IRS Makes Novel Use Of Outside Contractors—To Audit Microsoft

 

Earlier this year I wrote about the effort by some Senators to revive the private debt collector provisions that expired several years ago.  For the moment the revival of that bad idea seems to have lost steam.  A new and creative way to use private parties for what seems like a governmental function – the examination of a tax return – has surfaced and deserves watching.

The IRS has changed the regulation concerning who can participate in an examination to include private contractors.  It has hired a private law firm as an expert.  Microsoft appears to be the first examination using private contractors to become public.  The issue deserves attention in order to determine if this represents a new and better way to examine complex returns or a capitulation of what was previously considered a governmental function.

Today, Microsoft filed a FOIA suit against the IRS seeking to learn more about the terms of the contract between the IRS and Quinn Emanuel, a commercial litigation law firm (the complaint can be found here, along with the required declaration, and Exhibit I.aExhibit I.bExhibit I.c,  Exhibit I.dExhibit IIExhibit III, and Exhibit IV).  It appears that the IRS examination team wants to use the law firm to assist it in conducting the examination and has hired the firm as experts.  If successful, the FOIA litigation will make clear the precise intentions of the IRS as it moves to a new method of examining tax returns.  Those intentions, if they become public, will allow a better understanding of what appears to be a new avenue of removing the wall between government and private contractor in the area of taxation.

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Hiring private experts in tax cases does not present new or novel issues.  The IRS regularly hires experts to assist it in valuing property or other discreet functions where expert testimony or expertise in a particular subject not within the realm of the IRS is needed.  To my knowledge the IRS has not previously hired an expert to participate in the examination of a return but rather has hired experts to assist with discreet issues which turned up during the audit.  The hiring of Quinn Emanuel in conjunction with the promulgation of the new temporary regulation allowing private contractors to participate in questioning a taxpayer during the examination process suggests that the IRS seeks to try a new technique in the examination of large corporations presenting sophisticated issues that may test the capabilities of the IRS examiners and the Chief Counsel attorneys who assist them.

Some of the concerns raised about the use of private collectors appear relevant in deciding if this new direction brings a good or bad direction for the IRS.  Like collection, the examination of a tax return seems to represent a core government function.  If a private contractor can conduct a little bit of the examination of a return, at what point does the use of the contractor stop or could the entire examination process get turned over to third parties?  If using a private contractor to assist in the examination of a large and sophisticated corporate tax return becomes accepted, could private contractors also examine the returns of smaller corporations or individuals?  Where should the line between core government function and private action exist on the exam side of the equation and does it present different issues about government function than the collection side of this issue?  Does this need to stop at the examination level or should the IRS consider hiring private lawyers who might possess greater expertise than Chief Counsel lawyers to provide advice on the case or to try the case?

Bringing greater expertise to the examination of a large corporation makes sense if the IRS lacks the expertise currently but should such expertise come in the form of a private contractor or new government employees.  This case appears to start the IRS down a new path which, unlike the decision on the use of private debt collectors has not played out in the public. The temporary regulation is titled “Participation of a Person Described in Section 6103(n) in a Summons Interview Under Section 7602(a)(2) of the Internal Revenue Code.”  The description of the change suggests that the change clarifies “that persons with whom the IRS of the Office of Chief Counsel contracts for services described in section 6103(n) and its implementing regulations may be included as person designated to receive summonsed books, papers, records, or other data and to take summoned testimony under oath.” (emphasis added)

Section 7602 is the general summons provision of the Code.  The issue of the IRS using summonses in large case examinations has been much debated over the past year as the IRS has initiated a new strategy and received some tongue in cheek commentary from me in a prior blog post.  Historically, the IRS has used summonses very sparingly as a part of its examination of large corporations (and of small corporations and of individuals).  Summonsing information generally comes as a last resort when a taxpayer refuses to cooperate.  The examiners dislike the summons process because it significantly slows down an examination and fosters an adversarial atmosphere.  I do not know if summonsing has become routine over the past year following the issuance of the new audit guidelines by the IRS.

