Designated Orders: 7/9/18 to 7/13/18

William Schmidt from the Kansas Legal Aid Society brings us this weeks designated orders. Three orders in cases involving the Graev issue keep that issue, no doubt the most important procedural issue in 2018, front and center. As with last week, there is an order in the whistleblower area with a lot of meat for those following cases interpreting that statute. Keith

For the week of July 9 through July 13, there were 9 designated orders from the Tax Court. Three rulings on IRS motions for summary judgment include 2 denials because there is a dispute as to a material fact (1st order based on employment taxes here) (2nd order involves petitioners denying both having a tax liability and receiving notice of deficiency for 2012 here) and a granted motion because petitioner was not responsive (order here). What follows are three orders where Judge Holmes takes on Chai ghouls, an exploration of a whistleblower case, and two quick summaries of cases. Overall, the Chai ghoul cases and whistleblower case made for a good week to read judicial analysis.

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Chai Ghouls

All three of these are orders from Judge Holmes that deal with Chai and Graev issues. The first two discussed were later in the week and had more analysis. As you are likely aware, the Chai and Graev judicial history in the Tax Court has led to several current cases that need analysis regarding whether there was supervisory approval regarding accuracy-related penalties, as required by Internal Revenue Code section 6751. In each of these cases, the IRS has filed a motion to reopen the case to admit evidence regarding their compliance with 6751(b)(1).

  • Docket Nos. 11459-15, Hector Baca & Magdalena Baca, v. C.I.R. (Order here).

The Commissioner filed the motion to reopen the record to admit the form. The Bacas couldn’t tell the Commissioner whether or not they objected to the motion. When given a chance to respond, they did not object. The Bacas did not raise Code section 6751 at any stage of the case (petition, amended petition, trial, or brief). The Commissioner conceded 6662(c) (negligence or disregard) penalties because the only penalty-approval form found is the one for 6662(d) (substantial understatement) penalties.

The Court’s analysis sets out the standard for reopening the record. The evidence to be added cannot be merely cumulative or impeaching, must be material to the issues involved, and would probably change the outcome of the case. Additionally, the Court should consider the importance and probative value of the evidence, the reason for the moving party’s failure to introduce the evidence earlier, and the possibility of the prejudice to the non-moving party.

The Court then analyzes those elements set out above. For example, the Court finds the penalty-approval form to be properly authenticated nonhearsay and thus admissible. Ultimately, the Commissioner had less reason to anticipate the importance of section 6751 because it was following Chai and Graev that it was clarified the Commissioner had the burden of production to show compliance with 6751 when wanting to prove a penalty.

In this case, the Court states because the Bacas did not object to the accuracy-related penalties, that is some excuse for the Commissioner’s lack of diligence. Additionally, the Court concludes that it can’t decide the Bacas would be prejudiced because they never said they would be.

Takeaway – Respond when the court requests your opinion or you may suffer consequences that could have been avoided if you had raised your hand and notified the court of your concerns.

  • Docket Nos. 19150-10, 6541-12, Scott A. Householder & Debra A. Householder, et al., v. C.I.R. (Order here).

This set of consolidated cases differ from the Bacas’ case because of an objection submitted by the petitioners. Arguments by the petitioners begin that the record should not be reopened because the Commissioner’s failure to introduce evidence of compliance with 6751(b)(1) shows a lack of diligence, and the Commissioner doesn’t offer a good reason for failing to introduce the form despite possessing it when trying the cases. They argue they would be prejudiced by reopening the record because they have not had a chance to cross-examine the examining IRS Revenue Agent on their case. They argue the form is unauthenticated and that both the declaration and the form are inadmissible hearsay.

Again, the form is found to be admissible nonhearsay. Regarding the authentication argument, the IRS recordkeeping meets the government’s prima facie showing of authenticity. The Court brings up that the Revenue Agent in question was a witness at trial that the petitioners did cross-examine, it’s just that they did not have section 6751 in mind at the time. In fact, the Court reviews a set of questions the petitioners listed and finds that those answers likely would not have helped them so comes to the conclusion that they would not be prejudiced by admitting the form.

Overall, both parties should have been more diligent to bring up section 6751. Since they did not, the lack of diligence on the Commissioner’s part is counterbalanced by the probative value of the evidence and the lack of prejudice to the petitioners if the record were reopened to admit the form.

Takeaway – The IRS is not the only party on notice of the Chai and Graev issue. Petitioners bear responsibility to raise the issue of supervisory approval just as the IRS has a responsibility to show proper authorization of the penalty. The court seems to be shifting a bit from prior determinations.

  • Docket Nos. 17753-16, 17754-16, 17755-16, Plentywood Drug, Inc., et al., v. C.I.R. (Order here).

These consolidated cases also deal with the 6751 accuracy-related penalties and the IRS motion to reopen the record to admit penalty-approval forms. While the petitioners originally disputed the penalties, they conceded penalties on some issues but did not want to concede penalties on others. As a result, they did not object to the Commissioner’s motion. The Court did not grant the motion regarding penalties determined against the corporate petitioner as it would not change the outcome of the case. In Dynamo Holdings v. Commissioner, 150 T.C. No. 10 (May 7, 2018), the Court held that section 7491(c)’s burden of production on penalties does not apply to corporate petitioners, so that, in a corporate case, where the taxpayer never asked for proof of managerial approval and so did not get into the record either a form or an admission that no form was signed, the taxpayer had the burden of production on this section 6751(b) issue and had failed. For the penalties determined against the individual petitioners, the Court granted the motion since they did not raise any objections.

In all three cases, the Court orders to grant the IRS motion to reopen the record to admit the penalty-approval form attached to the motion (with the exception of the denial of the application to Plentywood Drug, Inc.).

Comments: I must admit when Judge Holmes mentions Chai ghouls in his orders it makes me think of Ghostbusters (Chai ghoul bustin’ makes him feel good?). In looking over these three cases, it seems to me they have the same result no matter what the petitioners did. It is understandable when the petitioners never objected to the penalties or the approval form. However, the Householders objected and still got the same result. Perhaps I am more sympathetic to the petitioners, but the reasoning also does not follow for me that petitioners would not be prejudiced by admitting a form that allows them to have additional penalties added on to their tax liabilities. 

Whistleblowers and Discovery

Docket No. 972-17W, Whistleblower 972-17W v. C.I.R. (Order here).

By order dated April 27, 2018, the Court directed respondent to file the administrative record as compiled by the Whistleblower Office. Petitioner filed a motion for leave to conduct discovery, the IRS followed with an opposing response and the petitioner filed a reply to respondent’s response. On June 25, the Court conducted a hearing on petitioner’s motion in Washington, D.C., where both parties appeared and were heard.

Internal Revenue Code section 7623 provides for whistleblower awards (awards to individuals who provide information to the IRS regarding third parties failing to comply with internal revenue laws). Section 7623(b) allows for awards that are at least 15 percent but not more than 30 percent of the proceeds collected as a result of whistleblower action (including any related actions) or from any settlement in response to that action. The whistleblower’s entitlement depends on whether there was a collection of proceeds and whether that collection was attributable (at least in part) to information provided by the whistleblower to the IRS.

On June 27, 2008, the petitioner executed a Form 211, Application for Award for Original Information, and submitted that to the IRS Whistleblower Office with a letter that identified seven individuals who were involved in federal tax evasion schemes. The first time the petitioner met with IRS Special Agents was in 2008 and several meetings followed. The IRS focused on and investigated three of the individuals listed on petitioner’s Form 211 following those initial meetings.

