A PT Anniversary and Court Finds IRS Summons on Coinbase Suggests an Abuse of Process

Today marks the 4th anniversary of Procedurally Taxing. Our first post, Welcome to Procedurally Taxing, discusses our goals for the blog. As I discussed in that initial post, we hoped to become a source for developments and to act as a filter to allow readers to hone in on some key issues relating to tax administration and tax procedure. When we started we had no idea how much work was involved in writing and editing. We also did not anticipate how much we would benefit from our readers, many of whom contact us, offer comments and become guest posters. So thanks to our readers for inspiring us to remain engaged.

Enough of the mush and on to some tax procedure.

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We have previously discussed the IRS issuance of a John Doe summons on Coinbase. The case has been proceeding and last week an order from a magistrate judge out of the Northern District in California held that an anonymous customer could intervene in the summons enforcement proceedings. This brief posts highlights some of those developments.

Coinbase is an exchange that deals in convertible virtual currency. It operates a bitcoin wallet. It is a big player in the virtual currency market. IRS has been concerned that parties using bitcoin are not complying with their tax obligations. Recall that in 2014 IRS issued Notice 2014-21, where IRS opined that virtual currencies are property for tax purposes, potentially triggering a gain or loss on sale or exchange of a virtual currency.

Flash forward a few years and IRS serves up its John Doe summons on Coinbase. The requested information was voluminous, including:

Account/wallet/vault registration records for each account/wallet/vault owned or controlled by the user during the period stated above including, but not limited to, complete user profile, history of changes to user profile from account inception, complete user preferences, complete user security settings and history (including confirmed devices and account activity), complete user payment methods, and any other information related to the funding sources for the account/wallet/vault, regardless of date.

At the recent ABA Tax Section meeting there was lots of talk about how the IRS summons was overbroad, potentially sweeping up small transactions and people whose information would likely be of no interest to the IRS.

Following service of the summons a number of parties, including Coinbase, sought to intervene to quash the summons. Coinbase also sought to narrow the scope of the summons.

This summer there was oral argument on the motions and IRS informed the court that it has narrowed the scope of the summons. The CA district court order on the motions describes that narrowing:

In particular, [IRS] now seeks information for users with at least the equivalent of $20,000 in any one transaction type (buy, sell, send or receive) in any one year during the 2013-2015 period. Further, the IRS does not seek records for users for which Coinbase filed Forms 1099-K during this period or for users whose identity is known to the IRS.

The order does a nice job laying out the procedures for IRS to get enforcement of a John Doe summons, highlighting that it (as with a generic third party or taxpayer summons) is not self-enforcing and also reviewing the special protections Congress set out in Section 7609(f) before the government can get records when it does not know the identity to whom the records belong.

As with any summons enforcement proceeding, the government has to show that it is issuing its summons in good faith and in pursuit of a Congressionally authorized purpose.

The interesting part of the recent order is the District Court considering whether one of the Coinbase customers has the right to intervene under the Federal Rules of Civil Procedure. There is a bit more to the issue than I describe but whether a party has a right to intervene in the absence of a privilege claim mostly turns on whether the IRS procedures amounted to an abuse of process.

In finding that there was an abuse, the court emphasized that the original summons was far too broad in relation to the government’s legitimate interest in seeking information that may pertain to potential evaders. It is worth honing in on the government’s position and the court’s rebuke:

As of 2014, Coinbase had one million users; thus, the IRS seeks broad data on likely hundreds of thousands of users. These records include complete user profiles including user payment methods, records of Coinbase’s due diligence on their customers, powers of attorney, complete user security settings and history (including confirmed devices and account activity), among other documents. The IRS offers no explanation as to how the IRS can legitimately use most of these millions of records on hundreds of thousands of users; instead, it claims that as long as it has submitted a declaration from an IRS agent that the IRS “is conducting an investigation to determine the identity and correct federal income tax liabilities of United States persons who conducted transactions in a virtual currency during 2013-2015” the Court must find that the Summons does not involve an abuse of process. It contends that “there seems to be a substantial gap between the number of people transacting in virtual currency (for which tax consequences might attach) and those that are reporting such transactions.”

(emphasis added)

The order pushes back on the government’s perspective, claiming that it “proves too much”:

Under that reasoning the IRS could request bank records for every United States customer from every bank branch in the United States because it is well known that tax liabilities in general are under reported and such records might turn up tax liabilities. It is thus no surprise that the IRS cannot cite a single case that supports such broad discretion to obtain the records of every bank-account holding American. While the narrowed Summons may seek many fewer records, the parties agreed to have the Court decide the motion on the original record, and so it has.

The order is also interesting for its rebuke of the government’s position that a customer (unlike Coinbase itself) did not have a protected interest that would allow it to intervene. There is little law in this area, bit the court order distinguishes between enforcement and issuance proceedings. The court holds that a customer who learns of the John Doe summons through some other means can intervene in an enforcement proceeding but not on the issuance of the summons itself:

There is nothing in the John Doe summons procedure adopted by Congress to provide protections to those to whom the IRS could not give notice that suggests that when the John Doe nonetheless learns of a summons from other means the John Doe has no interest in challenging the enforcement of that summons. The government’s assertion that to do so would place an undue burden on the IRS’s legitimate use of John Doe summons makes no sense. All that is being addressed here is the proposed intervenor’s right to intervene in a proceeding that is already taking place. Moreover, as the IRS concedes, if it knew of the applicant’s identity, it would have to give the applicant notice and the applicant would have the opportunity to challenge enforcement. It is thus unsurprising that the one case to have discussed the issue, at least that the parties have cited, assumed that a subject of a John Doe summons could challenge its enforcement.

