Stephen Olsen

About Stephen Olsen

Stephen J. Olsen’s practice includes tax planning and controversy matters for individuals, businesses and exempt entities for the law firm Gawthrop Greenwood, PC.

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Can Intentionally Filing an Improper Information Return Justify a Claim for Damages Under Section 7434?…Part II

In last Friday’s post, I outlined aspects of the private cause of action for fraudulent information returns under Section 7434, and specifically discussed some case law on whether or not an intentionally incorrect form could give rise to fraud under Section 7434 or if there had to be a fraudulent amount stated on the form.  The current trending opinion on this matter is that the amount must be fraudulent, not just the form, and the primary holding in this area is Liverett.  Today’s post will discuss the specific rationale in Liverett, and why I think the statute may be open to other interpretations.

In Liverett, the specific facts are not that important.  A worker thought she should have been an employee, but was treated as an independent contractor by her employer and issued a Form 1099-Misc.  The worker brought a Section 7434 claim against the employer, and also brought wage and overtime claims under the Fair Labor Standards Act.  The Liverett Court noted the prior cases in this area, but stated there was not an exhaustive analysis of the statute.

In reviewing the statute, the district court found the language of Section 7434 was ambiguous, stating:

This statute, at first glance, appears quite simple and straightforward. But, a more careful reading reveals that it harbors a significant ambiguity, the resolution of which impacts this case.

The source of the ambiguity in [Section] 7434(a) is the phrase “with respect to payments purported to be made to any other person.” Simply put, there is ambiguity as to what the phrase “with respect to…” modifies. On the one hand, [Section] 7434(a) may refer to an “information return with respect to payments purported to be made to any other person” that is “fraudulent.” On this reading, “with respect to…” describes “information return,” and such an information return that is false or misleading in any respect aimed at obtaining something of value is “fraudulent” and therefore actionable. On the other hand, “with respect to payments purported to be made to any other person” may be read as limiting “fraudulent.” Under this interpretation, the filing of an information return is actionable only if the information return is false or misleading as to the amount of payments purportedly made.

After coming to this conclusion, the court had to attempt to ascertain the meaning of the statute, which it concluded meant that the fraud had to be in the amount of the payment and not the form.  It came to this conclusion based on statutory construction, the legislative history, and the fact that the plaintiff had other federal statutes available to make claims under.  The court’s rationale is plausible under each, but I think there could be other interpretations.

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Before discussing each of the rationales below, I do want to reiterate this review was done because the court concluded the statute was ambiguous.  Various courts that previously reviewed this matter did not flag this issue, so it might be possible to argue there is no ambiguity.  Most people I have spoken with, upon initial reading of Section 7434, assume it means any fraud related to the information return.  For purpose of the remainder of the post, however, I will assume that the statute is ambiguous.

I think the statutory construction rationale provided by the court was the strongest, and I suspect the rationale that convinced other courts to follow suit.  The Court noted that the placement of the term “fraudulent” prior to the term “information return” was evidence of a broader interpretation, but said other statutory construction tenets required a more nuanced look.  The Court then looked to the definition of “information return” under Section 6724, which is “a statement of the amount of payments to another person”.  When that is read into Section 7434(a), the statute reads the private cause of action addresses “a fraudulent [statement of the amount of payments to another person] with respect to payments purported to be made…”  The Court concluded that reading the definition into the statute shows that if “with respect to payments” modifies information returns, then the language is redundant.

The court then states, “[i]n other words, an ‘information return,’ by definition, relates to the amount of payments to a person.”  It then concludes that if “with respect to payments made” has to modify fraudulent, and not “information return”, and therefore must pertain to an incorrect payment amount.

There are two separate conclusions here, which possibly both could be interpreted differently.  First, is the conclusion that “with respect to payments” must modify “fraudulent”; otherwise it is superfluous.    This reading ignores that information returns contain information beyond the payment amount, and seems to be based on definition of information return referring to payments.  The definition quoted, however, is not the entire definition from Section 6724.  After the quoted language above, the section continues to say “required by” and then a list of various Code sections requiring information returns.  Those various other Code sections have lots of other requirements of information to be included on the information returns, not just the payment amount.  If you read the full language of Section 6724, along with the requirements in the internally referenced Code Sections, then “with respect to payments” acts as limiting language to cause Section 7434 to only apply to the “payment” shown on the information return, which, by definition, has a broad range of other information included.  I’m not sure I love that interpretation, because I would rather any fraudulent information on the return be included, but it does show that there are other interpretations of the statute and that the above rationale ignores aspects of the definition.

What I also find troubling is that Section 7434(a) does not reference the “amount” of the payment, but the court concludes it must be an incorrect amount in order to be fraud.  Even if you assume “with respect to payment” has to modify fraudulent, it is another substantial step to say that has the same meaning as “fraudulent…with respect to [an incorrect statement of the amount of the] payment.”  In every, or just about every, discussion of fraud under the Code, mischaracterization is sufficient to show fraud.  This again is based apparently somewhat on the fact that “amount” is included in the definition of information return.

There is one reference to “amount” under Section 7434, which the court believed bolstered its position.  Section 7434(e) states, “The decision of the court awarding damages in an action brought under subsection (a) shall include a finding of the correct amount which should have been reported in the information return.”

As a contextual clue, I suppose I can understand finding support for the Court’s position, but there is nothing stating that the Court can only apply Section 7434 when the amount has been misstated.  Second, and I think more importantly, if employment income has been mischaractherized as “non-employment income”, then I think the correct amount that should have “been reported in the information return” should be $0.  The subsection seems to specifically be referencing the information return that was filed, and not all potential and possible information returns that the information could have been included on.

I’m not sure my arguments are perfect (and the above admittedly rambles), but I think a skilled lawyer could use them for the start of a potentially persuasive argument.

