Court has followed that purpose, rather than the literal words. When aid to construction of the meaning of words, as used in the statute, is available, there certainly can be no "rule of law" which forbids its use, however clear the words may appear on "superficial examination." The interpretation of the meaning of statutes, as applied to justiciable controversies, is exclusively a judicial function.  This duty requires one body of public servants, the judges, to construe the meaning of what another body, the legislators, has said.  Obviously there is danger that the courts' conclusion as to legislative purpose will be unconsciously influenced by the judges' own views or by factors not considered by the enacting body. A lively appreciation of the danger is the best assurance of escape from its threat but hardly justifies an acceptance of a literal interpretation dogma which withholds from the courts available information for reaching a correct conclusion. Emphasis should be laid, too, upon the necessity for appraisal of the purposes as a whole of Congress in analyzing the meaning of clauses or sections of general acts. 

 

United States et al. v. American Trucking Associations, Inc. et al., 310 U.S. 534. 543-544 (1940).  [Emphasis added.]  See, also, William and Helen Woodral v. Commissioner, 112 T.C. 19, (1999), citing, American Trucking for this principle.   

     In the instant case, this Court is being called upon to interpret and harmonize three applicable statutes.  “In the interpretation of statutes, the function of the courts is easily stated.  It is to construe the language so as to give effect to the intent of Congress.”  United States v. American Trucking, at 542.  The three statutes in the Speltz case form a “latticework of statutory provisions” requiring review and reconciliation such that they are “construed together and effect given to all of them.”  Owner-Operators Independent Drivers Association of America v. Samuel K. Skinner, Secretary of Transportation, 931 F.2d 582 (9th Cir.1991).  In analyzing this latticework of statutes, the principle of statutory interpretation the Supreme Court articulated in American Trucking is directly applicable to the AMT ISO statute.  In American Trucking, the rote and literal application of a statute was, in a particular situation,  leading to an unintended result not consistent with the legislative purpose of that statute itself, which became even more evident when considered in the context of a second applicable statute.  The Supreme Court thus narrowed the interpretation of the overly broad language to effect the purposes intended by Congress as a whole and in context, giving precedence to the second statute’s scope in order to effect Congress’s intent for both statutes. 

     Interestingly, in the instant case, the rote enforcement of the literal words of one (the AMT ISO Statute) of three related statutes is not effecting the intent of Congress for any of those Three Statutes.  Accordingly, the AMT ISO statute must be analyzed and understood in the context of the other applicable statutes and harmonized to the extent possible.  “Phrases must be construed in light of the overall purpose and structure of the whole statutory scheme.”  Woodral v. Commissioner, at 22, citing Dole v. United Steelworkers of Am., 494 U.S. 26, 35, 110 S.Ct. 929 (1990). 

B.  Proper analysis of the Speltz case requires consideration of the language and intent of the Three Statutes – not just the language of the AMT ISO Statute.  In most cases, the Three Statutes harmonize both in language and public policy; in the Speltz case, their exceptional circumstances lead to a disconnect between the AMT ISO literal language and its intent, and between the AMT ISO Statute and the other two applicable statutes.

 

     The Speltzes request for relief under the OIC Statute, from the unintended harm being caused them by the rote application of the AMT ISO Statute, does not put the IRS or this Court in a position where Section 7122 is undermining Congressional intent with respect to any other statute – including the AMT ISO Statute.  Rather, based on their special circumstances in their particular situation, the rote and literal application of the internal revenue laws is imposing an impossible-to-pay 220% tax rate or 11x the tax required of a similarly situated taxpayer - an unintended result not consistent with the legislative purpose of Congress for any internal revenue law.  In such a special case, Congress intended that the OIC Statute would operate to step in and provide relief from this unintended and unfair tax liability arising from unintended results arising from the literal application of the internal revenue laws (in this case, the AMT ISO Statute).

     In the Speltz Case, it would therefore be a mistake to look solely to the AMT ISO Statute, ignore the other applicable statutes, and conclude that since the liability is accurately imposed under the strict letter of the AMT ISO Statute, providing relief to the Speltzes would be contrary to current law.  Rather, in order to properly determine whether relief should be afforded the Speltzes under Section 7122, it is helpful to understand and appreciate the Congressional intent behind the other two statutes (the Incentive Statute and the AMT ISO Statute) involved in this latticework. 

     As articulated in United States of America v. Larry Joseph Lewis, 67 F.3d 225 (1995) footnote 9, “[s]tatutes should be harmonized to the extent possible.  Citing Hellon & Associates, Inc. v. Phoenix Resort Corp., 958 F.2d 295, 297 (9th Cir. 1992).  “Congress must be presumed to have known of its former legislation and to have passed . . . new laws in view of the provisions already enacted.”  Owner–Operators Indep. Drivers Ass’n of Am., Inc. v. Skinner, 931 F.2d 582, 586 (9th Cir. 1991).  Cited in Hellon, supra.  “Phrases must be construed in light of the overall purpose and structure of the whole statutory scheme.”  Woodral v. Commissioner, at 22.  In the present case, because three statutes are involved, these principles of statutory construction are best analyzed in two levels.[1]        

     First Level Analysis.  This first level analysis compares and harmonizes the Incentive Statute and the AMT ISO Statute.  The ISO AMT provision Section 56(3)(c) was passed after the Incentive Statute Section 421/422.  Tellingly, the AMT ISO Statute did not repeal the Incentive Statute.  Rather, the AMT added a “timing” prepayment element for ISOs that adjusted when some tax was paid (upon exercise vs. upon sale), which was then designed to be “trued up” upon sale of the stock when economic gain was determined.   The fact that Congress kept the Incentive Statute in place, and that the AMT ISO Statute merely added a timing prepayment and credit true-up element, shows that Congress did not intend to abrogate the benefits and incentives of incentive stock options by including ISOs in the AMT parallel tax regime.[2]  Had Congress wanted to terminate the key benefits and incentives of an incentive stock option (capital gains treatment for the stock if held at least 2 years from grant and 1 year from exercise), Congress would have just repealed Section 421 and 422, thereby eliminating incentive stock options altogether.  In such a case, all options would have become “nonqualified,” meaning they would be subject to regular income tax treatment upon exercise. 

     The reasoning behind Congress’s subjecting incentive stock options to this temporary prepayment is straightforward.  Congress’s general intent behind the AMT is to ensure that people recognizing economic gain not avoid paying tax altogether.  The AMT was “[o]riginally enacted in 1969 to apply to wealthy taxpayers who were using loopholes to escape tax altogether.”  National Taxpayer Advocates 2004 Report to Congress (hereinafter “NTA 2004 Report”), at 2.  This general Congressional intent applies specifically to ISOs as follows: if incentive stock options were not subject to the AMT prepayment tax triggered at exercise, an ISO holder could exercise, hold the stock and never sell (therefore never pay tax), but still derive economic benefit via hedging strategies and margin loans.  The AMT thus provides that a taxpayer prepays tax upon the exercise of incentive stock options, which prepayment creates a “credit” offsetting taxes owed upon sale of the stock.  In the case of incentive stock options, the AMT is not intended to increase the final tax paid on actual economic gain received upon sale of that stock (i.e. the capital gains rate[3]).

     In most markets and for most taxpayers, the interaction between these two statutes does not create hardship or abject  unfairness; both statute’s goals may be achieved when the value of the stock upon sale is roughly equal to the value upon exercise.  Thus, the application of the literal wording of the two statutes effects Congressional intent in the majority of circumstances, and the two statutes’ text and public policy goals harmonize. 

          Second Level Analysis.  This second level analysis compares and harmonizes the OIC Statute with the two other statutes.  Section 7122 was passed after both the Incentive Statute and the AMT ISO Statute, and grants the Secretary discretion to compromise “any civil or criminal liability arising under the internal revenue laws.”  Congress used expansive language to grant broad discretion to compromise tax liability under the internal revenue laws - which of course encompass both the Incentive Statute and the AMT ISO Statute.  This OIC broad discretion thus can act to “trump” the literal effect of the other internal revenue laws, in circumstances falling within the grounds for compromise.

     In analyzing a similar situation (of a later statute’s broad application overriding a prior statute’s contrary provision), the Court in Hellon & Associates, Inc. v. Phoenix Resort Corporation, 958 F.2d 295 (1992) stated that “[i]n adopting the language in question, Congress was well aware of the contrary provisions . . . and still used the expansive language “any order of remand.”  Id. at 298, citing In re RTC, 888 F.2d 57, 59 (8th Cir. 1989).       Section 7122 was passed as part of the IRS Restructuring and Reform Act of 1998, where Congress intended to create more flexibility for settling tax liabilities with taxpayers “who are sincerely trying to meet their obligations and remain in the tax system.”  Pub.L.No. 105-206 (1998); H.R. Conf. Rep. 599, 105th Cong., 2d Sess., 288-289 (1998).  Importantly, consistent with the legislative history, the Regulations implementing Section 7122 contain a provision allowing for compromise of tax liability based on “public policy/equity” grounds. 

     It is of course true that, as the law of the land, the Incentive Statute and the ISO AMT Statute represent public policies Congress intended with respect to compensation, incentives and taxation of incentive stock options.  The question then becomes, how can Section 7122 be harmonized with these previous statutes, especially in situations where it appears that the public policy/equity grounds set forth in the OIC Regulations “clash” with the results arising from the literal interpretation of the language of the other Statutes also considered to be implementing public policy?  The answer is that no tax law can be drafted perfectly such that it will always bring about the Congressionally-intended fair and equitable effect in every situation for every taxpayer.  Congress knew this, and passed Section 7122, instructing the Treasury to include equity/public policy grounds for compromise to remedy those situations where the literal interpretation of the tax laws fail their purpose and create inequitable results.

 

C. The Public Policy Goals of the OIC Statute are Harmonized with the Public Policy Goals of the Other Two Statutes, By Providing the Speltzes Relief Under Effective Tax Administration Guidelines.

