Tax Free Reorg and Statute of Limitations: When is a Document a Return?

The New Capital Fire v Commissioner case from earlier this month is another in the many cases involving statutes of limitation on assessment. The case involves an old issue;  whether a document constitutes a return for purposes of starting the clock ticking on the statute of limitations on assessment.

In this case, the twist was that one taxpayer (Old Capital Fire)  was merged out of existence in a transaction that was intended to qualify as a tax free reorg under 368(a)(1)(F) (an F reorg) Following the merger, the surviving corporation (New Capital Fire) filed a corporate tax return, and with that return it included a pro forma Form 1120 that it included with its corporate tax return. That pro forma 1120 included the information pertaining to Old Capital Fire’s operations in its last short year.

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Generally speaking, when there is an F reorg, as the opinion discusses, the regs under Section 381 require that “the part of the tax year before the reorganization and the part after constitute a single tax year, and the resulting corporation must file a single full-year return.”

The problem here was apparently IRS argued that there was no valid F reorg. IRS came in 9 years or so after New Capital Fire filed its return and sought to assess a tax relating to the return that it believed Old Capital was required to separately file. If no return was filed, under Section 6501(c)(3) IRS would have an unlimited time to assess additional tax.

The issue that the Tax Court considered was whether the pro forma 1120 that New Capital included with its return was a return for purposes of starting the SOL on assessment for the tax stemming from the supposedly blown reorg.

There is plenty of old law on whether a document filed with the Service counts as a return. In 1984 the Tax Court put together the story in the oft-cited Beard v Commissioner, where it identified the following test:

(1) the document must contain sufficient data to calculate tax liability;

(2) the document must purport to be a return;

(3) there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and

(4) the taxpayer must have executed the document under penalties of perjury.

Most of the New Capital Fire opinion centered on the third requirement, the need to have an “honest and reasonable attempt” satisfy the tax law. The IRS argued that the New Capital return was purposefully misleading. While it was not clear (to me anyway) what led the IRS to label it as such, the opinion noted that the New Capital return had a clear statement regarding the position that Old Capital was merged into New Capital and that the pro forma return reported “income, deductions, and credits that were included in the notice of deficiency at issue in this case.”

The opinion notes that many opinions have liberally applied the third Beard element, with a flunking only if the court found that the pro forma 1120 and the 1120 that disclosed the merger was “false or fraudulent with intent to evade tax as it pertains to Old Capital.” The Tax Court observed that the IRS came up short, as “New Capital’s 2002 return contained sufficient information to calculate Old Capital’s tax liability.”

As the opinion notes, citing cases like Zellerbach Paper v Helvering and Germantown Trust v Commissioner, perfect accuracy is not necessary. Even if New Capital whiffed and there was a separate obligation to file a different return relating to Old Capital’s short year, that mistake did not change the fact that IRS had what it needed to assess any additional tax within the normal time frame.

With that, the court concluded that IRS did in fact receive a return from Old Capital and IRS was out of luck (and time) to assess any additional tax that may have stemmed from Old Capital Fire’s merger.

Recent Tax Court Case Explores Tax Matter Partner SOL Extensions

TEFRA is still with us. Despite the coming launch of new partnership procedures in the Bipartisan Budget Act (BBA), TEFRA will remain relevant, as old cases work their way through the courts and also likely continuing to inform interpretations of many statutory holes in BBA. A recent Tax Court case, BCP Trading and Investments v Commissioner, explores whether alleged conflicts of interest taint what was an otherwise valid extension to the SOL on assessment.

I will skip the sordid details, but the case involves Son of Boss transactions implicating asset transfers to partnerships, with liabilities attaching to the assets in an effort to increase basis in the partnership and thus produce super sized partner tax losses. (Judge Holmes’ opinion describes the transactions for those who like that sort of thing).

The main procedural issue in the case involved claims that the consents to extend to the SOL on assessment that the tax matters partner (TMP) executed were invalid. The argument focused on how the TMP, Bolton, was under the influence of E&Y. E&Y was under criminal investigation for its role in structuring the transactions. That control, according to the argument, meant that the TMP had a conflict of interest, which invalidated the SOL extensions.

There is precedent for invalidating a TMP consent to extend the SOL. Transpac is a Second Circuit case which held that a TMP’s SOL extension did not have effect when IRS turned to a TMP who himself was under criminal investigation, when the partners individually would not extend the SOL.

