Larson Part I Post: Full-Payment Rule of Refund Suits Held to Apply to Assessable Penalties

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Frequent contributor Carlton Smith discusses last month’s Larson v United States out of the Second Circuit. The Larson opinion situates civil penalties in the context of the Flora full payment rule, the APA, the 5th Amendment’s procedural due process protections and the 8th Amendment’s prohibition on excessive fines. Today’s post looks at the Flora full payment issue. Future posts will address the other issues. Les

In Flora v. United States, 357 U.S. 63 (1958) (“Flora I”), and, again, in an expanded opinion at 362 U.S. 145 (1960) (“Flora II”), the Supreme Court held that a jurisdictional predicate to a district court or Court of Federal Claims suit under 28 U.S.C. § 1346(a)(1) for refund of an income tax deficiency is full payment of the tax deficiency.  In oral argument in a later Supreme Court case, Laing v. United States, 423 U.S. 161 (1976), the Solicitor General’s office made clear its position that Flora’s full payment requirement only applies where the taxpayer could have, instead, petitioned the Tax Court to contest the deficiency prepayment, but chose not to.  A recent opinion, Larson v. United States, 2018 U.S. App. LEXIS 10418 (2d Cir., Apr. 25, 2018), involved a tax shelter promoter penalty assessed under section 6707 – one of the many “assessable” penalties that Congress has enacted since Flora that may be assessed without first allowing prepayment review in Tax Court through a notice of deficiency.  In Larson, the DOJ argued contrary to what the SG’s office did in Laing, and the Second Circuit accepted this changed position – holding that the Florafull payment requirement also applies to assessable penalties for which there is no possibility of Tax Court prepayment review through deficiency procedures.

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Larson Facts

The facts of Larson were as follows:  Larson was criminally convicted in connection with promoting several tax shelters.  The IRS later decided to impose assessable penalties under section 6707 for the promoters’ failure to file the necessary form under section 6111 (Form 8918) with the Office of Tax Shelter Analysis in Ogden, Utah alerting the IRS to the shelters.  Under section 6707 at the time (though not currently), the penalty under section 6707 was calculated as 1% of “the aggregate amount [that taxpayers] invested in such tax shelter”.

The IRS proposed to assess penalties of $160 million on a collection of promoters (including Larson), jointly and severally.  This means that the “aggregate amount invested”, according to the IRS, was $16 billion.

Other promoters paid the IRS about $100 million toward the penalty.  Larson contested the $160 million penalty at Appeals, arguing that the amount actually invested in the shelters in cash was only about $700 million, meaning the total penalty should be $7 million.  The rest “invested” was through notes that the courts had now held to be bogus for income tax purposes, so he argued that they were bogus, as well, for purposes of calculating the penalty.  (Of course, the taxpayers must have used those bogus notes to inflate their bases for purposes of claiming deductions far beyond the cash they invested.)

Appeals did not agree with Larson’s argument for lowering the penalties to $7 million, though it did give him credit for the penalties already paid by other promoters, reducing what Larson owed to about $60 million.

Larson District Court Suit

Larson paid $1.4 million toward the penalties, filed a refund claim, and then sued for a refund in the district court of the Southern District of New York.  It is not clear why he paid $1.4 million, but it appears that he thought the section 6707 penalty was “divisible”, and that $1.4 million was enough payment of a divisible tax to give the court jurisdiction.  In a footnote in Flora II, the Supreme Court said that full payment would not be required if a divisible tax was involved — a footnote that many people take advantage of with respect to section 6672 responsible person penalties (which have been held to be divisible).

In his suit, Larson argued that he had made a sufficient jurisdictional payment to commence suit, but that, even if he did not, the court had alternative jurisdiction under the Administrative Procedure Act, mandamus, Due Process, and because the size of the penalty violated the Eight Amendment’s excessive fines clause.

Unfortunately for Larson, shortly after he commenced his suit, the Federal Circuit held in Diversified Group Inc. v. United States, 841 F.3d 975 (Fed. Cir. 2016), that the section 6707 penalty was not divisible, so Flora IIrequired full payment in order to commence a refund suit.  The district court in Larson cited and followed Diversified Group, also rejecting all the other bases for jurisdiction that Larson alleged.  Larson v. United States, 2016 U.S. Dist. LEXIS 179314 (SDNY 2016).  Stephen did a prior post on both Diversified and the Larson district court opinion.