The second rationale the court used was based on the legislative history, which I think is the weakest argument.  Enacted in TBOR 2 back in 1996, there is scant legislative history on this Section.  The reason for the statute provided in the legislative history was:

Some taxpayers may suffer significant personal loss and inconvenience as the result of the IRS receiving fraudulent information returns, which have been filed by persons intent on either defrauding the IRS or harassing taxpayers.

Most of the remainder of the legislative history summarizes the statute.  There are no additional references to the modifying language in question, or the term “amount”, or anything involving “incorrect amounts.”  In general, the language is very, very broad.

The court did note the final paragraph in the legislative history pertains to allowing sanctions for frivolous actions under Section 7434.  The court reasoned that if Congress was concerned with frivolous actions, it must have intended to have a narrow statute; however, that reading seems counter to the broad language actually provided by Congress.  I think it is safe to say Congress wanted to impose sanctions for frivolous actions, but I do not know that was intended to make a narrow statute (they could have drafted a narrow statute).

The final rationale provided by the Court was that the plaintiff had claims regarding worker classification under the Fair Labor Standards Act, which it stated was a comprehensive manner of handling worker classifications.  Since there was already a method of addressing worker misclassification, the Court concluded that Congress would not have intended Section 7434 to apply.  I think this is an incorrect conclusion for a number of reasons.

First, there are various provisions in the Code and administrative methods before the IRS for dealing with worker classification issues.  Clearly, Congress and the IRS do not view the FLSA as the sole statute dealing with this area.

Second, there are an unlimited number of examples of a civil or criminal dispute that would result in causes of action under various federal statutes.  Although FLSA is a comprehensive law dealing with overtime and minimum wage claims, I do not think it precludes a claim based solely on the tax aspects or the fraud and problems created by the employer filing an incorrect form.

This transitions into my third thought on this FLSA argument. FLSA might apply to W-2/Form 1099 issues, but it would not apply to any other correct payment amount but incorrect form issue.  I believe if we collectively thought about this, we could probably find many other examples (admittedly, W-2/1099 is the most common though).  For instance, what happens if an employee exercises non-qualified stock options but is only given a W-2 showing wages.  The amount might be correct, but some portion could be a gain properly reported on a Form 1099-B.  Or payments that should have been on a Form 1099-B or 1099-Div, but ended up on a W-2.  These are not subject to FLSA claims.

The Liverett court definitely represents the prevailing current rationale of courts; however, no circuits have reviewed this matter, and it will be easy for plaintiffs to make Section 7434 claims relating to this issue when making other claims against employers.  Although the Liverett court’s rationale is certainly plausible, I do think it may be possible for other district courts to take a more plaintiff favorable position on future matters.

Can Intentionally Filing an Improper Information Return Justify a Claim for Damages Under Section 7434?…Part I

As Les blogged last week, he moderated a panel on Friday dealing with Section 7434 private causes of action for the issuance of fraudulent information returns.  Les was good enough to invite me to participate and bring down the esteem of the panel which otherwise consisted of him and the wonderful Mandi Matlock.  Mandi, by the way, was a presenter extraordinaire, participating in three presentations at the ABA Joint Meeting in Austin. I don’t know how she did it, as I could barely do one coherently.   The materials from the conference and the audio of the panel can be found here.  Professor Bryan Camp was in attendance, and had kind words to say about the presentation in a brief post he did earlier this week on TaxProfBlog.

During the panel, Les outlined the general requirements for claims under Section 7434, and then presented various interesting questions regarding the interpretation and use of the statute to me and Mandi.  All of the questions were interesting, but I purloined the most interesting question, which was if a fraudulently filed incorrect information return, which states the correct payment amount, is sufficient for a claim under Section 7434.

This post will focus on that question, and try to flesh out my somewhat off-the-cuff arguments in the presentation on why a fraudulent incorrect information return with the correct payment amount could allow for a valid claim under Section 7434. This area is evolving, so I would love for our readers to comment on this post and indicate why I am completely incorrect, or add additional points or arguments in favor of my position.

I previously framed this issue in the prior post aptly titled “Intentionally Wrong Form Not Fraudulent Filing of Information Return?”   Although the title was not riveting, I think this is a really interesting issue, and I think all tax lawyers (business lawyers), and tax preparers should know about the Section.

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To get into this, let’s start with the statutory language in question:

In general. If any person willfully files a fraudulent information return with respect to payments purported to be made to any other person, such other person may bring a civil action for damages against the person so filing such return.

The question revolves around what must be “fraudulent” under the statute.  Is it sufficient that the information on the return is correct, but the filer fraudulently selected the wrong information return, or does the filer need to have fraudulently included an incorrect amount on the form?  And, perhaps another wrinkle, does the fraud have to be pertaining to the payment or specifically to the amount of the payment.

The most, by far, frequently seen area where this comes up is in the worker classification arena.  In these situations, a worker believes she is an employee but the employer issues a Form 1099-Misc.  That form states the correct amount of the payment, but misclassifies the compensation as “non-employment” compensation (or possibly “other income”).

The initial cases that looked at this (largely from the Southern District of Florida) determined that an incorrect form was sufficient to make a claim under Section 7434, but did not provide much in terms of analysis.  For instance, in Seijo v. Casa Salsa, 2013 WL 6184969 (SD Fla. 2013), a dance instructor challenged her classification as an independent contractor and the court stated the dance instructor “produced evidence from which a reasonable factfinder could conclude that  Casa Salsa violated [Section 7434] by filing Form 1099-Misc’s for the payments it made to her” because the instructor was not an independent contractor.   This was followed by two other cases from the Southern District, including Leon v. Taps & Tintos, Inc., 51 F.Supp.3d 1290 (SD Fla. 2014), which involved a similar issue with bar tenders/waiters, where the court again stated, “Plaintiff has sufficiently alleged that Defendant issued Form 1099-MISC…and that the issued form violated Section 7434 where Plaintiff could properly be classified as an employee rather than an independent contractor.” Very clear statements that the incorrect form was sufficient to make a Section 7434 claim.  Links to these cases can be found in my prior post, which is linked above.