 

     The public policy and equity provisions of the Regulations implementing Section 7122 must be interpreted such that they have meaning.  An “elementary principle of statutory construction” provides that, “a statute must, if possible, be construed in such fashion that every word has some operative effect.”  United States of America v. Larry Joseph Lewis, 67 F.3d 225, 229 (1995), citing United States v. Nordic Village, Inc., 503 U.S. 30, 112 S.CT. 1011 (1992).  While Section 7122 itself does not contain the terms “public policy” or “equity,” in the legislative history Congress gave the Treasury clear instructions to include these in the Regulations, and indeed they are reflected in the Regulations at 26 CRF 301.7122.  

     In 1998, Congress clarified that the bases on which the IRS could accept an offer in compromise (OIC) also included “effective tax administration” (ETA).  The Conferee Report to the 1998 legislation stated that the IRS was to “take into account factors such as equity, hardship, and public policy.”  IRS Restructuring and Reform Act of 1998, Pub. L. No. 105-206 (1998); H.R. Conf. Rep. 599, 105th Cong., 2d Sess., 289 (1998).  In relevant part, the Conferee Report stated:

[t]he conferees expect that the present regulations will be expanded so as to permit the IRS, in certain circumstances, to consider additional factors (i.e. factors other than doubt as to liability and doubt as to collectibility) in determining whether to compromise the income tax liabilities of individual taxpayers.  For example, the conferees anticipate that the IRS will take into account factors such as equity, hardship, and public policy where a compromise of a taxpayer’s liability would promote effective tax administration.  The conferees anticipate that, among other situations, the IRS may utilize this new authority to resolve longstanding cases by forgoing penalties and interest which have accumulated as a result of delay in determining the taxpayer’s liability.

 

H.R. Conf. Rep. 599, 105th Cong., 2d Sess. 289 (1998).

Congress therefore gave clear instructions to the Treasury to include “hardship, public policy and equity” as grounds for compromise in addition to doubt as to liability and doubt as to collectibility, and Treasury followed these instructions by including these grounds for compromise in the Regulations.  These words must therefore be given some “operative effect.”

     In fact, for any compromise of tax liability “arising under the internal revenue laws” to occur, some countervailing and superior compelling public policy must engage.  Some of these countervailing public policies are explicitly listed in the Regulations.  These include “doubt as to collectibility” – a practicable public policy principle that if the amount cannot be collected anyway, it does no good to continue to demand full payment, and “hardship” – which one could characterize as a public policy of showing mercy to someone who cannot pay their full tax liability without suffering hardship, due to situations such as serious illness or some other exceptional event.  In addition to these grounds, the Regulations (and the legislative history) call for grounds for compromise articulated as “public policy/equity.” 

     Public policy/equity grounds are positioned as a separate ground “when the other factors do not apply,” and must therefore be interpreted as having meaning different than, and in addition to, hardship and the other factors listed.  “Statutes must be interpreted as a whole, giving effect to each word and making every effort not to interpret a provision in a manner that renders other provisions of the same statute . . .superfluous.”  Boise Cascade Corp. v. U.S.E.P.A., 942 F2d, 1427, 1432 (9th Cir. 1991).  It must therefore be the case that Congress intended (and Respondent recognizes, having included these grounds in the Regulations) that public policy and equity grounds are separate bases for compromise of tax liability arising under the internal revenue laws.

     The OIC Statute and Regulations apply in a fairly straightforward manner with respect to situations involving doubt as to collectibility given the pragmatic aspects, somewhat less straightforward with respect to hardship (where Petitioners contend the IRS is taking an unduly narrow interpretation), and most challenging with respect to equity/public policy.  At first, the public policy/equity ground appears to create a “clash” of competing public policies arising under different internal revenue laws, where the open-ended and ambiguous “public policy/equity” ground in Section 7122 puts the IRS (or the Tax Court or District Court as the case may be) in the position of determining whether and what “public policy” exists that should trump a specific public policy articulated in the internal revenue laws. 

     Of course, the fact that a statute’s instructions may be difficult or challenging to follow does not alleviate those charged with obeying the statute from the responsibility to follow those instructions, and the discretionary nature of Section 7122 by its nature requires principled and thoughtful use of that discretion by the IRS.   Furthermore, this discretion is guided by a careful reading of the language of the applicable statutes and adherence to principles of statutory interpretation.   “To the extent that statutes can be harmonized, they should be, but in the case of irreconcilable differences between them the later and more specific statute usually controls the earlier and more general one.”  Hellon, supra at 297. Cite omitted. 

     In the instant case, the OIC Statute is a “later but more general statute.”  However, as in Hellon, this Section 7122 later but more general statute has explicit “expansive” language allowing a compromise of any liability arising under the [specific] internal revenue laws, clarifying that the application of the public policy principles embodied Section 7122, when they engage, takes precedence over the other internal revenue laws.

     Respondent’s position to date has been a simple and at first appearances a straightforward one; the IRS must follow the plain words of the AMT ISO statute and collect the full amount from Petitioners.  Failure to do so would be “re-writing the laws” and failing to follow Congressional intent.  In taking this position, the IRS “assumes Congress imposes tax liability only where it determines it is fair to do so.”  IRM 5.8.11.2.2(1) (Rev. 5-15-2004).  While this position is and should be the starting point in any analysis or discussion, it cannot and should not be the ending point. 

A logical extension of this principle would eliminate, [eliminate], equity and public policy as a basis for compromise (rather than just making acceptance on this basis “rare”), since every tax is imposed by law.  Tax laws, however, are not always “fair” when applied to a given set of circumstances.  Equitable and fair tax laws are simple and predictable.  They do not subject taxpayers to unreasonable surprise or require payment at a time when the taxpayer has not received a net amount sufficient to satisfy the liability.  They do not impose an income tax on a transaction in excess of the economic benefit received from it.

 

NTA 2004 Report at 433-434. [Emphasis added.] By focusing solely on the literal language of the AMT ISO Statute and overlooking Congressional intent of the AMT ISO Statute and ignoring entirely the other applicable statutes, Respondent fails in its responsibility to harmonize these Three Statutes.  Further, Respondent’s position eliminates Congressionally intended and statutorily mandated equitable grounds for taxpayer relief.

     In contrast, understanding the language and goals of each of the Three Statutes and applying these to the Speltz situation highlights the exceptional and unintended result of the literal language of the AMT ISO Statute.

D.  The Speltzes’ AMT ISO tax liability and the situation in which it has placed them, does not arise under an intended and normal working of the AMT ISO Statute.

 

     Under the normal inter-workings of the AMT ISO Statute and the ISO Statute, a taxpayer prepays her taxes at a 28% rate, on stock that generally holds its value or increases its value over time.  The taxpayer then follows the Congressionally-defined incentives to hold the stock as a long term investment in her company.  When the taxpayer sells the stock at the same value as when she exercised, she enjoys 72% of the value and receive a 13% tax credit (since the current capital gain rate, the rate to which she is entitled under the ISO Statute, is 15% rather than the 28% it was when the statute was passed).  That is the normal and expected workings and interaction of the Incentive Statute and the AMT ISO Statute.  In such a case, it is certainly the correct position that Congress intended this result, and it is certainly defensible that this is a fair result which does not subject taxpayers to punitive tax rates or inequitable treatment.

     This normal inter-working does not describe Petitioners’ exceptional situation. In contrast, Petitioners have now prepaid $122,490 on stock sold for a loss; all of their payments are therefore useless “credits” which cannot be used because a future sale for value will never occur.  Petitioners are not wealthy and therefore cannot liquidate other assets to pay the huge tax liability generated by the worthless stock.  Accordingly, they are being financially destroyed by this totally unexpected, unintended and disproportionate tax liability.  The Speltz situation and result is without question not how Congress intended these two statutes to interact; Congress did not intend that an incentive benefiting companies, the economy and the taxpayer turn into a “tax trap” for the taxpayer.

     It is obvious that ignoring the other applicable statutes in this latticework (the Incentive Statute and the OIC Statute) and using rote application of the literal text of the AMT ISO statute leads to an “absurd or futile result” and one that is “plainly at variance with the policy of the legislation as a whole.”  United States et al. v. American Trucking Associations, Inc. et al., supra. 

     Looking specifically at the Incentive Statute, the situation becomes even more absurd and at variance with Congressional intent.  Incentive stock options were intended to be an item of compensation rewarding hard work and investment, and benefiting companies and the economy.  Yet for the Speltzes they have become instead an insurmountable financial liability that is now (with interest and penalties) $271,235 on a $32,607 loss.  In the Speltz case, blindly imposing the full tax resulting from the literal application of the AMT ISO Statute means the desired Congressional intent for neither the AMT ISO Statute nor the Incentive Statute is being fulfilled.  Thus, Respondent’s claim that they are “merely following the intent of Congress” is a misunderstanding of the inter-workings and intent of the applicable statutes.  Further, Respondent’s fear that, should they apply Section 7122 to compromise the Speltzes liability under public policy/equity grounds they would be undermining the will of Congress as expressed in the ISO AMT statute, is misplaced.

     Petitioners contend that following the principles of statutory interpretation outlined above, the Section 7122 public policy and equity prong engages when the strict language of the tax laws are failing to fulfill their public policy goals intended by Congress.  The Section 7122 public policy/equity compromise therefore allows the IRS to use its compromise authority to address a tax liability situation that has “gone awry,” and align the taxpayer’s liability more closely with the desired Congressional intent under the applicable internal revenue laws.  As will be shown below, a proper understanding of the tax laws at issue and their intended purposes, and the Regulations promulgated to effect Congressional intent of these tax laws, shows that the Speltzes are entitled to relief under Section 7122 hardship grounds, and also under public policy/equity grounds.  Furthermore, providing relief to the Speltzes on these grounds follows, respects, and supports the Congressional intent for all Three Statutes.

E.  Respondent’s failure to properly utilize the OIC authority in Section 7122 is frustrating the intent of Congress to provide the equitable relief applicable to the Speltzes.

