From A to Z the IRS Throws Every Possible Argument at the Court in Unsuccessful Attempt to Avoid Attorney’s Fees

We have talked about what it takes to recover attorney’s fees from the IRS in prior posts here, here, and here.  The recent Court of Claims case of BASR Partnership v. United States, takes almost all possible defenses to attorney’s fees and puts them on display in one case.  For that reason the case deserves discussion.  One reason the IRS may have tried so hard to avoid attorney’s fees in this case stems from the fact that the taxpayer engaged in what the IRS no doubt considered abusive tax shelter activity and only avoided tax and penalties due to a snafu.  So, the fight over fees just added insult to injury with the IRS feeling that the taxpayers should have paid significant liabilities for its activities and yet ending up with no tax as well as payment by the IRS for the representation it received.

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In 2013, the Court of Federal Claims determined that the IRS did not timely issue an FPAA to BASR.  The IRS appealed to the Federal Circuit and lost again.  The IRS requested a Petition for En Banc Rehearing and the court denied that as well.   The government does not lightly seek en banc review.  It must have felt strongly on the merits of the FPAA issue, but I am not going to discuss that issue in this post.

After winning these significant victories which kept the IRS from making adjustments to the partnership for what the IRS viewed as abusive tax shelter activities, the taxpayer and its attorneys at Sutherland Asbill & Brennan sought attorney’s fees, and they sought fees at a higher rate than the statutory rate for attorney’s fees.  The IRS filed a motion to conduct limited discovery concerning the fees and the taxpayer responded.  After a conference with the court the taxpayer was required to “produce the client’s fee agreement, a copy of all legal bills sent to the client, and any proof of payment from the client.”  Then the IRS filed an objection to the motion for litigation costs and requested oral argument.  The taxpayer requested “fees for fees” seeking to add to its recovery and get reimbursed for the cost of fighting about the existence and amount of the fee award.

The first thing the taxpayer needs to do in seeking to recover fees is show that it is a “prevailing party” which means it must have (1) substantially prevailed with respect to the amount in controversy; (2) the IRS position was not substantially justified; and (3) the statutory requirements regarding net worth are met.  The taxpayer can meet the first two parts of this test, which are otherwise quite difficult to meet, if it makes a proper qualified offer and that is why we have discussed qualified offers to a significant extent in the prior posts cited above.  Making a qualified offer is the most direct path to obtaining fees since it moves the taxpayer past the substantially justified barrier.  In this case BASR made a qualified offer of $1 to the IRS to settle the FPAA issue.  As you can tell from the litigation I described above, the IRS did not settle the FPAA issue and fought it all the way to making the request for en banc reconsideration.  Because the IRS lost completely on the statute of limitation issue, the effect of its loss was that the taxpayer did better in the litigation than the $1 offer it made to the IRS since it owed $0 after winning the statute of limitation argument.  This put the taxpayer over a big hurdle to becoming a prevailing party and appeared to leave it only with net worth requirement.

In addition to showing that it was the prevailing party, BASR also needed to meet statutory tests set out in IRC 7430(b) involving (1) exhaustion of administrative remedies, (2) showing the fees and costs are allocable to the IRS and (3) showing that it did not unreasonably protract the proceeding.  My clients often fail the exhaustion of administrative remedies test because they do not avail themselves of the opportunity to go to Appeals prior to going to Tax Court.  Here, the IRS foreclosed the taxpayer’s option of using Appeals because it said that Appeals would not consider Son of Boss transactions.

Taxpayer argued that it needed the increased fee because it could not find any attorneys with expertise on this issue willing to take the case at the statutory rate.  Because of the billing rates of the firm it used, BASR seeks fees at a rate essentially twice what the statute suggests.  Almost no tax firm bills out at the statutory rate and taxpayers will always argue that their case is novel or complex but getting a higher rate than the one set in the statute is not necessarily easy just because the rate is out of sync with today’s fee schedules.

The IRS makes an argument regarding every possible issue that would prevent BASR from obtaining fees.  First, it argued that BASR did not pay or incur any litigation costs because the engagement letter was with William Pettinati, his wife and his son.  Second, the IRS argued that BASR was not a real party in interest because all of the fees were paid by these individuals.  Third, the IRS argues that the real parties in interest have net worths in excess of the statutory maximum.  Forth, the IRS argues that BASR did not make a qualified offer because the case did not involve a tax liability and the qualified offer provision does not apply to “any proceeding in which the amount of tax liability is not in issue.”  A clear example of this language would be a collection due process case in which the underlying merits of the liability were not at issue.  Fifth, the IRS argued that offer to settle for $1 was not made during the qualified offer period because the IRS never sent a letter of proposed deficiency so no qualified offer period ever began.  Sixth, the IRS argued that the offer of $1 was a sham since it was so low as to not be meaningful or in good faith.  Since I regularly make $1 offers when I make a qualified offer, I followed this particular argument with interest.  I have not encountered this argument from the IRS in the cases in which I have sought recovery.  Seventh, the IRS argued that the court should exercise its discretion not to award attorney’s fees since doing so would be unjust because of taxpayer’s participation in an invalid Son of Boss tax scheme.  Eighth, the IRS argued that the requested fees were unreasonable both because they exceeded the statutory maximum and because some were not in connection with a court proceeding.  Ninth, the IRS argued that BASR should not get paralegal fees for clerical tasks and tenth it argued that it should not receive fees for fighting the fee request.

The court walks through the responses filed by BASR before getting to its own conclusions on each of the issues raised by the IRS.  I will skip the responses and head straight to the court’s analysis.  Spoiler alert – the taxpayer gets attorney’s fees.

The Court found BASR was a prevailing party looking at partnership law.  It found that the individuals paid the costs because BASR was essentially defunct but that under Texas partnership law they had the right to bring the action on behalf of the partnership and to be reimbursed for doing so.  The Court was not persuaded that the form of the action trumped the substance.  It found that BASR had no money and therefore its net worth did not exceed the statutory maximum.  It found that BASR did have a liability at issue and that the offer was made during the qualified offer period.  It found that an offer of $1 was a reasonable amount to offer for a party that thought it did not owe the liability.  It found that even though the taxpayer may have engaged in tax shelter activities, the issue in this case was liability and it was not liable for the taxes so no basis existed for denying the fees on the basis of the shelter scheme.  It found that the fees were reasonable under the circumstances and that the paralegal fees were also reasonable.  It did make slight downward adjustments in fees and costs but these adjustments were minor in the scheme of the requested fees.  Finally, it found, what other courts have also found, that a prevailing party can receive fees for fighting fees.