More recently, Riordan v. ASAP Expert from the District of Kansas in May of 2017 entered a default judgement under Section 7434 for a plaintiff on this same W-2/1099-Misc issue.  In Riordan, however, the defendants did not defend the case, which likely makes it not very influential.

Before getting into the other newer holdings on this matter, I think it is important to note that Riordan highlights an issue in these cases, which is that these cases are between two private parties that are taking these as one-off cases.  There is no litigation strategy overall, and no common positions being taken.  This means the varied arguments contribute to the courts taking a less coherent approach than many tax cases involving IRS as a party, and that it may be incumbent on the defendants to raise the issue discussed herein.  Although this leads to uncertainty, it also is an opportunity for plaintiffs, as the responding lawyer may know nothing about this area of tax law.

Starting in 2016, courts began looking more closely at claims under Section 7434 with regard to this incorrect form issue.  Liverett v. Torres Adv. Ent. Sols., LLC, 192 F.Supp.3d 648 (ED Va. 2016), is turning into the seminal district court holding on this matter.  Liverett has been followed by Derolf v. Risinger Bros, which I wrote about before, and Tran v. Tran, 239 F.Supp.3d 1296 (MD Fla. 2017).  And, the Southern District of Florida has changed its tune, and stated that it did not adequately consider this matter in the past cases and will now be following Liverett. See Vera v. Challenger Air Corp, 2017 WL 2591946 (SD Fla. 2017) (seriously, if you are an aerospace company in Florida, is Challenger the best name-I’m still scarred from watching the ’86 incident).

So, is this issue done?  I don’t think so.  Most people making these claims will be making other claims about the incorrect forms, so it will be easy enough to tack on a Section 7434 cause of action, and I think the Liverett court’s rationale is not air tight.  Part 2 of this post next week will talk about Liverett and why I think there is some opportunity for a different conclusion than that court reached.

Your Psychologist Might Be a Physician, but Your Counselor is Not (Under Section 6511(h))

Last week, a Magistrate Judge for the District Court of the Western District of Washington in Milton v. United States (sorry, can’t find the order for free yet) granted the IRS’ motion for reconsideration on a refund claim based on financial disability.  The order may place some restrictions on the direction financial disability cases under Section 6511(h) have been headed.  We have covered this topic in great detail, including some small breakthroughs taxpayers have made in claiming financial disability under Section 6511(h).  Most recently, Keith wrote about the potential taxpayer victory in Stauffer v. IRS, where the Court declined to afford Rev. Proc. 99-21 deference regarding the definition of physician.  Keith’s wonderful write up can be found here. In Keith’s post he links to several of our prior posts on the subject, including a comprehensive two part post on the Tax Court case, Kurko, dealing with the same general concept written by Carlton Smith.  In addition, for those who want to learn more about Section 6511(h),  Chapter 11.05[2][b] of SaltzBook was recently rewritten to cover this topic in great detail.

As Keith notes in his write up in Stauffer, that case opened the door for potential relief under Section 6511(h) regarding the use of a psychologist to show disability, but this would have to be approved by the District Court (there is other Stauffer litigation, unfortunately alleging that Mr. Stauffer’s girlfriend at the end of his life may have inappropriately taken $700,000 from him).  The IRS filed objections to the ruling in late February, which were replied to in early March.  I have not found any other filings or orders in that case.

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I will borrow heavily from Keith’s post to frame the issue and the Court holding in Stauffer before touching on the holding in Milton:

The IRS filed a motion to dismiss for lack of jurisdiction because the claim for refund was untimely…  Examining the statute led to an examination of Rev. Proc. 99-21 which “sets forth in detail the form and manner in which proof of financial disability must be provided.”  The Rev. Proc. states that the claimant must submit “a written statement by a physician (as defined in section 1861(r)(1) of the Social Security Act, 42 U.S.C. 1395x(r), qualified to make such determination…”  The court noted that the Rev. Proc. does not define “physician” but borrows the definition from the Social Security statute.  The reference to section 1861(r)(1) creates confusion because that section does not have subsections.  Instead it has one large paragraph defining physician that includes five categories: (1) “a doctor of medicine or osteopathy,” (2) a doctor of dental surgery or of dental medicine,” (3) “a doctor of podiatric medicine,” (4) “a doctor of optometry,” and (5) “a chiropractor.”

*      *       *

The court notes that the Rev. Proc. does not receive Chevron deference because it expresses the view of one employee and not the view of the agency.  The Rev. Proc. receives deference “only to the extent that those interpretations have the power to persuade.”  The court then explains how the Rev. Proc. fails to persuade…

The court also cites to case law accepting the opinion of the treating psychologist while noting that the SSA and IRS definitions of disability are virtually identical.  So, the limitation argued by the IRS in its Rev. Proc. does not make sense and is inconsistent with the SSA rules it apparently sought to mimic…

Without a reasoned explanation and in light of the fact that the opinion of psychologist in these types cases is viewed as acceptable in other contexts, the Rev. Proc. does not provide persuasive authority.  The court states “I conclude that the defendant’s interpretation of the term ‘physician’ in Revenue Procedure 99-21 is not entitled to deference here.  I conclude further that to the extent the psychologist’s statement the plaintiff submitted supports a financial disability based on a mental impairment, the IRS was not required to reject it on the ground that it did not constitute a ‘physician’s statement.

In Stauffer, I believe the Court concluded that subsection (1) was the applicable definition the Rev. Proc. was seeking to use, although that is perhaps unclear, which Keith explains in his post.  Under (1), the definition is “a doctor of medicine or osteopathy.”  As quoted from Keith’s post above, the Court found that the Rev. Proc. was not persuasive on this matter, and that there was clear reason to believe a psychologist should be allowed to opine on financial disability, especially as regard mental impairment.