 

     Respondent’s failure to provide the relief authorized under Section 7122 is frustrating the purposes of this statute and preventing the Speltzes from benefiting from the relief  The IRS is effectively exercising a “pocket veto” by promulgating Regulations that reflect Congressional intent, but then refusing to follow those own Regulations.  In fact, in all of 2004, the National Taxpayer Advocate found only one ETA offer was accepted.  “The IRS remains unwilling or unable to accept ETA offers based upon equity and public policy considerations.  In FY 2004, a single offer was accepted by the IRS’ ETA offer group, which is responsible for processing them.”  NTA 2004 Report at 328.   

     It is therefore not surprising that the Joint Leadership of the Senate Finance Committee found the IRS refusal to utilize this tool for taxpayer relief “troubling” and have called for an independent investigation into the IRS failure to follow the Congressional intent of this statute.  See, Attachment 19; See also, November 30,2004 Joint Senate Finance Committee Leadership Response to the IRS Attachment 27.

     In Central Pennsylvania Savings Association v. Commissioner of Internal Revenue, 104 T.C. 384 (1995) the dissent expressed concern that “judicial review would be rendered an ineffective check on the Treasury’s ability to uproot settled law where it finds itself in disagreement with Congress on the tax benefits Congress has decided to confer on certain industries.” Id. at 404.  In the instant case, if the IRS is not required by the Court to make a good faith effort to properly effect the Congressional intent of the OIC Statute, Respondent will be encouraged to continue to use its pocket veto to frustrate Congressional intent.  While the OIC Statute presents challenges to implement and pitfalls if implemented improperly, the fact that a statute is difficult to follow or implement it does not relieve Respondent of the duty to do its best to follow and implement it.

     As Petitioners show herein, by following the current Regulations in a consistent and principled manner, Respondent would respect the Congressional intent for all Three Statutes.  Further, using this principled approach removes fear and concern that providing appropriate relief would lead to a situation where  other taxpayers could “take advantage” of this proper application of Section 7122.  Certainly, the Speltz situation fits squarely in the parameters of Section 7122 relief, and certainly few taxpayers will be eager to “take advantage” of this kind of relief and strike an offer in compromise with the IRS where they overpay their taxes and generate over $100,000 in prepayment credits.

 

SECTION 2.  Granting the Speltzes relief under the “public policy/equity” prong of Section 7122 would not undermine or conflict with the public policy goals of either the Incentive Statute or the AMT ISO Statute; rather, granting relief would support the public policy goals and congressional intent of both those statutes as well as the OIC Statute.

 

     In the December 1, 2004 Hearing on Respondent’s Motion for Summary Judgment, the Court and Petitioner’s Counsel discussed the interaction of the “public policy” language of Section 7122 and the public policies as codified in the Tax Code.  In that Hearing, Petitioner’s counsel argued that Section 7122 was an “umbrella” statute covering all other provisions of the tax code, and as such the Section 7122 and corresponding Regulations’ public policy provisions, when they engaged, were intended by Congress to “trump” the other provisions of the tax code.  Hearing Transcript at 60-61. 

     Petitioners’ maintain their contention that, to have any meaning whatsoever, the public policy and equity provisions of Section 7122 have precedence over the strict interpretation of the letter of the law of the other tax provisions.  Accordingly, while the laws in the internal revenue code represent public policy as a general matter and in most cases, in certain cases more compelling public policy and equity considerations come to bear which are valued more highly than the tax laws imposing the liability.

     Without detracting from or contradicting the conclusion of the discussion above, it is also correct to view Section 7122 as a “safety valve” that does not “trump” the other tax laws, but rather helps to effect the public policy goals of the other tax laws when the exact language in those tax laws is bringing about an unintended and unjust result.  In both the legislative history and in the corresponding Regulations, Effective Tax Administration is divided into two categories, the first of which is “hardship” and the second of which is “public policy/equity.”  The fact that the second prong is based on the combination of two concepts - public policy and equity – is instructive. 

     As discussed in Section 1 above, public policy is reflected in the internal revenue laws, so a compromise instruction in Section 7122 based purely on “public policy” would appear to set up a conflict of public policies between Section 7122 and the internal revenue law being “trumped” by Section 7122.  However, by including the term “equity” in the compromise prong, this potential conflict is reconciled in a logically consistent and fair manner.  It would be a mistake to fail to appreciate the reasons Congress used this term in conjunction with “public policy” in the legislative history and this term is also used in conjunction with “public policy” in the regulations.  The term equity is defined in Black’s Law Dictionary as:

 Justice administered according to fairness as contrasted with the strictly formulated rules of common law.  It is based on a system of rules and principles which originated in England as an alternative to the harsh rules of common law and which were based on what was fair in a particular situation. . . . The term “equity” denotes the spirit and habit of fairness, justness, and right dealing which would regulate the intercourse of men with men.

 

Black’s Law Dictionary, Fifth Edition, 1979.  [Emphasis added.]

     The use of these terms together supports the starting point of this discussion that the public policy goals promulgated by the tax laws are designed and intended to treat taxpayers equitably and fairly, and to tax assets in a fair and proportional manner.  “[Taxpayers’] willingness to comply depends in no small part on their trust in the system and their belief that the law is being administered fairly and across-the-board, with their neighbors down the street paying their fair share of taxes, too.” See, Attachment 18, former IRS Commissioner Mortimer Caplin, Ways and Means Oversight Testimony on June 15, 2004.  In fact, the tax laws provide for a series of different tax rates that are applied to all taxpayers fitting within the rate categories but which are all proportional to economic gain received. 

     The typical taxpayer in a typical economic situation pays the same as a similarly situated taxpayer (with the same income and deductions).[4]  However, the tax code is exceptionally complex[5], as is the economy to which it applies, and one of the ways in which a tax provision can go awry is if, in an exceptional circumstance, the provision subjects a taxpayer to unfair and disproportionate taxes – taxes that are not within the range of rates set by Congress and which are not proportional to the economic gain received from the asset being taxed. 

     In such a case, it is fair to conclude that the tax laws generating such an unequal and disproportionate tax are not fulfilling their public policy goals or Congressional intent.  As the following analysis will show, such is the situation in the instant case.  The tax being imposed on the Speltzes is not fulfilling the Congressionally intended public policy goals of the ISO provisions or the ISO AMT provisions.  In such situations, the public policy/equity provisions of Section 7122 engage not to “trump” the public policy goals of the other statutes, but rather to support the public policy goals of the other statutes that are being undermined by the strict interpretation and application of those tax laws in the special circumstances of a particular taxpayer.  A brief discussion of the statutes in question demonstrate that Congress did not intend the suffering being visited on the Speltz family, but this unintended aberration is occurring due to exceptional and unexpected events.

 

A.  The public policy goals of the Incentive Statute Sections 421 and 422.

    

     Congress created incentive stock options to “provide an important incentive device for corporations to attract new management and to retain the services of executives who might otherwise leave.”  See, S. Rep. 97-144, p. 98, (July 6, 1981).  The favorable treatment includes no regular tax due upon exercise of the stock (in contrast to nonqualified options), but tax is due only upon sale of the stock.  Furthermore, if the stock is held at least one year from date of exercise and two years from date of grant, the taxpayer receives the favorable capital gains rate on gain, rather than ordinary income rate.  See, Attachment 17, section entitled “Incentive Stock Options – Current Law.” 

     The Congressional intent and public policy goals behind the incentive stock option provisions are evident on their face:  Congress intended to provide a form of compensation that is an incentive for working at a company, and further wanted to provide an incentive to invest for the longer term in a company vs. taking a short term gain immediately after exercise (again, in contrast to nonqualified stock options where there is no incentive to hang on to the stock, and regular income tax is due upon exercise).

     Incentive stock options have become an important component of compensation in our economy, applying not just for executives but for employees at all levels in a company. Joint Venture: Silicon Valley Network listed several factors leading to the widespread use of incentive stock options:

1. Over the last decade, more and more companies have adopted broad-based stock option plans where all or almost all employees are granted ISOs, rather than only senior management.

 

2.  The Internet and telecommunications boom spawned an unprecedented number of start-up companies over the last few years.  These start-ups overwhelmingly favor the use of ISOs as a means of attracting and motivating employees, and many of these companies grant options to most, if not all of their employees.

 

3.  Even non-high tech companies increasingly turned toward ISOs in recent years, as opposed to less-favored non-qualified stock options (NSOs) as a way to help compete in tight labor markets.

 

Attachment 12, Abraham Brown, Proposal for Administrative Relief from AMT Liabilities Arising from Exercise of ISOs, prepared for the State Bar of California, Taxation Section, Tax Procedure and Litigation, August 2002 at pp. 4-5.

     The widespread and beneficial aspects of incentive stock options was also recognized in a recent Ways and Means Select Revenue Measures Hearing, where Subcommittee Chairman Rep. Jim McCrery stated, “Certainly – as with many incentive stock options that are around in your district, but certainly everywhere across the country, that is a tool that companies can use and they want to use; and employees like it, so we ought not to discourage the use of that through the tax treatment on the alternative minimum tax.”  Sept. 23, 2004 Committee on Ways and Means, Subcommittee on Select Revenue Measures, Transcript at p. 27, Attachment 28.

 

B.  The public policy goals of the Alternative Minimum Tax applied to Incentive Stock Options, Section 56(b)(3).   

 

     The Alternative Minimum Tax was enacted in 1969 to apply to a small number of very wealthy taxpayers who were utilizing tax loopholes to avoid taxes altogether.  See, NTA 2004 Report, p. 2.  The concern with respect to ISOs can be easily ascertained from the intent of the AMT and the workings of incentive stock options; that is the concern that a wealthy person would exercise their ISOs, extract benefit via margin loans, never sell the stock, and thereby avoid paying tax altogether.  In such a case the person would be enjoying the benefit of the value of the stock without paying his fair share of tax on that stock benefit.

