EIP CLE from ABA Tax Section’s Pro Bono and Tax Clinics Committee

The Pro Bono and Tax Clinics Committee of the ABA Tax Section will host another program in its series of programs to help practitioners understand the tax issues enmeshed in the CARES Act.  Scheduled for Thursday, May 28 from 1:00 to 2:30 PM ET, , this program, “Delivering Economic Impact Payments: More Challenges and Quandaries in the COVID-19 Era,” will compare and contrast the IRS’s 2008 stimulus experience with the 2020 experience, and will also discuss issues associated with superseding returns, EIP offsets, and particular issues linked to spousal abuse, identity theft, non-identity theft related tax fraud, return preparer misconduct, and strategies for dealing with the IRS when encountering these problems.

You can register for the program here.  Free registration and CLE credits are available for ABA Members, LITC attorneys, and government employees. The program will be recorded for later listening, but that recording will not offer CLE credit.

Nina Olson from the Center for Taxpayer Rights is moderating the panel.  Panelists include Caleb Smith from the University of Minnesota (a PT designated order blogger), Nancy Rossner from the Community Tax Law Project (a PT guest blogger), Josh Beck from the Taxpayer Advocate Service’s Attorney Advisor Group, and me.

This is the third program on COVID-19 issues hosted by the Pro Bono and Tax Clinics Committee.  Two of the earlier programs, “The Agony of a Missed Deadline or Was That Deadline Really Missed” and “Tax Implications of COVID-19 – Tax Collection in the Time of COVID-19,” are available at the links provided.  While viewing the programs on these videos does not offer CLE credits, they nevertheless provide the opportunity for understanding some of the urgent tax issues presented by the pandemic. These are three of the several programs the Tax Section has hosted on COVID-19 issues all of which can be found by visiting the COVID-19 Information and Tax News page of the Tax Section’s web site.     

BBA Partnership Tax Provisions and Bankruptcy– A Recipe for Disaster, Part 1

We welcome back guest blogger, A. Lavar Taylor.  Lavar’s practice is based in Southern California though you can find him pursuing cases around the country.  He spent the early days of his career in the General Litigation Division of Chief Counsel’s office where he learned the intricacies of the intersection of tax and bankruptcy.  We enjoy his insights today on a new issue that could vex bankruptcy and tax attorneys in the coming years.  Keith

Some of us practitioners are old enough to have endured the transition to the TEFRA Partnership audit provisions from the unwieldy pre-TEFRA rules that required the IRS to audit the tax returns of all partners in a tax partnership in order to assess deficiencies resulting from adjustments to Forms 1065 filed by those partnerships.  That transition required a considerable learning curve. Even 30+ years after the enactment of the TEFRA Partnership audit provisions, we have still been “learning through litigation” about the proper interpretation of some of the more poorly drafted TEFRA Partnership audit provisions.  See, e.g., Petaluma FX Partners, LLC v. Comm’r, 792 F.3d 72 (D. C. Cir. 2015).

The intersection between the TEFRA Partnership audit provisions and the bankruptcy/insolvency world has also proven to be quite interesting, as illustrated by the Ninth Circuit’s opinion in Cent. Valley Ag Enters. v. United States, 531 F.3d 750 (9th Cir. 2008). In that case, the taxpayer/debtor was allowed to challenge a claim filed by the IRS based on a TEFRA Partnership audit even though the IRS had issued an FPAA and the deadline for filing a Tax Court petition with respect to the FPAA had expired without any petition having been filed.  Outside of bankruptcy, no judicial challenges to the audit assessment made against that partner as the result of the TEFRA Partnership audit would have been permissible as of the date on which the Chapter 11 bankruptcy case was filed. But once inside Chapter 11, per the Ninth Circuit, the taxpayer/debtor/partner was entitled to challenge the merits of the audit assessment under section 505(a)(2) of the Bankruptcy Code.  The filing of the Chapter 11 by the partner allowed the debtor/taxpayer/partner to escape the otherwise preclusive effect of the failure of any party in interest to file a Tax Court petition in response to the FPAA.

Now, thanks to Congress, we are faced with learning an entirely new set of partnership audit provisions: the BBA Partnership audit provisions. Learning how these new provisions will operate in the real world is likely to be no less painful than it was to learn how the TEFRA Partnership audit provisions operate in the real world.

This learning process will be even more painful where a bankruptcy is involved. How much more painful? That remains to be seen, but masochists and sadists will likely rejoice.