In Milton v. United States, the taxpayer sought to push this argument slightly further.  Procedurally, the IRS had previously sought to dismiss the case for lack of jurisdiction.  The Court denied that motion in May, which can be found here.  That order did not focus on financial disability.  Instead, the Court held as follows:

Plaintiff waited until January 2014 to file his tax return for his income tax liabilities from 2000… Plaintiff asserts that he filed a subsequent late return in May 2014 for the same tax liabilities from 2000… Defendant concedes that the late return filed in 2014 constitutes both a return and a refund claim… Accordingly, Defendant appears to concede that Plaintiff meets the requirements of § 6511(a) because Plaintiff “duly filed” his refund claim within three years of his tax return. Because Plaintiff meets § 6511(a)’s time limitation, this Court may exercise jurisdiction over the lawsuit…

Defendant offers no authority to prove that § 6511(b)(2)(A)—the “lookback” period—has any bearing on subject-matter jurisdiction. The remaining arguments in Defendant’s brief are more appropriately analyzed in a motion for summary judgment.

If the Section 6511(h) argument was initially briefed, the holding on jurisdiction above would have rendered it moot.  I did not pull the briefs.  We have discussed whether the Section 6511(b) look back is jurisdictional or not.  I blogged the case Boeri v. United States, where the Federal Circuit determined it was not.  Carl Smith has forwarded to me what I believe the Ninth Circuit’s last statement on this issue was, which can be found in Reynoso v. United States.  The Ninth Circuit held it was jurisdictional, but did so without reviewing more current SCOTUS holdings limiting use of that term.  Given the Ninth Circuit’s holding, the Service was understandably unhappy with this result, and filed a motion for reconsideration.  The Judge granted the motion, determining that Section 6511(b)(2)(A) was jurisdictional, and the refund claim was outside of the time frame.

The taxpayer, in response, made an argument that he was disabled under Section 6511(h).  It does not specify his disability, but he submitted a statement from “Tim Liddle, a ‘MA, LMHC, MAC.’”  Those designations, I believe, are a Masters of Arts (presumably in counseling), a Licensed Mental Health Counselor designation, and either a Master Addiction Counselor or a Master of Arts in Counseling.  He was clearly a trained counselor who was assisting the taxpayer for some mental health issues.

I found two points of the holding here interesting.  First, the Court states “physician” under Rev. Proc. 99-21 is “a doctor of medicine or osteopathy, a doctor of dental surgery or dental medicine, a doctor of podiatric medicine, a doctor of optometry, or a licensed chiropractor. 42 U.S.C. § 1395x(r).”  As Keith noted in his post, it is unclear if this entire paragraph is intended to apply, or only “a doctor of medicine or osteopathy.”  The Court did not provide its rationale.  This could be an interesting issue moving forward with other cases.  It would also be fairly interesting to have a podiatrist or chiropractor provide an opinion about a taxpayer’s mental health.

And, second, the Court found that none of the above designations qualify as a physician, as it is defined.  This was a “fatal error”, finding that Congress deliberately drafted the definition of “physician” narrowly, and the matter was dismissed for lack of subject matter jurisdiction.  While the District Court for Massachusetts was willing to look at the SSA procedures in determining disability, the Washington court did not provide the same review.  I believe counselor notes can be used as evidence to show disability in an SSA hearing (if the requesting party consents to disclosure), although I am not certain if they are sufficient without other evidence.

The strides made in Stauffer and Kurko make sense.  Someone suffering from mental illness will likely see a psychologist.  For that person, it may be the absolutely 100% correct treatment option, and the failure to have contemporaneous interaction with a physician should not preclude them from making the claim.  It is not surprising, however, that this court did not extend the rationale to counselors at this point.

Intentionally Wrong Form Not Fraudulent Filing of Information Return?

When a taxpayer receives an accidentally wrong information return, it is natural for that person to be frustrated.  It creates filing problems, and usually it is impossible to get a corrected return.  When a taxpayer receives an intentionally incorrect information return, they usually freak out.  Cases coming out of Section 7434, which allows a taxpayer to make civil claims against the issuer of an information return for fraudulent filing of information returns, usually have entertaining fact patterns.  They often revolve around business partners (sometimes family members) seeking retribution against one and other for perceived wrongdoing. One angry person will issue an information return indicating huge amounts of money were paid as compensation to the other angry person.  Often there is other litigation going on over a business divorce. This post involves Section 7434, but the fact pattern is unfortunately pretty boring, as is the primary holding.  The Court did, however, make an interesting statement (perhaps holding) that intentionally issuing an incorrect information return with correction information would not constitute the fraudulent filing of an information return.  No Circuit Courts have reviewed this issue, and it was a matter of first impression for the Central District of Illinois.

In Derolf v. Risinger Bros Transfer, Inc., two truck drivers brought suit under Section 7434 against their employer for issuing them Form 1099s for the compensation they received from the employer, Risinger Bros, believing they were employees and should have received Form W-2s instead.  There are like absolutely no interesting facts in the summary.  No Smoky and the Bandit hijinks, or lurid lot lizard tails (don’t ask).  The plaintiffs were long haul truckers, who entered into “operating agreements” and “leases” with the trucking company.  Those agreements provided significant flexibility in how the truckin was accomplished.  The primary holding of the case was that the truckers were, in fact, independent contractors, and the trucking company was correct in issuing Form 1099s to them for the work instead of Form W-2s.

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That pretty well nips the Section 7434 issue in the bud, as Risinger Bros acted properly, but the District Court for the Central District of Illinois still addressed the potential issuance of a fraudulent information return.  In general, under Section 7434, the person receiving an incorrect information return can bring a civil suit against the issuer if the issuer willfully files a fraudulent information return as to payments purported to be made to any other person.  This provides a remedy for someone who receives false information returns that the issuer was using commit tax fraud or to create issues for the person receiving the return.  This requires a showing of bad faith or deceit, which is often the main issue in these cases, and why you get all the juicy details.