That the direct interests of the other parties are now involved in this proceeding is as the court implies a good development. Allowing information from customers to be directly introduced provides an opportunity for the court to be better informed. While the government has a clear view as to what it believes Coinbase customers are up to, the strong reaction to the IRS efforts and the IRS’s narrowing of the summons itself suggest that the IRS worldview may be a bit narrow.

Stay tuned, as the court will now likely address the merits of challenges to the summons itself.

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

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

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

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

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

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

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

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

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

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

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

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

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

            Potential Third Party Contacts

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

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

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

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

Grinches, Liechtenstein Royal Princes, Bankers, Toymakers (and Offshore Evasion): A Holiday Summons Tale

In today’s post returning guest blogger Dave Breen, the acting Director of Villanova’s Low Income Taxpayer Clinic, discusses the case of Greenfield v US. The issue in the case relates to the IRS’s cat and mouse game of finding assets and the unreported income from those assets that citizens have parked in offshore accounts. The issue in these cases does not generally involve much tax law.  The battle is won and lost on the issue of information.  If the IRS gets the information, the taxpayer generally loses.  Summons work is key and the Greenfield case is a major development.  For many years, Dave worked with IRS attorney John McDougal, whose retirement I wrote about last week.  In the spirit of the season, Dave recounts the story of the case and its implications.  Keith

A recent IRS setback in a summons enforcement case out of the Second Circuit piqued my interest, because I spent the final twelve years of my career in IRS Counsel working on IRS’s offshore initiatives addressing tax evasion through the use of offshore accounts in tax secrecy jurisdictions.  My take on this recent case is that taxpayers and some practitioners may believe that the era of IRS investigating offshore tax evasion has run its course.  I think this case does just the opposite.  The Court’s decision demonstrates that much of IRS’s data on offshore tax evasion is dated – possibly even too old to be of any value – but I also suspect that IRS has come to the same conclusion.  Rather than moving on to other areas of non-compliance though, I suspect IRS at this moment is developing more tools to secure the next wave of current information on offshore tax evasion.  This does not bode well for taxpayers who so far have avoided IRS’s inquiry into their offshore holdings.

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A bit of history

In 2000 IRS used permission to use John Doe summonses to secure information on U.S. taxpayers who accessed funds in their secret offshore accounts through American Express and Mastercard credit cards.  IRS’s first major success occurred in 2002 when the U.S. District Court entered an order requiring American Express to comply with IRS’s John Doe summons.  The information IRS received pursuant to this summons provided the data for what became known as the Offshore Credit Card Project.  Rather than go into the specifics, I refer readers to Keith Fogg’s 2012 Villanova Law review article Go West: How the IRS Should Foster Innovation in Its Agents. Subsequent offshore initiatives relied on data secured through John Doe summonses to UBS and other foreign banks, information received from whistleblowers, and information provided by taxpayers applying to one of IRS’s voluntary disclosure programs.

Despite the success in securing records identifying offshore tax evaders, the quality of the information IRS received was sometimes problematic, because it was out of date or incomplete.  For example, when a federal judge in Miami ordered compliance with the aforementioned John Doe summons in 2002, it only covered records for tax years 1998 and 1999 – “old years” in IRS parlance. Further, information received often did not dove-tail with IRS’s information.  IRS is driven by social security number, name, and to a lesser extent, last known address.  Credit card data is driven by credit card number and billing address.  This created a mismatch.  Once IRS received the summoned information it took many months to link a specific taxpayer to a particular offshore account through a credit card, assemble the case, and assign it to an agent specially trained in examining offshore transactions.  The IRM discourages IRS from beginning examinations of “old” tax years – generally those returns beyond the most recent two tax years – unless there are compelling reasons.  IRS prefers to examine more current tax years where plenty of time remains on the 3 year statute of limitations under IRC §  6501(a).   Although the 1998 and 1999 credit card data was sufficient to prove a taxpayer had a foreign bank account in 1998 or 1999, the information was not particularly helpful in proving how much income was unreported in those years or whether there was unreported income in later, more current years.

As a result, examiners assigned to these early cases often had to issue administrative summonses under IRC § 7602 to taxpayers for their most recent foreign bank account records to secure foreign account information for years after 1999.  The Department of Justice, which handles summons enforcement matters before the U.S. District Courts for IRS, has been extremely successful in securing orders enforcing these summonses, but the process takes time.  During this long process the data gets older and has diminishing value to IRS.  Proof that the data has a limited shelf life was recently demonstrated in a summons enforcement case.

Greenfield decision

In August 2016 the Second Circuit placed a speed bump along IRS’s road to identifying offshore tax evasion with dated information.  In United States v Greenfield, 118 AFTR 2d 2016-5275 (2016) the court vacated the District Court’s order enforcing an IRS summons and remanded the case for further proceedings consistent with its opinion.  The case is noteworthy for several reasons, but most importantly I see this as a wake-up call for IRS as well as a reminder to offshore tax evaders that IRS continues to pursue offshore tax evasion rigorously.