This case is a handbook for those battling about attorney fees.  While giving fees to a tax shelter promoter may seem galling, the fees result here from the untimeliness of the IRS action.  The case not only provides an issue by issue review of almost all of the issues that come up in an attorney’s fee case but also stands for the proposition that courts should not look at the equities of the underlying tax in determining if the taxpayer should receive attorney’s fees.

 

Whistleblower Who Prompted Voluntary Compliance Not Entitled to Reward

One of the more interesting Tax Court opinions of the last month is Whistleblower 16158-14W v Commissioner. The opinion concludes that a whistleblower who provides information that exposes taxpayer misconduct and brings about a voluntary change in a taxpayer’s behavior in future years is not entitled to receive a reward.

The case involves an employee/whistleblower who told the Service about his employer, a corporation (perhaps a financial institution) that failed to withhold on payments of interest and dividends to foreign persons. (As background, US persons paying US source payments to foreign persons are generally required to withhold at a 30% rate unless the foreign person establishes that it is subject to an exemption or lesser rate).

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The noncomplying corporation was already under audit for the 2006-08 years for unrelated issues. After the Whistleblower Office received the information about the corporation’s withholding noncompliance, it provided the information to LB&I and Criminal Investigation, and LB&I expanded the audit to include the withholding issues.

At the conclusion of the 2006-08 examination, the Service issued a no-change letter to the corporate taxpayer. After the exam, an employee of the Whistleblower Office and an employee of LB&I completed an evaluation of the whistleblower claim on Form 11369. The opinion discusses that evaluation:

The explanation attached to the Form 11369 stated that the whistleblower was correct that the taxpayer had made errors but the cause of the errors was an “honest mistake” made while updating its reporting systems. The explanation went on to say that “[i]t appears the * * * [taxpayer] has been convinced by its close call to become fully compliant with its withholding tax responsibilities and further examination is not warranted.”

Eventually, the Service issued a denial of the request for an award because the information that the whistleblower provided did not turn into “collected proceeds” under the whistleblower statute.

Section 7623(b)(1) provides that a whistleblower will “receive as an award at least 15 percent but not more than 30 percent of the collected proceeds (including penalties, interest, additions to tax, and additional amounts)”.

Section 7623(b)(1) also predicates the award on the Secretary’s proceeding with “any administrative or judicial action described in subsection (a)” There was no dispute that there was an administrative action in 2006-08, the original years under audit. Yet the taxpayer received a no change letter for those years.

What about future years, when the whistleblower alleged (and the Service did not dispute) that the taxpayer became voluntarily compliant, resulting in the Service collecting substantially more revenue than it otherwise would have absent the whistleblower coming forward?

This tees up the legal issue that the opinion addressed: can a whistleblower’s information that prompts a taxpayer’s voluntary compliance in future years serve as the basis of an award? In particular, does the additional revenue that the Service collects due to a taxpayer’s voluntary compliance amount to “collected proceeds” under Section 7623(b)(1)?

As this case was resolved on summary judgment, the opinion assumed that the whistleblower’s factual allegations were correct, i.e, that in fact his spilling the beans on the withholding noncompliance did in fact contribute to the corporation becoming compliant in future years.

The opinion concludes essentially that without the Service taking administration action in future years the information that the whistleblower provides cannot justify the payment of an award. The opinion gets there first by noting how prior opinions have addressed the scope of the term “collected proceeds”:

Section 7623(b)(1) provides that a whistleblower will “receive as an award at least 15 percent but not more than 30 percent of the collected proceeds (including penalties, interest, additions to tax, and additional amounts)”. Therefore, an award is predicated on the collection of proceeds. “Collected proceeds” is not defined in the statute. In Whistleblower 21276-13W v. Commissioner, we relied on the canons of statutory construction to define collected proceeds. We defined it as “all proceeds collected by the Government from the taxpayer”. We explained that “collected proceeds” is an “expansive and general term” a “sweeping term”, and “not limited to amounts assessed and collected under title 26”… (citations omitted).

Despite the expansive language in Whistleblower 21276-13W  v. Commissioner, it held against the taxpayer, primarily based on a policy concern about the difficulty of establishing a connection between the information that the whistleblower has provided to the Service and a taxpayer’s future conduct:

Collected proceeds do not include self-reported amounts collected when a taxpayer changes its reporting for years that are not part of the action. The Commissioner argues, and we agree, that because of the significant costs and heavy administrative burden, collected proceeds cannot include amounts collected for years after examination years on account of a taxpayer’s changing its reporting. (emphasis added)

In language that I found a bit harsh, the opinion states that the whistleblower’s argument takes the Whistleblower 21276-13W discussion of collected proceeds to an “irrational extreme to argue that self-assessed amounts collected for future years are proceeds collected by the Government. Indeed, many, if not all, of the Commissioner’s examinations will have some influence on a taxpayer’s reporting. However, any determination of an award based on additional amounts collected for years following examination years would be based on speculation.”

There is more to the opinion, including a discussion of how the regulations under Section 7623 in limited and different circumstances tether collected proceeds to future years’ positions if “adjustments to tax attributes made in the year of the action have direct carryover consequences for other years”; its discussion of how if the Tax Court accepted the taxpayer’s position it would effectively require the Court to impermissibly order the Service to conduct an examination of the taxpayer’s future years; and how the Service discussion in Form 11369 of the taxpayer’s future compliance at the end of the 2006-08 audit did not amount to an “implied settlement” for those future years.

This is a very tough outcome for the whistleblower. There are strong policy reasons to want to reward a person whose conduct causes future tax compliance. Given the limited statutory definition of the term “collected proceeds”, and the competing policy concerns that the opinion did not fully address (such as the benefit of information prompting voluntary compliance). I suspect that this is not the last word on some of these issues.