The Court in Derolf stated no misclassification occurred, but that it found the claim that the wrong information return resulted in a fraudulent filed information return to be “not cognizable as pled.”  The Court noted that “there appears to be a split amongst the district courts, and no authoritative precedent as to whether the nature of the fraud pertains solely to the pecuniary value of the payments at issue or whether the scope of the fraud encompasses broader concepts.”  In the case, the plaintiff cited to two cases from the Southern District of Florida, and a case from Maryland  for the proposition that it was not solely the amount that had to be fraudulent.  The Court in Derolf dismissed those cases as failing to actually address the issue (sort of a weak split).  In one of those three, Leon v. Tapas & Tintos, Inc., the court did state that where a Form 1099 was issued instead of a proper W-2, “that the issued forms violated Section 7434 where Plaintiff could properly be classified as an employee rather than an independent contractor,” but did not spend any time discussing that issue.   The plaintiff in Leon failed to properly plead bad faith, so the matter was tossed without further discussion.

The Court in Derolf instead focused on two other district court cases, Liverett v. Torres Adv. Ent. Sols. LLC and Tran v. Tran, which both stated the fraud had to be due to a misstatement in the amount.  Liverett had a very similar fact pattern, and did a deep dive into the statutory language and the legislative history on the matter.  In Liverett, the District Court for the Eastern District of Virginia found Section 7434 was ambiguous and it wasn’t clear if the fraud was on the payment amount or the information return itself, but based on statutory construction and legislative history that the fraud had to be on the amount.  I won’t go into great detail about the analysis, but I think aspects are open to other interpretations.  For instance, the Court relies on legislative history stating the rationale for enacting the statute as “some taxpayers may suffer significant personal loss and inconvenience as the result of the IRS receiving fraudulent information returns, which have been filed by persons intent on either defrauding the IRS or harassing taxpayers.”  H.R. Rep. No. 104-506, at 35 (1996).  This doesn’t seem like a slam dunk in showing Section 7434 applies only to incorrect dollar amounts and not incorrect forms.  Perhaps the most convincing aspect of the holding was that the plaintiffs in these types of cases have other avenues of redress, specifically the Fair Labor Standards Act (although, in theory, this type of claim could arise with other forms not included under a FLSA claim, such as a Form 1099-Misc being issued when a Form 1099-B was appropriate).  Keith also mentioned this tactic seemed like potential self-help by the plaintiff in skirting the normal process for worker determination achieved by filing the SS-8.  This can be a slow process; taking many months.  It seems possible that the defendant or the Service could take the position that if the plaintiff has not sought such a determination, it has not exhausted its administrative remedies (then what happens if the plaintiff has, but the defendant still issues a Form 1099 when a W-2 would be appropriate –probably still no Section 7434 relief based on this case).

Overall, I think the statute and legislative history could be read to allow Section 7434 claims based on the filing of incorrect information returns, and not just incorrect dollar amounts on information returns.  For now, there is somewhat of a split, but most District Courts that have taken a hard look at this have come down on the side that the fraud must be in the amount reflected on the information return and not on the type of return filed.  Since 2015, there have been at least five or six cases looking at this issue, so I suspect more courts will deal with it in the coming months.

 

Why Would the Service Stop Me From Paying Someone Else’s Taxes?

That is an incredibly misleading title.  You obviously can pay someone else’s taxes.  And, its fairly common to do so.  Executives often have their taxes on certain compensation paid by their employer.  I am sure it is also common for a relative to pay taxes for someone if they cannot pay it themselves.  Depending on the circumstances, this may create additional tax issues to work through.  For instance, if an employer pays tax for an employee, it will give rise to additional taxable income, on which you must pay tax…and if the employer pays that tax, it will give rise to taxable income, on which you must pay tax…and so on.  Here is an old Slate article discussing just this in the context of a Survivor winner Richard Hatch.  I vaguely recall he was sort of a jackass, and got dinged for tax evasion.   If a family member pays your taxes, it is likely a gift, giving rise to potential gift tax issues.

So, why the B.S. misleading post title?  Tax procedure.  The government released Legal Advice issued by Field Attorneys (LAFA) 20171801F earlier this month, which considered two questions:

  • May a person making a deposit under I.R.C. § 6603 for a potential transferee liability direct the Service to apply all or a portion of its deposit against the liability of another person liable for the same underlying liability?

  • If a person making a deposit is permitted to apply all or a portion of the deposit to the liability of another person liable, under these facts, may an attorney-in-fact for a person making a deposit under I.R.C. § 6603 direct the Service to transfer the deposit to pay another person’s tax liability?

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Based on the title you can probably guess the IRS position on this.  First, though, it might be worth a quick note on what a LAFA is, since this is probably the first time we have devoted a full post to one and perhaps the first time we have discussed them in general. This is advice written by field counsel for local field employees.  As it was not issued by the National Office, it is not Chief Counsel Advice (“CCA”).  We touch on CCAs somewhat frequently.  As defined by the Code, for disclosure purposes, CCAs are:

written advice or instruction, under whatever name or designation, prepared by any national office component of the Office of Chief Counsel which (i) is issued to field or service center employees of the Service or regional or district employees of the Office of Chief Counsel; and (ii) conveys… any legal interpretation of a revenue provision; any Internal Revenue Service or Office of Chief Counsel position or policy concerning a revenue provision; or any legal interpretation of State law, foreign law, or other Federal law relating to the assessment or collection of any liability under a revenue provision.

As such, CCAs often indicate the official IRS position on a matter.  Under the above definition, most field counsel advice is not required to be released, but sometimes the field counsel will seek review by the National Office.  The review probably (definitely?) still does not make the field advice a CCA, but it is generally released to the public anyway.

In the LAFA, the Service determined that no, the depositor could not direct the deposit to be used to pay the liability of another person liable for the tax underlying debt. Although that effectively answers both questions, since the second is contingent on the first, the LAFA also stated the transfer of a deposit could not be done by a POA if it were possible to transfer deposits.