     The AMT therefore imposes a prepayment tax upon the “value” of the stock at time of exercise, to ensure that the taxpayer cannot engage in the tax avoidance strategy outlined above.  However, because the true value of the stock to the taxpayer is not determinable at that time (the taxpayer has merely purchased the shares, not sold them) this tax is a prepayment characterized under the AMT code as a “timing” vs. “preference” item that is later adjusted based on actual economic gain realized.  The Capitol Tax Partners 2004 letter to the Treasury provided,

Another fundamental notion underlying the AMT is the prepayment concept with respect to timing items.  The AMT negates the benefit inherent in certain timing items by slowing down the ability of taxpayers to claim deductions (as in the case of accelerated depreciation) or accelerating the recognition of taxable income (as in the case of ISOs).  The AMT, particularly as modified by the Tax Reform Act of 1986, provides several mechanisms that ensure that the elimination of these deferral benefits does not create a permanent difference between a taxpayer’s regular taxable income and the AMTI . . . Thus, with respect to timing items, the AMT is a prepayment of regular tax liability that is intended merely to accelerate income recognition, rather than create it.

 

Attachment 17, Letter from Capitol Tax Partners to Internal Revenue Service, April 28, 2004.

     Based on the plain language, historical context, and the legislative history, the public policy goal intended by Congress is clear – to ensure that a taxpayer cannot utilize the “no payment until sold” aspect of incentive stock options to avoid paying taxes altogether on economic value enjoyed by the taxpayer.  The fact that this prepayment is a timing item demonstrates Congress did not intend to levy a permanent tax on “phantom” value but intended the tax paid, at the end of the day, proportionally match the economic value received.  Furthermore, Congressional intent can be deduced from what Congress did not do.   Congress did not repeal Section 421 and 422, and therefore intended to preserve the overall benefits of ISOs.

 

C.  The Exceptional Circumstances that Created the Unintended and  Inequitable Tax Treatment for the Speltzes, Even Though the Speltzes were Following the Incentive Structure and Reporting Structure Put in Place by Congress.

 

     Historical and current context must be understood in order to understand how the Congressional intent behind Sections 422 and Section 56(b)(3) are being thwarted in the Speltz situation.  The AMT was enacted to ensure wealthy Americans could not avoid paying a minimum amount of tax.  For such wealthy Americans, any ISO AMT liability can be easily offset with other assets.  Further, if the value of the ISO drops significantly so that the AMT prepayment “credits” cannot be fully utilized and applied to future gains from the stock, the credits can be used to offset other gains from other assets. 

     In contrast, the Speltzes ISO AMT liability arises in a very different context.  The Speltzes are not wealthy; they have no significant alternative assets from which to pay the liability; and they have no expectation of future ability to utilize the credits with substantial gains realized from other alternative assets; they were “trapped” by an exceptional period of unexpected economic collapse.  Joint Venture: Silicon Valley Network has listed several reasons why ISO AMT has affected taxpayers like the Speltzes so severely (and unintentionally):

...[reasons 1-3 listed above highlight the widespread use of incentive stock options]

 

4.  The stock market posted record highs in the spring of 2000, and then collapsed over the next 12 months, astounding even the most seasoned professionals . . . [the spreads created] very large AMT liabilities for many employees for which no withholding is required upon exercise . . .

 

5.  The relatively unknown AMT caught many employees by surprise.  Other employees were aware of the AMT but thought they could claim a full credit for the AMT once they sold the stock acquired by exercise of ISOs . . .

 

Attachment 12, Abraham Brown article at pp. 4-5.

     The unusual and exceptional situation and confluence of events (the “Perfect [Economic] Storm” as coined by Senator Lieberman, See, Attachment 10) is subjecting the Speltz family to an unfair and unintended application of the tax code.           

     Refusing to compromise this tax liability undermines the will of Congress as intended in Section 421-422, by punishing the Speltzes for following the incentives of Congress to invest in their company and work hard for its success.  Forcing the Speltzes to pay the full tax liability turns an element of compensation intended by Congress to reward hard work, into a financial anchor dragging the Speltzes down to ruin.

     Refusing to compromise the Speltzes tax liability undermines the will of Congress as intended in Section 56(b)(3) by turning what was supposed to be a law ensuring some tax was paid on an asset, into a law imposing an infinite, unrecoverable tax liability on a worthless asset, thereby destroying the Speltzes’ entire financial present and future. 

     In contrast, utilizing the public policy/equity prong of ETA to compromise the Speltzes’ tax liability supports the public policy goals of both Section 421-422 and Section 56(b)(3).  Here, ETA acts as a lens that helps to focus public policy goals that are severely out of focus due to exceptional circumstances.  While use of ETA would not perfectly focus those laws (i.e. the Speltzes have already paid out $124,000 on their ISO loss which undermines the incentive and compensation aspect of Section 422, and the Speltzes will still have a large AMT “credit” that is intended to be recovered under the AMT law but is in fact practicably unrecoverable),nonetheless ETA would prevent the situation from becoming even more “out of focus” than it already is (i.e. from putting the Speltzes in a situation where they pay $271,234 on their ISO loss and end up with even more unrecoverable credits).

 

D.  The IRS itself recognizes that the literal and rote application of the words of a statute do not always bring about a result in line with Congressional intent; the IRS therefore recognizes and applies the “economic substance” doctrine to effect a fair and equitable result in situations when the literal text of the internal revenue laws fails its purpose.

 

     In analyzing the inter-workings of the public policy prong of Section 7122 with the public policy as expressed in the other tax laws, the analysis cannot focus solely on “will applying Section 7122 to compromise the liability run contrary to the precise text of the tax laws imposing the tax” but must include the inquiry “will applying Section 7122 to compromise the liability undermine the will of Congress as intended by the tax laws imposing the tax.  The words of a statute serve as tools designed to create an intended result, in the case of the internal revenue laws – a fair and equitable apportionment of tax liability. 

     As with all tools, while they may be designed to work well in almost every situation, there are certain situations where using that tool will be destructive rather than constructive.  Blind and rote application of the tax laws can, in certain circumstances, undermine the very result intended by Congress.  Section 7122 and the supporting Regulations protect taxpayers from being destroyed by the tool intended to provide a fair and just result -  and which do produce a fair result in the vast majority of situations.  As stated in the National Taxpayer Advocate’s most recent report to Congress,

A technical application of complex laws sometimes produces inequitable results.  Such results may favor the government (called “traps for the unwary” or “tax traps”) or the taxpayer (called “tax shelters”) in any given instance.  IRS guidance that a compromise based on equity/public policy may not be made based upon the unfairness of the tax rules is inconsistent with the reality that even generally fair tax rules may, in certain circumstances, produce unfair results.”

 

NTA 2004 Report at p. 439. 

     The IRS itself recognizes these equitable and fairness principles and applies them to address tax shelters which, while technically compliant with the tax code, are being used by a taxpayer to enjoy an unintended and unfair reduction in taxes.  Not surprisingly,

[t]he tax shelter problem, however, has been addressed more aggressively than the tax trap problem.  The IRS has authority, procedures and motivation to fix many tax shelters administratively. . . . In contrast, no comprehensive procedures exist to identify and fix tax traps quickly before significant loss to taxpayers can occur.  Thus, some traps will remain undetected or at least unfixed for extended periods, especially those that affect only a small number of taxpayers.

 

NTA 2004 Report at p. 441.

     This inconsistent approach taken by the IRS is highlighted in the Speltz case.  In the December 1 Hearing, in backing away from the internal instructions that no ISO AMT liability could be compromised under ETA (See, FOIA response Attachment 23), Respondent stated “I think [because only one email was turned over in the FOIA request] by negative implication that suggests that Respondent has never formally developed some sort of position purportedly rejecting out of hand any offer in compromise based on effective tax administration in these kinds of circumstances.”  Hearing Transcript at 47, lines 10-14. 

     It is both surprising and disturbing that, despite the exceptional situation such as the one the Speltzes are suffering under, one similar to which (according to the IRS) tens of thousands of other taxpayers are suffering under, and which has been dragging on now for the Speltzes and for those tens of thousands of other taxpayers for almost four years at immense waste of time and expense for both taxpayers and the IRS, the IRS has yet to develop some sort of position. Yet, while it may not have formally developed any sort of position, the fact remains that the position taken to date with the Speltzes is to refuse relief.

     The IRS must recognize and implement a fair and consistent approach toward the internal revenue laws, captured in the adage “what’s sauce for the goose is sauce for the gander.”  The IRS can and should appropriately utilize an “economic substance” doctrine to close up cracks in the tax code through which tax revenues are unintentionally falling.  But, the IRS must also utilize the same “economic substance” doctrine to close up cracks in the tax code through which taxpayers are unintentionally falling. And the IRS has not only the statutory authority to do so in Section 7122, it has the regulatory instructions and procedures already in place to guide its application of that statute.  Further, such action would be perfectly consistent with other actions taken on equity principles such as closing tax shelters or granting an innocent spouse relief from tax liability.  Yet the IRS is either failing, or refusing, to provide taxpayers the “safety net” protections Congress afforded in Section 7122; such failure or refusal is on its face an abuse of discretion.

     The National Taxpayer Advocate has provided some practical recommendations as a starting point for developing a rational and principled approach for addressing the “tax trap” problem such as the one in which the Speltzes have fallen.

In cases involving “tax traps” which result in tax liability in excess of the economic benefit from a transaction, the law is operating inequitably regardless of the reasonableness of a taxpayer’s actions.  In such cases, factual inquiries are avoided simply by requiring the IRS to compromise to the extent the liability exceeds the economic benefit (further reduction of the liability, however, would require additional factual inquiry).  . . . Although this may result in relatively greater number of OIC submissions during an economic downturn when tax liabilities resulting from a transaction may be more likely to exceed the economic benefits from it, such trends may be helpful in alerting policymakers to the existence of tax traps so that they can be addressed through legal or administrative guidance.  Any resulting administrative burdens that this places on the IRS could be minimized through the adoption of standard settlement initiatives, such as those used for resolving tax shelter cases.

 

NTA 2004 Report at p. 443 and footnote 52. 

     In the Speltz case, it is unlikely that the IRS would have gone to more work and trouble by having a consistent and fair policy in place for AMT ISO liabilities, than the work and trouble it has gone through by not having a policy in place.  Certainly, taking the National Taxpayer Advocate’s advice would have resulted in a quick and fair resolution of the Speltz case.  The Speltzes did not make any money from the stock being taxed, they already paid $122,490 in prepayment tax on that stock, and their offer of paying another $4,000 to settle the OIC would therefore have been accepted by the IRS immediately without any lengthy process or negotiation.  While other ISO AMT cases may not be so straightforward and require a factual inquiry, even in those cases, having some basic principles of proportionality to guide a fair (or at least fairer – as few would find a $122,490 tax on a $32,000 loss as entirely fair) resolution would avoid the even more gross injustice of additional unintended, excessive taxation to which the Speltzes (and other ISO AMT victims) are being subjected.