The first taxpayer (and I use that term loosely for these three individuals) was the president of a specific corporation. In 2013, that individual was convicted of tax-related crimes including failing to file personal and corporate tax returns due in 2006, 2007, and 2008. This person received millions of dollars in unreported dividends (from a second corporation, also controlled by this individual). This individual was ordered to pay restitution of $37.8 million.

The second individual was the chief financial officer of the corporation. This person received approximately $13,000 per month from the corporation in tax year 2006 but failed to report that as taxable income, and did not file a tax return in 2007. After amending the 2006 tax return and filing the 2007 tax return, the criminal investigation ended. The Revenue Officer assessed trust fund recovery penalties for the final quarter of tax year 2006 and all four quarters of tax year 2007. This taxpayer filed amended tax returns for 2005 and 2006 in March 2009 and filed delinquent returns for 2007 and 2008 in July 2010. The IRS filed liens to collect trust fund recovery penalties of approximately $657,000 and income tax liabilities of $75,000 for tax years 2005 and 2006.

The third individual was an associate of the first two but had an indirect connection with the corporation. This taxpayer had delinquent returns for 2003-2011 and there was a limited scope audit for tax years 2009 and 2010. The IRS filed tax liens for unpaid income taxes totaling approximately $2.4 million for tax years 2003 to 2011.

For each of the individuals, the IRS executed a Form 11369, Confidential Evaluation Report, on petitioner’s involvement in the investigations. For taxpayer 1, the IRS Special Agent stated that all information was developed by the IRS independent of any information provided by petitioner. For taxpayer 2, the form includes statements the Revenue Officer discovered the unreported income and petitioner’s information was not useful in an exam of the 2009 and 2010 tax returns. For taxpayer 3, the form states the taxpayer was never the subject of a criminal investigation (which is inconsistent with the record) and that petitioner’s information was not helpful to the IRS.

The petitioner seeks discovery in order to supplement the administrative record, contending the record is incomplete and precludes effective judicial review of the disallowance of the claim for a whistleblower award. Respondent asserts the administrative record is the only information taken into account for a whistleblower award so the scope of review is limited to the administrative record and petitioner has failed to establish an exception.

The Court notes the administrative record is expected to include all information provided by the whistleblower (whether the original submission or through subsequent contact with the IRS). The Court’s review of the record in question is that it contains little information, other than the original Form 211, identifying or describing the information petitioner provided to the IRS. While the record indicates that there were multiple meetings concerning the three taxpayers, there are few records of the dates and virtually no documents of the information provided. The Court agreed with the petitioner that the administrative record was materially incomplete and that the circumstances justified a limited departure from the strict application of the rule limiting review to the administrative record.

The Court states the petitioner met the minimal showing of relevant subject matter for discovery since the administrative record was materially incomplete and precluded judicial review. The information petitioner seeks is relevant to the petitioner’s assertion that the information provided led the IRS to civil examinations and criminal investigations for the three taxpayers and led to the assessment and collection of taxes that would justify an award under section 7623(b). The IRS did not deny petitioner’s factual allegations and did not argue the information sought would be irrelevant so failed to carry the burden that the information sought should not be produced.

The Court limited petitioner’s discovery to three interrogatories concerning conversations with a Revenue Officer and two Special Agents, two requests for production of documents concerning notes and records of meetings with those three individuals.

Petitioner sought nonconsensual depositions if the IRS did not comply with the interrogatories and requests for production of documents. Since the Court directed the IRS to respond to the granted discovery requests, it is premature to consider the requests for nonconsensual depositions at this time. The footnote cites Rule 74(c)(1)(B), which calls that “an extraordinary method of discovery” only available where the witness can give testimony not obtained through other forms of discovery.

Respondent is ordered to respond to those specific interrogatories and requests for production of documents by August 17, 2018.

Comment: On the surface, this step forward looks to be a win for the petitioner as there seems to be a cause and effect that justifies a substantial whistleblower award. I discussed the case with an attorney with a whistleblower case in his background who commented that to get a whistleblower award the whistleblower had to be the first one to make the reporting and the information had to be outside public knowledge (though that was outside the tax world). From his experience, the government made it difficult to win a whistleblower award and I would say that looks to be the case here.

Miscellaneous Short Items

  • The Petitioner Wants to Dismiss? – Docket No. 11487-17, Gary R. Lohse, Petitioner, v. C.I.R. (Order here). Petitioner files a motion to dismiss for lack of jurisdiction, stating the notice of deficiency is not valid. The judge denies his motion because there is a presumption of regularity that attaches to actions by government officials and nothing submitted by the petitioner overcomes that presumption.
  • Petitioner Wants a Voluntary Audit – Docket No. 24808-16 L, Tom J. Kuechenmeister v. C.I.R. (Order here). Petitioner filed a motion for order of voluntary audit, also claiming that the IRS was negligent in allowing the third party reporter to issue the forms 1099-MISC for truck driving. As Tax Court is a court of limited jurisdiction, the Court cannot order the IRS to conduct a voluntary audit. While the petitioner was previously warned about possible penalties up to $25,000, this motion was filed prior to the warning so no penalty assessed for this motion. Petitioner’s motion is denied.

Takeaway: Each time here, the petitioner does not understand the purpose of the Tax Court. The petitioners may have come to a better result by treating Tax Court motions as surgical tools rather than as blunt weapons.

 

Remember to File a Refund Suit under the Shorter SOL when Congress Lets You Sue after Paying Only 15%

We welcome frequent guest blogger Carl Smith who writes about the time frame for filing a refund suit with respect to a divisible, assessable penalty. Here, the taxpayer’s attorney seems to have relied on the general rule allowing a taxpayer to bring a refund suit within two years after payment. Unfortunately for the taxpayer, that rules does not apply in this context. Keith

In a recent unpublished opinion of the Ninth Circuit in Taylor v. United States, an individual who was assessed multiple section 6694 return preparer penalties tried to take advantage of the statutory rule allowing him to bring a refund suit by paying only 15% of each penalty. However, it appears that he did not pay close attention to the provision of section 6694(c)(2) that requires an expedited suit for refund in that event. He brought a district court refund suit on February 25, 2016, a year and three months after he made the 15% payments and filed a refund claim. That suit would have been timely had the 2-year period after formal notification of claim disallowance applied under section 6532(a). But, section 6532(a) does not apply to such a 15% payment suit, and he missed the shorter statute of limitations applicable to a suit where 15% is paid. As a result, the Ninth Circuit affirmed the district court for the Eastern District of Washington’s dismissal of his refund suit for lack of jurisdiction as untimely. It seems to me that he can now pay the remaining 85% and file a new refund claim and sue concerning the 85%. But, I doubt that he can ever get back the 15% paid because the IRS disallowed that claim on January 29, 2016, so it is now more than 2 years since the claim for the 15% was disallowed. Any new suit for the 15% or the 85% would, I think, have to be brought under the section 6532(a) filing deadline after full payment.

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In Flora v. Unites States, 362 U.S. 145 (1960), the Supreme Court held that a suit for refund under 28 U.S.C. § 1346(a)(1) involving an income tax deficiency could only be brought if the taxpayer first paid 100% of the deficiency. Treating full payment as a jurisdictional prerequisite, said the Court, was not clearly required by the words of the statute or its 1921 legislative history. However, subsequent developments – including the 1924 creation of the Board of Tax Appeals to allow prepayment review of deficiencies – influenced the Supreme Court’s thinking.