So, what is going on here?  The LAFA is short on facts.  Those two pages are completely redacted.  It appears that there was transferee liability under Section 6901 from a transferor to a transferee (transferee 1), and then to another transferee (transferee 2).  I believe this was a subsequent transfer of the same assets, and transferee 2 was attempting to transfer its deposit to transferee 1. Section 6901 is a procedural provision that allows collection from a transferee based on liability under another federal or state law, so the liability could be for any number of reasons, and I am not sure what it was in this case.  The subsequent transferee, transferee 2, made a deposit for the potential tax outstanding under Section 6603, which allows for deposits to be made on potential outstanding tax.

In making the deposit, transferee 2 stopped interest from running on the potential tax debt, and potentially generated some interest payable to transferee 2 if the amount was returned (it also keeps things out of the refund procedures and statute of limitations).  Transferee 2 apparently was not the person who was going to end up paying the outstanding tax, and sought to transfer the deposit to the transferee 1, who presumably was going to pay the tax.  And, presumably had not made a deposit (or had not deposited sufficient funds).  Since transferee 2 could pay transferee 1’s tax debt, it seems conceivable that transferee 2 should be able to transfer its deposit to transferee 1.

The LAFA’s position, however, was that:

While a person making a deposit may direct the Service to use the deposit as payment of other of his liabilities, Rev. Proc. 2005-18 does not authorize a person to direct the Service to apply a deposit to pay another person’s liability.

Section 6603, which allows for deposits, states a “taxpayer may make a cash deposit…which may be used by the Secretary to pay any tax imposed…which has not been assessed at the time of the deposit.  Such a deposit shall be made in such manner as the Secretary shall prescribe.”  This language doesn’t necessarily preclude the transfer of the deposit to another taxpayer.

In the LAFA, the Service reviewed Rev. Proc. 2005-18 for the Service’s self-prescribed procedural rules under Section 6603.  The Rev. Proc. does have language that treats Section 6603 as allowing deposits for the taxpayer’s tax debts, and not that of others, or potentially shared debts.  It also states that the deposit does not constitute a payment until it is applied against an “assessed tax of the taxpayer.”  But, the Rev. Proc. does also allow the taxpayer to allocate deposit amounts against other assessments, and does not specify the assessments must be that of the taxpayer in other language.

The LAFA concludes though that while transferee liability is derivative of the transferor’s liability, multiple transferees may be liable for different debts, which it believed was evidence that transferees should not be able to transfer deposits.  Further, the Service’s own current guidance does not allow for such a transfer, which it deemed was sufficient reason to preclude the deposit transfer.  The guidance essentially says transferee 2 needs to request the deposit back, and then use the funds to pay the debt of transferee 1.  This does not, however, stop the underpayment interest of transferee 1 from accruing (although transferee 2 might be entitled to overpayment interest, if certain requirements were met – the overpayment and underpayment rates, however, are not necessarily the same.  For those who wish to learn more about deposits, payments, and interest rates, Chapter 6.06 and Chapter 11.05 of SaltzBook were recently updated and they cover these topics in great detail).

As to the POA issue, the guidance indicates that, even if a deposit could be transferred, the Form 2848 does not specifically allow for that action, and therefore would not be authorized.

So, what does this mean?  You clearly can pay someone else’s taxes, but the Service position is that a deposit cannot be shifted between taxpayers.  The reasoning is based on the Service’s own guidance, and not the statute.  For multiple parties potentially responsible for the same tax, to stop interest from running each will need to make a deposit of his, her, or its own maximum liability amount.

New Estate Tax Lien Discharge Procedures — Give the IRS All the Monies

In early April, the IRS issued updated guidance relating to the processing of the estate tax liens after June of 2016. See SBSE-05-0417-0011.   In June of 2016, various changes were made to the administration of the estate tax, including which groups in SBSE handled requests for the discharge of the estate tax lien.  The changes to the discharge were fairly drastic in some ways, and the Service took a significant amount of time getting around to announcing the changes (which it states is actually just the correct implementation of the law, perhaps implying the prior handling was incorrect).  The new provisions appear to force prepayment of tax, or at least handing over the funds, in exchange for the discharge of the lien in a broader range of situations, potentially creating a significant hardship for estates.  This has caught many estate administration lawyers off guard, altering sales, and angering many in the professional community.

The estate tax lien is somewhat different than other tax liens, and arises in every estate (you just don’t know it most of the time).  Under Section 6324(a), a lien is immediately imposed on all property in the “gross estate” of the decedent.  This includes property passing through the estate, but also most property passing directly to a beneficiary by operation of law, such as property held joint with right of survivorship, and most property passing by beneficiary designation.  As stated in the IRS guidance:

Unlike other tax liens, no assessment, no notice and no demand for payment are necessary to create the estate tax lien. It attaches at the time of the decedent’s death, before the tax is determined, and is security for any estate taxes that may be determined to be due. It is referred to as the “silent lien” and does not have to be recorded to be enforced.

Sneaky stuff, but arguably provides important protection for the Fed.  This lien attaches and remains in place for ten years after the date of death unless discharged.  There are some provisions extending the lien in circumstances where the estate tax is deferred, such as under Section 6166, but otherwise the use-by date is set at ten years.  As a side note, it is possible for a general tax lien to also be imposed under Section 6321, which could be in place longer, so in dealing with a lien estate tax practitioner must determine if one or both are in place.  See IRM 5.5.8.2.  For those looking to learn more about this lien, Keith and Les recently drafted chapter 14A.20 in SaltzBook, which covers the lien in depth, along with the transferee liability, how to request discharge, and various other interesting aspects of the “silent lien.”

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As indicated above, the lien is imposed immediately, while the audit could take months or years to occur, if ever at all.  Various situations would not be audited or do not require returns.  This can create issues, especially for illiquid estates, that need funds for administration costs.  If a fiduciary sought to transfer assets, especially when finicky title insurance and mortgage companies were involved, assurances would be needed that the property could be transferred free and clear.

