Help! The Government Took My Money and Gave it to a State!
By: John Ford, Senior Consultant, Government Contractor Services Group
We all know from folk lore that the IRS can seize property from a taxpayer if the taxpayer is delinquent in paying its Federal taxes. However, did you know that the government can seize money from a taxpayer and pay it to a state?
Cherry Bekaert’s GovCon Group recently had a client receive a notice that funds had been withheld on a contract with the Department of State related to a state income tax liability that the client and our tax department had received no prior notices of delinquency. After the outrage about the situation subsided, we decided to look into the matter further to determine the contractor’s rights and the rights of the government. This article will discuss the government’s ability to do so.
There are two statutes that give the government the right to pay money owed to a taxpayer, including government contractors, and pay that money to a state. First, 26 U.S.C. §6402(e), (also see 31 CFR §285.8 for implementing regulations) permits the Internal Revenue Service (“IRS”) to offset amounts owed to a contractor as a tax refund against “a past-due, legally enforceable State income tax obligation” if the IRS is notified by the state of the debt. However, this offset can only be made in regard to a state tax debt owed to the state in which the taxpayer is a resident. For these purposes, the statute permits an offset only if the address shown on the Federal return for the taxable year for which a refund is due is an address in the State seeking the offset. For contractors that owe taxes to more than one state, the offset can only be taken for a tax debt owed to the state where the contractor is a resident for Federal tax purposes.
As for what is a “past-due, legally enforceable State income tax obligation,” the statute defines it as:
(i) which resulted from—
(I) a judgment rendered by a court of competent jurisdiction which has determined an amount of State income tax to be due; or
(II) a determination after an administrative hearing which has determined an amount of State income tax to be due; and
(ii) which is no longer subject to judicial review; or
(B) which resulted from a State income tax which has been assessed but not collected, the time for redetermination of which has expired, and which has not been delinquent for more than 10 years.
As a result, before this authority can be invoked, the state must have provided the contractor with due process in determining that the tax is due.
Finally, the statute requires the IRS to notify the taxpayer/contractor why its tax refund has been reduced. If a reduction is made to a Federal tax refund due the contractor, the statute prohibits the contractor from filing suit against the IRS to recover the reduction. Any challenge to the reduction must be in an action against the state receiving the payment if any such action is available.
This presents an interesting situation for contractors. While Federal income taxes paid are not allowable on contracts subject to the cost principles, state income taxes are. Thus, if the government exercises this authority regarding a contractor, the amounts withheld and paid to the State should be considered allowable costs to the contractor under Federal Acquisition Regulation (“FAR”) 31.205-41. In addition, if the amount withheld includes interest, there is Federal Circuit case law from a case involving Lockheed Martin that these interest costs are also allowable if the state tax debt did not arise from an intentional under payment by the contractor. That is because FAR 31.205-20 only makes interest on borrowings unallowable. It does not address other forms of interest. Any penalty that is included in the withheld amount, however, would not be an allowable cost.
The second statute is 31 U.S.C. §3716(h), which permits the Secretary of the Treasury to enter into reciprocal agreements with states, including the District of Columbia and the possessions and territories of the U.S., providing for offsetting non-tax payments owed to a person, including contractors, against “any past-due, legally-enforceable debt owed to a State.”
This state debt does not have to be a tax debt. Additionally, the payment owed to the contractor does not have to be a tax refund payment, but can be a payment owed for supplies or services furnished to the government.
Note that this authority does not apply to debts owed to all states, unlike the offset authority under 26 U.S.C. §6402. Instead, for this authority to be used, the government and state must have entered into a reciprocal agreement under which the government agrees to help the state collect state debts, and the state agrees to help the government collect debts owed to the Federal government from state residents. Information obtained from the Treasury Department indicates that the government has entered into eleven such reciprocal agreements, including agreements with the District of Columbia, Virginia, Maryland and West Virginia. In FY 2016, the Federal government recovered $61.5 million for states. In return, the states recovered $46.8 million for the Federal government.
Another distinction between §6402 and §3716 is that the former defines what is a legally-enforceable debt while the latter does not. However, the Secretary has promulgated regulations implementing §3716 at 31 CFR 285. Subsection 285.5 states that legally enforceable means that “there has been a final agency determination that the debt, in the amount stated, is due, and there are no legal bars to collection by offset.”
Of particular interest to contractors is section 285.6, Administrative offset under reciprocal agreements with states. Under this regulation, once the Secretary receives notice of a delinquent state debt from a participating state, government disbursing officials “shall offset the Federal payments specified in the reciprocal agreement to collect the State debt.” There is no requirement that the Secretary look behind the state debt to determine if it is valid. However, the state official requesting the offset must certify that the creditor agency has made a reasonable attempt to provide each debtor with:
(A) Written notification, at least sixty days prior to submitting the debt and at the debtor’s most current address known to the agency, of the nature and the amount of the debt, the intention of the creditor agency to collect the debt through offset, and an explanation of the rights of the debtor;
(B) An opportunity to inspect and copy the records of the creditor agency with respect to the debt;
(C) An opportunity for a review within the creditor agency of the determination of indebtedness, including the opportunity to present evidence that all or part of the debt is not past-due or legally enforceable;
(D) An opportunity to enter into a written repayment agreement with the creditor agency; and
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(iv) The creditor agency has complied with all statutes, regulations, and policies applicable to the creditor agency’s assessment of interest, penalties and administrative costs (including, as applicable, 31 U.S.C. 3717), and that the creditor agency has provided a written notice to debtors explaining the creditor agency’s requirements concerning any such charges assessed against those debtors;
Before an offset occurs, there is a requirement for due process. However, unlike a tax refund offset, there is no requirement that the debt must be established through an adversary proceeding. Instead, the state debt can be determined by a state agency much like a contracting officer’s decision under the Disputes clause in the FAR.
While the statute does not address liability for an erroneous offset, section 285.6 states that neither the disbursing officer of agency owing the payment that has been offset will be liable if the contractor asserts that the debt was paid before the offset occurred. Thus, the regulations anticipate that any challenge to the offset will be lodged against the state.
Whether a refund suit against the state is the only remedy available to a contractor is an open question. The Contract Disputes Act, as implemented by FAR 33.210, states that the authority of contracting officers to decide or resolve claims does not extend to a claim or dispute for penalties or forfeitures prescribed by statute or regulation that another Federal agency is specifically authorized to administer, settle, or determine. In this regard, remember that the Secretary has discretion to enter into reciprocal agreements with states and that it is State law that is being applied by the state to determine if a debt exists. The Secretary only acts as a collection agent for the state under this scheme. Therefore, contractors affected by this type of offset could have a claim to recover the offset amount under the contract where the offset occurred.