It was not clear after Flora whether that full payment requirement would apply to assessable penalties, such as the section 6672 responsible person penalty, since there was no possibility of Tax Court prepayment review of the few assessable penalties then in existence. However, a footnote in Flora indicated that, in the case of divisible taxes, payment of one of one divisible portion would be enough jurisdictionally to found a refund suit. Relying on that footnote in Flora, less than three months after Flora, in Steele v. United States, 280 F.2d 89 (8th Cir. 1960), the Eighth Circuit held that the full payment rule of Flora applied to the divisible penalties under section 6672 such that suit was jurisdictionally proper if the taxpayer had fully paid only one penalty for one employee for each quarter involved in the suit.

Section 6672(c)(1) currently provides that if a taxpayer, within 30 days of notice and demand, makes such a divisible payment, files a refund claim, and puts up a bond for the rest of the assessment, then the IRS is barred from collecting by levy or bringing a suit for payment of the balance assessed so long as a taxpayer’s refund suit under (c)(2) is pending. (The IRS may, however, counterclaim for the balance in the suit brought under (c)(2).) Under (c)(2), a taxpayer who has done what is required under (c)(1) may bring a refund suit, but only within an abbreviated period – i.e., up to 30 days after the refund claim is denied.

There are a few other assessable penalties that have special jurisdictional payment and filing features similar to that of section 6672(c). Those penalties are under section 6694 (return preparer penalty), 6700 (penalty for promoting abusive tax shelters), and 6701 (penalty for aiding and abetting understatements of tax). The assessable section 6702 frivolous submission penalty once had similar features for a part-payment refund suit, but those were removed. In each of the three cases, section 6694(c)(1) or 6703(c)(1) (applicable to the section 6700 and 6701 penalties) provides that paying 15% and filing a refund claim within 30 days of notice and demand can be enough to bar the IRS from collecting by levy or bringing a suit for payment of the balance assessed so long as a refund suit under (c)(2) is pending. (Note the lack of a bond requirement for the balance, unlike under section 6672(c).) Under (c)(2), a litigant who has done what is required under (c)(1) may bring a refund suit, but only within an abbreviated period that is potentially shorter than the period for section 6672 penalties – i.e., under sections 6694(c)(2) and 6703(c)(2), within the earlier of (1) 30 days after the refund claim is denied or (2) six months and 30 days after the refund claim is filed. Note that the six months and 30 day alternative period is a much more limited period than the indefinite period to bring suit in section 6532(a) in the absence of a claim disallowance.

I speculate that what happened in the Taylor case is that, since he was familiar with the rule of section 6532(a) that effectively allows an indefinite period to bring suit in the absence of a notification of claim disallowance, he did not realize that, under section 6694(c)(2), he could not wait beyond six months and 30 days to bring suit after he filed his refund claim – even though his claim had not yet been disallowed. My speculation is because he actually did bring suit within 30 days after the claim was disallowed. But, that was too late. And nothing in either the district court or appellate court opinion gives a reason for his late filing that might suggest an equitable reason for late filing.

So, what did Taylor argue to get out of the box he put himself into?

First, in his district court written response to the DOJ’s motion to dismiss for lack of jurisdiction he argued that the filing deadline in section 6694(c)(2) is not jurisdictional, but is simply a statute of limitations that does not go to the power of the court. I am not sure why he made this argument, since he did not show facts for equitable tolling of a nonjurisdictional statute of limitations. Even if the filing deadline is not jurisdictional, it is still a mandatory claims processing rule with which he did not comply. He argued that (c)(2) is not jurisdictional, but only “sets limits on the time frame in which the IRS is prohibited from pursuing collection action of the penalties at issue.” The Ninth Circuit disagreed.

Here is the full text of section 6694(c)(1) and (2):

(c)  Extension of period of collection where preparer pays 15 percent of penalty.

(1) In general. If, within 30 days after the day on which notice and demand of any penalty under subsection (a) or (b) is made against any person who is a tax return preparer, such person pays an amount which is not less than 15 percent of the amount of such penalty and files a claim for refund of the amount so paid, no levy or proceeding in court for the collection of the remainder of such penalty shall be made, begun, or prosecuted until the final resolution of a proceeding begun as provided in paragraph (2). Notwithstanding the provisions of section 7421(a), the beginning of such proceeding or levy during the time such prohibition is in force may be enjoined by a proceeding in the proper court. Nothing in this paragraph shall be construed to prohibit any counterclaim for the remainder of such penalty in a proceeding begun as provided in paragraph (2).

(2)  Preparer must bring suit in district court to determine his liability for penalty. If, within 30 days after the day on which his claim for refund of any partial payment of any penalty under subsection (a) or (b) is denied (or, if earlier, within 30 days after the expiration of 6 months after the day on which he filed the claim for refund), the tax return preparer fails to begin a proceeding in the appropriate United States district court for the determination of his liability for such penalty, paragraph (1) shall cease to apply with respect to such penalty, effective on the day following the close of the applicable 30-day period referred to in this paragraph.

Apparently, the question whether the filing deadline under section 6694(c)(2) is jurisdictional has not been previously addressed in the Ninth Circuit. However, the Ninth Circuit in Taylor noted the virtually verbatim similarity of the language of section 6694(c) and that of section 6703(c). In Thomas v. United States, 755 F.2d 728 (9th Cir. 1985), the Ninth Circuit had held that the 30-day deadline in section 6703(c)(1) after a notice and demand to pay the 15% is a jurisdictional requirement of a refund suit in a case involving a section 6702 penalty that was at the time (but is no longer) subject to section 6703(c). In Korobkin v. United States, 988 F.2d 975 (9th Cir. 1993), the Ninth Circuit had held that the six months plus 30-day deadline in section 6703(c)(2) to file suit is a jurisdictional requirement of a refund suit involving a section 6700 penalty. Taylor followed these cases by analogy in holding that compliance with the filing deadline under section 6694(c)(2) is jurisdictional. So, the district court properly dismissed this untimely suit for lack of jurisdiction.

The second thing Taylor argued was that instead of having paid 15% of each penalty (as he originally directed the IRS to apply the payments) he should be deemed to have paid 100% of 15% of the penalties, so the district court had jurisdiction under section 1346(a)(1), and suit was timely under section 6532(a) with respect to the penalties that he had fully paid. This was an interesting argument, but it was first raised at oral argument on the DOJ’s motion to dismiss before the district court. The district court held that this argument was raised too late to be considered. The Ninth Circuit agreed that this argument was not timely raised.

Observations

Les and I recently blogged on Larson v. United States, 888 F.3d 578 (2d Cir. 2018), here and here. Larson involved a section 6707 penalty for failing to file a form with the IRS providing information concerning listed transactions as to which the rules of section 6703(c) do not apply. In Larson, the Second Circuit held that Flora requires full payment of such an assessable penalty as a jurisdictional prerequisite of a refund suit, even though there is no alternative Tax Court prepayment contest permitted for such penalty. Part of why Larson ruled the way it did was because the Second Circuit there noted that Congress, in sections 6694(c) and 6703(c), had created 15% exceptions to the full payment rule of Flora, but had not done so for other assessable penalties. Taylor also holds the 15% payment requirement to be jurisdictional, citing Flora.

The Ninth Circuit in Taylor failed to acknowledge that its ruling that the filing deadline in section 6703(c)(2) is jurisdictional is in conflict with that of at least one other Circuit court: In Dalton v. United States, 800 F.2d 1316 (4th Cir. 1986), the Fourth Circuit had held that the 30-day-after-claim-disallowance deadline in section 6703(c)(2) to file suit is a not a jurisdictional requirement of a refund suit involving a section 6702 penalty. Indeed, in Dalton, the court equitably tolled the filing deadline (tolling only being possible if the filing deadline is not jurisdictional). Taylor’s attorney cited Dalton in his opening Ninth Circuit brief.