In the spirit of the holiday season, I offer the following tale.

Once upon a time there was a toy maker named Harvey Greenfield, his son, Steven, and their toy shop, Commonwealth Toy, Inc.  We also have a Grinch, Heinrich Kieber, whose job was to copy, file, and safeguard records at Liechtenstein Global Trust (LGT) a financial institution owned by the Liechtenstein royal family.  One day, while tending to his copying duties at the bank, Mr. Kieber decided to press “2” instead of “1” and make an extra copy of records that identified individuals who banked (translate: “hid their untaxed income”) at LGT.  Kieber, playing “Secret Santa”, offered the documents to several nations.  Many told him to “go Fish,” while other countries, including the U.S. did not.  The U.S. found the information to be very helpful in finding out who was naughty and who was nice. Needless to say, Mr. Kieber’s decision did not make him any new friends among the 38,000 residents of Liechtenstein.  He was charged with theft of information under Liechtenstein law and promptly went into hiding, leaving a trail of Angry Birds in his wake.  Like the Cabbage Patch doll you stood 3 hours in line to buy for your daughter in 1983, his whereabouts today are unknown.

Back to the Greenfields.  Several of Kieber’s cache of confiscated documents tied Steven and Harvey to certain offshore entities that had been used, or were being used, to evade taxation.  It just so happens that at this time the U.S. Senate’s Permanent Subcommittee on Investigations had begun hearings in response to the LGT disclosure and a similar leak from the Swiss bank, UBS.  Harvey died in 2009, leaving Steven as primary beneficiary of the LGT holdings.  PSI twice invited Steven to come in and talk about LGT, Liechtenstein, and foreign accounts in general.  The first time Steven failed to appear.  PSI was not too pleased with being stood up for its Mystery Date with Steven, so they invited him again.  The second time he appeared but asserted his Fifth Amendment right to remain silent.

Enter the IRS, who decided to audit Steven’s 1040’s for 2005 – 2011.  But there was a snag.  Kieber did not copy everything about the Greenfields – just enough to identify them as beneficial owners controlling the funds in the offshore accounts.  These documents included some memos, a 2001 year-end statement for their Maverick Foundation (a stiftung, under Liechtenstein law), LGT account information forms for Maverick and two entities it owned, and a 2001 LGT profile for Maverick and another company.  Of particular interest to IRS was a March 23, 2001 memorandum prepared by LGT personnel, detailing a meeting in Liechtenstein between the Greenfields, LGT employees, and Prince Philip of Liechtenstein.  The memo stated in part:

“The clients are very careful and eager to dissolve the Trust with the Bank of Bermuda leaving behind as few traces as possible. The clients received indications from other institutions as well that U.S. citizens are not those clients that one wishes for in offshore business.”

Great stuff, but not enough for IRS to determine how much tax was owed.  IRS didn’t have a Clue as to Steven’s gross income.  To fill in the considerable gaps in information, IRS issued an administrative summons to Steven for records and testimony.  After discussions with Steven’s counsel regarding the breadth of the summons, IRS reduced its scope to the production of documents related to foreign entities to the 2001 through 2006 tax years.

Greenfield refused to comply with the “kinder, gentler” version of the IRS summons.  Convinced that this was no Trivial Pursuit, IRS refused to Lego of the issue and brought suit to enforce yet another less expansive version of the original summons in district court.  Steven wasn’t having any of that one either and defended by invoking his Fifth Amendment right to remain silent.

General Summons Law and Greenfield

Generally, a Fifth Amendment right to remain silent is not effective for documents because contents of documents are not testimonial.  Fisher v. United States, 425 U.S. 391 (1976).  However, while Fisher held that documents were not testimony, the Court held that the act of producing the documents could be testimonial, because it may communicate incriminatory statements of fact.  For example, if the only person with access to offshore bank statements is the person who controls the funds in them, the person coming to court with the bank statements is essentially saying (testifying or admitting), “The documents you want exist, I control them, they are authentic, and here they are.”  This is the “act of production” defense Steven raised.  But the Ping-Pong game did not end there.

The government’s comeback to the “act of production” defense is the “foregone conclusion” rule.  If the testimonial aspects of production are a “foregone conclusion”, that is, if the government can establish the “existence, control, and authenticity” of the records independent of the witness’s production of them, the act of producing them loses its testimonial nature.  But the government must be ready to establish independently that the documents exist, the witness controls them, and they are authentic.

Based on the record, the Court found the Government met the first two tests: it accepted the existence of the documents in 2001 and Greenfield’s control of them in 2001.  It was not so willing, however, to accept their authenticity and turned to the Government to establish the third prong of the test.

The Government elves had their work cut out for them.  They went back to their workshop and crafted several arguments with respect to the authenticity of the 2001 records. It put on its Poker face and argued that the 2001 documents could be authenticated in three ways: (1) an LGT employee could come to the United States and authenticate them in court; (2) Kieber himself could come out of hiding and authenticate them; or (3) authentication was possible through Letters of Request issued under the Hague Evidence Convention.

The Second Circuit wasn’t buying any of the Government’s arguments.  First, the Court found it unlikely that LGT would send a witness to the United States to authenticate the records.  Secondly, it was highly unlikely Kieber, who was in hiding, would do it; and (3) the Government could not show a single instance where Letters of Request issued under the Hague Evidence Convention had been used to authenticate documents from LGT or any other Liechtenstein financial institution in the past.  Why would the Government think it would work in this case?