The BCP Trading opinion (citations removed) describes Transpac further:

The TMP [in Transpac] s were, unsurprisingly, more receptive to the Commissioner’s request. They had “a powerful incentive to ingratiate themselves to the government,” and worked with the IRS in a criminal prosecution of the Transpac promoter because their immunity or suspended sentence depended on it. The TMPs signed the extensions right about the time they were especially trying to coax the government into granting them immunity or agreeing to lighter sentences.

The Second Circuit in Transpac held that the Commissioner couldn’t use these consents to bind the partners because he knew the TMPs had a strong incentive to cooperate with the government and had conflicting interests with the partners.

As BCP discusses, the issue is “very fact dependent.” The opinion distinguishes Transpac for two main reasons: 1) in BCP many of the individual partners did not turn IRS down in the face of individual requests to extend the SOL and 2) the TMP was not under criminal investigation when the IRS turned to him to sign the original extension.

BCP also argued that the E&Y role in the transactions should bring its actions into the lens as to whether the TMP had an impermissible conflict. One of the partnership employees, who started out working at the slippery sounding E&Y group with the acronym VIPER (which stood for Value Ideas Produce Extraordinary Results) went to BCP as a BCP employee to be a liaison with E&Y. BCP argued that the TMP was in effect controlled by the former E&Y/VIPER employee. The opinion gives that pretty short shrift, noting that the former E&Y employee left for messy reasons and that in any event the individual partners also signed consents to extend the SOL.

E&Y’s conduct, beyond its former employee’s role in the partnership, was not irrelevant to a related issue, however. BCP argued that the consents to extend were not valid because E&Y breached its fiduciary duty and exercised undue influence in getting the TMP to sign the consents. The opinion notes that while the consents to extend are not contracts (and should be treated as a waiver of a defense, rather than as a contract itself), contract principles are key to this inquiry. In light of those principles, the argument fell short, looking at contract principles to define undue influence:

Undue influence is unfair persuasion by a person who dominates a party or when, because of their relationship, a party justifiably assumes the person won’t do anything against his welfare.

It was here that the sophistication and extent of the partners’ other advisors worked against the undue influence argument. The opinion details the parade of high-profile advisors other than E&Y that were involved in looking over the shoulder of E&Y. In light of that, the opinion concludes that the evidence did not support a finding that E&Y manipulated the TMP to sign the consents to extend.

Conclusion

As we have discussed before it is difficult to argue against a signed consent to extend. The argument in BCP was a long shot, especially given the partners’ sophistication and the less than appealing atmosphere of a reviled tax shelter.

Can the Wrong Return Start the Statute of Limitations on Assessment

In In re Quezada, the bankruptcy court in Austin, Texas faced the issue of whether a Form 1040 could start the statute of limitations for filing Form 945.  The court declined to grant summary judgment to the IRS finding that the issue was one of substantial compliance and it did not have enough information to make the determination.  Because the issue of one return triggering the start of the statute of limitations for another is not an issue we have previously discussed, the case deserves some attention.

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Mr. Quezada is a brick layer and one whom the IRS says owes $1,269,561.89.  It will take him quite a while to lay enough bricks to pay off a liability of that magnitude.  Mr. Quezada not only lays bricks but he hires others to assist him.  The hiring of others leads to his problems.  Many people worked for him over the years.  He treated these other workers as independent contractors; however, he did not file or send the IRS the necessary forms (e.g. Form 1099) in connection with the payments to these individuals.  His substantial liabilities stem from this failure over a period of several years.

Assuming that the individuals who worked with him were independent contractors, Mr. Quezada still had reporting obligations to the IRS.  The IRS, in this proceeding, did not contest that the individuals working with Mr. Quezada were independent contractors.  He needed to provide the Taxpayer Identification Numbers (TINs) to the IRS of all of these individuals or withhold 28% of certain taxable payments and to report on Form 945 this “backup withholding.”  If an employer fails to withhold the taxes and to file the Form 945, the employer can still avoid liability by showing that the independent contractors reported and paid taxes on the payments received from the employer.  To meet this exception, the employer must obtain a Form 4669 (Statement of Payments Received) from each of the persons treated as an independent contractor.  This form involves the independent contractor declaring under penalty of perjury that a tax return was filed reporting all of the payments received from the employer.  If you have a large number of independent contractors and if some time has passed before the IRS comes looking for compliance with the payment rules, it could prove quite difficult to locate and persuade all of the individuals receiving these payments to sign such a document.