Representing Your Client in Tax Court with a Power of Attorney

In the tax clinic, we file very few Tax Court petitions because our clients do not come to us at the stage of receiving a notice of deficiency.  When we do file a Tax Court petition in response to a notice of deficiency, we sign the petition unless the taxpayer comes to us at the last second, preventing us from verifying the information in the petition.  In cases where the taxpayer shows up at the last second, we will assist the taxpayer in preparing a petition, have the taxpayer file the petition pro se, and obtain a power of attorney.  In most Tax Court cases worked by the clinic, the taxpayer comes to us because of the stuffer notice issued by the Tax Court after the individual has filed their petition.  In those cases, we do not typically enter an appearance but rather obtain a power of attorney.  I use the power of attorney rather than entering an appearance because I want the taxpayer to demonstrate to me that they will work with me to resolve the case and also because I want time to verify the information the taxpayer brings to the initial meeting before I jump in with an entry of appearance that requires court permission to undo.  For a cautionary tale on entering an appearance in a Tax Court case before you know your client see the post by guest blogger Scott Schumacher.

Chief Counsel’s office has struggled over the past decade in which I have worked in tax clinics about what to do with practitioners who obtain a power of attorney but do not enter an appearance in the Tax Court case.  On April 18, 2017, it issued Notice CC-2017-006 which is the latest, and the best, statement about how it will deal with practitioners like me who seek to represent clients in Tax Court cases using a power of attorney.  The latest notice supplements Chief Counsel Notice CC-2014-003 which replaced Chief Counsel Notice CC-2013-005.  I blogged about the 2013 notice here.  The latest notice amends prior notices based on the American Bar Association (ABA) Committee on Ethics and Professional Responsibility Formal Opinion 472 which provides guidance with respect to communication to persons receiving limited scope legal services.

For those of you following changes in the leadership of Chief Counsel’s Office, Notice CC-2017-006 is signed by Kathy Zuba as the Acting Associate Chief Counsel (Procedure & Administration).  Kathy replaces Drita Tonuzi who has become the Deputy Chief Counsel (Operations) following the retirement of Debra Moe.

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Tax Court Rule 201(a) tells practitioners before the Court to practice in accordance with the ABA Model Rules of Professional conduct making the opinions of the ABA Ethics committee more important in Tax Court practice than they might be elsewhere.  ABA Model Rule 4.2 provides that, “in representing a client, a lawyer shall not communicate about the subject of the representation with a person the lawyer knows to be represented in the matter, unless the lawyer has the consent of the other lawyer or is authorized to do so by law or a court order.”  The requirement that a lawyer (government or private) communicate with a party’s representative only applies to communications covered by the scope of the representation and only where “the lawyers knows that the person is in fact represented in the matter to be discussed.”

ABA Formal Opinion 472 gives guidance in situations in which the represented party has an attorney for some but not all aspects of the matter.  The Opinion requires the attorney to communicate with the opponent’s attorney if the communication concerns “an issue, decision, or action” covered by the limited representation.  If the matter is outside the scope of the limited representation then Model Rule 4.3, not 4.2, governs the communication.  The Opinion provides that when an attorney has “reason to know” the other party “may be represented with respect to some portion of a matter” the attorney should inquire about the nature and scope of the representation and not close their eyes to the obvious.

ABA Model Rule 4.2 must be read in conjunction with the Tax Court rules on representation in a Tax Court proceeding.  Tax Court Rule 24(b) provides that a petitioner who has not had counsel enter an appearance is deemed to be appearing “on the party’s own behalf.”  This rule limits what a representative with only a POA can do in Tax Court.  Such a representative cannot sign documents filed with the court such as a stipulation of fact or a decision document.  Such a representative also cannot stand up in court and speak on behalf of the client.

The Notice concludes, that despite the limitations placed on a representative operating only with a POA in the Tax Court case, Opinion 472 requires Chief Counsel attorneys to communicate with the limited scope representative “when the communication concerns an issue, decision, or action that is within the scope of the limited representation.”  The Notices also directs Chief Counsel attorneys to ask the taxpayer if he or she is represented “in some or all aspects of the Tax Court case” and further directs them to contact the limited scope representative if the taxpayer’s response does not make the scope clear.

Most Chief Counsel offices have probably already been operating more or less as the Notice provides.  For the offices that have not treated the POA as something requiring  recognition in a Tax Court case, the new Notice will make it easier for the POA to handle the case.  Working with a POA should generally make it easier for the Chief Counsel attorney.  I have experienced very little difficulty working with Chief Counsel’s office with a POA and hope the attorneys there with whom I have worked feel the same in working with the clinic.  We understand the limitations and regularly enter an appearance at some point after starting out with a POA.  The POA gives flexibility in situations in which the client needs immediate assistance but you are trying to come to an understanding of the case and sometimes an understanding of the client.  It allows you to give and get information from Chief Counsel and Appeals as you make a decision concerning whether to enter an appearance and provide full scope representation.  The Notice may not change the practice in many places but does provide a good statement of how the parties can work together in a Tax Court case even without an entry of appearance.

Counsel Clarifies the Limited Rights of Unenrolled Preparers in Tax Court Cases

Taxpayers who have filed a petition in Tax Court often still rely on their tax return preparers to help try to resolve the matter. Most unlicensed tax return preparers are not admitted to practice before IRS Counsel attorneys. Despite that, in a 2014 Chief Counsel notice the IRS emphasized that Counsel attorneys should interact with a taxpayer’s representative if there is a valid POA on file authorizing the representative to act on the taxpayer’s behalf.

Last week, in  Notice CC-2017-007 Counsel clarified its earlier procedure and discussed issues relating to a representative who is an “Unenrolled Return Preparer.”