The Court didn’t stop there.  Assuming arguendo that the Government passed the 2001 hurdle, it would still have to show that the documents existed and that Steven controlled them in 2013, twelve years later.  Existence and control in 2001 does not create an inference of existence and control in 2013.  Factors such as the type of records, the likelihood of transfer to another person, and the time interval involved all bear on the matter.  In rejecting the Government’s arguments the Court found any number of reasons why Steven may not have had a Monopoly on control of the records from 2001 to 2013 or that the documents still existed in 2013.  Therefore, the Court did not enforce most of the summons and Steven did not have to produce the records.

Conclusion

But before you settle your brains for a long winter’s nap, think about this.  Even though Steven may have sunk IRS’s Battleship, today IRS is not in any immediate Trouble.  In fact, it is already working on a new Mousetrap.  On November 30, 2016 IRS received permission to issue a John Doe summons to Coinbase, Inc., a virtual currency exchanger headquartered in San Francisco, California, that Les discussed last month in his post IRS Seeks Information via John Doe Summons Request on Bitcoin Users.  

The moral of the story?  Uno’s?  I suspect many clients with assets hidden offshore will still take a big Risk by not coming in under IRS’s voluntary disclosure program, but you don’t have to be a Mastermind to see that many of them will ultimately be Sorry.  But, I guess that’s The Game of Life.  Happy Holidays!

 

 

 

The Practice of Secret Subpoenas in Tax Court: Tax Court Out of Step with Other Courts and IRS Itself

I read with interest blogger Lew Taishoff, whose blog Taishoff Law mainly covers the Tax Court. Last week in The Stealth Subpoena is Alive and Well Lew discussed Tangel v Commissioner. Tangel reveals an odd practice that distinguishes Tax Court litigation apart from other federal courts.  Rule 45(a)(4) of the Federal Rules of Civil Procedure requires parties who issue subpoenas to third parties compelling the production of documents or other evidence to notify the opposing party of the subpoena issuance. Tax Court rules do not explicitly require a party to notify the other side. The absence of an explicit notice requirement with respect to subpoenas creates the possibility of surprise. In addition to being out of step with other federal courts, it is inconsistent with the Tax Court’s general approach of encouraging parties to communicate and cooperate.

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Tangel involves a series of motions that the taxpayers filed relating to IRS counsel having issued subpoenas to third parties under Tax Court Rule 147(a) or 147(b). We have not discussed Rule 147(a) or (b) but the Tax Court rules give the process for which a party may compel attendance of a person or of evidence at a trial or Tax Court proceeding. Essentially 147(a) applies to people required to give testimony; 147(b) extends the reach to commanding a person to bring documents or other evidence, with the Tax Court retaining discretion to quash or modify the latter subpoena if it is “unreasonable or oppressive.”

On their face, Tax Court Rules 147(a) and (b) do not mention of notice, and the subpoena is not filed with the court. It is thus not subject to the general Tax Court rules on notice, found in Rule 21(a). That rule provides that parties serve on other parties or other persons involved in the matter all filed paper including “pleadings, motions, orders, decisions, notices, demands, briefs, appearances, or other similar documents or papers relating to a case….”.

In Tangel, IRS counsel issued subpoenas to third parties and did not notify the Tangels. The order is brief and I have not read (nor can I unless I were to head down to DC) the underlying motions but the Tangels objected to the issuance of the subpoenas in part on the grounds that Counsel failed to notify them of their actions. Judge Chiechi, the judge in Tangel, dismissed that argument, noting that “[a] party that issues a subpoena under Rule 147(a) and/or (b) is not required to give prior notice to the other party.”

Tax Court practice is not always in lock step with federal court practice but not giving notice of a subpoena compelling the production of documents or other evidence seems wrong. Attorney Taishoff has discussed this aspect of Tax Court practice in a prior post called Judge Holmes’ Vendetta, where he discussed an order earlier this year in Ryder v Commissioner, which also involved the issuance of a subpoena under Rule 147(b). Unlike the outcome in Tangel, in Ryder, Judge Holmes explicitly disapproved of the practice of issuing subpoenas without notifying the taxpayer. In so doing, Judge Holmes gave a history lesson on why it is likely that Tax Court rules differ from the federal rules of civil procedure:

We do have to disagree with the Commissioner, however, that this absence of a rule creates an implication that secret subpoenas are favored. We promulgated our Court’s Rule 147, which governs subpoena practice, back in 1973. Tax Court Rules of Practice and Procedure, 60 T.C. 1057, 1137 (1973). At that time, we said that our goal was a rule substantially similar to FRCP 45. Id. Back then, FRCP 45 didn’t require notice for subpoenas. Fed. R. Civ. Proc. 45 (1970). The notice requirement was added in 1991 to give parties the same opportunity to challenge nonparty subpoenas for documents that they had to challenge subpoenas for depositions (since FRCP 30 and 31 already provided notice protection in these circumstances). See Fed. R. Civ. Proc. 45 advisory committee’s note (1991). We have never publicly stated that we intended to deviate from Article III practice — it’s just an example of the two sets of rules drifting apart over time.

We think that the current federal rule is a good one in litigation that is, as in these cases, especially hard-fought. The Court will therefore adopt the notification requirement of Federal Rule 45 as a modification to the pretrial order that governs this case.