In this case, Mr. Quezada failed to do any of the three things that could have kept him from having a huge liability for the backup withholding.  He did file his own return for the years at issue reporting the income and expenses of the business.  Of course, this provides no assistance to the IRS in identifying the individuals he paid and how much he paid.  Because several years had passed before the IRS came to him to question his employment tax situation, he argues that the time for the IRS to do this has passed.  The IRS counters that his failure to file Form 945, the correct return for reporting the backup withholding, keeps the statute of limitations on assessment open for an unlimited period.

The IRS argued that filing Form 1040, while nice and important for other reasons, has nothing to do with the liability at issue in this case.  The bankruptcy court finds that no court has ruled on the issue of whether a Form 1040 can trigger the three-year limitations period for Form 945; however, it notes that several cases have addressed the issue of one return triggering the statute of limitations where taxpayer has failed to file another return.  The leading case on this issue is Commissioner v. Lane-Wells Co., 321 U.S. 219 (1944).  In Lane-Wells, the issue concerned whether filing a corporate tax return could cause the statute of limitations to run on the taxpayer’s obligation to file a personal holding company return.  The Supreme Court rejected the taxpayer argument that a corporate return would trigger the time limitation for file a personal holding company return.

Finding that the liabilities were separate, the Court found the need to file each of the returns.  The test articulated by the Court was that the statute of limitations is not triggered by the different return if the information in that return is insufficient to “show the facts on which liability could be predicated.”

In a case with facts closer to those presented by Quezada, the Ninth Circuit in Springfield v. United States, 88 F.3d 750 (9th Cir. 1996) held that filing Form 1099 did not start the time period where the taxpayer was required to file Forms 940 and 941.  In that case, the taxpayer treated salesmen as independent contractors rather than employees and then argued that it put the IRS on notice of the issue when it submitted the Forms 1099 for these individuals.  The Ninth Circuit opinion created a narrower test finding that the issue of whether one return could trigger the statute of limitations for another turned on “whether the return filed sets forth the facts establishing liability.”  It found that Form 1099 did not provide the IRS with the necessary information.

The bankruptcy court in Quezada concluded that the rationale in these cases turned on substantial compliance.  It looked at the elements of a return as articulated in Beard v. Commissioner, a case we have discussed often in the context of what triggers a discharge when a return is filed late.  The bankruptcy court determined that the decision of substantial compliance turns on the specific facts of each case and since it did not have the Form 1040 filed by the Quezadas, it could not make a decision at this point.

I have sympathy for the Quezadas because many, if not most, of the individuals paid during the years at issue probably did file tax returns and pay taxes on the wages paid to them.  Probably, the Quezadas will be paying the tax twice in effect.  I will be surprised if the bankruptcy court finds a way to hold that the Form 1040 takes the place of Form 945.  To make matters worse for the Quezadas, if the bankruptcy court finds that their Form 1040 cannot take the place of Form 945, that decision also means that the liability cannot be discharged because of the unfiled return.  I suspect an offer in compromise may be in their future.

9th Circuit Finds No Conflicts of Interest or Duress in Taxpayer Challenges to Extensions of the Statute of Limitations

A recent published Ninth Circuit opinion, Twenty-Two Strategic Investment Funds v US, illustrates the difficulties taxpayers face when they argue that the courts should disregard a consent to extend the statute of limitations (SOL) on assessment due to an advisor’s conflict of interest or a taxpayer’s alleged duress.

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Twenty-Two Strategic Investments involved an investment in the ill-fated KPMG BLIPs loss generating foreign currency investment tax shelter.

For those wanting a brief summary of the shelter, the opinion serves that up nicely:

In order to participate in the BLIPS program, a client would establish a single-member limited liability company (“LLC”), which would take out a specific loan with a participating lender and contribute all of the loan funds to a strategic investment fund, an LLC managed by Presidio, which would then purchase foreign currency assets. After a brief period, usually about sixty days, the client would exit the BLIPS program, the assets would be sold, and the loan would be repaid with interest and pre-payment penalties. The result of this series of transactions was a tax loss for the client approximately equal to the amount of the offset he or she was seeking.

Presto. Tax losses. The only problem was that IRS and DOJ got wind of the scheme, and civil liability and even criminal sanctions followed. This post, however, is not so much about BLIPs but the after effects for one of the unlucky investors who the IRS eventually came after in light of the BLIPs going bust.

The procedural issues in the case turned on the taxpayer arguing that extensions of the SOL on assessment were invalid. There were two reasons that the taxpayer argued the extensions were invalid: 1) the taxpayer’s accountant and return preparer Smith had a conflict of interest which the IRS knew about and 2) the individual taxpayer Gonzales left holding the bag on the consequences of the disallowed losses signed the extension under duress. If the extensions were invalid, the assessments were out of time.