I have repeatedly noted in PT that, under recent Supreme Court case law since Kontrick v. Ryan, 540 U.S. 443 (2004), filing deadlines are no longer considered jurisdictional, unless Congress has made a rare “clear statement” in the statute that it wants what is usually a nonjurisdictional claim processing rule (a filing deadline) to be treated as jurisdictional. Of course, the Circuit court opinions in Thomas, Korobkin, and Dalton were decided before Kontrick and its progeny, so do not analyze section 6703(c) under the proper current case law. I am disappointed, however, that the Ninth Circuit in Taylor (here in 2018) did not think to reconsider its holdings in Thomas and Korobkin in light of the more recent Supreme Court authority. Appellate judges know that authority quite well and should employ it, even where (as in Taylor’s case) both parties failed to cite it in their briefs. See Volpicelli v. United States, 777 F.3d 1042 (9th Cir. 2015) (not merely relying on prior precedent, but analyzing the wrongful levy suit filing deadline at section 6532(c) under recent Supreme Court case law and holding the deadline not jurisdictional and subject to equitable tolling).

As PT readers know, Keith and I have recently argued (with little success so far) that Tax Court filing deadlines for stand-alone innocent spouse actions (at section 6015(e)(1)(A)) and Collection Due Process actions (at section 6330(d)(1)) should no longer be considered jurisdictional under recent Supreme Court case law. We have lost those cases mostly because those provisions use the words “the Tax Court shall have jurisdiction” in the same sentences that provide the filing deadlines. It appears that one could make a stronger case that the filing deadlines in sections 6694(c)(2) and 6703(c)(2) are not jurisdictional: First, the sentences in those provisions do not contain the word “jurisdiction”. Indeed, they do not speak at all to the district court’s jurisdiction or powers. Taylor is right that these provisions really only give deadlines to file and “set[] limits on the time frame in which the IRS is prohibited from pursuing collection action of the penalties.” That does not comport with the Supreme Court’s current view that “Congress must do something special, beyond setting an exception-free deadline, to tag a statute of limitations as jurisdictional . . . .” United States v. Wong, 135 S. Ct. 1625, 1632 (2015). Second, the Supreme Court “has often explained that Congress’s separation of a filing deadline from a jurisdictional grant indicates that the time bar is not jurisdictional.” Id. at 1633 (citations omitted). Here, the real jurisdictional basis for a 15% payment refund suit is still located at 28 U.S.C. § 1346(a)(1), far away from these Internal Revenue Code sections. So, I respectfully disagree with the Ninth Circuit’s holding in Taylor that these filing deadlines are jurisdictional. [Sigh]

The Ninth Circuit Reverses the Tax Court Decision in Altera

We welcome back guest bloggers Professor Susan C. Morse and Stephen E. Shay. Professor Morse teaches at University of Texas Law School and Steve Shay teaches at Harvard. Both are great speakers and writers with a deep knowledge of international taxes honed when they worked together at the Boston law firm of Ropes and Gray. They provided insight on the Altera decision in which the Tax Court decided the case in a fully reviewed 15-0 opinion back in 2015 after the filing of their amicus brief, immediately prior to the oral argument and following the oral argument. The opinion provided perhaps the most important procedural development of 2015 and the reversal is big news as well. The post is a little longer than our normal post but the opinion it discusses is much longer and more important than most of the cases we cover. This is a big win for the IRS. Keith

On July 24, the Ninth Circuit upheld a key IRS transfer pricing regulation, worth billions of dollars in federal revenues, that requires sharing employee stock compensation costs as a condition for a “qualified cost sharing arrangement” or QCSA. In Altera Corp. v. Commissioner, a 2-1 panel reversed the Tax Court’s decision, which had invalidated the regulation under the Administrative Procedure Act (APA).

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The conditions for a qualified cost sharing arrangement are described in U.S. tax regulations. If these are satisfied, the IRS will not make transfer pricing adjustments to the costs shared and will treat the cost sharing subsidiary as the co-owner, for tax purposes, of the intellectual property (IP) rights whose costs were shared. QCSAs benefit U.S. multinationals, since they allow MNCs to allocate to non-U.S. subsidiaries (usually in low-tax countries) income from their ownership of the IP.

The “sharing” of the cost of stock options granted to employees (such as engineers) who develop the intellectual property means that some related tax deductions are shifted to the non-U.S. subsidiary (to match with the shifted profit) rather than all of the deductions reducing the U.S. parent’s taxable income. These amounts are very large in the tech sector in particular and the industry has fought for years to avoid treatment of these expenses as costs to be shared in a QCSA. The failure to allocate the costs supports unjustified income shifting from the U.S. to countries where the foreign subsidiaries are located.

Altera, now part of Intel, claimed that its taxable income would be $80 million less if it were not required to share stock option costs. The Wall Street Journal has reported that the issue is worth at least $3.5 billion to Google alone. If the regulation were invalidated, the U.S. government would lose billions of dollars in tax revenue.

Treasury Regulation 1.482-7A was promulgated in 2003 under the authority of Internal Revenue Code Section 482, after notice and comment. Section 482 charges the Commissioner with reallocating income or deduction items “clearly to reflect” related taxpayers’ taxable income.

Altera argued that Section 482 required application of a narrow version of the “arm’s length” principle that only allowed the IRS to take account of costs if they were found in comparable cost sharing arrangements between unrelated parties. Because the stock option cost sharing regulation took the position that all relevant expenses had to be shared, and did not carve out stock option expenses not shared by unrelated parties, Altera contended – and the Tax Court agreed — that Treasury’s regulation was arbitrary and capricious and therefore invalid under the procedural strictures of the APA for failure to adequately explain its position in response to contrary comments. The Tax Court relied on the 1983 Supreme Court precedent State Farm and held that the reasoning supporting the stock option cost sharing regulation could not be discerned from materials such as the Preamble to the final regulations.

The thorough Ninth Circuit opinion starts with a history lesson on Section 482. The concept of “arm’s length” as primarily a comparable transactions method, which Altera focuses on, stems from 1968 regulations, which the court acknowledges featured a new “focus on comparability” (slip op. at 16). But the court explains that comparable transactions never had a monopoly on Section 482 adjustments. Cases in the 1940s, 1950s and 1960s had rejected the view that Section 482 only turned on comparable transactions. As of 1981, more than ten years after the 1968 regulations, the GAO found that only 3% of IRS adjustments were based on “direct comparables.” (Slip op. at 17)

In 1986, a statutory amendment to Section 482 added a sentence, which requires income allocations “commensurate with the income attributable to the intangible.” In 1994 and 1995, regulations regarding direct and cost sharing intangible transfers were promulgated in response to the statutory change. The cost sharing regulations implemented the commensurate with income standard by conditioning shared ownership of intellectual property under QCSAs on shared allocation of all relevant costs incurred to produce the intangibles. As the Ninth Circuit explained in a footnote, “[c]ontemporary commentators understood that [in the cost sharing regulations], by attempting synthesis between the arm’s length and commensurate with income provisions, Treasury was moving away from a view of the arm’s length standard grounded in comparability.” (slip op. at 21 n. 4) The regulations involving direct transfers of intangibles also adopted some exclusively internal pricing rules using profit splits, which were understood as part of the arm’s length standard. These regulations have not been challenged by taxpayers for failure to rely on (unavailable) comparables. In 2003, Treasury promulgated the regulation at issue in Altera, which explicitly requires the sharing of stock option expense when a firm seeks the protection of a cost-sharing agreement under U.S. regulations.