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This post discusses one of the many problems that are going to arise when the BBA Partnership audit provisions collide with the Bankruptcy Code, namely, how to classify, for purposes of the Bankruptcy Code, claims for audit assessments of income taxes arising under the BBA Partnership Audit proceedings. I plan to follow up this post with additional posts which will further discuss the problems that are going to arise as the result of the intersection of these two statutory schemes. A discussion of these issues appears timely in light of the current economic climate.

Classifying income tax claims under the Bankruptcy Code is important. How income tax claims get classified under the Bankruptcy Code determines matters such as: a) the order in which such claims get paid in Chapter 7 relative to other types of claims, b) whether such claims must be paid in full in a Chapter 11 case or in a Chapter 13 case, c) the terms on which such claims can or must be paid in a Chapter 11 case or in a Chapter 13 case, and d) the extent to which such claims can be discharged in bankruptcy.

Without getting too technical, there is a big distinction under the Bankruptcy Code between income tax claims that are for tax periods that end prior to the date of the filing of the bankruptcy petition (“pre-petition tax claims”) and income tax claims for tax periods that end after the date of the filing of the bankruptcy petition (“post-petition tax claims”).  Pre-petition income tax claims, if not secured by the proper filing of a tax lien notice, are either “general unsecured” claims or “priority” claims. See, e.g., Bankruptcy Code 507(a)(8)(A), which determines what pre-petition income tax claims are treated as “priority” tax claims.

Post-petition income tax claims are sometimes (but not always) entitled to be paid as an administrative expense in the bankruptcy case.  In other cases, post-petition income tax claims are not treated as administrative expense and cannot be paid out of proceeds held by a Chapter 7 Trustee and cannot be paid at all under a Chapter 11 plan.

In any bankruptcy case, unsecured pre-petition tax claims, whether treated as “priority” tax claims or as “general unsecured” claims, do not get paid until all administrative expense claims have been paid in full. Also, “priority” tax claims get preferred treatment over general unsecured claims in all types of bankruptcy cases.  

Thus, determining whether an income tax claim is a pre-petition claim or is instead a post-petition claim is important. Also, if an income tax claim is a pre-petition claim, determining whether that claim is a “priority” tax claim or is instead a “general unsecured” tax claim is important. Similarly, if an income tax claim is a post-petition claim, determining whether or not that post-petition income tax claim is an administrative expense claim is important.  See, e.g., Towers for Pacific-Atlantic Trading Co. v. United States (In re Pacific-Atlantic Trading Co.), 64 F.3d 1292 (9th Cir. 1995), which dealt with all of these issues in the context of an IRS claim for taxes for the tax year during which a corporate debtor/taxpayer went into chapter 11 bankruptcy.

Those of you who have some familiarity with the BBA Partnership audit provisions should already have an idea of where this discussion is headed.  Under the BBA Partnership provisions, an audit of a partnership return for the year 2019 which ends in the year 2023 and which generates a deficiency can result in any of the following:  1) deficiency assessments against the 2019 partners for the 2019 tax year, 2) a deficiency assessment against the partnership for the tax year 2023, or 3) deficiency assessments against the 2023 partners for the tax year 2023. 

Suppose, then, that the tax partnership files for chapter 11 at the end of 2022 and that this Chapter 11 case remained pending as of the end of 2023 without a chapter 11 plan being confirmed.   If an IRS audit of the partnership’s 2019 tax return comes to an end in 2023 and the taxes are assessed against the partnership for the year 2023 in 2024, how should that claim be classified under the Bankruptcy Code?  The claim is for the 2023 tax year, a post-petition year.  That suggests that the claim is a post-petition claim. But the claim is clearly based on pre-petition activity. Thus, there is an argument that the claim against the partnership should be treated as a pre-petition claim, even though the claim is for a post-petition tax year.

If the claim is to be treated a pre-petition claim, is the claim entitled to priority treatment under section 507(a)(8) even though that section only applies to claims for tax years that ended before the date on which the bankruptcy was filed? If the claim is to be treated as a post-petition claim, is the claim an administrative expense claim allowed under section 507(a)(2) of the Bankruptcy Code? Resolution of these issues will be important not only to the IRS, which will want to be paid what it is owed, but also to the 2023 partners of the partnership, who can be held personally liable for the partnership’s 2023 income tax deficiency assessment if it is not paid by the partnership.

