Two recent cases highlight the most current view of the "duty of consistency doctrine" (DOCD) and how it can be used to collect tax even if a year relevant to the analysis is closed by the statute.¹ The application of DOCD is based on an equitable doctrine that will generally prevent a taxpayer from benefiting from a change in facts or application of the law to a specific set of facts after certain tax positions have been taken by the taxpayer. It can be viewed as similar to those cases where a taxpayer has not been allowed to "argue against their own form" in determining the tax consequences arising from of a particular set of facts. However, DOCD is "an affirmative defense and the party asserting it — typically the IRS — bears the burden of establishing the facts."²

Duty of Consistency Doctrine

The DOCD "arises when the following elements are present (1) the taxpayer has made a representation or reported an item for tax purposes in one year, (2) the Commissioner has acquiesced in or relied on that fact for that year, and (3) the taxpayer desires to change the representation, previously made, in a later year after the statute of limitations on assessments bars adjustments for the initial year."³ Thus, the DOCD can apply for potential adjustments that might have arisen in a closed tax year, even in situations in which the taxpayer’s original representations as to the facts used in preparing that closed year’s tax return are found to be in error. It is also important to note that information used or asserted by a taxpayer in preparing its tax return is considered a representation as to the relevant items on that return for purposes of the DOCD test.

Squeri

In Squeri, the taxpayers were S-Corp shareholders for the years 2009 to 2011, the years under audit, and for relevant prior years. The 2008 tax year was closed due to the expiration of the statute of limitations. For the years under review, the cash-basis S-Corp inappropriately used the deposits method to determine cash receipts for purposes of calculating its income and loss as a result of its business operations. For example, the S-Corp received checks in 2008 that were not deposited in its bank until January 2009. As a result of this impermissible method, the taxpayers treated the date of the bank deposits as the date of the receipt of income. The Service recalculated the income and loss for each of the years from 2009 to 2011 to treat the amounts received before the end of each of those years as income for the year of the receipt of the payment. However, because the 2008 tax year was not open, the Service accepted the taxpayer’s bank deposits in January 2009 as the receipt of the income from the checks that were provided to them in 2008. In finding for the Service, the Tax Court found that each of the three requirements for application of the DOCD was met: (1) the taxpayers filed their 2009 tax return using the date of the bank deposit as the date of the income; (2) the Service relied on the taxpayers’ filings on the bank-deposits method for purposes of the 2008 tax year because the tax year was allowed to close under the statute of limitations; and (3) the taxpayers’ attempts to allocate the January 2009 bank deposits to the 2008 tax year would prejudice the Commissioner because there was no authority to reopen the 2008 tax year to properly tax that income, and, thus, the January 2009 deposits essentially would have gone untaxed under the taxpayers’ requested relief.

Horstemeyer

In Horstemeyer, the taxpayer owned several entities through which he operated his medical business. In 2012, the taxpayer, his wife and the entities that he owned negotiated tax settlements in the Tax Court for tax years 2005 to 2008, and the Tax Court entered orders for these tax liabilities. In July 2014, the Service filed motions against the taxpayer, under the theory that the taxpayer was the "alter ego" of his operating entities, in order to collect the amounts due from those entities under the Tax Court’s orders. In August 2014, the taxpayer filed for bankruptcy and received his discharge in December 2014. In January 2015, the taxpayer/debtor filed a motion with the bankruptcy court to determine that his personal liability was fully discharged in the bankruptcy proceeding and that the Service was precluded from raising the "alter ego" theory in seeking to collect, from his personal assets, taxes due from the entities he owned under the 2012 Tax Court order. One of the assertions made by the taxpayer/debtor in advancing his motion was that the Service was barred by the DOCD from asserting an "alter ego" claim against him when that claim was arguably inconsistent with the position taken at the Tax Court by the Service. While finding that the case was not appropriate for summary judgment because of the factual issues at stake, the bankruptcy court discussed in detail whether the DOCD could be asserted against the Service. In a review of numerous cases applying the DOCD, the bankruptcy court concluded that "[i]t is unclear whether the duty of consistency doctrine applies to the IRS."⁴ In its review, the court did not identify any case in which a court applied the DOCD to the Service, but identified a Sixth Circuit case that found explicitly that "the duty of consistency only applies against the taxpayer."⁵

Pepper Perspective

The two recent cases addressing the potential application of the DOCD illustrate the general ability of the Service to successfully argue that taxpayers should not benefit from their own mistakes if they result in less tax being paid. In particular, even if a specific method of reporting income is incorrect under the applicable accounting method and recognition of income rules, the Service can follow the incorrect approach taken by the taxpayer if doing so results in the collection of what arguably was owed by that taxpayer. This issue needs to be considered, in particular, when taxpayers are under examination and are proposing to make adjustments to taxable income or deductions that potentially arise from closed tax years. Even though a legal argument may be available as to why the open tax years should be adjusted to the permitted method, the Service may still be free to argue for application of the unpermitted method in order to collect the amount of tax it believes is owed. In addition, even when the Service may not have asserted all potential arguments during a negotiation of the settlement of tax liabilities, taxpayers need to be aware that it is possible for other theories to be advanced by the Service and that taxpayers may not be in a good position to assert the DOCD against the Service to preclude alternative arguments that could result in the collection of tax.

Endnotes