The Ninth Circuit opinion adheres to general administrative law requirements, consistent with the Supreme Court’s 2011 Mayo decision. The court first evaluated Treasury’s compliance with § 706 of the APA under the State Farm’s “reasoned decisionmaking” understanding of the clause prohibiting “arbitrary” or “capricious” agency action. Then it considered whether the agency’s interpretation of the statute was permissible under Chevron.

Altera’s State Farm argument ran as follows. In the notice-and-comment process, tech industry and other commentators said that requiring related parties to share stock option costs couldn’t be arm’s length because unrelated parties did not share such costs. Commentators contended that nothing could replace comparable transactions, not even if exposure to a contract counterparty’s stock price would be unacceptable for unrelated parties but appropriate for related firms. Altera claimed that Treasury’s response to these comments was inadequate under § 706 of the APA.

Treasury responded, for example in the Preamble to the final regulation, by saying that the comments about comparable transactions were beside the point, because Section 482 does not require comparable transactions. In the regulation’s Preamble, Treasury justified the stock option cost-sharing regulation as consistent with “the legislative intent underlying section 482,” “the commensurate with income standard” and “the arm’s length standard.” Treasury’s view was that “arm’s length” meant a result consistent with what arm’s length parties would have bargained for, not a result that had to be predicated on comparable transactions.

Said the court: “[T]he thrust of Altera’s [State Farm] objection “was that Treasury misinterpreted § 482. But that is a separate question – one properly addressed in the Chevron analysis. That commentators disagreed with Treasury’s interpretation of the law does not make the rulemaking process defective.” (slip op. at 32) The court held that Treasury complied with the State Farm requirement because its regulatory intent could be discerned. It plainly “set forth its understanding that it should not examine comparable transactions when they do not in fact exist and should instead focus on a fair and reasonable allocation of costs and income,” (slip op. at 32). It treated the arm’s length standard as “aspirational, not descriptive.” (slip op. at 43)

The Ninth Circuit followed its State Farm analysis with an analysis of Chevron deference. Here, the question was not whether Treasury had clearly articulated its understanding of its authority under § 482, but rather whether it had stayed within the limits of that authority. As to Chevron step one, the court quickly found that Congress left gaps in transfer pricing law for the Treasury to fill with guidance. It is hard to see a different path. The statute includes broad delegation language, saying that “the Secretary may … allocate gross income, deductions [and other items of commonly controlled organizations] if he determines [it] necessary in order … clearly to reflect … income.”

The court’s Chevron step two analysis was also straightforward. When Congress added the commensurate with income standard to the statute in 1986, it communicated that “the goal of parity is not served by a constant search for comparable transactions” and that “the amendment was intended to hone the definition of the arm’s length standard.” (slip op. at 41) The commensurate with income statutory language directed Treasury to do precisely what it did, which was to promulgate internal standards to address the inadequacy of a narrow, comparable transactions approach to arm’s length. The court rejected the argument that Xilinx Inc. v Commissioner, a 2010 Ninth Circuit case, controlled its decision, in part because Xilinx involved the interpretation of pre-2003 regulations, which did not mention stock options.

Judge O’Malley, a Federal Circuit judge sitting by designation, dissented. On the Chevron issue, she wrote that Xilinx should control. Despite the 1986 addition of the “commensurate with income” standard to the statute and the express mention of stock option costs in the 2003 revisions to Treas. Reg. 1.482-7A, she wrote that the regulations had a “fundamental ‘purpose’” (slip op. at 51) consisting of the narrow, traditional arm’s length standard derived from comparable transactions. On the State Farm issue, she wrote that “Treasury may well have believed that, given the fundamental characteristics of stock-based compensation in QCSAs, it could dispense with arm’s length entirely…. But the APA required Treasury to say that it was taking this position….” (slip op. at 59).

Judge O’Malley also suggested a different interpretation of the text of Section 482, saying that the commensurate with income standard’s reference to a “transfer (or license) of intangible property” was not broad enough to include a qualified cost-sharing agreement. This interpretation, raised in an amicus brief submitted by Cisco Systems, cannot be right. Absent a cost-sharing agreement (or another kind of transfer or license other than a QCSA), intangibles would be owned by the affiliate whose workers created them. For Cisco, this would likely be Cisco Systems, Inc., the parent, publicly traded California-incorporated company that sits atop of the multinational Cisco firm and presumably employs Cisco’s engineers. But because of the cost-sharing agreement, some rights, for instance non-U.S. rights, to the intangibles are owned for tax purposes by a non-U.S. subsidiary, say Cisco Systems Netherlands Holdings B.V., which is apparently the holding company for Cisco’s European, Middle East and Africa business. The only explanation for Cisco Systems Netherlands Holdings B.V.’s tax ownership interest in intangibles created by Cisco Systems, Inc. is that, at least for tax purposes, Cisco’s cost-sharing agreement transferred or licensed intangibles from the U.S. parent to the (low-tax) non-U.S. subsidiary. Also, in practice, in addition to the transfer or license for tax purposes worked by the QCSA, cost sharing arrangements are accompanied by IP licenses to the cost sharing subsidiaries to protect their use of the IP.

A request for panel rehearing is not likely, since one of the panelists in the majority, Judge Stephen Reinhardt, unexpectedly passed away in March 2018. However, the taxpayer might request the Ninth Circuit to review the Altera decision en banc (which would not include Judge O’Malley, the dissenting judge, since she sits on the Federal Circuit). And appeal to the Supreme Court is possible as well.

Altera now involves a remarkable tangle of complex legal issues. It raises federal courts rules, international tax regulations, and intricate administrative case law. How strong is Altera’s hand in the event of appeal?

The federal courts issue is procedural: how should a judge’s vote be recorded when the judge dies before an opinion is issued? A footnote explains that “Judge Reinhardt fully participated in this case and formally concurred in the majority opinion before his death.” This is consistent with Ninth Circuit rules and the approach of some other circuits (though not all), giving perhaps little reason to think that the Ninth Circuit would reconsider the issue en banc. If the question is Supreme Court review, Altera might not be the best case for further consideration of this issue. There should be no actual concern that Judge Reinhardt would have changed his mind. Reinhardt voted for the government twice in Xilinx, as he was in the majority in the initial case and in dissent on rehearing. This means that he thought the government properly required the sharing of stock option costs even under the pre-2003 regulations that did not mention them.

The international tax and administrative law questions together raise the issues of compliance with Chevron deference and State Farm APA requirements. Here too, Altera does not hold a strong hand. Despite Judge O’Malley’s efforts, it is impossible to read the statute as limiting Treasury’s authority to the narrow, comparable transactions view of arm’s length analysis that the taxpayer advances. As the history of Section 482 shows, the statute clearly is not limited to traditional arm’s length analysis based on comparable transactions. This validates Treasury’s Preamble disagreement with commentators’ view that comparable transactions had to be used as a starting point.

In other words, the question is not close. Even if Chevron deference were cut back to Skidmore “power to persuade” deference, there would still be room under Section 482 for regulations that did not follow the narrow version of arm’s length based on comparable transactions. Plus, Altera covers an area that is a paradigm of technical tax expertise (unlike, for instance, the issue said to be outside Treasury’s wheelhouse in King v. Burwell). Even if the Supreme Court is inclined to consider limits to Chevron deference, Altera is not a good vehicle for that project.