This post will not address the other grounds alleged for jurisdiction, but Les will be doing a later post on at least one of those other grounds.

Larson Appellate Arguments

 In his Second Circuit Appeal, Larson repeated all of his arguments for why the district court had jurisdiction, but abandoned his argument that section 6707 penalties are divisible.  Rather, Larson’s main argument was now that Flora II did not require full payment in a case like section 6707 penalties where no prepayment review was available in the Tax Court through a notice of deficiency.  Larson also argued that he couldn’t afford to pay the roughly $60 million left to make full payment, so requiring him to make full payment would leave him without a practical remedy for judicial review.

Flora II

Flora II expanded upon the opinion in Flora Iand corrected a significant misstatement in the earlier opinion.  Hereafter, I will discuss only Flora II.  In Flora II, the IRS had sent the taxpayer a notice of deficiency for income tax.  He did not file a Tax Court petition, but rather paid part of the deficiency, filed a refund claim, and brought suit for refund in district court. The Supreme Court held that a jurisdictional predicate to a refund suit under 28 U.S.C. § 1346(a)(1) is full payment of the tax.  But, the way it got to this holding was curious.

The statute being interpreted first appeared in the Revenue Act of 1921.  But, the court found that, even though there were statutory antecedents, with regard to whether full payment is required for a refund suit, the actual “statutory language . . . is inconclusive and legislative history . . . is irrelevant”.  Flora II, 362 U.S. at 152.

So, the Court then turned to three subsequent enactments of Congress to conclude that section 1346(a)(1) required full payment:

  • The establishment of the Board of Tax Appeals in 1924, which allowed taxpayers to contest deficiencies without prepayment, seemed to be done with the assumption that the Board was needed because refund suits concerning deficiencies otherwise required full payment.
  • In 1935, Congress amended the Declaratory Judgment Act (28 U.S.C. § 2201) to prohibit declaratory judgments “with respect to taxes”. The Court noted that if full payment were not required, then nothing would stop a taxpayer from paying $1, filing a refund claim, and suing for a refund. The latter would effectively be a suit for a declaratory judgment.
  • The adoption of section 7422(e), which provides that, if a refund lawsuit is underway when the taxpayer receives a notice of deficiency for the same taxable year, the taxpayer may either continue the suit in district court or move it to the Tax Court, but not litigate simultaneously in both courts.The Court concluded that the logic of not requiring full payment for a refund suit would be that a taxpayer could simultaneously conduct a deficiency suit in the Tax Court and a refund suit in the district court – a situation that section 7422(e) does not contemplate.

The Flora II court concluded with the following observation:

A word should also be said about the argument that requiring taxpayers to pay the full assessments before bringing suits will subject some of them to great hardship.  This contention seems to ignore entirely the right of the taxpayer to appeal the deficiency to the Tax Court without paying a cent.  If he permits his time for filing such an appeal to expire, he can hardly complain that he has been unjustly treated, for he is in precisely the same position as any other person who is barred by a statute of limitations.

362 U.S. at 175 (footnote omitted).

Laing

Laing v. United States, 423 U.S. 161(1976), involved income tax termination and jeopardy assessments under section 6851 and 6861 at a time when those sections did not state that the IRS must issue a notice of deficiency in connection with making such assessments.  The IRS had made such an assessment and argued that it was not required to issue a notice of deficiency before or after the assessment.

At the oral argument, the Solicitor General’s Office assured the Court that there would be no problem with the FloraII full payment rule, since Flora II did not require full payment if no deficiency notice could be sent to the taxpayer.  Here is a portion of the SG’s office oral argument that was quoted to the Second Circuit on page 6 of the Larson reply brief:

What this Court held in Flora was that under general circumstances a taxpayer cannot bring a refund suit until he has paid the full amount of the assessment.  In reaching that decision, the Court painstakingly went through the legislative history in connection with the creation of the Board of Tax Appeals, and there were indications going both ways as to what Congress really intended.  But I think that the really operative portion of the Chief Justice’[s] opinion in Flora was the fact that there the taxpayer had another remedy.  He could have gone to the Tax Court, and that made all the difference in Flora . . . .

For those interested, attached are all the briefs filed in Larson:  the appellant’s brief, the appellee’s brief, the reply brief(which contains the entire Laing oral argument transcript as an addendum), and an amicus brieffiled by the tax clinics at Harvard and Georgia State.  I believe that Keith will be doing a further post about what the amicus brief discussed.