Sorting out these classification issues in this very simple fact pattern, based on the law as it presently stands, will take years of litigation. There will undoubtedly be variations of this fact pattern, and there will be bankruptcy cases involving the partners in a partnership subject to the BBA Partnership audit provisions in which claim classification issues arise.  Such claim classification issues are but a small fraction of the issues that will arise in bankruptcy cases involving individuals and entities subject to the BBA Partnership audit provisions.

Conclusion of Part I

It will be far more efficient to solve these problems through legislative and administrative action, rather than through litigation. The first step in this process, however, is to identify the problems that need to be solved. I hope to identify additional problems in future posts, and I invite the PT Community to help identify the problems that are out there. (For those of you interested in reading a short article which identifies some of the due diligence that bankruptcy professionals must perform as the result of the enactment of the BBA Partnership audit provisions, I invite you to review the following article which appeared in Business Law News, published by the California Lawyer’s Association, which can be found here.

Proposed Changes to Tax Court Rule 24

On April 21, 2020, the Court issued a Press Release announcing proposed amendments to its Rules of Practice and Procedure and providing for public written comment to be received by May 31, 2020.  On May 18, 2020, the Tax Court issued a follow up press release noting that it’s not receiving mail at the moment since the clerk’s office is closed and directing those seeking to submit comments on recent proposed amendments to the Tax Court’s practice and procedure rules should email the comments to the court clerk at Rules@ustaxcourt.gov.  This makes sense given that mailing your comments to the Tax Court could cause them to arrive after the Court makes its decisions regarding the rule changes.

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So, what rules does the Court want to change?  In the April 21 press release, the Court seeks comments on changes to Rule 24 regarding practice before the Court together with some conforming amendments.  One of the biggest changes concerns limited appearance introduced last fall as an experiment.  The Court has decided that the experiment went well, and it seeks to adopt the limited appearance rules into its permanent rules along with other changes.  The press release contains a track changes copy of Rule 24 as well as a clean copy.  To help you understand the new rule and decide if you want to make comments, here is a clean copy of proposed Rule 24:

Post-Amendment Rule 24

RULE 24. APPEARANCE AND REPRESENTATION

(a) Appearance:

(1) General: Counsel may enter an appearance by signing and filing:

(A) the petition or other initial pleading or document;

(B) an entry of appearance; or

(C) a substitution of counsel in accordance with paragraph (d).

See Rules 22, 23, and 26 related to signing and filing papers with the Court.

(2) Required Information: Any paper that counsel may use to enter an appearance must include:

(A) the case name and docket number (if any); and

(B) counsel’s name, mailing address, email address (if any), telephone number, and Tax Court bar number.

(3) Counsel Not Admitted to Practice: An entry of appearance filed by counsel not admitted to practice before the Court is not effective until counsel is admitted. Where it appears that counsel who is not admitted to practice can and will be promptly admitted to practice, the Court may recognize that counsel in a pending case. See Rule 200 for the procedure for admission to practice before the Court and Rule 201(a) regarding conduct of practice before the Court.

(4) Limited and Special Appearance:

(A) Limited Entry of Appearance: Counsel may file a limited entry of appearance to the extent permitted by the Court.

(B) Special Appearance: The Court may, in its discretion, temporarily recognize an individual or counsel as the party’s representative, and no separate entry of appearance is necessary.

(5) Law Student Assistance: A law student may assist counsel with drafting a pleading or other document to be filed with the Court and, with the permission of the presiding Judge or Special Trial Judge, and under counsel’s direct supervision, may present all or any part of the party’s case at a hearing or trial. A law student may not, however, enter an appearance in any case, be recognized as counsel in a case, or sign a pleading or other document filed with the Court.

(b) Representation Without Counsel:

(1) General: A party that is not represented by counsel may proceed as follows:

(A) an individual may represent himself or herself;

(B) an authorized officer may represent a corporation;

(C) an authorized member may represent an unincorporated association; and

(D) a fiduciary may represent an estate or trust.

(2) Required Information:

(A) The initial pleading or other paper filed by a party must include the party’s name, mailing address, email address (if any), and telephone number.

(B) If the initial pleading or other paper is filed by an authorized representative or fiduciary, it must also include the authorized representative’s or fiduciary’s name, mailing address, email address (if any), and telephone number.

(c) Withdrawal of Counsel:

(1) Notice of Withdrawal as Counsel: Counsel desiring to withdraw as counsel for a party may file a notice of withdrawal as counsel if:

(A) more than one counsel have entered appearances for that party;

(B) the notice of withdrawal is filed no later than 30 days before the first day of the Court’s session at which the case is calendared for trial; and

(C) there is no objection to the withdrawal.