This is a published Ninth Circuit opinion, and that is in part why it drew my interest (there are not so many published circuit court tax procedure opinions). Yet the taxpayer’s arguments were pretty thin.

On the conflict issue, the taxpayer had pointed out that his accountant Smith “instrumental in selling the [tax] shelter to Gonzales,” received a commission for involving Gonzales in BLIPS, and signed the 2000 tax return that the IRS was auditing.”

There are some cases in the TEFRA context (this is a TEFRA case but TEFRA discussions on the blog draw as much interest as last week’s PBS documentary on steel manufacturing in Warsaw Pact countries following the reforms of Soviet Premier Kosygin so I will skip those) where criminal investigations of the tax matters partner resulted in an impermissible conflict that the courts concluded prevented the TMP from binding the partnership.

Here, however, the issue related to the individual taxpayer binding himself, not from a TMP who the courts noted had incentives to extend the SOL that ran directly counter to the individual investors ultimately potentially liable for civil taxes and penalties.

Not enough for a conflict that would bring into question the extension’s validity:

Other than this vague implication of wrongdoing, Gonzales offers no evidence that Smith’s involvement in promoting BLIPS and his involvement in preparing Gonzales’s 2000 tax return combined to create a conflict of interest three years later when the IRS approached Gonzales himself about extending the limitations period. There is no evidence in the record that the IRS contacted Smith during the time he was advising Gonzales to request that Gonzales agree to extend his limitations period. Nor is there evidence that Smith ever provided any advice to Gonzales regarding extending his limitations period. Furthermore, as the district court observed, “[a]lthough Steve Smith represented Gonzales during the audit that flowed from his 2000 tax return, Gonzales had designated different representation before signing the consents.

The remaining issue concerned Gonzales’ argument that he signed the extensions under duress. Duress generally requires evidence of wrongful pressure to coerce someone into signing a contract or other agreement that they would ordinarily not sign. Duress in the tax context is an “action[] by one party which deprive[s] another of his freedom of will to do or not to do a specific act.” Price v. Comm’r, 43 T.C.M. 18 (T.C. 1981), aff’d, 742 F.2d 1460 (7th Cir. 1984).

Gonzales’ duress argument centered on two main events: IRS met with him without his legal representative and an IRS agent served a summons on him at his residence before asking him to extend the SOL. As with the conflict argument, the court had little problem disposing of it as a challenge to the extension.

Gonzales can recall no details of the meeting other than its location. He cannot remember any questions agent Doerr asked him or any particular things agent Doerr said that were intimidating or coercive. His testimony was that he was worried that he might be in legal trouble and that the IRS could ruin his life. His conclusion was founded on inference. However, the fact that the agent declined to assure Gonzales that the IRS would not be pursuing lawful action against him does not justify an inference that Gonzales was deprived of his freedom of will to such a degree that he signed the consents to the extensions under duress.

Similarly, the court noted that there was nothing out of the ordinary with the agent serving a summons at his residence; in fact, Section 7602 provides that it may be “delivered in hand to the person to whom it is directed, or left at his last and usual place of abode.” Simply put, that the summons caused Gonzales stress was not enough; stress or taxpayer fear following IRS agents taking legally authorized actions do not amount to duress.

Parting Thoughts

Taxpayers sign extensions of the SOL for many reasons. After the fact, it is difficult to unwind those extensions, just as it is difficult to unwind a stipulation, as Keith discussed last week here.

The duress issue in this case to me is the more interesting of the two. There are a handful of cases where the courts have found that IRS agents have impermissibly threatened taxpayers to sign documents. For example, in the 1973 TC memo opinion Robertson v Commissioner an agent’s specific threat to seize a taxpayer’s house if he did not sign a form constituted duress.

Duress also comes up in the context of determining whether a spouse agreed to file a joint tax return or other document (including an extension of the SOL) in light of pressure or abuse coming from the other spouse. There are a handful of cases as well looking into whether a spouse’s actions reach the level of duress. That is an issue we discuss in the Saltzman Book treatise; the upshot is that on occasion coercive forces both outside and inside the marriage have reached the level for a court to conclude that the document would not have been signed except for the constraint applied to the taxpayer’s will.