 

 

 

Detrimental Reliance on the IRS

The Tax Clinic at Harvard has, so far, unsuccessfully litigated on behalf of individuals misled by the IRS regarding the last date to file a Tax Court petition as discussed here. Getting bad advice on when to file a Tax Court petition represents only one way in which bad advice from the IRS can mislead a taxpayer. In Kerger v. United States, No. 3:17-cv-00994 (N.D. Ohio 2018) another situation in which incorrect advice can harm a taxpayer surfaces. In all of these cases the individual at the IRS does not seek to mislead but a wrong answer from someone who would seem to hold a position of knowledge and authority can send taxpayers down the wrong path.

In this case the Kergers seek a declaration that certain taxes were discharged in a prior bankruptcy case. The IRS argues that the Declaratory Judgment Act prohibits such an action against the United States. Of course, as discussed in a recent post, the debtors could obtain a determination of wrongful collection if the taxes were discharged and the IRS kept pursuing them. Here, the IRS not only defended against the suit but used the suit as an opportunity to reduce the taxes to judgment which will have the effect of keeping them around forever (or at least until the taxpayers can successfully discharge them in their next bankruptcy.)

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The Kergers asked the court to equitably estop the IRS from collecting taxes they contend a previous bankruptcy discharged. In 2008 the Kergers filed a chapter 11 bankruptcy case in 2008 but eventually converted to a chapter 7 in 2010. Individual chapter 11 cases do not happen with great frequency. I did not study their bankruptcy case to determine why they needed to convert. The tax debt may have caused the conversion because they would have to commit to full payment of all priority taxes in order to confirm their chapter 11 plan. Following the conversion, they obtained a discharge after which the IRS pursued collection of the liabilities at issue in this case. The Kergers disagreed that the tax debt survived bankruptcy but could not obtain a response from the IRS.

In 2014 they had to abandon their home due to the presence of mold. The cost to fix the mold problem was estimated at $100,000. They decided to sell the house; however, the IRS had filed a notice of federal tax lien which created a problem in selling the property since the sale would result in payment of the tax liability prior to their ability to receive any proceeds. Their attorney contacted the IRS to obtain a payoff amount since the amount they would need to pay could influence their decision to sell. The IRS representative told the attorney that the Kergers did not owe any taxes. The IRS sent transcripts showing no liability and a conversation with an Appeals Officer confirmed that the lien would release due to the absence of a liability.

Relying on the representations of the IRS, the Kergers spent the money to clean the house, prepared for an auction and purchased a new home. The home sold on August 15, 2015, “with the understanding that the IRS liens would fall off before the thirty day closing period concluded.” Before the running of the 30 days, the Kergers received several pieces of certified mail notifying them of the taxes owed. The Kergers learned that the IRS had moved their liabilities from master file accounts to non-master file accounts due to the bankruptcy. Of course, the IRS individuals with whom the Kergers and their attorney spoke looked only at the master file accounts and did not access the non-master file accounts where the data about their liabilities resided.

The Kergers brought the case seeking a declaratory judgment that the bankruptcy discharged the liabilities or, in the alternative, that the actions of its employees equitably estopped the IRS from collecting on these liabilities. The opinion does not state why the Kergers brought suit seeking a declaratory judgment rather than an action for a determination that the action of the IRS violated the discharge injunction. The court does mention that their complaint expressly states “there is no issue as to the discharge raised in this Complaint.” The district court had little trouble determining that it could not grant a declaratory judgment because the language of the statute clearly bars the court from doing so because it lacks subject matter jurisdiction.

In an effort to save the Kergers, the court found that the claim of equitable estoppel could survive bankruptcy because an issue regarding the discharge of the liability exists. The court does not decide this aspect of the case but allows the case to continue so that the debtor can present information about the tax liability and show that the discharge provisions apply. The case does not contain enough information to allow me to speculate whether they have a chance to show the taxes were disqualified in the prior bankruptcy. The court does not say that it intends to hold for them as a result of the bad advice they received from the IRS. As of the writing of this post, the court had not issued a ruling on the discharge of the liabilities.

The court also discusses the pleadings and finds Twombly and Iqbal concerns. We have discussed this issue previously. Here, it finds the pleadings adequate.

We have discussed it before but switching accounts from master file to non-master file can cause confusion at the IRS as well as with the taxpayer. If the taxpayer whom you represent has a liability that you think exists and you see an IRS transcript that says nothing is owed, you need to talk to the IRS about the possible existence of a non-master file account. Do not get joyous prematurely. Taxpayers who have filed a joint return and who go into bankruptcy, request innocent spouse relief, or otherwise have some action on their account that causes it to need to be split must exercise caution when reading master file transcripts. Usually, the master file transcript has a transaction code removing the liability that hints of the creation of another account. If you are concerned, get someone at the IRS to pull the non-master file transcript before celebrating the end of the liability. Maybe the Kergers will still find relief in this case but generally, relying on bad advice from the IRS in this setting does not eliminate the liability. The IRS may apologize as it takes the next collection action.

 

 

 

Quick Takes: Altera, Senate Finance Committee Testimony on IRS Reform

I am trying to meet a deadline before a last gasp of summer vacation in California, and I have had a little less time than usual for blogging.  Tax procedure and tax administration developments wait for no one, however, and much has been happening this week. I will briefly discuss and add some links to two major developments: the Altera case and the Senate Finance Committee Subcommittee on Tax and IRS Oversight hearing.

Altera

As I am sure many readers know, the Ninth Circuit reversed the Tax Court in the heavily anticipated case of Altera v Commissioner, a case we have blogged numerous times. The basic holdings in the Ninth Circuit case all involved the broader question as to whether Treasury exceeded “its authority in requiring Altera’s cost-sharing arrangement to include a particular distribution of employee stock compensation costs.”

The Ninth Circuit, in a divided opinion that included now deceased Judge Stephen Reinhardt in the majority, concluded that the Treasury did not. In so doing, it held that Treasury did not violate the APA in its rulemaking, and under Chevron the court deferred to Treasury’s take on the substantive issue of allocation of employee stock compensation costs.

We will have more on this decision in PT. In the meantime, here are some comments on the decision in the blogosgphere:

Dan Shaviro in Start Making Sense trumpets the 9thCircuit getting to the right outcome

Leandra Lederman in The Surly Subgroup, who like Professor Shaviro wrote an amicus arguing for reversal, succinctly summarizes the holding

Jack Townsend, who in his Federal Tax Procedure blog, in addition to linking to his excellent and free tax procedure book offers his take on the case, including his gloss on Chevron and his forecast that if the Supreme Court gets to this one there is a good chance for the Supremes “screwing it up”

Chris Walker at Notice and Comment who expresses unease about the process, especially the aspect of including as part of the majority a judge who passed away prior to the Court’s issuing the opinion

Alan Horowitz at Miller & Chevalier’s Tax Appellate blog, discussing the holding and likely petition for rehearing by the full circuit

Senate Hearing on Tax Administration

The Senate Finance Committee’s Subcommitte on Taxation and IRS Oversight had a hearing yesterday on improving tax administration.

Here is a link to the audio; witnesses, whose written testimony is linked above, were

  • Caroline Bruckner, Managing Director of the Kogod Tax Policy Center at American University ;
  • Phyllis Jo Kubey, Member of the National Association of Enrolled Agents and the IRS Advisory Council ;
  • Nina Olson, the National Taxpayer Advocate ;
  • John Sapp, the current Chair of the Electronic Tax Administration Advisory Committee advising the Internal Revenue Service, and
  • Rebecca Thompson, the Project Director of the Taxpayer Opportunity

Senator Portman’s introductory statement is here—in it he notes the 20thanniversary of the IRS Restructuring and Reform Act, and how he and Senator Cardin recently introduced the Taxpayer First Act(following the House passing its version of legislation).