(2) Motion to Withdraw as Counsel: Counsel desiring to withdraw as counsel for a party but who is ineligible to do so under subparagraph (c)(1) must file a motion requesting leave.

(3) Motion to Withdraw Counsel by Party: A party desiring to withdraw the appearance of that party’s counsel must file a motion requesting leave.

(4) General Requirements:

(A) Any notice or motion under this paragraph must include a statement that counsel or the party provided prior notice of the notice or motion to the counsel’s client or the party’s counsel and to each of the other parties to the case or their counsel and whether there is any objection to the motion.

(B) Any motion to withdraw as counsel or to withdraw counsel must also include the party’s then-current mailing address, email address (if any), and telephone number.

(d) Substitution of Counsel:

(1) No later than 30 days before the first day of the Court’s session at which the case is calendared for trial, counsel who has not previously appeared for a party in that case may enter an appearance by filing a substitution of counsel substantially in the form set forth in Appendix, Form 8.

(2) The substitution of counsel must state that:

(A) substituted counsel seeks to enter an appearance for the party;

(B) current counsel’s appearance is withdrawn for the party;

(C) current counsel provided prior notice of the substitution to the counsel’s client and to each other party or their counsel; and

(D) there is no objection to the substitution.

(3) The substitution of counsel must be signed by current counsel and by substituted counsel, contain the information required by subparagraph (a)(2), and be filed by the substituted counsel.

(4) Counsel entering an appearance as substituted counsel within 30 days of the first day of the Court’s session at which the case is calendared for trial must file an entry of appearance under subparagraph (a), and any related withdrawal of counsel must be undertaken in accordance with subparagraph (c).

(e) Change in Required Information: A party or counsel must promptly notify the Clerk in writing of any change in the information required under this Rule, or of the death of counsel, for each docket number involving that party or in which counsel has entered an appearance.

(f) Change in Party or Authorized Representative or Fiduciary: Where (1) a party other than an individual participates in a case through an authorized representative (such as an officer of a corporation or a member of an association) or through a fiduciary, and there is a change in the representative or fiduciary, or (2) there is a substitution of parties in a pending case, counsel signing the motion resulting in the Court’s approval of the change or substitution will thereafter be deemed first counsel of record for the representative, fiduciary, or party. Counsel of record for the former representative, fiduciary, or party desiring to withdraw as counsel must file a motion in accordance with subparagraph (c)(2).

(g) Limitations on Representation:

(1) Conflict of Interest: If any counsel of record (A) was involved in planning or promoting a transaction or operating an entity that is connected to any issue in a case, or (B) represents more than one person with differing interests with respect to any issue in a case, then that counsel must either secure the client’s informed written consent; withdraw from the case; or take whatever other steps are necessary to obviate a conflict of interest or other violation of the ABA Model Rules of Professional Conduct. See Rules 1.7 and 1.8, ABA Model Rules of Professional Conduct. The Court may inquire into the circumstances of counsel’s employment in order to deter such violations. See Rule 201.

(2) Counsel as Witness:

(A) Counsel may not represent a party at trial if the counsel is likely to be a necessary witness within the meaning of the ABA Model Rules of Professional Conduct unless: (i) the testimony relates to an uncontested issue; (ii) the testimony relates to the nature and value of legal services rendered in the case; or (iii) disqualification of counsel would work substantial hardship on the client. See Rule 3.7, ABA Model Rules of Professional Conduct.

(B) Counsel may represent a party at trial in which another professional in the counsel’s firm is likely to be called as a witness unless precluded from doing so under the ABA Model Rules of Professional Conduct. See Rules 1.7 and 1.9, ABA Model Rules of Professional Conduct.

In addition to the change to allow for limited participation, the Court allows in the rules for counsel to withdraw with a notice rather than a motion if done in time.  Up to this point if you entered your appearance, you had to file a motion in order to withdraw your appearance.  Some practitioners, including me, are reluctant to enter an appearance when a prospective client shows up on our doorstep often after receiving the Tax Court’s stuffer notice alerting them to the possibility of clinic representation.  I do not like to jump into a case until I am comfortable with the client and the issues in the case.  So, I often obtain a power of attorney and work with the Chief Counsel attorney or Appeals under the POA to learn about the case before deciding whether to formally enter an appearance.  The new rule makes me more likely to enter an appearance knowing that I can pull out without having to file a motion and obtain court approval.