Mr. Taishoff suggests perhaps that the judges in Ryder and Tangel get together and “discuss bringing Tax Court into the last decade of the Twentieth Century, if not into the second decade of the Twenty-First.” An earlier post of his suggested the Ryder approach find its way in a published opinion. Another thought is perhaps it is time for the Tax Court to modify its rules and coordinate Tax Court practice with that in other federal courts through a rule change.

It is interesting as well that the Tax Court practice is somewhat inconsistent with the IRS’s administrative practice. Consider the related issue of the notice that is required to be given when the IRS contacts third parties in an examination. As of 1998, Section 7602(c) provides that an employee of the Internal Revenue Service may not contact any person other than the taxpayer with respect to the determination or collection of the tax liability of such taxpayer without providing reasonable notice in advance to the taxpayer that contacts with persons other than the taxpayer may be made.”

This RRA 98 notice of third party contact rule has generated some controversy. The statute fails to define reasonable notice for these purposes, and IRS and taxpayers have fought about whether the IRS’s inclusion of generic notice in its Publication 1 at the start of an exam constitutes “reasonable notice” of a third party contact. For example, earlier this year a district court in California in Baxter v US that found that Publication 1 was insufficient as a matter of law to constitute the advance notice that Section 7602(c) contemplates. That resulted in the district court finding that the IRS did not meet the prima facie good faith requirement under US v Powell and to the court’s quashing of a summons IRS served on a third party.

TAS in its 2015 annual report flagged IRS third party contact procedures as one of its most serious problems, making the sensible point that advance adequate notice allows taxpayers the possibility of themselves providing the IRS what it needs without the possible damage to a taxpayer’s business or reputation that may follow IRS third party contacts. That report criticizes the IRS use of generic notice, finding them “ineffective because they do not identify the information the IRS needs, inform the taxpayer the IRS will make a [third party contact] in the taxpayer’s particular case, or provide the taxpayer with enough advanced notice to deliver the information before the contact.” TAS 2015 Annual Report MSP # 12, at p. 123 (note omitted).

It seems to me that similar taxpayer interests are implicated when considering notice rules for subpoenas at trial, with possibly more at stake in terms of both taxpayer reputation and damage and a heightened need to know what the other side is gathering as a trial looms. It seems prudent for the Tax Court to modify its approach and require both parties to give notice consistent with the Federal Rules of Civil Procedure. This will reduce surprise and provide another chance for the taxpayer himself (if the government is seeking the information) to serve up what is needed, all at rather minimal costs to the government.

 

 

IRS Seeks Information via John Doe Summons Request on Bitcoin Users

Last week in federal district court in Northern California the Department of Justice filed a petition seeking authority to obtain records the records of all customers who bought virtual currency from Coinbase, a virtual currency exchange company, from 2013 to 2015. The John Doe summons request came on the heels of a TIGTA report on the challenges associated with the growing use of virtual currency, which I discussed here in TIGTA Issues Warning on Compliance Issues Associated With Use of Virtual Currencies.

We have not previously discussed John Doe summons requests. Essentially, a John Doe summons is a summons that does not identify the person with respect to whose liability the summons is issued. The government has used it extensively in its efforts to uncover the identities of taxpayers hiding assets in previously undeclared offshore accounts. (We discuss the use of John Doe summonses in Saltzman and Book IRS Practice and Procedure Chapter 13.05[2], and readers who want more should review the chapter’s discussion).

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Sections 7609(c)(3) and (f) authorize the Service to issue a John Doe summons pursuant to an investigation of a specific, unidentified person or ascertainable group or class of persons. The summons requires district court approval in an ex parte proceeding. Before granting the summons, in addition to the investigation requirement the DOJ on behalf of the Service must also show a reasonable basis to believe that that person or group or class of persons may fail or may have failed to comply with any provision of the internal revenue laws; and that the identity of the persons and the information sought in the summons is not readily obtainable from other sources.

When the IRS seeks the use of a John Doe summons, the IRM provides that the Service should be far along in its development of the issues relating to the request:

The Service should no longer be in the information-gathering or research stage of a project when it decides to seek court authorization to serve a John Doe summons. The project research should be sufficiently developed to enable the Service to identify a specific tax compliance problem. The Service should be prepared to investigate the tax liabilities of specific taxpayers based on the information received from the John Doe summons.

IRM 25.5.7.4.2 Necessary Purpose (Nov. 22, 2011).

To support the issuance of the John Doe summons request, the DOJ typically provides the district court declarations from IRS revenue agents who are in a position to provide information as to how the particular facts justify the issuance of the summons.

We have uploaded the declaration of the IRS Revenue Agent David Utzke that was filed in support of the John Doe summons request to seek the customer records. It makes for fascinating reading, detailing what IRS has learned to date on ways that US taxpayers are using the currency to (attempt to) disappear from the taxman and how the IRS in its constant game of a whack a mole is trying to figure out the ways that this technology will complicate IRS efforts to combat offshore evasion.