The temporary regulation says that the contractor can fully participate in a summons interview and describes full participation to include “receipt, review, and use of summonsed books, papers, records, or other data, being present during summons interviews, questioning the person providing testimony under oath, and asking a summonsed person’s representative to clarify an objection or an assertion of privilege.”  The temporary regulation cites to transfer pricing as a circumstance in which outside contractors often assist the IRS by providing specialized knowledge.

The temporary regulation acknowledges the potential concerns of having an outside contractor perform an inherently governmental function and states that the IRS will ensure that the core functions surrounding the summons will remain in the control of the IRS – “deciding whether to issue a summons, deciding whom to summon, what information must be produced or who will be required to testify.”  The explanation with the temporary regulation states that the IRS employee will issue the summons and says that it will safe guard the inherent governmental function by making sure that an IRS employee is always present when the private contractor ask questions of a summonsed witness testifying under oath.

The issuance of the temporary regulation giving private contractors the right to examine taxpayers during a summons drew one public comment from the Texas bar.  The comment made by the Texas Bar to the temporary regulation acknowledged that giving a private contractor information obtained during a summons enforcement was appropriate and that having an IRS employee consult with an expert during the interview was an appropriate use of the expert but expressed concern with the expert actually questioning the summonsed party.  The commenter expressed concern relating to the issue of multiple counsel examining a witness during trial.  Courts do not permit more than one counsel to examine a witness and for many of the reasons it is not allowed in court, the Texas Bar commentators felt it would present problems in examining a witness during a summons enforcement proceeding.  They also expressed concern about loss of control over the contractor by the government agents and attorneys coupled with the legal uncertainty of the authority of a private contractor to examine a witness.  They questioned whether the statute provided authority for the regulation citing the language of the statute which authorizes “only an officer, employee or agency of the Treasury Department to take testimony of witnesses.”

This should be an interesting issue to follow.  Whether it will receive attention from Congress or the IRS employee union could add to that interest but it will almost certainly come to the attention of the court system when the IRS seeks the examination under oath by a contractor.

Summary Opinions for 11/07/14 & 11/14/14

Trying to get somewhat back on schedule with the SumOp’s, so we are covering two weeks of material in this post.

First, I want to note that Keith has a really interesting post up on Forbes regarding Microsoft filing a FOIA suit yesterday against the IRS to determine the extent to which the IRS is using an independent contract (here the law firm Quinn Emanuel) in its examination.  This is going to be a very hot  topic moving forward.  That post will find its way to PT later today, but probably not until late in the afternoon.

Before getting to the items we missed over the last few weeks, we had a very strong guest post by Christopher Rizek on the Sexton v. Hawkins case, which was very well received two weeks ago. You should check it out if you didn’t read it when we originally posted.  In October, we had a somewhat related post from Michael Desmond on the future role of Circular 230 in tax compliance, which can be found here.  The comments to that post, which are found here, have recently expanded significantly, as various Villanova LLM students were asked to respond as part of their professional responsibility class.  The students provide some quality feedback, astute observations, and ask some good follow up questions.

To the other procedure.