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As we have discussed before, following the judicial rejection of the Service’s plan to require unlicensed preparers to pass a test and complete continuing education requirements, the Service launched a voluntary testing and education program called the Annual Filing Season Program (see for example Some More Updates on IRS Annual Filing Season Program and Refundable Credit Errors). Under that program, unlicensed preparers take 18 hours of continuing education and take a test on federal tax law. The return preparer seeking to obtain certification of compliance with the annal filing season program must also renew their preparer tax identification number (PTIN) and consent to adhere to and be subject to the obligations in Circular 230 addressing duties and restrictions to practice before the Service and Circular 230 § 10.51, which addresses sanctions and disreputable conduct. The benefits of opting in to the Annual Filing Season Program include becoming part of a searchable database of preparers and the right to represent taxpayers in examinations, though not before Appeals, Counsel or Collection.

That representation ability is a key perk for unenrolled preparers; it generally was available to all signing preparers before 2015 though by now limiting representation to the unenrolled preparers who comply with the Annual Filing Season Program, the Service has hoped to generate interest in and demand for what it required through its ill-fated mandatory testing and education regime.

Form 2848 specifically now has a designation for the class of unenrolled preparers who opt in to the Annual Filing Season Program; designation “h”, which is for “Unenrolled Return Preparer.”

Last week’s Chief Counsel notice discussed the limits of these representational rights for Unenrolled Return Preparers. Most importantly, representation is still limited to matters involving examination of a tax return. A challenge for the Service is drawing the line between assistance in an exam matter and in a matter that progresses beyond an exam because the taxpayer, often with shadow assistance by an unlicensed preparer, has filed a petition in Tax Court. Despite the limits of the representational powers of unenrolled return preparers, in the current Chief Counsel Notice the Service clarified that “if the involvement of an unenrolled return preparer is beneficial to the resolution of the case, Counsel attorneys may work with the unenrolled return preparer, in a non-representative capacity, to develop the facts of a case.”

In the Notice, Counsel thus takes a practical approach to the issue. Most cases in Tax Court involve pro se taxpayers, and many disputes in court revolve around facts. My experience is that in many instances the involvement of a third party can assist in the resolution of the case. The 2017 Chief Counsel Notice states that the preparer may assist the taxpayer in gathering information or in substantiation of items on the return, and that Counsel attorneys may permit the preparer to attend meetings.

The Notice does remind its attorneys to clarify with the taxpayer and the preparer that for the unenrolled return preparer there is no general authority to represent taxpayers in Tax Court cases, and that Counsel has no obligation to communicate with the preparer or even include the preparer in meetings if the preparer is abusive or if the interests of the preparer conflict with the interests of the taxpayer.

There are a couple of points worth highlighting in the Notice. First, with the increased reach of special due diligence penalties applying to more refundable credits, it is becoming somewhat more likely that a conflict between a preparer and a taxpayer may arise. In addition, as with other third parties who are not representatives of a taxpayer, Counsel’s communications with unenrolled preparers could expose the Service to possible 6103 violations if the communications proceed without the involvement of the taxpayer. As such, the Notice reminds its attorneys that it should communicate with the unenrolled preparer only if the taxpayer “is present, either in person or on the telephone, or in the unenrolled return preparer’s capacity as a third party record keeper or a potential witness.” In addition, because I suspect that taxpayers may not fully appreciate the limited powers of unenrolled preparers, the Notice states that to “avoid confusion Counsel attorneys should clarify with both the petitioner and the unenrolled return preparer that unenrolled return preparers do not have the authority to represent petitioners in dealings with Chief Counsel, even if the petitioner purports to consent to the representation.”

Conclusion

In sum, the Notice seems helpful for all parties. As taxpayers become more familiar with the limits associated with preparers who have not opted in to the Annual Filing Season Program, the Service encourages what it could not mandate; that is, the use of preparers who in fact have demonstrated some minimal level of competence and who demonstrate the additional accountability and visibility associated with the annual filing season program. I think that the approach of providing the incentive to use some preparers as compared to others, so long as that incentive is tied to furthering the goal of good tax administration rather than lining the pockets of some preparers over others, is a good model for IRS oversight over an industry that plays a key role in tax administration.

False Return Conviction Provides Basis for Collateral Estoppel to Prevent Discharge

For a brief period the Tax Court treated a conviction for filing a false return, IRC 7206(1) as the basis for sustaining the civil fraud penalty using collateral estoppel.  The period ran from the decision in Considine v. Commissioner, 68 T.C. 52 (1977) to its reversal in Wright v. Commissioner, 84 T.C. 636 (1985) (reviewed).  In the recent unpublished bankruptcy appellate panel (BAP) case of Terrell v. IRS, BAP No. WO-16-007 (Bankr. 10th Feb 17,2017), the 10th Circuit BAP sustained the decision of the bankruptcy court and held that a guilty plea for filing a false return provides the basis for collaterally estopping the debtor from challenging the discharge of his taxes for the year of the plea.  Though unpublished, the opinion, without much analysis, pushes the scope of collateral estoppel on the issue of criminal conviction and civil fraud toward a more favorable position for the IRS.  Reasons exist for drawing a distinction between collateral estoppel in the bankruptcy discharge context and civil fraud penalty.  Had the court articulated those reasons, I would have come away from the opinion with a more comfortable feeling.

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The Tax Court opinions, cited above, determining first that collateral estoppel applies to civil fraud and then subsequently determining it does not provide lengthy analysis concerning the scope of a false return plea.  From the perspective of punishment both tax evasion, IRC 7201, and filing a false return will get the taxpayer to the same prison sentence almost every time.  Because the elements of the two crimes differ slightly and because proving the filing of a false return is slightly easier, prosecutors lean towards a false return conviction at times. Chief Counsel attorneys used to complain bitterly when Assistant United States Attorneys would accept a plea to a false return count rather than evasion because it meant a lot more work in the subsequent civil case; however, the change to 6201(a)(4) to allow assessment of the restitution amount may have taken some of the sting off of the situation.

The difference in the elements of the two crimes plays a role in deciding whether collateral estoppel applies.  The Tax Court examined this difference closely in its opinions applying the elements of the crimes to the civil fraud penalty while the BAP does not do spend as much time applying the elements of the crime to the elements of the applicable discharge statute.