 

Having a Correct Statute of Limitations Date on the IRS System

Chief Counsel Advice 2017040416063446 points to an error in the current IRS calculation of the collection statute of limitations.  The advice concludes with a statement that the author of the relevant IRM provision is “open to revising” the IRM and related exhibit in order to clarify the correct time frame.  This is a rather casual statement regarding something that matters a great deal in certain circumstances.  While it’s nice to learn that the IRS is open to having the collection statute calculated correctly on its system, I would hope it would be desperate to ensure the accuracy of its systems, because otherwise many challenges to its calculations will result.

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Guest blogger Patrick Thomas wrote about the collection statute of limitations previously and the difficulty in calculating this period.  His post includes links to studies by the National Taxpayer Advocate and the Treasury Inspector General for Tax Administration finding that the IRS regularly makes mistakes in calculating the collection statute of limitations.  Les wrote about a case the IRS lost because it incorrectly calculated the collection statute of limitations including the suspension triggered by installment agreements.  The recent CCA points to one of the difficulties and strongly suggests that the IRS current system incorrectly calculates the collection statute of limitations.  Yet, the author of the relevant section of the internal revenue manual governing the calculation of the statute of limitations is merely “open to revising” the manual.

The problem identified in the CCA concerns installment agreement; however, it is a potential problem for many of the IRS systems.  When a taxpayer requests an installment agreement, the statute of limitations on collection gets suspended for the period of time the IRS considers the IA because the IRS is prohibited by IRC 6331(k)(2)(B) from levying on a taxpayer’s property while the IA offer is pending and “if such offer is rejected by the Secretary, during the 30 days thereafter (and, if an appeal of such rejection is filed within such 30 days, during the period that such appeal is pending.)”

Because the IRS wants to make sure that it does not levy if the taxpayer has requested an appeal during the 30 day period, it builds 45 days into its system before it takes collection action after rejecting an IA.  This reasonable decision, which exists in other situations than just the IA, bleeds over into the way the IRS system now calculates the collection statute of limitations.  Instead of suspending the statute of limitations on its system for the period the IA is pending plus 30 days, the statutory time period of suspension, the IRS system suspends the statute of limitations for the period the IA is pending plus 45 days, which includes an extra 15 days for the administrative but not statutory period of suspension.  This extra 15 should not appear in the calculation of the statute of limitations but does.

Someone at the IRS noticed the problem and brought it to the attention of Chief Counsel’s office who, in turn, brought it to the attention of the person with the IRS responsible for setting the time frames on the collection statute of limitations.  The casual response does not leave me with a comfortable feeling that the problem will soon be fixed or that the person is scouring the system to find other instances of the same problem.  Yet, there are times when the IRS takes collection action at or near the last day of the collection statute of limitations.

The timing issue I encountered most often when working for Chief Counsel involved the filing of collection suits.  Department of Justice Tax Division attorneys burdened with many cases and accustomed to working with deadlines routinely filed collection suits very close to the statute of limitations on collection.  They rely, or at least pay attention to, the collection statute of limitations date provided to them in the suit letter by the Chief Counsel attorney who frequently relies on the collection statute of limitations date provided by the client.  Here is one example of how that date is routinely calculated incorrectly.  I suspect there are many others and the earlier work referenced by the NTA and TIGTA would attest to that fact.

The more suspension periods Congress creates the more difficult it is to correctly calculate the statute of limitations, but the IRS must build a proper system or it will routinely seek to collect from taxpayers who no longer owe the tax.  Doing so would violate the taxpayer bill of rights and just be wrong.  The IRS should not be casual about getting the statutory periods correct.  This should be a high priority.

9th Circuit Reverses District Court in Case Involving Exceptions to SOL For Failing to Disclose a Listed Transaction

We have often discussed statutes of limitation. Yesterday’s post discussed the government’s unlimited time period to assess civil penalties that are not based on the filing of a tax return. Today’s post discusses the consequences of a taxpayer failing to file a form that it is supposed to file when it engages in a listed transaction. In an opinion that surprised me, in May v US, (an unpublished opinion) the 9th Circuit reversed and held that the taxpayer’s failure to file the form resulted in the application of an extended SOL on assessment even when the IRS admitted that it had knowledge of the information that the form itself would have contained.

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First some background: Section 6707A imposes a civil penalty for failing to include information pertaining to a listed transaction on a tax return. Under Section 6707A a listed transaction is “a reportable transaction which is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of [Section] 6011.”