As the TIGTA report discussed, virtual currency usage complicates tax administration. Its use is growing (see paragraph 28 of the declaration where Revenue Agent Utzke estimates that the transaction value in dollars of bitcoin usage in 2015 exceeded $10 billion). I write this as I have just returned from a conference on how advances in technology and social knowledge can improve tax administration. Utzke’s declaration reveals what he has learned from investigating taxpayers who have used bitcoin as a way to hide income, including how some taxpayers shifted to bitcoin when IRS offshore efforts heated up a few years ago (see paragraph 32 for example). This first major public IRS effort to address the challenges of virtual currency reveals that with technological changes and advances come new ways that black-hatted taxpayers can game the system.

Update: For more on the John Doe summons request on Coinbase, see our Forbes blogging colleague Kelly Phillips Erb in IRS Wants Court Authority to Identify Bitcoin Users & Transactions

Jack Townsend at Federal Tax Crimes has an excellent and more detailed discussion of the summons request, including Coinbase’s likely opposition to the request, Jack’s initial take on the uphill battle the company faces, and the SOL impact of the John Doe summons request.

Clarke Case Finally Comes to End: Eleventh Circuit Orders Enforcement But Also Leaves Door Open For Allegations of Improper Purpose

We have written a few times on the Clarke summons enforcement case, most recently when I discussed the district court’s 2015 opinion finding in favor of the government. As you may recall, following the 2014 Supreme Court Clarke decision, which rejected the 11th Circuit’s more permissive allowance of evidentiary hearings in summons enforcement cases, the 11th Circuit remanded the case to the district court to evaluate the merits of the challenge. The district court ordered the summoned parties to comply without an evidentiary hearing and found that that allegations of retaliation and misuse of summons power to circumvent Tax Court discovery did not as a matter of law amount to allegations of improper motive. On appeal, the 11th Circuit affirmed the district court’s holding that the parties failed to raise a plausible inference of improper motive but disagreed with the district court that none of the alleged improper purposes amounted to an improper motive to issue a summons as a matter of law.

I will briefly describe the holdings below; Jack Townsend Federal Tax Crimes also this past weekend posted on the case for those who want more.

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Retaliation and circumvention of Tax Court discovery could be improper motive

Before finding in favor of the government and ordering the parties to comply with the summonses, 11th Circuit suggested that in limited circumstances, allegations relating to the IRS using the summons process to retaliate for a failure to extend the sol on assessment and to circumvent Tax Court discovery rules could amount to an improper purpose.

It addressed the retaliation issue first. While noting that IRS may have little alternative to issue a summons when a taxpayer neglects to extend the statute, it criticized the opinion below for failing to “meaningfully address the legal issue of whether issuing a summons only to retaliate against a taxpayer would be improper as a matter of law. We believe that it would.”

The challenge for parties alleging retaliation for failing to extend the sol is in the proof, and arguably the opinion below equated that difficulty with an impermissible blanket for the government:

The factual difficulty in differentiating between a retaliatory summons and a summons issued after a taxpayer’s refusal to extend the limitations period has no bearing on this legal question. We conclude that issuing a summons for the sole purpose of retaliation against a taxpayer would be improper as a matter of law.

The discussion of whether circumventing discovery through summons had a similar feel, noting the difference between questions of proof and a blanket conclusion that there could be no impermissible purpose when a summons is issued that may. The opinion notes that using a summons to circumvent Tax Court discovery rules “would clearly be an improper purpose for the IRS to issue a summons in bad faith outside a legitimate investigation….” Looking to law finding that the validity of the summons is tied to the date of issuance, and given the deference to IRS’s power to investigate, the circumstances under which a taxpayer could successfully allege improper circumvention of discovery are likely rare. Despite the narrow circumstances, the court did open the door slightly:

That the summoned information may assist the IRS in preparing for its case in the tax court is of no consequence… We stress that given our deference to the IRS’s broad authority to investigate, the circumstances under which a taxpayer could successfully allege improper circumvention of tax discovery are exceptionally narrow. However, we will not limit courts from examining distinct scenarios that may plausibly support such allegations. Accordingly, we conclude that issuing summons in bad faith for the sole purpose of circumventing tax court discovery would be an improper purpose as a matter of law.

The Challenge Failed to Raise Plausible Inferences of Improper Motive

In the second main part of the decision the Court declined to order the district court to hold an evidentiary hearing. The 11th Circuit applied the Supreme Court’s standard to the case at hand, and noted that the “submissions raise many allegations, but no plausible inference of improper motive.”

More on that finding:

First, the submission that the timeline of the issuance of the summonses supports an inference of retaliation by the IRS requires substantial conjecture that is both implausible and unsupported by the record. Further, none of Appellants’ submissions suggest that the summonses were issued in bad faith anticipation of tax court proceedings rather than in furtherance of Agent Fierfelder’s investigation. As conjecture and bare allegations of improper purpose are insufficient as a matter of law, we conclude that Appellants failed to meet their burden under Clarke and the district court did not abuse its discretion denying Appellants’ request for an evidentiary hearing.

The opinion included some more discussion of how the fact that the issuance of the summons may have assisted in the Tax Court proceedings did not in and of itself amount to improper purpose, including a discussion of how the TEFRA provisions explicitly state that nothing in TEFRA “shall be construed as limiting the authority granted to the [IRS] under section 7602 [the summons provision].”

At the end of the day Jack Townsend’s conclusion in his post  accurately encapsulates the post-Clarke world of improper purpose challenges:

The bottom line is that the opinion reinforces that avoiding summary enforcement once the IRS makes the Powell prima facie showing will be possible but extremely rare.  Necessarily, each case will be decided on its unique facts, but merely raising possible improper purposes is not the same as showing plausible inferences of improper purposes.