The changes to Rule 24 potentially impact anyone who practices before the Tax Court.  Though there is not much time left before the deadline, consider submitting comments if parts of the changes make you more comfortable about practicing in the Tax Court or less comfortable.  I am sure that the Court would appreciate hearing from as many voices as possible.

Pending Cert Petition in Altera: Tax Law in an Administrative Law Wrapper

Susan Morse & Stephen Shay return to discuss the Altera case. This piece is cross posted at JREG’s Notice & Comment blog. Keith

Each day of the COVID crisis we see unprecedented administrative action to respond to the pandemic. At the same time, litigants continue to ask courts to consider whether administrative agencies have exceeded their authority, sometimes relying on claims of deficient process. One such case is Altera v. Commissioner, in which the taxpayer filed a cert petition that asks the Supreme Court to review a Ninth Circuit decision upholding a tax regulation. The government submitted its brief in response on May 14, and the Court will presumably consider the case in conference before its summer recess. The taxpayer has not filed a reply as of this writing.

In its brief, the government stays squarely on the administrative law playing field laid out by the taxpayer’s petition. The government’s reply takes on – and, we think, successfully defeats – the core premise that underlies the taxpayer’s administrative law arguments.

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In 2015, Altera won a unanimous decision in the Tax Court, which invalidated a 2003 regulation as arbitrary and capricious under State Farm. Then the government won in the Ninth Circuit before the original three-judge panel in 2018 (withdrawn because of the death of Judge Reinhardt), before a revised three-judge panel in 2019, and when the Ninth Circuit denied the taxpayer’s request for a rehearing en banc in 2019. We contributed amicus briefs [here (with coauthors Leandra Lederman and Clint Wallace), here and here] on behalf of the government before the Ninth Circuit, and have blogged previously about the case here and here. In February, the taxpayer submitted a petition for certiorari to the Supreme Court.

The tax issue in Altera involves a final Treasury regulation promulgated in 2003. The reg applies to qualified cost-sharing agreements, or QCSAs, made between U.S. firms and their offshore subsidiaries. A QCSA requires an offshore subsidiary to pay its share of the costs of developing IP. If QCSA requirements are met, the offshore subsidiary owns non-U.S. rights to intangible property developed by its U.S. parent company for tax purposes. Then the firm can shelter resulting offshore profit from U.S. tax. As relevant here, the 2003 regulation at issue in Altera conditions the favorable tax treatment available for QCSAs on the inclusion of stock-based compensation costs in the pool of shared costs.  

Technology and other multinational firms that use stock option compensation (and use strategies to shift profit from intellectual property across borders) have had an understandable and longstanding interest in this issue. An appendix to Altera’s cert petition lists 82 companies that noted the Altera issue in their public financial statements. One entry alone – that of Alphabet, Inc. – reports $4.4 billion at stake.

We think the regulation gets it right as a matter of tax policy. It properly prevents stock-based compensation deductions from reducing U.S. taxable income when these expenses support foreign profit. The regulation falls securely under the Commissioner’s statutory discretion (under I.R.C. Section 482) and responsibility to ensure clear reflection of income. It squares with modern financial accounting rules. And it aligns with OECD and other international efforts to combat base erosion and profit shifting to low-tax jurisdictions.

But the hook in the cert petition is not the tax issue. It is an administrative law issue. The taxpayer hopes to persuade four justices that Altera is an attractive opportunity to rein in an administrative agency’s power and further limit the case law that supports administrative agency discretion. Perhaps it appears particularly juicy because the administrative agency at issue is the Treasury, given the complicated history and relationship between Treasury regulations and administrative law. Indeed, the regulation in this case was promulgated well before the Supreme Court held, in its 2011 Mayo case, that Chevron deference (rather than National Muffler review) applies to tax regulations just as it applies to other federal regulations.

The taxpayer’s administrative procedure argument includes two main claims. The first is that Treasury did not provide a reasoned explanation for the regulation and that the regulation was therefore arbitrary and capricious under State Farm. The second is that the government engaged in post hoc rationalization to defend the regulation, in violation of Chenery I. (A third claim, derivative of the first two, asks whether, assuming a regulation is held procedurally defective, a court may nevertheless uphold it under Chevron.)