The majority in Laing held that the IRS was required to send a notice of deficiency, so it did not reach the issue of whether Flora II required full payment for a refund suit in the absence of the possibility of receiving a notice of deficiency.

But, Justice Blackmun (joined by Chief Justice Berger and Justice Rehnquist) wrote a lengthy dissent in which he argued that no notice of deficiency was required in connection with a termination or jeopardy assessment.  However, he concluded that the taxpayer could bring suit in district court without full payment of the assessment.  After quoting part of the quote that I have quoted above from Flora II, Justice Blackmun wrote:

This passage demonstrates that the full-payment rule applies only where a deficiency has been noticed, that is, only where the taxpayer has access to the Tax Court for redetermination prior to payment.  This is the thrust of the ruling in Flora, which was concerned with the possibility, otherwise, of splitting actions between, and overlapping jurisdiction of, the Tax Court and the district court.  Where, as here, in these terminated period situations, there is no deficiency and no consequent right of access to the Tax Court, there is and can be no requirement of full payment in order to institute a refund suit.

423 U.S. at 208-209 (citation omitted).

Larson Second Circuit Ruling

In its opinion in Larson, the Second Circuit held that Flora II required the full payment of the section 6707 penalty before a refund suit could be brought.  It quoted the passage from Flora IIthat I have quoted above, yet argued that the availability of Tax Court deficiency review was not critical to the holding of Flora II.  The Second Circuit wrote:

While it is true that Flora I and Flora II acknowledge the existence and availability of Tax Court review, see Flora I, 357 U.S. at 75–76; Flora II, 362 U.S. at 175, Tax Court availability was not essential to the Supreme Court’s conclusion in either opinion.  The basis of the Flora decisions is that when Congress enacted § 1346(a)(1) it understood the statute to require full‐payment to maintain “the harmony of our carefully structured twentieth century system of tax litigation,” not that the full‐payment rule only applies when Tax Court review is available. Flora II, 362 U.S. at 176–77.

Slip op. at 10.

The Larson court did not acknowledge that the government had changed position as to the applicability of the full payment rule between Laingto Larson.  The Larson court did quote Justice Blackmun’s statements from his dissent in Laing, but noted:  “Justice Blackmun’s view did not garner majority support.  No subsequent majority of the Supreme Court has adopted that understanding of the statute.” Slip op. at 12 n.8.

As more evidence that full payment was required to commence the section 6707 refund suit, the Second Circuit noted that other assessable penalties have been enacted by Congress since Flora II with specific provisions that allow for payment of 15% before a refund suit can be commenced.  (“[O]ur reading is supported by Congress’s decision to provide partial payment review for other assessable penalties, but not for § 6707. See 26 U.S.C. §§ 6694(c), 6703(c).”  Slip op. at 8.)

After rejecting the other bases alleged by Larson for jurisdiction (which I won’t discuss here), the court concluded that this is a problem for Congress, writing:

We close with a final thought.  The notion that a taxpayer can be assessed a penalty of $61 million or more without any judicial review unless he first pays the penalty in full seems troubling, particularly where, as Larson alleges here, the taxpayer is unable to do so.  But, “[w]hile the Flora rule may result in economic hardship in some cases, it is Congress’ responsibility to amend the law.”  Rocovich v. United States, 933 F.2d 991, 995 (Fed. Cir. 1991).

Slip op. at 22.

Observations

The most surprising thing about the Larson opinion, to me, is that this issue of Flora’s application to assessable penalties has not been litigated before – i.e., until about 60 years later.  But, then most assessable penalties are either severable, require only 15% payment to commence suit, or are rather nominal in amount, so there were few in a position to argue that a full payment requirement to commence an assessable penalty refund suit was neither required by Flora II nor economically practicable.

The second most surprising thing is that both Flora II and Larson defend their statutory interpretation exclusively by reference to understandings of later Congresses when legislating.  I have always read that one is not to pay much attention to what later Congresses think a statute means.

But, ultimately, I was not surprised at the Larson ruling, and I don’t think Keith was either. I refer people to my statutory proposal made some years ago:  “Let the Poor Sue for a Refund Without Full Payment”, Tax Notes Today, 2009 TNT 191-4 (Oct. 6, 2009).  Although my proposal was designed primarily for the poor, it would help Larson (assuming that he gets himself on an installment agreement or in currently not collectible status first).  The opinion in Larson just underscores the need for a legislative fix.