 

The Limits of the “One Inspection” of Taxpayers’ Books and Records Rule

We have discussed parties’ challenges to IRS administrative summons on a few occasions. Courts give IRS wide latitude in seeking documents and evidence in the exam process. One limitation on IRS powers is the Code itself, as Section 7605(b) provides that “only one inspection of a taxpayer’s books of account shall be made for each taxable year unless ․ the [Treasury] Secretary ․ notifies the taxpayer in writing that an additional inspection is necessary.” A recent case out of the Seventh Circuit, US v Titan International, illustrates that despite the one bite at the apple rule, the IRS gets another bite when a subsequent request for records that IRS previously may have requested relates to a differing year’s tax liability.

Here are the facts and the basic issue before the court.

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Titan received an IRS summons issued in connection with an audit of its 2010 tax year. The summons ordered Titan to turn over records relating to 2009, including its general ledger and travel records. Titan had previously turned over those records in connection with the IRS’s audit of its 2009 year. The 2010 audit concerned a loss carry-forward from 2009.

Titan refused to comply with the summons. It argued before the district court and on appeal that Section 7605(b) prevents the IRS from inspecting the 2009 records it had already provided unless the IRS “makes a finding of necessity and notifies the taxpayer in writing of that finding.”

Titan argued that the prohibition in Section 7605(b) that IRS gets “only one inspection of a taxpayer’s books of account shall be made for each taxable year…” means that absent a finding of necessity and notice, the IRS cannot request information relating to the same year even if IRS needed the documents in another year’s examination:

Titan argues that the statute limits the IRS to a single inspection of a “taxpayer’s books of account” created for a particular taxable year, unless the Secretary finds a second inspection “necessary” and sends written notice to that effect. In other words, Titan reads “for each taxable year” as modifying “taxpayer’s books of account.” On this interpretation, Titan’s 2009 records—already inspected during the audit of its return for tax year 2009—cannot be inspected again in connection with the audit of its 2010 tax return (or any subsequent tax-year audit, for that matter) unless the Secretary first sends written notice of necessity.

The Seventh Circuit rejected that interpretation on two main grounds: a plain reading of the statute and applying a couple of cases that illustrate the statute’s limits.

On the matter of statutory interpretation, the court felt that Titan’s argument was strained:

Titan’s interpretation is disjointed and curiously omits some of the language of the statute. The key statutory phrase is this: “[O]nly one inspection of a taxpayer’s books of account shall be made for each taxable year.” The more natural reading of this language limits the IRS to one inspection of a taxpayer’s books per audit of a given year’s tax return (subject, of course, to notice and a finding by the Secretary that a second inspection is necessary). Read in this more natural way, § 7605(b) does not bar the summons of Titan’s 2009 records for the purpose of auditing its 2010 tax return.

The Seventh Circuit’s discussed two main cases, one decided in favor of the taxpayers and the other in the IRS favor. The taxpayer-friendly case was Reineman v. United States, 301 F.2d 267 (7th Cir.1962). In that case, the taxpayer purchased horses for a breeding business and deducted costs on its 1954 tax return. IRS requested records in an audit of the taxpayer’s 1954 tax return. IRS made adjustments to the 1954 return. IRS then audited the 1955 tax return, but in so doing took another look at the 1954 adjustments. IRS “reopened the 1954 audit (without written notice from the Secretary) and again adjusted the [1954] deduction for the six horses.” The Seventh Circuit said that ran afoul of Section 7605(b):

The 1954 records inspected by the IRS to adjust the deduction for the second time were wholly irrelevant to the 1955 audit. We concluded that the second inspection of those records violated § 7605(b) because it was an “additional inspection” of the taxpayers’ books for the purpose of reopening the 1954 tax return.

The second relevant case is Digby v. Commissioner, 103 T.C. 441 (1994). In that case IRS audited a 1987 tax return and during the examination looked at records pertaining to a couple’s S Corp stock basis to determine whether the couple could claim losses. The couple was able to demonstrate that it had basis to support a deduction. The IRS later also examined the 1988 individual tax return, which also had reflected losses from the S Corp. In the second audit, the IRS found that the couple did not have sufficient basis and disallowed the losses for both 1987 and 1988. The couple argued that the second request ran afoul of Section 7605(b). The Tax Court disagreed, and in so doing gave a detailed walk through the statute and its legislative history and its relation to the Supreme Court Powell decision. “[In Powell] the Supreme Court held, with respect to section 7605 (b) that, generally, “no severe restriction was intended”, and regarding unnecessary examinations, courts are not required “to oversee the Commissioner’s determinations to investigate.” As the Seventh Circuit explained:

The tax court concluded that the second inspection of the records was not a violation of § 7605(b) because that inspection was undertaken for the purpose of examining the 1988 tax return, and—unlike Reineman—those records were necessary to complete that audit. The court ruled that an additional adjustment of the tax return for an earlier taxable year is not a violation of § 7605(b) so long as it was not coupled with an additional inspection of the taxpayer’s books for the purpose of adjusting that year’s tax liability.

