Taxpayer Not Allowed to Exclude Amounts from Income Merely Because IRS Allowed the Position on Three Prior Amended Returns

The fact that the IRS had granted the taxpayer’s position on three prior returns that his military retirement was not subject to tax did not require the IRS to accept that same position on a later return.  The case of Taylor v. Commissioner, TC Summary Opinion 2017-4 dealt with this issue of how much reliance a taxpayer can place on the IRS’s acceptance of a return position in an earlier year.

The taxpayer in this case had retired from the Army after completing the length of time necessary to qualify for retirement in 2002.  Although he did not separate due to disability, he did file an application with the VA in 2002 for compensation for service related disabilities.  He was awarded such compensation which was not reported by the VA to the IRS, which he did not report as taxable on his return for the year in question (2010) and which the IRS was not arguing was taxable compensation to him.

Independent of that payment, he was also paid $28,740.03 from the Defense Finance and Accounting Service (DFAS) as net retirement due to him from his previous service in the Army.  His pay was reduced by $1,059.95 due to his election to receive VA disability compensation and by $19,160.02 for a portion of his retirement awarded to his former spouse.  The $28,740.03 payment was reported to the taxpayer on a Form 1099R, but he did treat that as taxable on his 2010 return.

Mr. Taylor excluded it because he previously filed three amended income tax returns (for 2006, 2007 and 2008) where he had claimed a refund of taxes related to his military retirement, arguing that it should not be taxable.  He prepared a worksheet showing how he had calculated the excludable portion of his retirement—or, more appropriately, what he believed was excludable.  The processed these refund claims and paid the taxpayer the reduction in tax claimed, along with interest.

For the 2010 return the taxpayer attached a similar worksheet outlining why the amount on the Form 1099R was not taxable to him.  But in this case the IRS decided to examine his return, and took the position the entire amount shown on the Form 1099R was taxable.  And, unfortunately for the taxpayer, the amount he was receiving as retirement benefits based on his years of service is not excludable from income.

The taxpayer conceded that fact in this case (largely, I expect, because he had been in court for 2009 previously and lost in that case—Taylor v. Commissioner, TC Summary Opinion 2015-51).  But the taxpayer argued that even though he now saw the error of his ways, the IRS should not be allowed to take a contrary position for 2010 since the taxpayer prepared the return with this position relying on the IRS’s acceptance of that position for the three amended returns.

The legal name for this position is one based on “estoppel,” specifically equitable estoppel.  The Court explains the concept as follows:

Equitable estoppel is a judicial doctrine that “precludes a party from denying his own acts or representations which induced another to act to his detriment.” Graff v. Commissioner, 74 T.C. 743, 761 (1980), aff’d, 673 F.2d 784 (5th Cir. 1982); see Megibow v. Commissioner, T.C. Memo. 2004-41, 2004 Tax Ct. Memo LEXIS 43, at *23. “The doctrine of equitable estoppel is based upon the grounds of public policy, fair dealing, good faith, and justice and is designed to aid the law in the administration of justice where without its aid injustice might result.” Graff v. Commissioner, 74 T.C. at 761.

However, the Court goes on to note that generally the doctrine can only be invoked against the government in rare cases.  The Court notes that “[e]quitable estoppel has been applied against the Government only where justice and fair play require it.”

The Court outlined what had to be shown by the taxpayer in this case:

In order to invoke the doctrine of equitable estoppel against the United States petitioner must establish: “(1) conduct constituting a representation of material fact; (2) actual or imputed knowledge of such fact by the representor; (3) ignorance of the fact by the representee; (4) actual or imputed expectation by the representor that the representee will act in reliance upon the representation; (5) actual reliance thereon; and (6) detriment on the part of the representee.” Hofstetter v. Commissioner, 98 T.C. at 700.

The Court pointed out the IRS did not make a mistake of fact but rather had a mistake of law.  The Court notes “[e]quitable estoppel does not bar or prevent the IRS from correcting a mistake of law. Auto. Club of Mich. v. Commissioner, 353 U.S. 180, 183-184 (1957); Schuster v. Commissioner, 312 F.2d at 317; see Wilkins v. Commissioner, 120 T.C. 109, 113 (2003).”

The Court thus found:

By accepting petitioner’s amended tax returns and issuing refunds for 2006, 2007, and 2008, employees of the IRS incorrectly applied the law requiring military retirement pay be included in gross income. The IRS may correct mistakes of law “even where a taxpayer may have relied to his detriment on the* * * [IRS’] mistake.” Dixon v. United States, 381 U.S. 68, 73 (1965); see 12 Greenfeld v. Commissioner, T.C. Memo. 1966-83, 1966 Tax Ct. Memo LEXIS 201, at *5 (holding IRS not estopped from disallowing net losses after failing to make such changes during audits of prior year tax returns). The IRS has the power to correct mistakes of law because an IRS employee by neglect or otherwise cannot bind the IRS to an erroneous interpretation of law. Graff v. Commissioner, 74 T.C. at 762. Thus respondent is not estopped from correcting the mistake of law for 2010. Accordingly, the Court concludes that equitable estoppel is not applicable and respondent is not estopped from determining that petitioner’s military retirement pay is includable in gross income for 2010.

This case is a good reminder of the fact that we must be careful not to read too much into an IRS concession in a “real world” case we may encounter and must caution our clients that just because an acquaintance of theirs successfully claims to have taken a position on a return and “survived exam” that does not mean that the position reflects the law.