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  • Veolia Environment is still fighting with the IRS over document discovery.  We touched on this last year around this time.  The case again discusses privilege regarding various draft reports by experts, and other lawyer communications.  For one draft valuation, which was then shared with the company’s accountants at PWC, the Court found privilege had not been waived, stating, “PWC is not an adversary nor a conduit to an adversary.”  That seems like a favorable view on what is required to blow privilege.  The case goes through many other specifics as to the types of documents that remained privileged.
  • Jumping to a case from early October that we (I) missed in Comparini v. Comm’r, where the Tax Court determined it had jurisdiction to review an IRS determination to deny the taxpayers’ whistleblower claim.  The letter was not formatted as a determination, and prior letters had been sent to taxpayers; however, letter was the first one to use term “determination”, stated the matter was closed, and did not indicate any further administrative procedures were available.  The Court found that prior letter could have been a determination, but this later letter was also a determination (there is an interesting back and forth in the concurring and majority opinion about the basis for jurisdiction).  The concurring opinion, and Judge Holmes in comments to the CA Bar Association, both noted that the Court is having to spend a lot of time on procedural matters and jurisdictional questions due to the Whistleblower Offices’ habit of issuing various statements that seem to be determinations, and not having set forms for indicating when a determination had been made.  Tax Litigation Survey has coverage here.
  • Another older item that I didn’t catch.  The Service issued an Action on Decision  with regard to the Dixon case from last September, which we wrote about here.  The case had to do with an employer’s ability to designate employment tax payments that were not withheld at the source.  The Service believes the Tax Court was wrong in Dixon in deciding such payments can be designated against a taxpayer’s specific liability.
  • From Jack Townsend’s Federal Tax Crimes Blog, a discussion of the jury instructions in the Weil case as regard the good faith defense.  Not a long post, but interesting summary of this attack on the government’s case, and how the instructions could have influenced the jury.
  • Earlier this year, Google killed off one of its coupon saving sites, Zavers (reminds me of Zima’s “zomething different” slogan—don’t use Z’s where they are not needed—your company will fail), but the remains of the aggressive tax planning of Zavers’ chief technology officer have been resurrected by the Tax Court in Brinkley v. Comm’r.  As a side note, it is nice to be Google, who bought Zavers for close to $100MM in 2011, probably spent a bundle more on it, and are now walking away, as it was not growing fast enough (so says the article linked above).  The underlying matter has to do with Mr. Brinkley’s characterization of his income as capital gains, whereas the Service and Tax Court thought a portion should be ordinary income.  He had apparently been very clear that his ownership should never dip below 3% of the stock, which Zavers agreed to; however, at the time of the Google purchase, he owned around 1%.  In the end, he was paid as though he still held 3%.  The two tax procedure items involved the shifting of the burden, and reliance on a practitioner as reasonable cause.  Neither treads new ground.

On the shifting of the burden, the taxpayer argued that he offered reasonable evidence that an item of income reported on an information return was incorrect, shifting the burden under Section 6201.  The Court, however, was relying on other evidence submitted by the IRS, and not the information return, so the burden did not shift.  Mr. Brinkley also argued that he complied with Section 7491, and produced “credible evidence to support his position as to a factual issue, complie[d] with substantiation requirements, and cooperate[d] with the Secretary with regard to all reasonable requests for information,” but the Court found that Mr. Brinkley failed to offer any credible evidence of his position.

As to the reliance, the Court found that Mr. Brinkley failed to disclose his percentage of the stock to his advisers, how much that was valued at, and  did not provide them with all the documents from the deal.  It is clear law that where the adviser is not informed of all pertinent information, the taxpayer cannot rely on the adviser’s advice or work to get out of a penalty.

  • Susquehanna Bank, which was purchased last week by a North Carolina bank, recently won a lien priority case in the Fourth Circuit.  The Court held the district court incorrectly determined a trust deed, which the bank received prior to the IRS lien, but failed to record, was entitled to priority under Section 6323(h) based on Maryland law relating the recording of the trust deed back to the execution date.  However, the holding was affirmed because the bank was protected by Maryland’s equitable conversion law, which directs that when a taxpayer executes a deed in exchange for a loan prior to a lien filing, the deed took priority.
  • Kurko v. Comm’r is packed with tax procedure.  Lew Taishoff’s blog has some coverage here.   The cases discusses credit elect overpayment jurisdiction before the tax court, tolling for financial disability under Section 6511(h), how those interact, and the Court’s “next friend” rules under Tax Court Rule 60(d).  The Court encouraged Ms. Kurko, who suffered from substantial mental health issues, to have someone file a Motion to Be Recognized as Next Friend.  The Court said such motion should recite that:

o   The person filing would like to be recognized as Ms. Kurko’s next friend and would represent her best interests;

o   That Ms. Kurko cannot prosecute the case without help;

o   The person has a significant relationship with Ms. Kurko; and

o   There is no other person better suited to serve as next friend.