In Considine the Tax Court reasoned:

(a) that it had previously held that a conviction for willfully attempting to avoid tax (I.R.C. § 7201) established fraudulent intent justifying a civil fraud penalty, see Amos v. Commissioner, 43 T.C. 50, aff’d, 360 F.2d 358 (4th Cir. 1965); (b) that the Supreme Court had held that “willfully” has the same meaning in section 7206(1) (false return) as in section 7201 (attempt to evade tax), see United States v. Bishop, 412 U.S. 346, 93 S.Ct. 2008, 36 L.Ed.2d 941 (1973); and (c) therefore that a conviction for filing a false return, without more, establishes fraud justifying the civil penalty.

Considine v. United States, 683 F.2d 1285, 1286 (9th Cir. 1982)(the 9th Circuit criticizes the Tax Court’s decision in citing to Considine v. Commissioner, 68 T.C. at 59-61)

In reconsidering and reversing Considine, the Tax Court in Wright stated:

“In a criminal action under section 7206(1), the issue actually litigated and necessarily determined is whether the taxpayer voluntarily and intentionally violated his or her known legal duty not to make a false statement as to any material matter on a return. The purpose of section 7206(1) is to facilitate the carrying out of respondent’s proper functions by punishing those who intentionally falsify their Federal income tax, and the penalty for such perjury is imposed irrespective of the tax consequences of the falsification. As noted above, the intent to evade taxes is not an element of the crime charged under section 7206(1). Thus, the crime is complete with the knowing, material falsification, and a conviction under section 7206(1) does not establish as a matter of law that the taxpayer violated the legal duty with an intent, or in an attempt, to evade taxes.” (internal citations omitted)

The IRS Chief Counsel’s office at page 63 of its Tax Crimes Handbook states that “there is no collateral estoppel as to civil fraud penalties under this section. The section 7206 (1) charge is keyed into a false item, not a tax deficiency. Collateral estoppel arises only with a conviction or guilty plea to tax evasion.”  Similarly, IRM 25.1.6.4.3 provides that “A conviction under IRC 7206(1), filing a false return, does not collaterally estop the taxpayer from asserting a defense to the civil fraud penalty since conviction under IRC 7206(1) does not require proof of fraudulent intent to evade federal income taxes. In these cases, additional development is required to establish the taxpayer’s intent to evade assessment of a tax to be due and owing.”

At issue in Terrell is whether the his guilty plea for a false return places him squarely within the elements of 523(a)(1)(C).  Section 523 of the bankruptcy code sets out the actions with respect to individual debtors that prevent, or except, the discharge of a debt.  Congress has added to the list over the years since the adoption of the bankruptcy code in 1978.  The list of excepted debts in 523 numbers 19 and several of those 19 subparagraphs of section 523(a) have more than one basis for excepting the debt from discharge.

The provision relating to tax debts, 523(a)(1), has three separate bases for excepting a debt from discharge.  Subparagraph (A) excepts debts that achieve priority status under section 507(a)(8).  This subparagraph, in general terms, prevents debtors from discharging relatively new tax debts.  Subparagraph (B), which has been the subject of many posts, prevents debtors from discharging tax debts for which the debtor has never filed a return or filed a late return within two years of the filing of the bankruptcy petition.  Subparagraph (C) at issue in this case prevents debtors from discharging tax debts “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

The question before the BAP concerns the language of the discharge exception for making a fraudulent return and the language of IRC 7206(1) for filing a false return.  Section 7206(1) holds a taxpayer liable for a felony tax offense if he “willfully makes and subscribes any return, statement, or other document, which contains or is verified by a written declaration that it is made under the penalties of perjury, and which he does not believe to be true and correct as to every material matter.”  Does this statute, which does not require any understatement of tax but merely a false statement, match the elements of bankruptcy code section 523(a)(1)(C) such that the conviction under IRC 7206(1) requires a finding of collateral estoppel regarding the discharge of the underlying taxes.

The BAP, after acknowledging that Mr. Terrell presented “no arguments as to why the bankruptcy court’s application of collateral estoppel was in error” says yes because (1) “the issue in the Criminal Case is identical to the issue presented in the Adversary Proceeding” because the same factual issues existed in both statutes; (2) his “guilty plea in the Criminal Case constitutes a full adjudication on the merits”; (3) both the debtor and the IRS were parties to the criminal case; and (4) the debtor “had a full and fair opportunity to litigate the Criminal Case.”

The language in 523(a)(1)(C) “made a fraudulent return” may sufficiently line up with the language of IRC 7206(1) to allow collateral estoppel to work here but I would like the court to work a little harder to make that connection for me.  The Tax Court eased into a similar conclusion with respect to the fraud penalty and an IRC 7206(1) conviction and then had to walk it back after the 9th Circuit brought its attention to the elements of that crime.  The standard of proof for the IRS in a 523(a)(1)(C) case is preponderance of evidence unlike the clear and convincing standard needed for sustaining the civil fraud penalty.  There are certainly differences between the Considine situation and the Terrell case but enough similarities to deserve more analysis.  I am not yet convinced.

Court Allows IRS to Proceed With Summons Issued to Taxpayer in the Medical Marijuana Business

Last week’s article in the New York Times Legal Marijuana Ends at Airport Security, Even if It’s Rarely Stopped discusses the increasingly odd situation of passengers who are legally entitled to possess and use marijuana finding themselves at risk when they transport marijuana across state lines, even if the air travel originates and ends in states where the possession and use is legal. The federal income tax treatment of the marijuana industry likewise reflects an odd reality: those in the business are expected to pay tax on their sizeable profits, yet Section 280E prohibits those in the business from claiming deductions that they would be entitled to if they were trafficking in other products that did not constitute a controlled substance under federal law.

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In the NYT article, a spokesperson for TSA stated that it does not actively look for marijuana when it screens passengers; yet if an agent comes across it in her screening (as an agent did with my banana and apple I forgot about placing in my wife’s carry on bag on our flight last month from Frankfurt), she will alert local law enforcement.

In contrast with TSA, IRS appears to be pretty active in enforcing its mandate under Section 280E.  High Desert Relief v US, out of a district court in New Mexico, highlights a couple of procedural issues, including the IRS’s ability to use its considerable summons powers to gather information about the businesses and their compliance with the federal civil tax laws.