 

SECTION 3.  Section 7122 and corresponding Regulations 26 CFR 301.7122-1 grant the Secretary of the Treasury discretion to compromise the Speltzes’ tax liability considering the special circumstances raised by the Speltzes in their offer in compromise; that discretion must be exercised fairly and with careful consideration.

 

     A.  The IRS Has Discretion to Compromise the Speltz Tax Liability Based on Special Circumstances and Hardship Factors.

 

     Section 7122 subpart (a) provides, “The Secretary may compromise any civil or criminal case arising under the internal revenue laws.”  [Emphasis added.]

     Section 7122 corresponding regulations 26 CFR 301.7122 (hereinafter, the “Regulations”) reiterates the language in Section 7122, that “The Secretary may compromise any civil or criminal case arising under the internal revenue laws.”  The Regulations provide that the scope of this compromise applies to “taxes, interest and penalties.”  26 CFR 301.7122-1(a)(2).

     The Regulations then go on to list the grounds for compromise as follows:

(1) doubt as to liability 26 CFR 301.7122-1(b)(1). 

This applies when a dispute exists as to the correct tax liability under the letter of the law.  This ground is not applicable in the instant case and therefore will not be discussed further.

(2)doubt as to collectibility, 26 CFR 301.7122(b)(2). 

This applies when the taxpayers assets and income are less than the full amount of the liability. A dispute exists as to the applicability in the instant case as discussed in the Initial Opposition and further discussed herein below.  In particular, the dispute involves the application of doubt as to collectibility with special circumstances.  The analysis of “special circumstances” for purposes of granting relief under DCSC is the same as that for effective tax administration (i.e., hardship and/or public policy/equity considerations apply), discussed below. “These same considerations are also supposed to be applied to offers based upon doubt as to collectibilty with special circumstances.” NTA 2004 Report at 328 note 99, citing IRM 5.8.11.2 (Rev. 5-15-2004).

(3) effective tax administration hardship prong, 26 CFR 301.7122(b)(3)(i). 

This applies when the IRS could collect the full amount, but to do so “would cause the taxpayer economic hardship within the meaning of Section 301.6343-1.” A dispute exists as to the applicability in the instant case as discussed in the Initial Opposition and further discussed herein below.

(4) effective tax administration public policy and/or equity prong, 26 CFR 301.7122(b)(3)(ii). 

This applies when none of the three prior grounds applies.  A dispute exists as to the applicability in the instant case as discussed in the Initial Opposition and further discussed herein below.

The legislative history emphasizes that Section 7122 is to be construed broadly to grant relief as appropriate.  The conference report provided:

The conferees believe that the IRS should be flexible in finding ways to work with taxpayers who are sincerely trying to meet their obligations and remain in the tax system.  Accordingly, the conferees believe that the IRS should make it easier for taxpayers to enter into offers in compromise agreements . . .

 

H.R. Conf. Rep. 599, 105th Cong., 2d Sess., 288-289 (1998).  S. Rep. 105-174 [Emphasis added.]  The conference committee also stated that “the Conferees anticipate that the IRS will take into account factors such as equity, hardship and public policy where a compromise of an individual’s tax liability would promote effective tax administration.”  Id.  [Emphasis added.]  Moreover, the Treasury Regulations, which guide the IRS, adopt the liberal approach described in the legislative history by stating that “the IRS may compromise to promote effective tax administration where compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability.”  26 CFR 301.7122-1 [Emphasis added.]

Finally, the IRS itself recognized its authority to compromise ISO AMT tax liability when it stated in the December 1, 2004 Motion for Summary Judgment Hearing (hereinafter, the “Hearing”), that “[ ] if you look at the regulations under Section 7122, the offer in compromise regulations, they make clear that every case is determined on a case by case basis and every case lies within Respondent's discretion.”  Hearing at p.47 lines 15-19. [Emphasis Added.]

The Internal Revenue Manual allows the IRS to reject offers for public policy reasons, but states that rejections for public policy reasons should be “extremely rare” and reserved, in large part, for situations in which the taxpayer’s behavior is potentially criminal. Policy Statement P-5-89, discussed in Section 5.8.7.7 of the Internal Revenue Manual.

  

     B.  The IRS does not have discretion to refuse to consider factors raised by a taxpayer; in assessing offers in compromise the discretion must be exercised in a fair manner after proper consideration of the factors raised by the taxpayer.

 

     While the IRS has discretion in considering whether to accept an offer in compromise, that discretion is not unfettered nor is it unbounded.  The Regulations state that “Once a basis for compromise under paragraph (b) of this section has been identified, the decision to accept or reject . . . is left to the discretion of the Secretary.”  26 CFR 301.7122(c).[6] 

     The phrasing of the Regulation above suggests that the a basis for compromise must be considered once it has been identified, meaning that the IRS does not have discretion to decide not to even consider circumstances raised by the taxpayer.  To the extent there is any question, that is cleared up later in the Regulations, which state  “The determination whether to accept or reject an offer to compromise will be based upon consideration of all the facts and circumstances, including whether the circumstances of a particular case warrant acceptance of an amount that might not otherwise be acceptable under the Secretary’s policies and procedures.”  Id.  [Emphasis added.]

     The IRS must, therefore, consider the special circumstances of a taxpayer’s situation.  This the IRS failed to do.

SECTION 4.  The IRS failed to consider (or if it did consider it failed to properly consider), under the principles and processes laid out in Section 7122, corresponding regulations 26 CFR 301.7122, and the corresponding IRM provisions, the special circumstances raised by the Speltzes in their offer in compromise.

 

     In spite of the clear mandate of the Regulations that the IRS must consider all the facts and circumstances raised by the taxpayer, the IRS failed to consider any circumstance raised by the Speltzes.  Rather, in every Respondent document, the sole reason for rejecting the Speltzes’ offer in compromise was that the IRS could collect the full amount by liquidating all the Speltzes’ assets and garnishing the Speltzes’ wages.  It is on its face an abuse of discretion to fail to even use the discretion mandated by Congress, by exercising a pocket veto circumventing Congress intent and thereby eliminating grounds for providing relief to taxpayers. 

     The comprehensive listing below of the stated reasons for rejecting the Speltzes offer contained in the IRS communications to the Speltzes and in the IRS internal documentation, demonstrates the IRS based its decision solely on ability to pay, and failed even to consider the Speltzes’ special circumstances:

     (a) Notice of Determination.  “The offer was rejected due to the taxpayers having the assets and ability to full pay the liability.”  Notice of Determination.  [Emphasis added.] Attachment 3.  The Notice of Determination does not contain any discussion of the special circumstances raised by the Speltzes.  In fact, the “Issues raised by the taxpayer” section states merely “The offer in compromise was rejected.”  Id.

     (b) October 9, 2002 Letter.  “Based upon your current financial condition, we have determined that you have the ability to pay your liability in full within the time provided by law. . . . Your options at this time are to pay your liability in full, enter into an installment agreement, withdraw your response and appeal your offer’s failure to gain acceptance . . .”  Letter from Robert Dallas, Revenue Officer.  [Emphasis added.]  Attachment 8.

     (c) Declaration of Eugene H. DeBoer.  “My review led me to conclude that I agreed with the revenue officer who considered petitioners’ offer in compromise; i.e. that petitioners did not qualify for an offer in compromise because the outstanding liability for 2000 could be fully paid with use of an installment agreement.”  Declaration of Eugene H. DeBoer. [Emphasis added.] Attachment to Respondent Motion for Summary Judgment.

     (d) Respondent’s Motion for Summary Judgment.  “Based on National Standards, the revenue officer determined that if petitioners entered into an installment agreement, they could pay in full the outstanding liability for 2000.  As a result, petitioners’ Offer in Compromise was rejected.”  Motion at p.2, paragraph 5.  [Emphasis added.]  “Appeals Officer DeBoer agreed with the revenue officer who considered petitioners’ offer in compromise; i.e. that petitioners did not qualify for an offer in compromise because the outstanding liability for 2000 could be fully paid with use of an installment agreement.”  Motion at p.3, paragraph 8.  [Emphasis added.]  “However, the petitioners do not qualify for an offer in compromise because the outstanding liability for 2000 could be fully paid through use of an installment agreement.”  Motion at p.5, paragraph 15.  [Emphasis added.]

     (e) Offer in Compromise Recommendation Report.  “The taxpayers have the ability to pay the liability in full under installment agreement guidelines, making an offer to compromise unacceptable.”  OIC Recommendation Report, Conclusion Section.  [Emphasis added.]  Attachment 29.  (Petitioners have stipulated to allow Respondent to include the OIC Recommendation Report in the record.)

Not a single IRS document provides any analysis or statement of consideration for the special circumstances the Speltzes raised. 

     Respondent’s treatment of the Speltzes is similar to the IRS’s treatment of the taxpayer in Robinette v. Commissioner of Internal Revenue, 123 T.C. No.5.  In finding the IRS abused its discretion, the Court found that “[the IRS agent] did not have an open mind to the issues [taxpayer’s counsel] presented at the hearing.  He did not consider that the taxpayer acted in good faith. . . . Moreover, he failed to independently analyze whether the terms of the offer-in-compromise had been materially breached.”  Robinette at 44.  In the instant case, the IRS has not had an open mind to the issues presented by the Speltzes; the IRS has not considered that the Speltzes have acted in good faith; the IRS has not independently analyzed any of the special circumstances present in the Speltz case.

     The IRS claimed in the December 1 Hearing that the Offer in Compromise Recommendation Report shows that the Speltz special circumstances were considered.  To the contrary, the Recommendation Report does not address any of the special circumstances the Speltzes raised.  Rather, it misstates the Speltz argument and then summarily disposes of that misstated argument. 