Under the old rules, release or discharge was handled by different groups depending on whether a return was filed or audit was occurring.  If no return was filed or a return was under audit, Exam reviewed the request. This used to be outlined in IRM 4.25.14.2, which has subsequently been updated to indicate Exam will no longer be handling discharge requests.  Specialty Collection Advisory used to handle all other requests relating to the estate tax lien, which was covered under IRM 5.5.8 and IRM 5.12.10.

The prior procedures would allow the fiduciary to request a discharge of the lien on the property to be sold by filing a Form 4422, Application for Certificate of Discharging Property Subject to the Estate Tax Lien. This was fairly routine in the past and occurred quickly, allowing property to be sold and estates to obtain the proceeds.  This was allowed under Section 6325 if the lien was “fully satisfied or provided for.”  Presumably, the “provided for” language was what was relied upon prior to payment and the issuance of a closely letter.  The regulations added some additional requirements regarding “necessity” of the estate.

In SBSE-05-0417-0011, the Service outlined the new procedures for requesting discharge, and it appears the conditions for obtaining discharge have become a bit more strict.  Beginning in June of 2016, responsibly for all discharge applications of the estate tax lien were shifted to Advisory to be handled by its “Estate Tax Lien Group.”   Information about requesting the discharge, including the address to send such requests, is found on the IRS webpage here.  The directions provide that such requests must be filed “at least 45 days before the transaction date”, which is roughly a month or more longer than such requests used to take.  This is irksome, but not as problematic as some other changes that have been made.

After noting discharge is completely discretionary, the advice indicates considerations that Advisory may take into account, including situations where Advisory does not need to consult with Exam prior to issuing a discharge, stating:

In many instances, decisions concerning the discharge application can be made from the information provided on the Form 706 (if applicable) and the Form 4422 without the need to coordinate with Examination Estate & Gift. For example, if based on the information provided with the Form 4422 and internal account records you are able to determine that the estate tax liability has been paid, or the estate is not subject to a Form 706 filing requirement, or the value of other property disclosed on the Form 4422 that will remain subject to the estate tax lien is more than ample to protect the government’s interest in the payment of the estate tax, coordination with Examination Estate &Gift is not ordinarily necessary (emph. added).

The advice goes on to cover situations where Advisory will need to coordinate with Exam or Chief Counsel when considering discharge.  I emphasized some language in the above quote, because that language would seem to indicate discharge is appropriate where there is clearly more than sufficient other assets to timely pay the estate tax, which historically occurred.  Other language would give the same impression:

In many instances, in determining whether to grant an estate tax lien discharge, the issue you will need to consider is whether the estate tax liability is adequately provided for, meaning that the government’s interest in collecting the estate tax is secured… In determining whether an estate tax liability is adequately provided for, you have discretion and should exercise your judgment in making that decision based on the particular circumstances…[and] you may also consider the criteria in IRC § 6325(b) as a guideline in making your decision as the estate tax liability will generally be adequately provided for when one or more of the IRC § 6325(b) criteria set forth below is satisfied. In addition, there may be other circumstances where you and your manager determine that the estate tax liability has been adequately provided for under the particular circumstance involved.

This again would indicate payment at the time of discharge is not required, although gets a little thornier perhaps by reference to Section 6325(b), which allows for discharge in various circumstances, such as having double the potential liability available, partial payment, substitution of proceeds at sale, substitution of other assets (deposits, bonds, etc.).

The advice then covers some common scenarios.  For instance, if no Form 706 is required to be filed, no discharge is offered, and instead  Letter 1352 is issued indicating no return must be filed.  When a return is required, but no tax is due, the advice indicates escrow may not be needed.  But, if there are questions as to the veracity of the claim, additional research may be needed, and perhaps escrow.

Then  it starts to get problematic, stating:

if the Form 4422 shows an estimated estate tax greater than the net proceeds from the property being sold, and no estimated payment has been made, then the net proceeds should be paid or escrowed before granting the discharge.

For an estate that is illiquid, holding only real property or closely held business interests, this could be very problematic.  And, anecdotally, it appears some estates are running into this issue.  Although the estate tax is a priority claim, there are various other administration costs that can be paid first (my fave, attorneys’ fees).  It could also impact the payment of state death taxes, the timing of which can be more important that federal taxes.  In Pennsylvania, for instance, prepayment of inheritance tax at the three month mark will provide a five percent discount off the tax bill.  At least one tax practitioner has requested some type of hardship request from having to pay over the funds, and been rebuffed.

It also brings into question what will happen for someone who would have requested an extension to pay tax under Section 6161 or Section 6166.  I suppose the funds could be escrowed until the return is filed, but the funds may have been needed to run a closely held company or pay another debt.

I do not necessarily begrudge the IRS attempting to ensure payment, but this seems like an attempt to solve a problem that may not have existed.  I would be interested in seeing whether or not the IRS often gets stiffed on federal estate tax by people who request a discharge and have indicated tax may be due (my suspicion is no, but I could be wrong).  If this is not a problem, it seems like this change that can drastically and negatively impact estate administration (and potentially the value of estate assets) is misguided.  It would also be good if the IRS became a bit more flexible on a case by case basis – there cannot be that many of these per year — which the guidance seems to still allow.  From the anecdotal evidence, it would seem that the factors in Section 6325(b) may have been applicable in having assets worth double the tax debt still under the lien, but funds have still had to be paid or escrowed.

The take away for now is that 1) you have to apply much more in advance from closing and 2) if you need the proceeds from the sale, you probably need to make a compelling argument under Section 6325(b) why the fisc would be lighter for it.

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.