Five out of six filings submitted to the Supreme Court on behalf of the taxpayer – including the primary cert petition and four out of five amicus briefs – hang their respective hats on a single premise. This premise is that Treasury first suggested that comparability analysis was relevant under the stock-based compensation QCSA regulation, and then Treasury broke its word. The government’s brief takes this premise head-on and, we think, persuasively disproves it.

Altera’s petition claims that in 2002 and 2003, “the government never said it was … adopting a new approach to cost-sharing” (8) and that the rationale that the “commensurate with the income” language supported the new approach “appeared nowhere in the rulemaking record.” (10-11) Amicus briefs argue that the government advances “a new statutory interpretation” in litigation (Chamber of Commerce 16), describe the government’s allegedly “newfound litigation position that comparables are irrelevant” (Cisco 11), assert a “transparent post hoc rationalization” (National Association of Manufacturers 15) and claim that there would have been comments on “the applicability and scope of the arm’s length standard” in notice-and-comment if taxpayers had only been aware that the government meant to make comparability analysis irrelevant to the determination of an arm’s-length result for stock-based compensation costs in the QCSA context. (PricewaterhouseCoopers 16).

Interestingly, the fifth of five amicus contributions supporting Altera – a brief filed by a group of former foreign tax officials – paints a picture of continuity, rather than change, in arguments made by Treasury and the IRS. It acknowledges that both in 2002 and 2003 and also in litigation before the Ninth Circuit, the government “ignor[ed] … potentially comparable transactions” and simultaneously “claim[ed] that its approach comported with the arm’s length standard.” (9-10) 

The government argues as follows in its brief in opposition to Altera’s cert petition: The taxpayer’s arguments “conflate (i) the arm’s length standard … and (ii) the use of comparability analysis” and “misunderstan[d] the relationship between the two concepts.” (19) In its rulemaking, the government did not suggest that empirical analysis and comparability were relevant to the determination of an arm’s length result in this context. Rather, the internal method adopted by the regulation is “an alternative to comparability analysis as a means of achieving an arm’s length result,”(20) consistent with the statute, as “Section 482 does not require any analysis of identified comparable transactions between unrelated parties.” (21) Moreover, the rulemaking and litigation record shows a constant commitment to a method that is not based on evidence of comparables. The government’s rulemaking record, as well as its arguments in litigation, consistently references the “commensurate with income” statutory language added in 1986. (24) So the “commensurate with income” argument made in litigation was not new either.

The government’s narrative gets this right. As the government’s brief explains, the regulatory history – not to mention the plain language of the regulation describing an arm’s-length result in this context – makes clear that interested taxpayers and tax advisers knew that “the proposed regulation would make any evidence of comparable transactions irrelevant” in the context of QCSAs. (22) Taxpayers certainly understood the proposed regs’ departure from comparability analysis. They just didn’t agree with it. Indeed, the battle lines over comparability analysis in the context of stock-based compensation costs were already clearly drawn, well before Treasury issued its Notice of Proposed Rulemaking in 2002. As the Software Finance and Tax Executives Council explained during the 2002 notice and comment period: 

On audit, in Advance Pricing Agreement negotiations, in docketed Tax Court cases, in published field service advice, and in speeches by Service officials … the Service has taken the position that stock-based compensation … must be included in related parties’ cost sharing pools. … Taxpayers have steadfastly and vehemently disagreed[, … absent] any evidence that unrelated parties … share stock option “costs” in their own cost sharing pools. 

This disagreement between taxpayers and the government was a tax policy dispute over the role of comparables in transfer pricing between related parties. Taxpayers argued that the arm’s length principle required comparables, even in the specific case covered by the QCSA regulation. The government consistently took the opposite position, beginning well before 2002 and continuing through the present cert petition in Altera.

Taxpayers may still disagree with the government on the tax policy issue. But that ship has sailed. Indeed, there are other examples of transfer pricing methods that do not rely on comparable transactions. One is the 1994 promulgation of the residual profit split method, also contained in a final regulation issued under I.R.C. Section 482.  

The issue before the Supreme Court is an administrative law issue. A necessary premise of Altera’s argument is that Treasury started with, but then abandoned, a commitment to empirical comparables analysis for its rule covering stock-based compensation in QCSAs. And as the government explains, this premise does not hold up.