The National Taxpayer Advocate blogged on the hearing, including her take encouraging “everyone who cares about improving tax administration to watch the hearing and read the testimony submitted.”

Celebrating the 5th Anniversary of Procedurally Taxing

Today marks the 5th Anniversary of the first Procedurally Taxing post. As we have mentioned before, the blog is the brainchild of Les. He recruited Steve and me to join him in this endeavor as he recruited us to join him in working on the “IRS Practice and Procedure” treatise. When we met to discuss the blog prior to the first post, we anticipated that we might post once or twice a week. Before the end of the first year, we were posting almost daily, and we have tried to keep up the daily posting practice though there are days when we do not get our act together. Regular readers know our blog does not run like clockwork but rather operates based on the varying schedules of those of us trying to pull it together.

In the first post Welcome to Procedurally Taxing! Les wrote the following:

Welcome to Procedurally Taxing. Our blog will be a place where you can learn about important developments in federal tax procedure and tax administration, as well as occasional musings on general items that interest us. We started this blog because we want to be a site that readers can trust to learn about important developments. In addition, Keith, Steve and I are all involved in editing and rewriting books that deal with tax procedure; we are constantly reading and thinking about cases and administrative developments that may not jump out at the reader. We will highlight some of these less obvious developments and provide analysis and context reflective of our many years of practice in the area.

The most amazing stats of our first five years involve you. We have 1841 email subscribers to the blog. It has been 1825 days since we started. We have maintained a pace of approximately one additional email subscriber per day since the beginning of the blog. We know that readers access the blog through media other than email but the one additional subscriber per day stat has been a constant. You have accessed the web site slightly over 750,000 times since we started.

Some other stats about the blog:

– 373 guest posts written on a wide variety of topics which greatly enriched the blog

– 332 posts by Les, 372 by Keith, 164 by Stephen and 3 by Christine (plus 10 guest posts)

– 96 posts by frequent guest blogger Carl Smith

– 392 comments by frequent commenter Bob Kamman

In addition to bringing on Christine as a regular contributor, we have added regular bloggers Samantha Galvin, William Schmidt, Caleb Smith and Patrick Thomas, who comment on the Tax Court’s designated orders.

We hope that we have met our stated goal to keep you current on important developments in federal tax procedure and administration. We also have reported on less obvious developments and we have definitely provided our views on the developments.

As we mark this anniversary we invite you to comment on the blog – the good, the bad and the ugly. Tell us about anything that has made the blog useful or not useful to you and tell us how we can improve it going forward. Thanks for being our loyal readers. Our hats are off to you.

Designated Orders 7/2/2018 – 7/6/2018

Samantha Galvin from University of Denver’s Sturm Law School brings us this week’s designated orders. The first two orders she discusses demonstrate the difficulty pro se taxpayers have in determining when to appeal an adverse decision while the third order is a detailed opinion regarding the factors necessary to obtain a whistleblower award. The whistleblower case reminds us that many dispositive orders have the same amount of analysis as many opinions but when issued as an order lack any precedent and generally fly under the radar of those looking for Tax Court opinions. Keith

The week of July 2nd started off light but ended with a decent amount of designated orders – three are discussed below. The six orders not discussed involved the Court granting: 1) a petitioner’s motion to compel the production of documents under seal (here); 2) respondent’s motion for summary judgment when a petitioner did not respond nor show up at trial (here); 3) respondent’s recharacterized Motion to File Reply to Opposition to Motion for Summary Judgment (here); 4) respondent’s motion for summary judgment on a petitioner’s CDP case for periods that were already before the Tax Court and Court of Appeals (here); 5) respondent’s motion for summary judgment in CDP case where petitioners’ did not provide financial information (here); and 6) an order correcting the Judge’s name on a previously filed order to dismiss (here).

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Ring the Final (Tax Court) Bell on Bell

Docket No. 1973-10L, Doug Stauffer Bell and Nancy Clark Bell v. CIR (Order here)

This first order is for a case that William Schmidt blogged about (here). Bob Kamman also followed up on this case, in the comments to William’s post, with useful background information that sheds light on the petitioners’ circumstances. In the last designated order, the Court had ordered petitioners to show cause as to why the Court should not dismiss their case for failure to prosecute no later than June 28. Petitioners did not respond to the order to show cause, so the Court has dismissed the case.

If you recall the petitioners filed for bankruptcy three separate times while their Tax Court case was pending but ultimately failed to complete the bankruptcy process each time. Then they prematurely appealed to the Fourth Circuit, which dismissed their case for lack of jurisdiction after finding that the IRS appeals’ determination (issued after remand by the Court) was not “a final order nor an appealable interlocutory or collateral order.”

Now that the Court has dismissed their case it becomes appealable, however, the petitioners’ lack of meaningful participation in the process up to this point unfortunately does not bode well for an appeal.

The next order I discuss also involves a premature attempt to appeal a not-yet-final Tax Court decision.

Appeal after Computations

Docket No. 12871-17, Duncan Bass v. CIR (Order here)

This case is pending under rule 155 and it is somewhat understandable why petitioner thought the decision was final. Petitioner was served a bench opinion on June 8, 2018, and subsequently appealed to the Fifth Circuit, however, the bench opinion was an interlocutory order and the Court withheld entry of its decision for the purposes of permitting parties to submit computations, as rule 155(a) allows.

Interlocutory orders are generally not appealable, but there is an exception for “orders that include a statement that a controlling question of law is involved with respect to which there is a substantial ground for differences of opinion” and “an immediate appeal from that order may materially advance the ultimate termination of the litigation.” The order in this case does not contain such a statement. As a result, the Court orders the parties to continue to comply with rule 155 to resolve the computational issues so that the Court may enter a final, and thus appealable, decision.

A Disappointed “Whistleblower”

Docket No. 8179-17W, Robert J. Rufus v. CIR (Order here)

The petitioner in this case is an accountant who was hired to help prepare a statement of marital assets as part of a divorce proceeding, which gave him access to his client’s soon-to-be ex-husband’s (“the ex-husband’s”) tax information. This information led petitioner to believe that the ex-husband had underreported gifts and treated gifts as worthless debts. He provided information about these two violations in an initial and supplemented submission to the Whistleblower Office, which ultimately denied him an award.

In this designated order, respondent moves for summary judgment on petitioner’s challenge of the denial of the award. Respondent argues that it did not abuse its discretion in denying the award because, although the ex-husband was audited and tax was assessed, the IRS did not rely on the information petitioner provided.

Regarding petitioner’s initial submission, the IRS examined the ex-husband’s underreporting of gifts but found that there was not enough independent, verifiable data to support a gift tax assessment. The ex-husband had also filed amended returns which included worthless debts of $23 million and generated losses which he carried back and forward in amended 2003, 2004, and 2006 returns. Petitioner was aware of these amended returns and provided the IRS with information about the worthless debts in a supplemented submission, alleging that the debts were actually gifts to family and friends. According to respondent, the large refund amounts claimed on the returns are what triggered the audit, rather than petitioner’s information.

The information petitioner sent was never seen or used until after the case was closed because the assigned revenue agent believed, for unexplained reasons, that the information was based on grand jury testimony and was tainted. In the audit, the revenue agent concluded the ex-husband failed to substantiate the bad debts he claimed and assessed tax accordingly.