     The Conclusion Section, [mis]states the Speltz argument by stating  “As to the taxpayer’s claim accompanying the Form 656 that the Alternative Minimum Tax is unfair, IRM 5.8.11.2.2(2) states: ‘Where a taxpayer is clearly liable for taxes due to operation of law, a finding that the law is unfair would undermine the will of Congress.’”  [Emphasis added.]  As has been stated clearly above, the Speltzes have never argued that the Alternative Minimum Tax is unfair.  In fact, even the IRS recognizes the Speltzes are not making that argument, as in the IRS Motion for Summary Judgment, the IRS acknowledges that “Petitioners’ representative also argued that the underlying liability was an unfair application of the alternative minimum tax.”  Motion for Summary Judgment at paragraph 14.

     “Unfair/inequitable/against public policy application, is precisely what must be argued in order to qualify for review under Section 7122 effective tax administration guidelines.  Indeed, if the IRS is allowed to misconstrue an “unfair application” argument as an “unfair law” argument then no taxpayer can ever seek relief under Section 7122, Section 7122 will be meaningless, Congress will have wasted its time in passing this legislation, and the IRS will be able to thwart Congressional intent by pocket vetoing this legislation.

     In every OIC case brought by taxpayers under Section 7122, the liability will necessarily be arising under the internal revenue laws, and in every case the only grounds for relief will be those provided for in Section 7122 and corresponding Regulations, which include special circumstances creating an unfair and unintended application of the tax law involved triggering the hardship and/or public policy/equity grounds.

In her recent report to Congress, the National Taxpayer Advocate stated:

In 1998, Congress directed the Secretary to consider offers based on hardship, equity and public policy grounds.   The IRS’s processing of these “effective tax administration” (ETA) offers is also troubling.  For example, the IRS generally believes that ETA is not an appropriate vehicle for compromising penalties or interest where relief is not available under the Code’s specific interest or penalty relief provisions.  We understand the underlying concern that limitations on penalty and interest relief provided elsewhere in the Code might be inappropriately circumvented if ETA relief were available in circumstances where the interest and penalty relief provisions of the Code do not apply.  ETA relief, however, is only available if no other basis for compromise exists.  Therefore, if the IRS’ reasoning is accepted, ETA relief will never be available to compromise interest or penalties under any circumstances, notwithstanding express legislative history to the contrary.

 

The IRS follows a similar rationale to reject ETA offers involving alternative minimum tax (AMT) issues.  The IRS summarily rejects ETA offers in cases where one of the inequities faced by the taxpayer is an “unfair” operation of the AMT.  The IRS reasons that a compromise of AMT liabilities would circumvent the will of Congress.  However, this position overlooks the possibility that the “unfair” operation of the tax rules may be one of many factors that may justify the acceptance of an ETA offer based upon the unique circumstances of a particular taxpayer.

 

Fiscal Year 2005 Objectives Report to Congress (June 30, 2004).  [Emphasis added.]       

     As will be shown in Section 5 below, the Speltzes raised numerous special circumstances that showed their tax liability was exceptional, was creating a hardship, and was a situation that called for relief under both the hardship ground and the public policy/equity ground of Section 7122.

 

SECTION 5.  Proper consideration of the Speltzes’ special circumstances shows that, in the Speltzes’ exceptional situation, the Speltzes are entitled to relief both under Section 7122 hardship and also public policy/equity principles, and failure to provide that relief is an abuse of discretion.

 

     The facts in this Section 5 are taken from those raised and listed in the Initial Opposition and its Attachments.

 

     A.  The Speltzes are entitled to relief under the hardship prong of effective tax administration (or hardship prong of doubt as to collectibility with special circumstances). 

 

     The Speltzes are entitled to relief under the hardship prong of Effective Tax Administration or alternatively doubt as to collectibility with special circumstances.[7]  The facts and circumstances discussed in Section 3 of the Initial Opposition and related Attachments (e.g. Speltz 656 OIC Submission and Affidavit), summarized below, tell the compelling story of hardship.  The Speltzes are facing this incredible hardship due to a strange and unexpected confluence of events that transpired to destroy their many years of hard work and careful planning with an unexpected and unintended tax code financial wrecking ball.

     Most mid-America young families like the Speltzes would think it a financial hardship if they invested $35,000 of their hard-earned money and lost it all.  For the Speltzes, that was just the beginning of their saga.  Despite losing this significant amount of money, the Speltzes discovered that they nevertheless owed both State and Federal prepayment taxes as if they had made about $800,000 on their investment.  The real taxes on this phantom income amounted to over $250,000, more than twice their entire annual income for 2000.  Not having any other assets on which to draw to pay these taxes, they managed to get a loan from their bank to pay as much of the tax bill as possible.  Even after stretching themselves beyond the limit financially and paying over $120,000 in federal tax, they still owe over $100,000.  This remaining federal tax bill has now swelled to $147,000 with interest and penalties. 

     Their debts and financial responsibilities (the Speltzes have three young children) have now left them unable to pay off the bank loan, and the bank is garnishing their wages, forcing them to slip a little more behind financially every month.  This financial disaster has even forced them to adjust their personal plans to have another child.  With the IRS demanding the full federal tax payment, the Speltzes face the immediate loss of their home and vehicles.  Long term, despite being responsible hard-working taxpayers who already have accrued mammoth tax credit overpayments, the Speltzes face the long-term specter of wage garnishments for years to come (which will merely serve to increase their tax overpayment credits), no college funds, no retirement savings, no discretionary income, constant financial stress, and likely bankruptcy. 

     All this because they worked hard, were “rewarded” by receiving incentive stock options from the Company for which they worked, invested in their company by purchasing those options, followed the Congressional incentives to hold on to that stock and invest in the long-term success of their company, honestly followed the tax law and reported their exercise and the phantom gains, and have diligently worked and sacrificed to pay as much as possible of the prepayment tax on this phantom gain.   

     This is a hardship story.

     In spite of this compelling story, however, the IRS has taken a rigid and inflexible stance with the Speltzes, denying them relief based on the rote application of National Standards without considering the unique equitable factors in the Speltz case.

     The National Taxpayer Advocate 2004 Report to Congress addresses the IRS’s improperly and unnecessarily rigid approach and adherence to “standards” in reviewing a case for DATC and hardship:

OICs based upon “doubt as to collectibility” (DATC) that are not returned are subject to a rigid evaluation process that in some cases ignores reality.  To the extent this process reduces the IRS’ ability to realistically evaluate each individual’s offer, it is inconsistent with the IRS’ goal of collecting liabilities a the earliest possible time and at the least cost to the government.”  NTA 2004 Report at 321. . . .

The IRS continues to have difficulty calculating a reasonable offer amount.  Id. at 324. 

. . .

The IRS established national and local standards as guidelines for certain expenses such as groceries, household expenses, housing, and transportation.  Despite these guidelines, the Code requires IRS employees to evaluate the facts and circumstances of each taxpayer in determining an acceptable offer amount. [citing IRC Section 7122(c)(2); Treas. Reg. Section 301.7122-1(c)] . . . .  While one case is not conclusive, the fact that the IRS did not take a realistic look at the taxpayer’s offer, provide a convincing rationale for its decision or settle the case (which was not decided within two years) suggests that in some cases the IRS may be having difficulty deviating from the expense standards.  Id. at 325.

 

In the Speltz case, in calculating the Speltzes’ alleged ability to pay (leading to the conclusion the Speltzes are not qualified for relief based on hardship) the IRS has failed to consider the numerous exceptional circumstances involved in the Speltz case.  This failure has resulted in a case that has been dragging on for almost four years at immense expense and additional hardship to the taxpayers and immense expense of both money and time for the IRS and others (including this Court).

     Petitioners maintain that it is truly a hardship and an exceptional special circumstance to have a crushingly large “prepayment” tax imposed on an asset on which the taxpayer lost money.  The hardship suffered by the Speltzes in their good faith attempts to use other assets, borrow from the bank, and borrow from friends and family to pay as much of this “prepayment” tax as possible should be taken into consideration by the IRS in determining if it should cause yet more hardship by demanding yet more prepayments.  This is especially true when, as in the Speltz case, it is clear no money or benefit will ever be generated from this asset (since the stock is sold for a loss), but that the “prepayments” will become useless “credits” for the taxpayer.

     The IRS supports its stance that the Speltzes are not entitled to relief under the hardship prong based on the fact that certain assets the Speltzes own are above the National Standards.  However, the Regulations provide that “The determination of the amount of such basic living expenses will be founded upon an evaluation of the individual facts and circumstances presented by the taxpayer’s case.  To guide this determination, guidelines published by the Secretary on national and local living expense standards will be taken into account.”  26 CFR 301.7122(c)(2).  [Emphasis added.] 

     Two points are especially important to note in this provision.  First, the first sentence sets out the rule for making the determination as “an evaluation of the individual facts and circumstances presented by the taxpayer’s case.”  In the second sentence, the national and local living expense standards are meant to provide “guidelines,” not be the dispositive determination based on rote application of fitting every taxpayer into the same box. 

     Certainly, the Regulations require consideration of the unique and exceptional circumstances that the Speltzes are being asked to pay $271,234 in tax on a loss of $32,607.  Moreover, the fact that the Speltzes had no other assets and have only through exceptional measures paid more than half of their liability (measures which have resulted in their wages being garnished by the lender) is also an exceptional circumstance that should be taken into consideration.  The Speltzes are hardworking, compliant taxpayers who have three young children.  The Speltzes do not fit into the category of taxpayers who actually received money on which they failed to pay tax and yet are behind on their taxes, in which case perhaps a more aggressive collection position is justified. 

     The Speltzes did not enjoy any benefit from the asset on which these taxes are imposed, and the context of the tax being imposed is an internal revenue law designed to provide for prepayment on future income that then is offset by actual income received in the future.  It is arguably ipso facto a hardship to have to pay tax on something a taxpayer never received, because it requires the taxpayer to use other assets to pay (despite the fact they already paid taxes on those assets) or borrow the funds (thereby incurring an interest-bearing liability) to pay this tax.