Executive Order on Regulatory Relief to Support Economic Recovery

Monte Jackel returns to discuss an executive order issued this week by the President. Keith

On May 19, 2020, the President signed an executive order (Order) relating to regulatory relief to support economic recovery from the coronavirus crisis. Section 1 of the Order states:

“Agencies should address this [crisis] by rescinding, modifying, waiving, or providing exemptions from regulations and other requirements that may inhibit economic recovery, consistent with applicable law and with protection of the public health and safety, with national and homeland security, and with budgetary priorities and operational feasibility. They should also give businesses, especially small businesses, the confidence they need to re-open by providing guidance on what the law requires; by recognizing the efforts of businesses to comply with often-complex regulations in complicated and swiftly changing circumstances; and by committing to fairness in administrative enforcement and adjudication.”

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The reference to “regulations” is to EO 13892, section 2(g), which states that the term means a legislative rule under section 553 of 5 USC, the Administrative Procedure Act (APA). This means that the executive order would only apply to tax regulations to the extent they are legislative rules and not interpretative rules. The IRS view is that most tax regulations are interpretative and not legislative but the courts have recently deviated from following the IRS view. [see this prior post here on PT for further discussion].

The Order then states:

“The heads of all agencies are directed to use, to the fullest extent possible and consistent with applicable law, any emergency authorities that I have previously invoked in response to the COVID-19 outbreak or that are otherwise available to them to support the economic response to the COVID-19 outbreak. The heads of all agencies are also encouraged to promote economic recovery through non-regulatory actions.”

This provision of the Order, as it could apply to federal tax matters, seems to authorize continued and expanded use of the tax related provisions of sections 7508 and 7508A. See below.

The Order then states:

“The heads of all agencies shall identify regulatory standards that may inhibit economic recovery and shall consider taking appropriate action, consistent with applicable law, including by issuing proposed rules as necessary, to temporarily or permanently rescind, modify, waive, or exempt persons or entities from those requirements, and to consider exercising appropriate temporary enforcement discretion or appropriate temporary extensions of time as provided for in enforceable agreements with respect to those requirements, for the purpose of promoting job creation and economic growth, insofar as doing so is consistent with the law and with the policy considerations identified in… this order.”

Does the Order apply to tax regulations and, if so, how? In cases outside of tax, it is relatively easy to determine what is and is not a legislative rule. Outside of FAQs not being legislative rules because they are not “authority” under section 6662 in the first place, the determination of what is a legislative rule in the tax realm at present is being determined by the courts on a case-by-case basis. Essentially, from where we stand right now, legislative rules are those that impose substantive rights and duties not directly dealt with in the applicable statute.

Assuming that there is some uniform approach taken by the Treasury Secretary to implement the Order on the issue of tax legislative rules, the next question is what action can the Treasury Secretary take with tax regulations and other items considered legislative rules for this purpose?

The following are possibilities:

  1. Tax regulations that raise revenue because of the substance of the rule would seem to impede economic growth and recovery because the taxpayer has less net after-tax cash than if the rule provided otherwise. Does this mean that all tax regulations, if deemed legislative rules, should be rescinded or suspended if such action would reduce the taxpayer’s net after-tax economic position? That is not likely to be how the IRS views the situation but guidance may be needed to flush this out.
  2. As briefly noted earlier above, the Order seems to lean in favor of the IRS issuing more extensions of applicable due dates pursuant to the authority of section 7508A due to the March 1, 2020 emergency presidential declaration on the coronavirus. This would mean that the IRS’s announced position that tax due dates will not be extended beyond July 15, 2020 may need to be re-examined by that agency. How else could the Order be interpreted in this area of law?
  3. There was a prior regulatory effort under executive orders previously issued by the president relating to withdrawing regulations deemed too burdensome or perhaps lacking legal authority and limiting the use of new regulations generally, among other matters.  A limited list of regulations was produced by the IRS and Treasury a few years back and action was taken on a number of those items. Does the subject Order mean that this process will need to be repeated by Treasury and the IRS, perhaps more thoroughly than previously? Guidance should perhaps be issued on that as well.

As Professor Hickman and others have espoused over the years, due to the long period where tax regulations were, more or less, given a free pass under the APA, it is often not clear today how regulatory edicts generally, such as the subject Order, are to be applied to tax regulations given that the process of how and to what extent tax regulations are subject to the APA continues to be a developing area of law. Now would appear to be a good time to push this process along.

Bankruptcy and Farm Debt

The provision for farmers in the bankruptcy code is unusual, in part, because Congress placed it in an even numbered chapter while leaving the rest of the bankruptcy in odd numbered chapters and, in part, because of the amazingly different way Congress treats debts owed by farmers.  The case of In re Richards provides a glimpse of some of the unusual provisions in chapter 12 of the bankruptcy code.  At issue is whether the IRS can offset a tax refund against debts owed by the farming couple.