The Whistleblower office sent petitioner a letter denying his claim regarding the gift tax liabilities to which petitioner responded stating that his claim involved the gift tax liabilities and the treatment of gifts as worthless debts. The Whistleblower Office then sent a final determination reviewing each item, and with respect to the worthless debt the IRS stated that it had identified the issue prior to receiving information from petitioner.

Petitioner petitioned Tax Court on that final determination arguing that the exam was initiated due to his information and the information was directly, and indirectly, beneficial to the IRS and resulted in the assessment of tax, penalties, and interest but he offered no evidence to support these claims. He also argued that respondent was too focused on the timing of his supplemented submission in an attempt to deny the award.

A whistleblower is entitled to an award if the secretary proceeds with any administrative or judicial action based on information submitted by the whistleblower. Additionally, the award is only available if the whistleblower’s target’s gross income exceeds $200,000, and if the amount or proceeds in dispute exceed $2,000,000. The IRS must take action and collect proceeds in order to entitle the whistleblower to an award. If the IRS’s action causes the whistleblower’s target to file an amended return, then the amounts collected based on the amended return are considered collected proceeds.

Since the petitioner in this case did not provide additional evidence, the Court reviews the administrative record which reflects that petitioner’s first submission was related to the gift tax issue, on which no proceeds were collected. The administrative record also reflects that petitioner’s supplemented submission about the worthless debts was not used in the exam of the amended returns and the revenue agent received the information after the returns were already selected for exam. Based on its review of the administrative record, the Court grants respondent’s motion for summary judgment.

 

Eleventh Circuit Upholds Enforcement of Summons Relating to Law Firm and Its Clients (And Sweeps in the 1980 Miracle on Ice)

The Eleventh Circuit opinion in Presley v US ostensibly is about how IRS can summons a bank for information relating to deposits from a law firm’s clients. The opinion starts with a recounting of the 1980 Winter Olympics, when the US Olympic hockey team, against heavy odds, beat the Soviets.  Drilling into the details, the opinion includes the average age of the US team (22), links to the E.M. Swift’s Sports Illustrated article on the win, references the 2004 Disney movie Miracle, and how one of the players (Jack O’Callahan), was so moved by Coach Herb Brooks’ pregame speech that he could recount it decades later.

What is the connection between the power of the IRS to gather information from third parties and the Miracle on Ice?

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Writing for a unanimous panel, Judge Rosenbaum contrasts the uphill battle that the US hockey team faced from the battle that the plaintiffs faced:

But forget about tough odds the U.S. hockey team faced, Plaintiffs face-off with something even more formidable…

According to the opinion, more formidable than the Soviet team is the considerable power that the IRS has to get information via its summons powers. The opinion nicely summarizes the statutory framework and Supreme Court guidance that stack the deck heavily in favor of the IRS.

The facts are straightforward. The plaintiffs are a lawyer and his law firm, and they sought court protection to avoid their bank’s compliance with summonses the IRS issued in connection with an exam of Presley’s individual income tax liability.

As the opinion discusses the IRS summonses sought records “pertaining to any and all accounts over which [each Plaintiff] has signature authority,” including bank statements, loan proceeds, deposit slips, records of purchase, sources for all deposited items, and copies of all checks drawn.

Presley objected to the bank’s turning over information related to their clients’ trust and escrow accounts, arguing essentially that his clients’ Fourth Amendment expectation of privacy would be violated if the IRS obtained the information about the clients’ financial transactions with the law firm.

The opinion starts by describing that there is some uncertainty whether the law firm, rather than the clients, can make the Fourth Amendment argument. After all, it is the clients whose privacy interests are at stake. This is akin to a standing dispute; i.e., does the law firm have standing to make the case that its clients’ privacy interests may be violated?

The opinion is able to sidestep that issue, noting that unlike traditional Article III standing disputes, Fourth Amendment standing is not jurisdictional, meaning that the opinion can effectively decide the matter on the merits without weighing in on whether technically Presley can in fact make the argument.

Getting to the merits, Presley argued that in light of the clients’ privacy interests in the financial information the IRS must show probable cause to enforce the summons. The court disagreed, noting that probable cause would only be required if the clients had a reasonable expectation of privacy in the financial records.  The opinion says that there is no such expectation, referring to what is known as the third-party doctrine and citing to the 1976 Supreme Court case US v Miller (also involving an IRS summons and a bank):

[A] party lacks a reasonable expectation of privacy under the Fourth Amendment in information “revealed to a third party and conveyed by [that third party] to Government authorities, even if the information is revealed on the assumption that it will be used only for a limited purpose and the confidence placed in the third party will not be betrayed.”

Presley tried to distinguish Miller, because unlike in that case, there was an intermediary between the clients and the bank, i.e., the clients transferred money to the law firm, which then made deposits on behalf of the clients. The court found that distinction insignificant:

Nor does it matter that Plaintiffs’ clients gave their records to Plaintiffs rather than directly to the bank. Plaintiffs conveyed their records, such as checks for deposit in Presley Law’s escrow or trust accounts, knowing that the firm would, in turn, deposit these items with the Bank. So if Plaintiffs cannot escape Miller directly, Plaintiffs’ clients cannot avoid its application indirectly. In short, Miller precludes us from holding that Plaintiffs’ clients have a reasonable expectation of privacy in the summoned records.

There were two other issues of note in the opinion. Presley also argued that even if there was no Fourth Amendment requirement that the government show probable cause to ensure enforcement, the Florida constitution had a heightened privacy protection for these circumstances. The Eleventh Circuit declined to consider the impact of the Florida constitution on the reach of IRS summons powers, noting that state laws that “conflict with federal laws by impeding the ‘full purposes’ of Congress must give way as preempted,” a doctrine known as the Supremacy Clause. That has come up before in tax cases, as courts have enforced IRS summonses despite, for example, state law doctor-patient privileges.

Once dispelling with the argument that the IRS had to establish heightened probable cause to justify the summonses, the opinion rested on a traditional application of the Powell factors, which in effect is a proxy for the Fourth Amendment protection that an IRS search met the lesser standard that it not be unreasonable. Noting that Presley did not claim a conflict with Powell, and that there was no claim that the IRS was using the summons power as a subterfuge to investigate the clients or violate attorney-client privilege, the opinion found “no reason to discern why the summons should not be enforced.”

As a final argument, Presley argued that the district court failed to comply with the so-called John Doe summons procedures under Section 7609(f). That requires the IRS to go to a district court in an ex parte hearing when it seeks information about unnamed third parties. We have discussed that a few times in PT, and I discuss it heavily in Chapter 13 of Saltzman and Book, including in the context of the IRS investigation of crypto currency users.

Here, while the IRS sought information that included information about unnamed third parties (the clients), the main targets were the law firm and Presley himself, who were named on the summons and who did receive notice of the IRS actions. Moreover, the plaintiffs in Presley conceded that their clients were not the subject of the IRS investigation, unlike in the Bitcoin dispute where IRS has been trying to gather information to allow it to determine whether Bitcoin customers were complying with federal tax laws.

For good measure, additional Supreme Court precedent, Tiffany v US, allows the IRS to effectively issue dual purpose summonses that could also provide information about unnamed third parties, provided that the IRS complies with the notice provisions under Section 7609(a)—which it did here.

Taken together, the defenses that the government mustered were more formidable than Vladislav Tretiak, and the bank will have no choice but to comply with the summons and I doubt there will be a Disney movie about this story.