High Desert Relief (HDR) operates a legal medical marijuana business in New Mexico (its motto is “relief through high quality medicine”). IRS began examining its 2014 and 2015 tax years, and as part of the examinations it issued third party summonses to a bank and the New Mexico Department of Health and another state agency.

HDR sought to quash the summonses, essentially on the ground that the IRS could not satisfy the Powell requirements that its actions were conducted pursuant to a legitimate purpose because IRS was using its civil summons powers to conduct a criminal investigation. The government responded and included an affidavit from the Revenue Agent, claiming that she issued the summonses to “assess the correctness of [HDR’s] returns and determine if HDR has unreported taxable income” and to “substantiate the gross receipts reported in HDR’s tax returns.”

As part of its argument, HDR claimed that Section 280E requires a “finding of criminal behavior” that is beyond what was needed in the summary summons process. Unfortunately for HDR, a number of cases have already rejected this and similar arguments. Section 280E, though referencing a criminal statute, does not require any outside determination that a crime has been committed. Quoting from a 2016 federal district court case out of Colorado, Alpenglow Botanicals v US, the opinion explained that

[t]rafficking as used in § 280E means to buy or sell regularly. Californians Helping to Alleviate Med. Problems v. C.I.R., 128 T.C. 173, 182 (T.C. 2007). As such, the real issue here is whether the IRS has authority to determine if, in the course of plaintiffs’ business, they regularly bought or sold marijuana. The Court cannot understand why not. Such a determination does not require any great skill or knowledge, certainly not skill or knowledge of a criminal investigatory bent….

While Section 280E references a criminal statute, as the HDR court explained, IRS civil examinations can investigate “whether a party violates the [Federal Controlled Substances Act] without conducting a criminal investigation.”

There were a couple of other arguments worth highlighting. HDR argued that the information was available for the IRS; under US v Powell, in establishing that the summons was issued in good faith, IRS must show that the information was not already in the Service’s possession. HDR had claimed it made all the requested information available to the IRS. Yet, in making the information available, HDR conditioned its release on it getting “assurance from the IRS, that the IRS will use the information furnished for this civil audit, and not to support the IRS’s determination that the Taxpayer’s business consists of illegal activities.”

The court found that this conditioned availability was not enough. In addition to HDR not showing that there was a complete overlap between the requested documents and what HDR offered to make available, the court pointed to Section 6103(i). That, in certain situations, requires IRS release of tax return information for other federal laws not relating to tax administration. Restricting the IRS’s use of the information was not the same as providing the requested information.

Another issue in the case received relatively little attention and perhaps is the meatiest of the procedural issues. HDR argued that it was not given sufficient notice of the IRS’s use of a third party summons. Section 7602(c) (1) states that during an IRS inquiry and IRS employee may not contact a third party “with respect to the determination or collection of the tax liability of such taxpayer without providing reasonable notice in advance to the taxpayer that contacts with persons other than the taxpayer may be made.”

The IRS argued that its sending to HDR a Publication 1 was sufficient notice. That publication, which IRS sends to every taxpayer subject to audit, states the following:

            Potential Third Party Contacts

Generally, the IRS will deal directly with you or your duly authorized representative. However, we sometimes talk with other persons if we need information that you have been unable to provide, or to verify information we have received…. Our need to contact other persons may continue as long as there is activity in your case.

Without analysis, the district court in New Mexico found that the generic publication was adequate for purposes of Section 7602(c)(1). As I recently described in the revision to the Saltzman Book IRS Practice and Procedure treatise in the chapter on examinations at 8.7[4] Third Party Contacts and in Chapter 13 addressing the IRS summons power, last year in Baxter v US a federal district court in California concluded that in fact the generic notice is insufficient to meet IRS’s notice requirements for these purposes. The district court held that the government had to tell the taxpayer which third party it was going to contact. This issue deserved a little more attention in the opinion, and as I have noted in the Saltzman write up, the courts are applying Section 7602(c)(1) and reaching differing outcomes. IRS in years past given more specific notice but lately has defaulted to its Pub 1 for these purposes. The current IRS approach seems to be inconsistent with regulations and Congressional purpose in enacting the notice provisions, and I suspect that other courts will give this issue greater attention.

A final issue in HDR is worth mentioning. The taxpayer argued that the “federal criminal drug laws with respect to state-legal marijuana sales [are] dead letter.” As such, it looked to old cases under Section 162 that allowed beer and liquor distributors deductions for activities that technically violated state laws, such as gifting beer or providing rebates to distributors. States turned a blind eye to those practices and did not enforce the laws prohibiting them. The main difference is that while Section 162 disallows deductions for activities in violation of state law, the Code itself provides that the limitation on deduction under Section 162 only applies if the state law is “generally enforced.” No such limitation appears in Section 280E.

The bottom line for HDR is that Section 280E does not in any way limit the government’s broad reach to access documents and information in a civil examination. The tax system thus contributes to the schizophrenic legal approach to the marijuana business. While the federal government is willingly collecting tax revenues and enforcing the internal revenue laws, the marijuana industry operates on a different substantive plane.

What is a “Record” for FOIA

In today’s post, I am covering a somewhat stale, non-tax holding in American Immigration Lawyers Association v. Executive Office for Immigration Review (“AILA”), a case dealing with a FOIA request “seeking disclosure of records related to complaints about the conduct of immigration judges.”  It will also touch on the DOJ response to the case, which was issued in January.  Perfect for a tax procedure blog that tries to stay somewhat current.  The case, decided by the DC Circuit, is important, however, because the determination of what could be redacted from a record, once it is determined the record was responsive to the FOIA request.  Specifically, whether non-responsive aspects of the record could be redacted (spoiler – Sri Srinivasan says “no”). This has far reaching potential consequences with FOIA requests beyond the narrow scope of the request, including to FOIA requests made in relation to tax cases or requests for information about how the Service administers the laws.