Section 6501(c)(10) is an exception the general SOL rules and addresses a taxpayer who “fails to include on any return or statement (that Section 6011 requires to be included in the return or statement) for any taxable year any information with respect to a listed transaction.” If this information is omitted, the time for the assessment of any tax imposed by the Code arising out of the transaction, “shall not expire before the date which is [one] year after the earlier” of (A) the date the Service receives the information required to have been filed, or (B) the date that a material advisor complies with the Service’s request for the list the material advisor is required to maintain on the transaction in which the taxpayer has participated.

Treasury promulgated regs under Section 6011 that specify how a taxpayer is to disclose the transaction. Regulation § 1.6011-4 provides that “[a] taxpayer required to file a disclosure statement under this section must file a completed Form 8886, ‘Reportable Transaction Disclosure Statement’ … , in accordance with … the instructions to the form” and that “[t]he Form 8886 … is the disclosure statement required under this section.”

May involved a transaction that the taxpayer failed to disclose on his 2004 tax return, which he filed in 2005. The transaction at issue that he failed to include on his 2004 tax return was about $165,000 in pass through income. May eventually agreed that the transaction that gave rise to the omitted income was a listed transaction. At the district court, the Service argued that only the taxpayer’s filing of Form 8886 triggered the statute of limitations for purposes of Section 6501(c)(10)(A). The Service admitted that it had knowledge of the information that the taxpayer was supposed to report in the form but that May’s failure to file Form 8886 meant that the statute of limitation was still open (the trial court and appellate opinion do not specify how the IRS got the information but IRS conceded that it had it). May argued that the Service’s knowledge of the information in the form, rather than his filing the form, was the starting point for the one-year period.

 At the district court, May won, with that opinion stating that “common sense confirms that the statute of limitations does not open or close based on which piece of paper a taxpayer chooses to employ.”

Over a brief but spirited dissent, the 9th Circuit reversed. In finding for the government, the 9th Circuit tied the 6501(c)(10) exception to what it viewed as clear directive under the 6011 regulations to submit the 8886:

6501(c)(10)(A)’s reference to “the information so required” under § 6011 functions as an incorporation by reference of the disclosure requirements of Treasury Regulation § 1.6011-4(d), which requires that a taxpayer disclosing a listed transaction do so on Form 8886 and send a completed copy of that disclosure to the OTSA[Office of Tax Shelter Analysis]. It is undisputed that May neither filed a Form 8886 nor sent it to the OTSA. For that reason, May failed to do what was required to start the running of the § 6501(c)(10)(A) statute of limitations. Thus, the one-year limitations period of § 6501(c)(10)(A) did not commence, and the IRS’s assessment of the penalty was timely.

As support, the majority felt that looking to 6501(c)(10) in isolation was not coherent with the overall scheme, and it repeated the maxim from the 1984 Supreme Court case Badaracco v Comm’r that statutes of limitations “barring the collection of taxes otherwise due and unpaid are strictly construed in favor of the Government.”

The dissent viewed it quite differently, focusing on how Section 6501(c)(10) itself does not require the submission of any particular form and that the regulations under 6011 failed to clearly specify the SOL consequences of failing to submit information on any particular form:

It would have been simple to write a statute that stated that the limitations period starts to run on “the date when the taxpayer provides the information to the Secretary on the form specified by the Secretary,” but that’s not how Congress wrote the statute. Alternatively, it would have been simple for the Secretary to have promulgated a regulation that clearly informed all taxpayers that providing information to the IRS doesn’t count unless the information is provided on the specified form.

I must say I am surprised by the 9th Circuit opinion. As the dissent noted, it might have been appropriate to remand for the trial court to refine its standard to avoid a broad reading of the opinion that would invite questions and litigation in other circumstances as to whether IRS had sufficient knowledge:

I have no quarrel with the Government’s position that the taxpayer should be required to provide the relevant information in a coherent form to the appropriate tax agents. An interpretation that started the limitations period as soon as some IRS office, somewhere, had the information or as soon as IRS agents collectively had the information would be both illogical and open to abuse. I don’t disagree that it might be appropriate to remand this case to the district court to apply a more precise interpretation of the statute. But I am not persuaded by the Government’s interpretation, especially in the context of a civil penalty, and cannot join my colleagues in adopting it.

It seems to me if the IRS admits to knowledge of the information then in appropriate circumstances then to elevate the Form itself as the sole trigger elevates a literal form over substance.