     A close review of the facts in the Speltz situation shows they have suffered significant hardship already in paying an excess tax of $122,490; forcing them to pay the full amount of excess tax liability would create even greater hardship.  See, Initial Opposition Section 3.  The facts in the Speltz case lead inexorably to the conclusion that the Speltzes qualify for relief under the “hardship” prong of effective tax administration, and failure to provide that relief is an abuse of discretion.

 

B.  The Speltzes are Entitled to Relief Under the Public Policy and Equity Prong of Effective Tax Administration (or Public Policy/Equity prong of Doubt as to Collectibilty with Special Circumstances). 

 

     Assessing and analyzing the Speltz facts and special circumstances under the Regulations’ guidelines leads to the conclusion that the Speltzes’ offer in compromise should be accepted under the public policy/equity prong of ETA (or DCSC).  The Regulations provide clear guidelines on when the public policy and equity principles apply to authorize compromise, as follows:

   (ii) . . . [when no other grounds apply], “the IRS may compromise to promote effective tax administration where compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability. Compromise will be justified only where, due to exceptional circumstances, collection of the full liability would undermine public confidence that the tax laws are being administered in a fair and equitable manner. A taxpayer proposing compromise under this paragraph (b)(3)(ii) will be expected to demonstrate circumstances that justify compromise even though a similarly situated taxpayer may have paid his liability in full.

 

   (iii) No compromise to promote effective tax administration may be entered into if compromise of the liability would undermine compliance by taxpayers with the tax laws.

 

   . . .

  

   (C)(ii) Factors supporting, but not conclusive of, a determination that compromise would undermine compliance within the meaning of paragraph (b)(3)(iii) of this section include, but are not limited to –

   (A) Taxpayer has a history of noncompliance with the filing and payment requirements of the Internal Revenue Code;

(B) Taxpayer has taken deliberate actions to avoid the payment of taxes; and

(C) Taxpayer has encouraged others to refuse to comply with the tax laws.

    

    

     Taking each requirement in seriatim demonstrates not only clear ground for relief, but demonstrates that failure to grant relief would be an abuse of discretion.[8]

     (a) “where compelling public policy or equity considerations identified by the tax payer provide a sufficient basis for compromising the liability” 

·        The Speltzes are being asked to pay $271,234 in tax, interest and penalties based on an asset on which they have suffered an actual out-of-pocket loss of $32,607. 

·        The Speltzes are not wealthy and do not have other assets they can liquidate or leverage to pay this tax; they have only been able to pay $122,490 toward this mammoth tax liability by borrowing from a bank (which is now garnishing their wages as they can’t afford to repay).

·        The ISO AMT tax is a “prepayment” tax of 28% which is meant to be applied toward future gain on the stock.  The Speltzes would have had to have received over $800,000 for a fair offset to occur.  Of course, the stock is worthless, but the Speltzes are still being forced to pay taxes as if they made over $800,000 even though in fact they lost $32,607.

·        Under the AMT code, the ISO AMT tax becomes a “credit” meant to be offset by future gain on the stock.  Since no such gain will ever occur on the Speltzes’ stock, the Speltzes have in actual fact currently overpaid their taxes $104,000 (calculated by taking the amount the paid to date - $122,490 - and subtracting the regular tax owed on actual income they earned in 2000 - $18,678).  The IRS is demanding they overpay over $250,000, including interest and penalties.

·        Ironically, this tax is being imposed on an asset that is intended by Congress to be a reward for hard work and entreprenurism.  (See, full discussion of the Incentive Statute in Section 2 above.)  Congress did not create Incentive Stock Options to trap and destroy hardworking Americans.

·        And also ironically, this tax is being imposed by a tax provision that was intended by Congress to ensure that very wealthy people paid at least some tax on certain assets on which they were avoiding taxes.  (See full discussion of the Alternative Minimum Tax provision Section 56(b)(3), in Section 2 above.)  The Speltzes are not wealthy, as their current net worth is negative $60,000.  Furthermore, the “some” tax was intended by Congress to be 28% of actual gain.  But the Speltzes have already paid $122,490 in tax based on stock on which they lost money, which was not what Congress intended.

     (b) “due to exceptional circumstances, collection of the full liability would undermine public confidence that the tax laws are being administered in a fair and equitable manner”

·        The tax code is intended to be a fair and equitable code, where everyone pays their fair share of taxes.  The current highest tax bracket is 36%.  The Speltzes tax rate for 2000 was over 220%.

·        The IRS is demanding the Speltzes pay $271,234 in tax, interest and penalties based on an asset on which they have suffered a loss of $32,607.

·        the Speltzes are being forced to pay taxes as if they made over $800,000, even though in fact they lost $32,607.  Other taxpayers who are paying the taxes demanded of the Speltzes actually made $800,000.

     (c) “A taxpayer proposing compromise under this paragraph (b)(3)(ii) will be expected to demonstrate circumstances that justify compromise even though a similarly situated taxpayer may have paid his liability in full.”

·        A similarly situated taxpayer as the Speltzes (i.e. same income, same number of children, same mortgage deduction) would have paid $18,678 in taxes in 2000.  The Speltzes have already paid almost 7 times that amount, and the IRS is demanding the Speltzes pay nearly 15 times that amount.  The “circumstance that justifies compromise” is that the Speltzes are being asked to pay 15 times the amount of tax paid by a similarly situated taxpayer – based on the Speltzes “phantom gain” on stock from which they actually made no money.

·        Alternatively, a similarly situated taxpayer who exercised incentive stock options like the Speltzes but whose stock did not dramatically decline in value, would be able to pay his liability in full because he would have the stock assets with which to pay the liability.  Again, the “circumstance that justifies compromise” is that the Speltzes are being taxed for phantom gain on stock that dramatically declined in value – unlike the similarly situated taxpayer in this example who is being taxed on $800,00 actually received.  

·        The Speltzes are not unable to pay their tax because they squandered money they had in their possession; they are unable to pay their tax because they never had the money on which they are being taxed and the taxes being imposed based on that “phantom gain” are so large they are swamping their financial boat.

     The proper interpretation of the meaning of “similarly situated” must be carefully determined to avoid reaching an unfair result.  It would, of course, be both unfair and illogical to conclude that “similarly situated” means “another ISO AMT victim of special circumstances similar to the Speltz family.”  An analogy to civil rights law highlights the error and inequity of this approach, and confirms this could not be what Congress intended.

     For example, if an American is discriminated against due to her ethnicity, in determining whether she is being treated differently than a “similarly situated” American, a Court would not require the woman to show how she was treated differently than other woman of her ethnicity.  This approach would result in the inequitable and unjust result that if the discriminator was discriminating against all persons of her ethnicity, then she would not be entitled to relief.  Rather, the Court will require that the woman show she is being treated differently than other people who are not of her ethnicity.  This achieves the desired result that in our society the laws are intended to protect all persons and ensure they are being treated fairly and not suffering discrimination.

     Similarly, the goal of our tax laws is for all people to pay their fair share.  Thus, to define the “similarly situated” requirement as meaning “someone suffering from the same requirement to overpay significant prepayments” renders it impossible to achieve the just result intended.  That would mean that the Speltzes would have to show why their 15X tax burden is “worse” than some other ISO AMT victim’s 15X tax burden.  That would also mean that the IRS could say “as long as all ISO AMT victims are being treated “equally unfairly” we can say they are all being treated fairly – certainly a perverse postulate and result.  And of course the fact is that would just mean all were being treated equally – but not fairly.

     The fair, and frankly common sense, approach Petitioners outlined in the bullet points above leads to a fair and just result, support public policy goals, and avoids “slippery slope” unintended consequences.  Since the laws are intended to treat everyone fairly, in the first example (a similarly situated person that makes the same amount of money as the Speltzes and who has the same deductions) the Speltzes should be granted relief because they have special and unusual circumstances that are unintentionally forcing them to pay more than their fair share of tax.  In the second example, (a similarly situated person who exercised ISOs but whose stock did not decline precipitously in value) granting relief to the Speltzes would not “open the door” to that similarly situated person to also demand relief, because unlike the Speltzes that person would have actually received the $800,000 and would have no equitable grounds on which to request relief.

     (d) “No compromise to promote effective tax administration may be entered into if compromise of the liability would undermine compliance by taxpayers with the tax laws.” Factors supporting, but not conclusive of, a determination that compromise would undermine compliance within the meaning of paragraph (b)(3)(iii) of this section include, but are not limited to – (A) Taxpayer has a history of noncompliance with the filing and payment requirements of the Internal Revenue Code;

(B) Taxpayer has taken deliberate actions to avoid the payment of taxes; and (C) Taxpayer has encouraged others to refuse to comply with the tax laws

·        The ISO AMT prepayment tax is reported to the IRS solely by the taxpayer, with no independent matching report.  Accordingly, if a taxpayer does not independently report, it is extremely unlikely the IRS will ever discover the failure to report.  In spite of this, the Speltzes did not try to fly under the radar but honestly reported their ISO AMT tax liability, and are suffering greatly as a result.  In fact, currently, there is tremendous incentive for taxpayers not to report their ISO AMT liability.

·        It is against public policy to punish taxpayers who properly and voluntarily choose to comply with the ISO AMT provisions, and OICs should be accepted with taxpayers facing hardship under the ISO AMT provisions.  The IRS can encourage voluntary compliance by addressing difficult and unintended applications of the Internal Revenue Code that might undermine confidence and belief in the tax system.

·        Respondent’s own Recommendation Report indicates that the Speltzes have been compliant taxpayers, and that this is the first time they have not timely paid their taxes.  See Recommendation Report.

Reviewing these factors again confirms the conclusion that the Speltzes are exactly the kind of taxpayer for whom the public policy/equity prong of ETA provides relief.  The Speltzes have a history of compliance; they took deliberate action to self-report their ISO AMT tax liability and have taken deliberate and aggressive action to pay as much as possible; they have not encouraged others not to comply; they have not received economic benefit for which they have not paid taxes, but have paid taxes based on economic benefit they never received; no other taxpayer could view the Speltzes as “getting a break” from paying their fair share of taxes were the Speltz offer in compromise to be accepted; compromising the Speltzes liability will actually encourage other taxpayers to voluntarily comply with the AMT ISO provisions knowing that in the event of exceptional circumstances in the economy or their company the IRS will consider their situation in fairness and equity.