The substance of the case does not matter much for this discussion, although it is interesting that such terrible allegations have repeatedly been made against the immigration judges.  Various complaints included disrespectful and at times racist treatment of defendants, and sometimes fairly reprehensible treatment of counsel.  Unfortunately, this is probably old hat for people who work in this system; makes me somewhat thankful when I do catch a helpful Appeals Officer or Revenue Agent or the quality work usually done by the tax court.  In this case, AILA requested all information relating to complaints about the immigration judges.  Interestingly, I believe some faulty redacting relating to this case may have resulted in the summary of the complaints being released, along with the judges’ names. I just redacted the heck out of about 1500 pages using Adobe, and now I am a little nervous.  I would assume the FOIA folks redact far more frequently than me.

Procedurally, FOIA generally requires the feds to make certain information available to the public, but subject to nine exceptions.  See 5 USC § 552(a).   The pubic is allowed to request the documents, and the agency must provide them, but has the ability to withhold the documents if the entire document is subject to an exemption, or can redact portions that are properly withheld and provide the rest of the document.  The exemptions can be found listed here.  For those of you interested in learning all about the intersection of FOIA and tax practice and procedure, Les recently updated chapter 2 of SaltzBook, which covers this in great detail, including all the exemptions and how to use FOIA requests in your practice.

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In AILA, what is important is that various documents were found that were responsive to the extensive requests made.  Many of those documents contained portions that were responsive to the request, and portions that were responsive but also fit into one of the exemptions.  Aspects of some of the documents were also non-responsive.  Meaning, portions of the documents did not relate to the request that was made.  Agency practice, I believe including the IRS, was to redact all portions of the document that were exempt, and also to redact all the portions of the document that were non-responsive to the request.  When in doubt, keep it out.

This practice had been somewhat sanctioned by various district courts, and was in question in AILA.  The DC Circuit, however, disagreed with the district courts.  In discussing the “ostensibly non-responsive material” (you know this isn’t going to go your way when “ostensibly” is applied to your position), the Court noted that the government’s position was that it was not under any obligation to release information concerning matters unrelated to the FOIA request.  Not a wholly absurd position.  In the Vaughn index, examples were given as to why the portions of the documents were not responsive, such as information relating to the judge needing to clean his/her office, and vacation plans.   That is all interesting, but not germane to the request.

Although the lower court and other district courts had addressed this issue, it was the first time the DC Circuit had taken the matter up.  The Court began by providing some background information, stating FOIA requires “’each agency, upon any request for records which (i) reasonably describes such records and (ii) is made in accordance with published rules stating time, place, fees (if any), and procedures to be followed, shall make the records promptly available to any person.’ 5 USC § 552(a)(3)(A).” Further, in “responsive records” certain portions may be redacted pursuant to the exemptions.  The only provisions, however, related to responsive records, and withholding information, is found within those exemptions.  The court stated, FOIA creates a process for an agency to follow when responding to a FOIA request:

First, identify responsive records; second, identify those responsive records or portions of responsive records that are statutorily exempt from disclosure; and third, if necessary and feasible, redact exempt information from the responsive records. The statute does not provide for…redacting non-exempt information within responsive records.

Relying on a handful of SCOTUS cases that required FOIA exemptions to be narrowly construed, the Court did not see how it could authorize the redacting of aspects of records that were found to be responsive.  As stated above, the manner in which agencies generally redacted was contrary to this holding.

We do not know the exact significance of the holding yet, and the Court somewhat foreshadowed what impact this case may have.  The Court stated:

The practical significance of FOIA’s command to disclose a responsive record as a unit…depends on how one conceives of a “record.”  Here the parties have not addressed the antecedent question of what constitutes a distinct “record” for FOIA purposes…for purposes of this case, we simply take as a given [the government’s] own understanding of what constitutes a responsive “record,” as indicated by its disclosures…

Although FOIA includes a definition section…that sections provides no definition of the term “record.”  Elsewhere, the statute describes the term record as ‘include[ing] any information that would be an agency record…when maintained by an agency in any format, including an electronic format’…but that description provides little help in understanding what is a “record” in the first place.”

In the text of the case, the Court compares the definition of “record” under FOIA to the definition of record under the Privacy Act, which states it is “any item, collection, or grouping of information.” See 44 USC § 2201(2).  Although not completely clear, it is more instructive than no definition at all.

In AILA, the Court’s holding was clearly not going to sit well with the government, but the Court provided the framework for each agency to rethink how it approached FOIA requests in a manner that mitigated what the agencies viewed as a negative holding.  The DOJ somewhat took them up on that offer.  In January of 2017, Office of Information Policy released guidance entitled, “Defining a ‘Record’ Under FOIA” addressing the holding in AILA.  The guidance notes that after AILA, “it is not permissible to redact information within a record as “non-responsive.”  It also highlighted the fact that the Court looked to the “sister statute” of FOIA, The Privacy Act, 5 USC 552a(a)(4) for the potential definition of “record” as “any item, collection, or grouping of information.”

From this, the guidance encouraged the agencies to use the Privacy Act definition and use a “more fine-tuned, content-based approach to the decision,” as to what a record is, and determine if an entire document is the record, or just a page, or just a paragraph.  In AILA, the Court stated it may be impossible to withhold one sentence of a paragraph, and DOJ agreed.  The guidance provided some practical pointers about how an agency must then report the number of records the agency has that is responsive.  It should also clearly identify each record and if it contains multiple subjects so “the requester can readily see why and how the agency divided the document into distinct ‘records’.”

AILA was a substantial departure from how agencies, including Treasury, and the Service, handled FOIA responses.  The case, however, provided a roadmap to mitigate the shift, which the Government apparently will seek to implement.  The practical impact may be less overall pages, but with less redaction.

 

Multiple Appellate Courts Again to Weigh in on Meaning of Freytag

We welcome back frequent guest blogger, Carl Smith.  Carl writes about the ongoing litigation seeking an answer to the status of the Tax Court within our constitutional framework and other issues spun out by Freytag.  Keith 

In Freytag v. Commissioner, 501 U.S. 868 (1991), the Supreme Court held that the Appointments Clause did not prohibit the Tax Court’s Chief Judge from appointing Special Trial Judges because the Tax Court was one of the “Courts of Law” mentioned in the Clause and because the Chief Judge could act for the Tax Court.  In reaching these rulings, the Supreme Court made subsidiary holdings that have puzzled the lower courts.  Two subsidiary holdings in particular are being disputed currently in the Courts of Appeals:

First:  Did the Supreme Court’s observation that Tax Court Special Trial  Judges can enter final decisions in some cases under what is today § 7443A(b)(7) mean that, in order to be an “Officer” of the United States subject to the Appointments Clause procedures (as opposed to being a mere employee), a government worker must have the power to enter final rulings on behalf of the government?