Court Rules Abusive Tax Shelter Penalty Has No SOL; Laches Also Not A Defense

Groves v US involves a taxpayer who was assessed over $2M in penalties for failing to register transactions as tax shelters. The penalties stemmed from conduct in years 2002, 2004 and 2005, but the IRS did not assess the penalties until 2015. Groves argued that the IRS assessments, coming over a decade after the conduct that gave rise to the penalty, was too late. The federal district court for the Northern District of Illinois disagreed.

I will briefly explain the opinion below.

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Under statutory procedures that allow for a refund claim following partial payment of the tax shelter penalty, Groves paid 15%, and filed a refund claim alleging that the penalty was assessed outside the normal three-year statute of limitations under Section 6501(a) or a 5-year SOL under Title 28 that applies to civil penalties. He also alleged in the alternative that the doctrine of laches barred the government from assessing the penalty for conduct that stretched back the better part of a decade.

After IRS denied the claim, Groves filed suit in federal district court. The court agreed with the IRS, holding that the penalty under Section 6700 for failing to register a tax shelter was not subject to the normal statute of limitation scheme and that laches was of no help.

We are in the process of finishing the new chapter in Saltzman and Book on statutes of limitation (SOL); it should be out in the fall (with this chapter will mark the rewriting of all original 18 chapters in the book, with a new 19th chapter on CDP). In the SOL chapter we discuss the odd intersection of civil penalties and SOL issues. Many penalties are not subject to readily observable statutes of limitations. For civil penalties that are not “return-based” penalties, courts have increasingly found that those penalties are not subject to any statute of limitations.

What are non return-based penalties? The key feature is that the conduct that gives rise to the civil penalty is not tethered to the filing of a tax return; in other words, as in Groves, what triggered the liability was the conduct of promoting tax shelters and failing to inform the IRS of his promotion rather than the filing of a return.

Groves argued that because the Code states that the 6700 penalty is to be assessed and collected in the same manner as taxes it should thus be subject to the general SOL rules as per Section 6501(a). The opinion disagreed:

Section 6700 assessments do not depend on the filing of a tax return,” but rather “occur … after the IRS becomes aware that an individual’s activities are prohibited by Section 6700.” The mismatch between the triggering event under § 6501(a)—the taxpayer’s filing a return—and the basis for liability under § 6700—being involved in a tax shelter and making false statements about its benefits—makes the § 6501(a) limitations period an inappropriate fit for the assessment of § 6700 penalties.

Groves countered that there was a return at issue, that is, the individuals who took up his advice and filed returns taking positions consistent with his shelter advice. The court emphasized that the penalty under Section 6700 only looked to whether promoter makes “a statement that falsely touts the shelter’s tax benefits.”

The court also addressed 28 USC § 2462, a non-tax law based SOL that applies to civil penalties. That statute states that “[e]xcept as otherwise provided by Act of Congress, an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued ….”

The opinion concluded (as have other courts) that the IRS assessment of a 6700 penalty does not arise from “an action, suit or proceeding” because the IRS assessment arises from in the court’s view an ex parte act rather than an adversarial adjudication. Adjudicative action is a prerequisite to the 28 USC § 2462 SOL applying. As support, the court emphasized that Groves had no right to any pre-assessment administrative adjudication of the penalty, and a number of courts have held that the assessment itself was agency conduct not in the nature of an action or suit for these purposes. Groves served up a number of other creative § 2462 arguments, but the court rejected them, largely on the grounds that the IRS imposition of the penalty was not in any way based on a hearing or other adversarial procedures.

Finally, the court considered whether laches applied. Laches is an equitable defense that gives the court the power to hold that a legal right or claim will not be enforced if a party unreasonably delays in bringing the claim and the delay prejudices the other party. There is uncertainty as to whether a laches claim can be made against the government in tax cases. A Fifth Circuit case, Sage v US, after concluding that no SOL applied to the 6700 penalty, stated in dicta that the doctrine was the only curb on IRS assessment power.

Groves is appealable to the 7th Circuit, and the district court noted that the circuit had not held whether laches is available as a defense to a government tax suit. (for an interesting discussion of laches, including its history, see Judge Posner’s discussion in the 7th Circuit Lantz case from 2010). Groves concluded that laches is probably not a defense in tax cases, and that even if laches were an available defense it only applied in narrow circumstances that were not present in the case. One of the circumstances is when there is an egregious delay. On that point  the court pointed to a 2005 Second Circuit case, Cayuga Indian Nation v Pataki. In Cayuga, the US intervened on behalf of the tribe in an ejectment action that stemmed from conduct over 200 years old and pertained to actions surrounding a treaty signed in 1795. Unlike Cayuga, “this case, by contrast, involves a delay of just over ten years. Although ten years is not an instant, the difference between a ten-year delay and a 200-year delay is one in kind, not of degree.” Another circumstance where laches may apply is when the government action pertains to an adjudication of private rights. As to that circumstance, the court noted that “few areas of government activity are more canonically sovereign than taxation.”