Comments

  1. Stu Bassin says:

    Thanks for an informative post.

    I had followed the issue, but had not been aware of the Laing case. The fact that the SG, in Laing, essentially conceded that Flora would not apply to the position argued by the taxpayer in Larson would seem to be an important fact. If the Government has now quietly reversed that position to prevail in Larson, that would seem to be dirty pool.

    Was the Laing concession presented to the Second Circuit? What was its response? If that argument was not before the Second Circuit, would it make sense for the taxpayer to file for reconsideration on that basis?

    • Carl Smith says:

      Stu,

      The government’s position in Laing was prominently featured in the reply brief in Larson, and indeed, the entire oral argument transcript of Laing was attached to the reply brief as an addendum. I heard the oral argument. None of the judges mentioned the issue of the DOJ’s change of position. And the opinion doesn’t mention it either.

      Also a bit disingenuous is the Larson opinion saying that Justice Blackmun’s Laing opinion has not, since Laing, garnered a majority on the Supreme Court. First, the other six justices in Laing had no occasion to discuss this full payment issue, since they all though that a notice of deficiency had to be issued that would allow Tax Court review without full payment. One or more or all of those other justices might have agreed with Justice Blackmun on the Flora applicability issue. All the justices in Laing who reached the Flora issue thought full payment was not required where a notice of deficiency was not required to be issued. Second, the Supreme Court has not revisited Flora since Laing, so how would we know if there might be five votes for not requiring full payment where review through a deficiency notice is not possible.

  2. William Clayton says:

    This particular case doesn’t gain much sympathy from me. Here Larson is a convicted tax felon who had a shot in Appeals. The best argument his people came up with was that the bogus notes shouldn’t count as amounts invested in the scam. However those amounts are exactly what drained the US tax system of billions of dollars that ordinary folks like me have to make up to the government. I guess we won’t be finding out if there would have been a better argument set forth this time around.
    While there may be situations where paying an insurmountable tax bill would be unjust without an opportunity for a court to hear you out, this case just doesn’t have much in the way of sympathy factors. Larson apparently had 1.4 million to pay toward the tax even after his criminal conviction.
    I wonder if he could challenge the assessment in court once he receives a CDP notice?

    • Carl Smith says:

      William,

      I agree with you that Mr. Larson is not a sympathetic character. Indeed, even if he got into court on the merits, if I were the judge, I would rule against him both on the issue of statutory interpretation of “amount invested” and the constitution’s Excessive Fines Clause. If the bases of all taxpayers in the transactions are $16 billion (to justify a 1% $160 million penalty), then, assuming all this basis was used to generate deductions and assuming an approximate 40% federal tax rate, then $6.4 billion in improper federal tax reduction occurred in aggregate. I don’t know how much of the $6.4 billion the IRS managed to recover, but in the absence of the promoters filing the Form 8918 alerting the IRS to the shelters, I bet a lot of that $6.4 billion was never recovered.

      I am no expert on the matter of what promoters charge as fees for recommending transactions, but I bet it was a percentage of the tax saved. Let’s assume that the fees were 5% of the tax saved. That would make the total fees received $320 million — more than the IRS assessed penalty.

      It is my understanding that to prove an Excessive Fines Clause violation, one has to show the fine is out of all proportion to the harm caused. I just don’t see that here. Likely far more than $160 million in harm was caused as a result of the promoters not filing the disclosure form.

      Note that while Larson argued that he could not come up with the additional $60 million for a refund suit, he never said how much he was worth. He may or may not still be sitting on a pot of cash or an expensive home.

      CDP was brought to the attention of the court in the amicus brief. But, CDP is no solution for Larson. He had an Appeals conference concerning how to calculate the penalty when the penalty was originally assessed (though had no opportunity to “appeal” the results of that conference to any court). Since he has already had an “administrative proceeding” (an Appeals conference), section 6330(c)(4) bars challenging the underlying liability again in CDP. Further, even if he could get reconsideration of the underlying liability in CDP, the Greene-Thapedi opinion of the Tax Court states that the Tax Court has no refund jurisdiction in CDP. So, the Tax Court could never order the IRS to repay any of the $1.4 million already paid on the penalty. Larson argued that he owed none of the penalty because the aggregate penalty for all promoters should have been only $7 million, and that other promoters paid far more than that amount, so that by the time Larson paid the $1.4 million, nothing more was due.