Second:  Subsidiary to its holding that the Tax Court was one of the Courts of Law, in which, if any, Branch of the federal government did the Supreme Court place the Tax Court?

This brief post tells the reader where and when the Freytag subsidiary holdings are currently being litigated in the Courts of Appeals.

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Who is an Officer?

As to the first subsidiary issue – the finality of rulings to be an Officer – in 2000, the D.C. Circuit in Landry v. FDIC, 204 F.3d 1125, held that Freytag required that Officers have final ruling authority, and since FDIC ALJs did not have such authority, FDIC ALJs need not be appointed under the Appointments Clause.  Relying on Landry, the Tax Court in Tucker v. Commissioner, 135 T.C. 114, 165 (2010), affd. on different reasoning 676 F.3d 1129 (D.C. Cir. 2012), held that because rulings by Appeals in CDP are not “final” (according to the Tax Court), Appeals Team Managers and Settlement Officers conducting CDP hearings need not be appointed, either.  Also relying on Landry, the D.C. Circuit last year in Raymond J. Lucia Cos., Inc. v. SEC, 832 F.3d 277, held that because SEC ALJs do not exercise final authority (the SEC does), SEC ALJs do not need to be appointed.

I have reported on the fight over the constitutionality of the lack of appointment of SEC ALJs and its possible impact on whether ALJs borrowed by the Treasury to hold Circular 230 sanctions hearings need to be appointed, as well, in several blog posts (here, here, here, and here).  In my most recent post, I noted that the Tenth Circuit in Bandimere v. SEC, 844 F.3d 1168 (Dec. 27, 2016), rejected Landry and held that Freytag does not require that a federal worker exercise final ruling authority before having to be appointed under the Appointments Clause, and so SEC ALJs, because of their extensive judge-like powers on important topics, needed to be appointed.  I predicted that this Circuit split over SEC ALJs would shorty end up before the Supreme Court.

Well, I was at least premature.  The D.C. Circuit is trying to avoid the Circuit split.  Instead, on May 24, it will rehear Lucia en banc over the issues of whether Landry misinterpreted Freytag and whether the D.C. Circuit should overrule Landry in favor of the Bandimere holding.

As an aside for those interested in separation of powers issues, the D.C. Circuit that day will also rehear en banc the earlier panel holding that the Consumer Financial Protection Bureau is not constitutionally formed because the Bureau is headed only by a single Director.  PHH Corp. v. CFPB, 839 F.3d 1 (Oct. 11, 2016) and 2017 U.S. App. LEXIS 2733 (Feb. 16, 2017) (“If the en banc court, which has today separately ordered en banc consideration of Lucia v. SEC, 832 F.3d 277 (D.C. Cir. 2016), concludes in that case that the administrative law judge who handled that case was an inferior officer rather than an employee, what is the appropriate disposition of this case?”).

In Which Branch is the Tax Court Located?

As to the issue in Freytag about the Branch in which the Tax Court is located, this issue has come up in litigation over the validity of the President having a removal power over Tax Court judges in § 7443(f).  In Kuretski v. Commissioner, 755 F.3d 929 (D.C. Cir. 2014), cert denied 135 S. Ct. 2309 (2015) (on PT last blogged here and here, the D.C. Circuit found that there was no interbranch removal separation of powers issue because the Tax Court, like the President, was located in the Executive Branch – and Freytag’s language was not to the contrary.  In Battat v. Commissioner, 148 T.C. No. 2 (Feb. 2, 2017), the Tax Court recently rejected Kuretski’s holding that the Tax Court per Freytag was part of the Executive Branch and instead held that per Freytag the Tax Court was located somewhere else (though the Tax Court wouldn’t say exactly where).  Still, the Tax Court in Battat felt that the removal power, even though interbranch, did not run afoul of the separation of powers doctrine because the Tax Court doesn’t decide cases that could be heard by courts at common law.

In a recent post, I noted that Joe DiRuzzo and his firm had a number of cases in which the removal power issue was challenged pre-trial (as in their Battat case).  Joe had sought permission from the Tax Court for interlocutory appeals under § 7482(a)(2)(A), but the Tax Court had refused to authorize interlocutory appeals.  Well, Joe doesn’t easily take “no” for an answer.  And in light of the fact that the Tax Court said it only could decide the removal power issue under the rule of necessity – since all of its judges were inherently implicated and biased by the potential validity of the removal power – I don’t blame Joe for not taking a “no” from the Tax Court this time.  He has in fact appealed four of his firm’s cases that present the Battat issue, on an interlocutory basis, to three different Courts of Appeals:  Teffeau v. Commissioner, Tax Court Docket No. 27904-10, Fourth Cir. Docket No. 17-1463 (opening brief due May 22); Elmes v. Commissioner, Tax Court Docket No. 22003-11, Eleventh Cir. Docket No. 17-11648 (opening brief due May 22); Thompson v. Commissioner, Tax Court Docket No. 6613-13, Ninth Cir. Docket No. 17-71027 (opening brief due June 29); and Battat v. Commissioner, Tax Court Docket No. 17784-13, appealed to the Eleventh Circuit, but no docket number yet available from the Eleventh Circuit.  Interestingly, Joe had moved to invalidate the notice of deficiency in Elmes under the reasoning of Scar v. Commissioner, 814 F.2d 1363 (9th Cir. 1987), but that motion was denied in an order (found here:  https://www.ustaxcourt.gov/UstcDockInq/DocumentViewer.aspx?IndexID=7089658) issued on April 17, 2017 – several days after Joe appealed the case to the Eleventh Circuit.

We will keep you updated on developments in all of these Freytag-related appeals.