 

Second Circuit Tosses Penalties Because of IRS Failure To Obtain Supervisor Approval

–Or, Tax Court Burnt by Second Circuit’s Hot Chai

Yesterday the Second Circuit decided a very important decision in favor of the taxpayer pertaining to the Section 6571 requirement that a direct supervisor approve a penalty before it is assessed.  In Chai v. Commissioner, the Second Circuit reversed the Tax Court, holding the Service’s failure to show penalties were approved by the immediate supervisor prior to issuing a notice of deficiency caused the penalty to fail.  In doing so, the Second Circuit explicitly rejected the recent Tax Court holdings on this matter, including Graev v. Commissioner, determining the matter was ripe for decision and that the Service’s failure prevented the imposition of the penalty.  Chai also has interesting issues involving TEFRA and penalty imposition that will not be covered (at least not today), and is important for the Second Circuit’s rejection of the IRS position that the taxpayer was required to raise the Section 6571 issue.   It is lengthy, but worth a read for practitioners focusing on tax controversy work.

PT regulars know that we have covered this topic on the blog in the past, including the recent taxpayer loss in the very divided Tax Court decision in Graev v. Commissioner.  Keith’s post on Graev from December can be found here.  For readers interested in a full review of that case and the history of this matter, Keith’s blog is a great starting point, and has links to prior posts written by him, Carlton Smith, and Frank Agostino (whose firm handled Graev and also the Chai case). Graev was actually only recently entered, and is appealable to the Second Circuit, so I wouldn’t be surprised if the taxpayer in that case files a motion to vacate based on the Second Circuit’s rejection of the Tax Court’s approach in Greav.

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Before discussing the  Second Circuit holding, I will crib some content from Keith, to indicate the status of the law before yesterday.  Here is Keith’s summary of the holding in Graev:

The Court split pretty sharply in its opinion with nine judges in the majority deciding that the IRC 6751(b) argument premature since the IRS had not yet assessed the liability, three judges concurring because the failure to obtain managerial approval did not prejudice the taxpayers and five judges dissenting because the failure to obtain managerial approval prior to the issuance of the notice of deficiency prevented the IRS from asserting this penalty (or the Court from determining that the taxpayer owed the penalty.)

That paragraph from Keith’s post regarding the holding doesn’t cover the lengthy and nuanced discussion, but his full post does for those who are interested.  The Second Circuit essentially rejected every position taken by the majority and concurrence in Graev, and almost completely agreed with the dissenting Tax Court judges (with a  few minor differences in rationale).

For its Section 6751(b) review, the Second Circuit began by reviewing the language of the statute.  It highlighted the fact that the Tax Court did the same, and found the language of the statute unambiguous, a conclusion with which the Second Circuit disagreed.

Section 6751(b)(1) states, in pertinent part:

No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination…[emph. added]

The Tax Court found the lack of specification as to when the approval of the immediate supervisor was required allowed the immediate supervisor to approve the determination at any point, even after the statutory notice of deficiency was issued or the Tax Court reviewed the matter.

The Second Circuit, however, found the language ambiguous, and the lack of specification as to when the approval was required problematic.  The Second Circuit stated “[u]understanding § 6751 and appreciating its ambiguity requires proficiency with the deficiency process,” and then went through a primer on the issue.  To paraphrase the Second Circuit, the assessment occurs when the liability is recorded by the Secretary, which is “essentially a bookkeeping notation.”  It is the last step before the IRS can collect a deficiency.  The Second Circuit stated the deficiency is announced to the taxpayer in a SNOD, along with its intention to assess.  The taxpayer then has 90 days to petition the Tax Court for review.  If there is a petition to the Court, it then becomes the Court’s job to determine the amount outstanding.  As it is the Court’s job to determine the amount of the assessment, the immediate supervisor no longer has the ability to approve or not approve the penalty.  The Second Circuit agreed with the Graev dissent that “[i]n light of the historical meaning of ‘assessment,’” the phrase “initial determination of such assessment” did not make sense.  A deficiency can be determined, as can the decision to make an assessment, but you cannot determine an assessment.

The Second Circuit then looked to the legislative history, and found the requirement was meant to force the supervisor to approve the penalty before it was issued to the taxpayer, not simply before the bookkeeping function was finalized.  The Court further stated, as I noted above, if the supervisor is to give approval, it must be done at a time when the supervisor actually has authority.  As the Court noted, [t]hat discretion is lost once the Tax Court decision becomes final: at that point, § 6215(a) provides that ‘the entire amount redetermined as the deficiency…shall be assessed.”  The supervisor (and the IRS generally) can no longer approve or deny the imposition of the penalty.  The Court further noted, the authority to approve really vanishes upon a taxpayer filing with the Tax Court, as the statute provides approval of “the initial determination of such assessment,” and once the Court is involved it would no longer be the initial determination.  Continuing this line of thought, the Second Circuit stated that the taxpayer can file with the Tax Court immediately after the issuance of the notice of deficiency, so it is really the issuance of the notice of deficiency that is the last time where an initial determination could be approved.

This aspect of the holding is important for two reasons.  First, the Second Circuit is requiring the approval at the time of the NOD, and not allowing it to be done at some later point.  Second, this takes care of the ripeness issue.  If the time is set for approval, and it has passed, then the Court must consider the issue.

Of potentially equal importance in the holding is the fact that the Second Circuit stated unequivocally that the Service had the burden of production on this matter under Section 7491(c) and was responsible for showing the approval. It is fairly clear law that the Service has the burden of production and proof on penalties once a taxpayer challenges the penalties, with taxpayers bearing the burden on affirmative defenses.   The case law on whether the burden of production exists when a taxpayer doesn’t directly contest the penalties is a little more murky (thanks to Carlton Smith for my education on this matter).  The Second Circuit made clear its holding that the burden of production was solely on the Service, and the taxpayer had no obligation to raise the matter nor the burden of proof to show the approval was not given.  The Service had argued the taxpayer waived this issue by not bringing it up earlier in the proceeding, which the Second Circuit found non-persuasive.

As to the substance of the matter, the Second Circuit held the government never once indicated there was any evidence of compliance with Section 6751.  Since the Commissioner failed to meet is burden of production and proof, the penalty could not be assessed and the taxpayer was not responsible for paying it.  A very good holding for taxpayers, and we would expect a handful of other case to come through soon.  Given the division within the Tax Court, and the various rationales, it would not be surprising to see other Circuits hold differently.