  • The Tax Court had occasion to review the 2006 changes to Section 6664, and the removal of the reasonable cause defense to the gross valuation misstatement penalty in Reisner v. Comm’r.  Prior to 2006, old Section 6664(c)(2) allowed the reasonable cause defense to the penalty when value was provided by a qualified appraiser and the taxpayer made a good faith attempt to determine the value.  That was tossed in the 2006 amendment for gross valuation misstatements (those with only substantial valuation misstatements can still show reasonable cause).  In Reisner, the taxpayer received a charitable deduction for a façade easement.  A portion carried forward to 2005 and 2006.  The Service determined the donation was valueless, and no deductions were allowed.  The gross valuation misstatement penalty was not imposed in 2004 or 2005 because the taxpayer was able to show reasonable cause.  For 2006, the return was filed after the changes to the statute, and the Service imposed the penalty on the carryover charitable deduction.  The Court held the penalty was correctly imposed, stating:

Because their 2006 return was filed after the effective date of 2006 amendments to I.R.C. sec. 6664(c)(3), Ps are precluded under that section from raising a reasonable cause defense to imposition of the gross valuation misstatement penalty for the underpayment on their 2006 return attributable to the carryover of their charitable contribution deduction.

An interesting result, where the action was protected in the initial year, but the statutory change resulted on penalties in future years based on the same transaction.

  • The Ninth Circuit reversed the Tax Court in JT USA, LP v. Comm’r, holding Section 6223(e)(3)(B) was clear and unambiguous and did not allow a partner in a partnership to elect out of the TEFRA proceedings unless the partner elects to have all his or her partnership items treated as non-partnership items.  For the majority, that was all partnership items, regardless if those were owned through other entities.  From the case:

 

26 U.S.C. § 6223(e)(3)(B), entitled “Notice to Partners of Proceedings,” reads in pertinent part, “In any case to which this subsection applies, if paragraph (2) does not apply, the partner shall be a party to the proceedings unless such partner elects – . . . (B) to have the partnership items of the partner for the partnership taxable year to which the proceeding relates treated as nonpartnership items.

In the prior proceeding, the tax Court held that that “§ 6223(e)(3)(B) permits taxpayers to opt out of the partnership proceeding with respect to their indirect interests but to leave in that proceeding their alleged remaining direct partnership interests.”  The Ninth Circuit disagreed, and said that the plain language states it is all or nothing when it comes to opt out.  The opinion was split, and the dissent stated the taxpayer should have the ability to completely elect out with regard to their direct interests in the partnership, but not do so with the indirect interest in the partners (and/or the other way).  I found this surprising, and my initial (somewhat uninformed) thought is that the tax court had this right.

 

Summary Opinions for the weeks of July 4th and July 11th

Special double feature this week.  Summary Opinions will cover items we did not otherwise cover in the previous two weeks.

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  • IRS has announced that ITINs will now only expire if not used on tax returns for five consecutive years.  They used to expire after five years.
  • From Accounting Today, a story on the TIGTA Report regarding the Service’s poor handling of amended tax returns.   TIGTA found about 20% of the amended returns had erroneous refunds issued.  On the bright side, four out of five didn’t .  That would have landed you a solid B- in college; enough to return the following semester and continue drinking.
  • From Jack Townsend’s Federal Tax Crimes Blog, a write up of US v. McBride, where a lawyer was indicted for tax obstruction, and the prosecution requested the indictment be sealed.  Jack uses the word skullduggery, which is pretty awesome, but the post generally covers when indictments should be sealed and the reasons that, in general, they should not.
  • In Public.Resource.org v. US, the Northern District of California has dismissed the Government’s motion to dismiss the FOIA request of Public.Resource.org for all types of nonprofits’ Form 990s in machine readable format.  The Feds claimed that FOIA is trumped by the Code sections dealing with the release of Forms 990.  The Yes We Scan organization is able to fight another day as the Court found that there was no basis for the Service’s position, and the position would undermine FOIA.
  • The Frank Sawyer Trust of May 1992, which we very briefly mentioned in SumOp before, requested the Tax Court reconsider its prior holding that it was liable as a transferee for tax debts of entities it had held.  The two items in dispute were whether the IRS should apply equitable recoupment for estate tax overpayments in the settlor’s wife’s estate, and if the trust should be responsible for the penalties imposed on the entities.  Terribly oversimplified, the same income tax issue giving rise to the tax debt also caused the trust to be able to sell the entities at higher prices.  Those entities were in the spouse’s estate, and the resulting tax inflated the entities value and arguably a refund of estate tax due on that amount.  The Court stated the test for recoupment as:

 

[t]o apply equitable recoupment, the taxpayer must prove the following elements: (1) the overpayment or deficiency for which recoupment is sought by way of offset is barred by an expired period of limitation, (2) the time-barred overpayment or deficiency arose out of the same transaction, item, or taxable event as the overpayment or deficiency before the Court, (3) the transaction, item, or taxable event has been inconsistently subjected to two taxes, and (4) if the transaction, item, or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.

 

Only points two and three were in dispute.  The Court found that income and estate tax can be imposed on the same item and that the Service was inconsistently treating the two taxes arising from that same item.  As to the penalties, the actions giving rise to the penalties occurred months after the sale by the trust.  The Court found the Service failed to evidence the connection between the trust and the inappropriate acts, and declined to impose the penalties on the taxpayer.  An interesting case, and one that I suspect will be appealed – again (it has already gone up to the First Circuit at least once).

  • In Heckman v. Comm’r, the Tax Court has held that the extended six year statute of limitations applies for assessment on a taxpayer when the taxpayer receives a distribution from a disqualified ESOP in an amount exceeding 25% of his gross income for the year.  Section 6501(a) imposes the general three year statute, but that can be extended under Section 6501(e)(1)(A) to six years when a taxpayer makes an omission on his return in an amount that is greater than 25% of the amount of gross income stated on the filed return (As I’m sure you will all remember, this provision has received a lot attention over the last few years regarding inflated basis transactions).  If you adequately disclose the transaction or item, the normal three year statute still applies.  The disclosure must be legit though, and can just be you yelling it at an IRS building as you drive by.  The Court found the possible verbal disclosure some years later, and the return of a related entity that had some clues as to the ESOP termination were insufficient disclosure, and allowed the six year statute.  This situation was fairly egregious, and the same individual controlled all aspects of the entities, ESOP and his personal returns.  But what about the situation where the individual did not know his ESOP distribution was not properly tax deferred, or perhaps were an IRA rollover is not valid for reasons outside the taxpayer’s control?  Probably the same result, as the statute speaks only to “omits from gross income”, and has no language regarding knowledge or intent.  See Benson v. Commissioner.  I would still research the issue, and try to come up with a good argument, especially if there was no reason your client should have known about the omission.
  • Big Mo Vaughn has struck out with the Tax Court (much like all his plate appearances with the Mets at the end of his career – horrible acquisition by then GM Steve Phillips, almost as bad as Mr. Phillips decision to have an affair with a twenty-something-year-old intern at ESPN). The Court found he did not show reasonable cause for failure to file his tax return and failure to pay his taxes where there was not evidence if he even asked his accountant or financial advisor if it had been done.  Unfortunately, Mo’s financial advisor apparently stole close to $3MM from him during this same time period.  In a clever argument, Mo argued this caused him to be “disabled”, which was in line with a bankruptcy case, Am. Biomaterials Corp, 954 F2d 919, out of the Third Circuit.  Unfortunately, the Tax Court sided with Valen Mfg. Co. v. US, 90 F3d 1190, out of the Sixth Circuit, which held  in Am. Bio the CEO and CFO were the bad actors, making it impossible for the corporation to comply.  Whereas in Valen, the bookkeeper failed to file, but the executives remained able to review the bookkeepers actions.  The Tax Court said Mo was more like the executives in Valen, who could have questioned his crook of a financial planner.