Naturally, Titan argued that its case was like Reineman. The Seventh Circuit disagreed:

This case is more like Digby than Reineman. The IRS first inspected Titan’s 2009 records to verify its net operating loss in connection with an audit of its 2009 tax return. The IRS now seeks to inspect those same records for the purpose of auditing Titan’s 2010 tax return in order to determine the validity of its 2010 net-operating-loss carryforward. Much like the pass-through loss at issue in Digby (and unlike the deduction at issue in Reineman), the net-operating-loss carryforward on the 2010 tax return cannot be verified unless the IRS inspects the 2009 records.

Conclusion

In our past discussion of summons litigation (e.g., the Clarke case still percolating post Supreme Court and on appeal following the district court order I discussed last year, IRS efforts to get records for offshore accounts, and in the IRS’s examination of Microsoft that Keith discussed here), the courts tend to give IRS wide powers to get access to relevant documents. As Titan shows, IRS can make a second request for documents it received in an earlier year’s audit if those documents relate to another year’s potential tax liability. As the discussion of Digby illustrates, so long as the IRS in seeking enforcement of a summons can connect the requested documents to a later year’s potential tax consequences, IRS not only gets a second look at the documents but also gets a chance to reopen that earlier audit.

Summons Enforcement For Undisclosed Offshore Accounts: The I Don’t Have Em Defense Is Not an Easy One to Win

Last year’s Supreme Court Clarke decision reshuffled the deck when it comes to summons enforcement litigation. Cases are now applying Clarke in different scenarios, and it seems that district courts are allowing more evidentiary hearings to consider bad faith or improper purpose defenses to summons enforcement. Even if a party can convince the district court judge to grant a hearing, those wishing to contest enforcement of the summons face an uphill climb. For example, in the Microsoft challenge to the Service’s use of Quinn Emanuel in its examination of Microsoft the November 23rd district court order granting the enforcement of the summons reflected the notion that a party challenging enforcement “bears a heavy burden” and that even if the government has an improper purpose in issuing the summons so long as there is some proper purpose the court will order enforcement (Keith wrote in the Tax Controversy Posts blog on the Microsoft issues prior to the court decision; I suspect we will return to the Microsoft litigation though note that BNA [free link not available] is reporting today that Microsoft is complying with the November court order).

Last month in US v Malhas the district court in Illinois considered the issue in the context of IRS seeking to enforce a summons when the taxpayer raised a “lack of possession” defense, a defense that defendants have traditionally had a hard time invoking, which is described in SaltzBook Chapter 13.04[5].

Malhas arose in the context of an IRS investigation of a taxpayer’s supposedly undisclosed offshore accounts. In this post I will describe the case and look at the way that the district court resolved the case in favor of the government.

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Background

IRS was investigating Wade Malhas’ 2006-08 tax years, with the investigation looking at liabilities allegedly stemming from undisclosed offshore accounts with UBS. IRS issued a summons; Malhas appeared but failed to produce documents. US eventually filed a petition to enforce the summons; Malhas responded and raised as an affirmative defense that he did not have the documents, known in summons enforcement litigation as the “lack of possession defense.” In support of his defense, Malhas filed an affidavit alleging that he had taken all reasonable steps to ensure that the documents were not in his custody. The government responded, stating that Malhas’ “blanket assertion” was not true, and that he failed to categorically show that he was not able to comply.

In support of its position, the government referred to the heavy burden that defendants typically have faced when raising the lack of possession defense. Generally, the cases have provided that the “burden falls squarely on the shoulders” of the defendant when raising this defense.

Malhas in response to the government’s position, added more to the blanket assertion, stating that the assets had been transferred to another international bank (Banque Baring Brothers Sturdaza) and that in any event he had given up all control of the bank account at issue back in 2004, when he transferred signature authority to a third party he had never met and cancelled his signature authority over the bank.

Court Says A Hearing is Justified

That was enough for the district court to order an evidentiary hearing. Recall that under Clarke the Supreme Court and in cases arising pre-Clarke where taxpayers have raised the lack of possession defense, if the defendant makes more than a threshold showing in support of an affirmative defense, courts may allow an evidentiary hearing. In Malhas, the affidavit claiming that the account was closed and that he transferred control prior to the years in question was enough to trigger the hearing.

Malhas makes clear that getting the hearing is far from tantamount to success; at the hearing the burden still is on the defendant. Some courts go into more detail than others in terms of discussing the discretion that the district courts should exercise. Other courts are much less specific.

In any event, the government at the evidentiary hearing came with evidence rebutting Malhas’ claim that he did not have possession, including “a plethora of documents and records illustrating Malhas’ connections with the international banks” and “pointing out that Malhas’ password. . . enabled him to access the accounts at issue without a signature.” Malhas failed to bring forth more evidence, and in fact two days before the hearing filed an emergency motion asking for a delay but in so doing suggested that the delay might allow the government to get more information from the bank in question.

Conclusion

Jack Townsend described the Malhas case last week in a post in his Federal Tax Crimes blog. As readers know, Jack is all over issues pertaining to offshore accounts, and his post has some good information, including that according to Bloomberg the transferee bank is known as being one that caters to wealthy athletes.

At the end of the day, the court felt that Malhas failed to meet his heavy burden and ordered him to comply with the summons by January. The case shows that defendants have a steep hill to climb. Perhaps though the court’s willingness to grant the evidentiary hearing in this case stems in part from a trend that will allow more such hearings post-Clarke. As Malhas shows, however, that may do little other than give a defendant some additional time and place some additional pre-enforcement burdens on the government.