Parting Thoughts

It does to me seem odd that the government has no limits on when it can assess these (and some other) penalties. Over the last couple of decades there has been a vast increase in the number of civil penalties in the Code. When Congress gets around to revising the civil penalty regime, it would be well served to look at these non return based penalties and impose some outside limits on when the government can  assess these penalties.

 

Tax Court Holds That Veteran’s Submission of Election to Exclude Foreign Earned Income is Too Late When Submitted After Service Issues a Substitute Return

This week’s Redfield v Commissioner illustrates the harsh and sometimes unfair results that sometimes attach when a taxpayer misses a deadline. The taxpayer in this case was a disabled 12-year Marine veteran who served in Afghanistan; he was suffering from PTSD and memory loss. After leaving the Marines he returned in 2010 to accept a civilian position at an airfield in Kandahar. Unfortunately his physical and mental condition worsened and he returned back to the States later in 2010. The case illustrates perhaps a gap in our tax system: the Service is required to enforce most deadlines without regard to whether the taxpayer’s disability contributed to the taxpayer’s delinquency.

Redfield’s tax troubles arose from his failing to file a tax return for the 2010 year, the year in which he had some foreign source income from the time he was working as a civilian in Kandahar. In 2014, IRS eventually prepared a substitute for return under Section 6020(b). Redfield did not respond to the stat notice that accompanied the SFR; instead he filed a delinquent 2010 return, which attempted to exclude the foreign source income from his shortened civilian gig in Kandahar.

Section 911 provides that citizens and residents living and working outside the US can exclude some of that earned income (the cap is adjusted for inflation and is about $100,000 these days). I will not spend much time on the nuances of the foreign earned income exclusion but Section 911 states that a taxpayer wishing to avail himself of the exclusion has to elect its application. The statute also directs the Treasury to issue regs to implement the regime. Treasury issued regs under Section 911 that fill in the details of that election: the when and the how are spelled out in detail.

The case considers whether Redfield satisfied the regulation’s timing requirement. The regs establish 4 methods of making the election 2 of them require the election to be made either with or in response to a timely filed return; a third requires that the election be made within one year of a timely filed return. That did not happen here.

The main issue revolved around the fourth method. It allows a taxpayer to file the election if it is made before the Service “discovers that the taxpayer failed to elect the exclusion.” In particular, the Tax Court considered whether the Service’s SFR amounted to its discovering that Redfield did not elect to exclude the wages he earned while working in Afghanistan.

Unfortunately for Redfield, in McDonald v. Commissioner, T.C. Memo. 2015-169 the Tax Court held that the Service discovers the failure to make the election no later than the issuance of the substitute for return. Redfield’s election was submitted years after the SFR, and the Tax Court held that he was out of luck.

The Tax Court acknowledged the harshness of the outcome, but felt that its hands were tied:

We acknowledge petitioner’s military service to this country and recognize that he emerged far from unscathed from his tours of duty in Afghanistan. We understand that the procedural requirements for making a timely [foreign earned income exclusion] election are not exactly intuitive and that the scars petitioner incurred during his military service may have contributed to the tax delinquency at issue.

While these facts may be relevant to the penalty and additions to tax that the IRS determined, they do not alter the requirement of a timely election. As to that requirement we must give effect to the regulations that the Secretary has issued under his delegated authority from Congress and to this Court’s prior construction of those regulations. That being so, we unfortunately have no alternative but to hold that petitioner did not make a timely and valid [foreign earned income exclusion] election for 2010. He is therefore not entitled to exclude from gross income any foreign earnings under section 911.

Some Parting Thoughts

Keith has written extensively on the impact of disability and time deadlines in the Code. An article he co-wrote a few years ago suggests that Congress should more directly apply the concepts of financial disability to other deadlines that taxpayers may not meet.

Deadlines by their nature may at times work and produce an unfair substantive result. The Service administers a complex tax system and processes many million tax returns. Yet it seems that for taxpayers who suffer from mental and physical disabilities, especially for veterans whose injuries arose in service for our country, there should be a safety valve for the Service or the court to provide relief when the failure to meet a deadline  is connected to the taxpayer’s disability.