    • I think the assessed person can pursue a CDP proceeding, with Tax Court prepayment remedy if administrative relief is denied. See IRM 8.22.8.10.5 (10-01-2012), IRC 6707 or 6707A Disclosure Penalties (“2. A taxpayer may dispute a IRC 6707 and IRC 6707A penalty in CDP if the taxpayer did not have a prior opportunity to do so”). I also think that the assessed person can contest liability in a collection suit brought by the Government or, possibly, in a bankruptcy suit (although I have not researched that issue, which I think depends upon dischargeability).

      • Lavar Taylor says:

        In a bankruptcy case, the penalty could be litigated if the IRS filed a claim for the penalty. The Court would also have jurisdiction to determine the amount of the penalty under section 505(a) in the absence of the filing of a claim by the IRS, but the government might bring an abstention motion, which might or might be granted.

        The most important point as far as I am concerned is that the penalty is completely dischargeable in Bankruptcy if the conduct giving rise to the penalty occurred more than three years prior to the date of the Bankruptcy petition. I have represented multiple clients who discharged 6700/6701 penalties in Bankruptcy.

        • Thanks to Jack Townsend for raising the same question about bankruptcy that I had, and to Lavar Taylor for answering it.

          In his reply to another comment, Carl Smith wrote “Note that while Larson argued that he could not come up with the additional $60 million for a refund suit, he never said how much he was worth. He may or may not still be sitting on a pot of cash or an expensive home.” Avoiding bankruptcy court is an indication to me that he still may own substantial assets.

  3. Norman Diamond says:

    ‘A recent opinion, Larson v. United States, 2018 U.S. App. LEXIS 10418 (2d Cir., Apr. 25, 2018), involved a tax shelter promoter penalty assessed under section 6707 – one of the many “assessable” penalties that Congress has enacted since Flora that may be assessed without first allowing prepayment review in Tax Court through a notice of deficiency.’

    Doesn’t a penalty under section 6707 exist only when the taxpayer was alleged to owe tax and had an opportunity to dispute in Tax Court whether the underlying tax was owed? If the IRS refused to issue a Notice of Deficiency then Tax Court would refuse to take jurisdiction and the alleged underlying tax was not actually owed.

    In contrast, a penalty under section 6702 exists even when the taxpayer isn’t alleged to owe tax. Every court refuses to take jurisdiction and the taxpayer can’t even get their withholding refunded. (For a while this blog has been posting my comments; what was different about last Friday’s comment?)

    ‘In a footnote in Flora II, the Supreme Court said that full payment would not be required if a divisible tax was involved’

    Another footnote in either Flora I or II admitted that full payment might not be required if no tax was owed and only penalties were alleged. This is indeed a hardship when alleged penalties exceed a year’s salary. If the IRS issues a Notice of Determination then the IRS can concede 100% of the penalties after calendar call in Tax Court, but if the IRS refuses to issue any statutory notice then the IRS can continue using offset to collect every amount owing to the taxpayer until and even after the taxpayer’s death.

    ‘The most surprising thing about the Larson opinion, to me, is that this issue of Flora’s application to assessable penalties has not been litigated before – i.e., until about 60 years later.’

    It has been brought to the attention of the 9th Circuit which ignored it. It was mentioned in a Supreme Court petition which was closed because 45 years of working had given the petitioner an appreciable fraction of the amount of savings needed for retirement and the petitioner declined to spend 3 months’ salary to print booklet style petitions.

    But again the petitioner didn’t owe any tax, remains owed a refund of withholding, and remains in a Kafkaesque position of IRS, DOJ, and courts changing their mind about what the frivolous position was.

    “The fact that the SG, in Laing, essentially conceded that Flora would not apply to the position argued by the taxpayer in Larson would seem to be an important fact. If the Government has now quietly reversed that position to prevail in Larson, that would seem to be dirty pool.”

    No kidding. Dirty pool is their job. A former Assistant Attorney General for Taxation testified to Congress about identity theft and asserted that the IRS would always make good on refunds owing to the taxpayer, at the same time as the same Assistant Attorney General for Taxation was persuading Court of Federal Claims and the Federal Circuit to refuse to make the IRS make good on refunds owing.

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