The careful and systematic review of the Speltz facts in the context of each of the elements of the public policy/equity prong of the ETA, leads to the conclusion that failing to grant the Speltzes relief was an abuse of discretion.

A review of the exchange between the National Taxpayer Advocate and the IRS on non-hardship ETA OIC’s is instructive in demonstrating the IRS’ failure to properly implement this Congressional directive.

NTA:  The IRS remains unable or unwilling to accept ETA offers based upon equity and public policy considerations.  NTA 2004 Report at 328.

 

IRS Response:  The “non-hardship” ETA OIC is a situation where no doubt exists that the liability is valid, and payment of the tax would not create an economic hardship for the taxpayer.  However, due to circumstances of the case, the inequity of requiring the taxpayer to pay the entire liability would be so apparent that the IRS should allow the taxpayer to compromise the tax debt for less than the amount owed.  This component of the OIC program was designed to allow the IRS to settle difficult or unusual cases, where other collection alternatives did not seem appropriate.  In practice, however, we have received very few cases that meet these criteria. Id. at 334.

 

NTA Reply to the IRS Response:  The IRS states that as part of the joint review of non-hardship ETA OICs, TAS did not identify cases that the IRS should have accepted.  As stated previously, the purpose of this review was not to identify specific cases that were decided incorrectly.  Because the IRS has not specific criteria that, if present, would result in the acceptance of an OIC based on non-hardship ETA considerations, it would have been impossible to identify cases that were decided incorrectly even if the limited case file excerpts provided the reviewers included all the relevant information.  IRS comments state that “experience shows that the inequitable conditions that contribute to tax delinquencies also tend to create economic hardship on the affected taxpayers.  The IRS routinely accepts ETA OICs based on economic hardship . . .”  However, IRS has informed TAS that it does not record such data.  Thus, we have no way of verifying IRS’ statement. Id. at 338.

      

     Petitioners maintain that, as discussed in this Supplemental Motion, public policy and equity principles can apply even where hardship does not apply.  However, Petitioners also maintain that their situation fits into that described by the IRS above; the inequitable factors leading to the tax liability are also creating hardship, and therefore the Speltzes are entitled to relief under both the hardship and public policy/equity prongs of effective tax administration. 

     Yet, in spite of being entitled to relief under two prongs of effective tax administration, because the IRS has taken an improperly rigid view of “hardship” that fails to properly consider special circumstances, and because the IRS has failed to even consider the Speltzes’ special circumstances under the public policy/equity grounds, the Speltzes have been denied the relief they should have received years ago under Section 7122. 

     Certainly if ETA hardship and/or public policy/equity does not engage in a situation like the Speltzes where

then it is hard to imagine a situation where public policy/equity principles would engage or apply or have any meaning whatsoever. 

     Petitioners believe it is rare indeed that the IRS is faced with a taxpayer’s failure to pay – and that failure to pay is based on the taxpayer’s inability to prepay tax on future income which prepayments become a credit used in the future to offset tax owed when the future income event occurs.  In the Speltzes’ case, they are in actual fact not “behind” or “delinquent” on payments of current tax owed on economic benefit received, but are “behind” on prepayments of future tax that will never be owed because the economic benefit will never be received – truly an exceptional situation.

          Petitioners contend that Section 7122 has meaning, and that meaning applies to compromise the unfair, inequitable tax liability imposed on the Speltzes, which is further creating a great hardship.  Under Section 7122, the Speltzes are entitled to relief based on hardship, and also based on public policy/equity principles.

     The “relief” the Speltzes are requesting is that they only be required to pay - not 2x, not 3x, but 7x their fair share of taxes, rather than 15x their fair share.  In light of the prepayment amounts already paid, it should even be unnecessary for the Speltzes to offer more than they have already paid. 

     While in some cases the use of discretion under Section 7122 may require fine judgments and close calls, this is not that case.  If it not an abuse of discretion to refuse relief to a taxpayer who has already paid 6 times more than a similarly situated taxpayer, and who is being financially destroyed by a demand to pay 15x their fair share, then it is hard to imagine a situation where any taxpayer would be entitled to relief.  And, it is hard to imagine that the hardship and public policy/equity provisions of Section 7122 have any meaning or application whatsoever or would ever engage to provide relief.

 

CONCLUSION

In the Initial Opposition, Petitioners provided a detailed recitation of the material facts in dispute in this case.  In this Supplemental Motion, Petitioners have focused on the legal framework and analysis for the Three Statutes applicable to this case, and in particular the OIC Statute and Regulations.  The Supplemental Motion thus provides additional support as to why the facts relating to the Speltz special circumstances, and the facts relating to the IRS failure to consider (or failure to properly consider) those special circumstances both from a process and substantive standpoint, are material. 

Accordingly, based on the arguments set forth in the Initial Motion and this Supplemental Motion, Petitioners contend that genuine issues of material fact exist with respect to (a) whether Respondent failed to follow its own administrative processes in reviewing Petitioners’ case, (b) whether Petitioners truly can pay their tax liability within the time period and under the conditions set by Respondent, (c) whether Respondent failed to even consider significant special circumstances raised by the Petitioners in their case, and (d) whether Respondents ignored public policy and equity considerations altogether or, even if Respondent did consider the special circumstances the Speltzes raised, it abused its discretion in concluding that such circumstances did not qualify for relief under the hardship and/or public policy/equity prong of DCSC or ETA guidelines, as applicable.

WHEREFORE, it is prayed that Respondent’s Motion for Summary Judgment be denied.  

Date: _______________        By: ______________________  

                             TIMOTHY J. CARLSON

                             Tax Court Bar No.  CT-0407

                             1530 N. Key Blvd. #1320

                             Arlington, VA  22209

                             Telephone:  (301) 515-6584

 


[1] Note that certain statements as to legislative history and Congressional intent relating to the Three Statutes are made in this Section 1 that are more fully developed in Section 2.  This Supplemental Motion was structured in this manner to provide the Court a cogent argument flow in Section 1 that was not being constantly broken by supporting quotes from legislative history or historical context.  Section 2 therefore provides detailed support for Section 1.

 

[2] This interaction between the ISO Statute and the AMT ISO Statute is distinguishable from the situation regarding attorneys fees addressed in the recent Banks and Banaitis Supreme Court decision.  In Banks and Banaitis, the AMT code permanently changed the treatment of attorney fee deductions, whereas in the present situation the AMT ISO Statute is a timing modification creating a “credit” intended to be used to offset future gains, which are then taxed at the rate intended by the Incentive Statute, with the credits returning to the taxpayer upon sale of the stock.  In technical terms, Banks and Banaitis involved a “preference” vs. “timing” item under the AMT.    Further, the tax for both Messrs. Banks and Banaitis was in fact proportional to the settlement amounts each received.   Unlike the Speltzes, they were not prepaying taxes on settlement amounts they in fact didn’t and never would receive.

 

[3] Note that at the time of passage of the AMT ISO Statute, the capital gains rate was 28%, so the prepayment rate coincided with the final tax rate owed.  Since that time, the capital gains rate has decreased to 15%, creating a “gap” of 13% between the prepayment rate and the final rate, so that even if the stock is sold for the same price as when it was purchased a taxpayer will end up with a 13% AMT credit.  While this has an element of illogic, it is not an issue that has any bearing on this case and any perceived “unfairness” of this 13% disconnect is negligible compared to the Speltz situation where the tax rate on the asset in question (the stock) is not 13% above the intended rate but rather is literally infinite ($220,000 tax owed on a loss of $32,000).

[4] This is not intended to be a theoretical discussion as to whether the current tax rates are reasonable or “fair”, but this discussion assumes that a tax is “fair” if the same  tax rate is being applied equally to all similarly situated taxpayers and is a reasonable percentage of the economic gain received from an asset within a range equal to or less than the highest tax rate currently imposed.

 

[5] “A study published in April 2001 by the Joint Committee on Taxation put the number of words in the Code at approximately 1,395,000. . . . Subsequent tax legislation has expanded the number of words significantly.  NTA 2004 Report at 2, Note 1.

[6] One interesting thing to note in this provision is the use of the phrase “once a basis for compromise . . . has been identified.”  It is noteworthy that the Regulations do not require the taxpayer to raise the specific basis, but rather require only that the basis be identified.  The Speltzes did, of course, indeed raise the special circumstances basis for compromise in several instances of correspondence with the IRS.  Further, the special circumstances were evident on their face given the severely disproportionate liability. 

[7] The only difference between these two categories for OICs hinge on whether or not the Speltzes have the ability to pay.  If they do not, they would fall under the doubt as to collectibility with special circumstances category.  If they do, they would fit in the effective tax administration category.  In either case, the assessment of their “special circumstances” is the same.

[8] See, also, the Initial Opposition Section 1 which provides a parallel analysis of the IRS policies set forth in the IRM, demonstrating that a proper application of these IRM provisions to the Speltz facts leads to a conclusion the Speltzes are entitled to relief.  Further, the analysis shows the IRS failed to properly follow these policies in its determination that the Speltzes are not entitled to relief.

[9] Petitioners would like to clarify for this Court a slanting of the facts Respondent engaged in numerous times both in the Motion for Summary Judgment and in the Hearing.  Respondent consistently mischaracterizes the Speltzes as trying to “get away” with offering only $4,000 to satisfy a $125,000 liability.  The fact is that the $4,000 offered is in addition to more than $122,000 the Speltzes have already paid.  Petitioners’ would therefore request that, in fairness to the Speltzes and consistent with the facts, in discussion and briefing Respondent refrains from this mischaracterization, and properly characterizes the Speltzes’ offer as $126,000, of which $122,000 has already been paid.  For that matter, while Petitioners are not retracting their $4,000 OIC, Petitioners believe that in all fairness they should be granted an OIC based solely on the overpayments already made; they should not have overpay an additional $4,000 to settle their case.