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When chapter 12 came into the bankruptcy code in the early 1980s, the nation was in the midst of a farm crisis.  Interest rates had reached stratospheric highs, and many farmers were going bankrupt as a result.  Movie makers even took notice of the crisis.

In creating chapter 12 Congress created a remedy that kept most farmers from filing bankruptcy.  The basic remedy allowed farmers to rewrite their debt through chapter 12 to reduce the debt to the current value of the land and to reduce the interest rate to the current interest rate.  Knowing what would happen in a bankruptcy case, most banks worked with their debt-laden farm clients to restructure debt and avoid the cost of bankruptcy to all parties.

Even the generous provisions allowing farms to rewrite their debt did not work for all farmers and some still needed to file bankruptcy.  Congress decided that it needed to create additional relief in the last major bankruptcy reform package in 2005.  In that legislation it recognized that sometimes farmers sold part of the farm in order to generate cash and that such sales often involved low basis property, which created large capital gains and the resulting tax debt.  To address this problem, Congress passed BC 1222(a)(2)(A) which transforms priority tax claims into general unsecured claims.  This is a huge deal in allowing farmers to confirm plans and to discharge the taxes that do not get paid.  I will not go into a long explanation of why but trust me that this is important for both reasons.

Because even BC 1222(a)(2)(A) did not provide enough protection for farmers who sold property while the bankruptcy case was pending, Congress subsequently pass BC 1232 to allow farmers to strip priority status off of sales occurring after the filing of a bankruptcy petition.  A good deal for farmers.

The Richards confirmed their chapter 12 plan and in the plan was the following language that “no creditor shall take action to collect on any claim, whether by offset or otherwise, unless specifically authorized by this Plan”. That same paragraph later recites that “[t]his paragraph does not curtail the exercise of a valid right of setoff permitted under §553”.

Section 553 preserves a creditor’s right to offset if it exists outside of bankruptcy law.  Generally speaking, debts need to be mutual and pre-petition in order to allow offset in bankruptcy.  The court noted the current split of authority concerning whether the IRS can offset a liability of a debtor once a plan is confirmed.  The court provided:

Courts are divided as to whether a confirmed plan under §1141, §1227 or §1327 bars the IRS from exercising its §553 setoff rights. Courts within the Seventh Circuit have held that, absent an express plan provision extinguishing such rights, a creditor’s §553 rights survive confirmation. Section 553 provides that “this title does not affect any right of a creditor to offset a mutual debt” and courts have reasoned that the “effect of confirmation” provisions are contained in “this title” (Title 11) and thus, do not affect the creditor’s §553 rights. U.S. v. Munson, 248 B.R. 343, 346 (C.D. Ill. 2000 (§553 trumps §1327); In re Bare, 284 B.R. 870, 874-75 (Bankr. N. D. Ill. 2002) (“confirmation of a debtor’s plan . . . does not extinguish prepetition setoff rights, especially . . . where the plan does not specifically treat those setoff rights”). However, a creditor’s §553 setoff rights may be extinguished by express provision under a confirmed plan. Daewoo Int’l (America) Corp. Creditor Trust v. SSTS Am. Corp., No. 02 Civ. 9629 (NRB), 2003 WL 21355214 at *4 (S.D.N.Y. 2003) (“[i]ndeed, where there is a specific provision in the confirmation order prohibiting setoff claims, courts have indicated that the right to setoff may not survive the confirmation plan”); IRS v. Driggs, 185 B.R. 214, 215 (D Md. 1995); In re Lykes Bros. Steamship Co., 217 B.R. 304, 310 (Bankr. M.D. Fla. 1997) (holding that §1141 takes precedence over §553 where plan of reorganization specifically prohibited setoff).

We have been writing about offset quite a lot lately because of the role it plays in the EIP payments and in other matters here, here and here. We are also adding a new section on offset into Chapter 14A of the Saltzman and Book treatise “IRS Practice and Procedure.”  Bankruptcy adds another level of issues involving offset.

Here, the bankruptcy court decides that it does not need to get into the debate over the effect of confirmation, because the offset performed by the IRS in this instance did not satisfy the requirements of §553.  The refund was post-petition while the debt to which the IRS made the offset was prepetition, meaning that the debts lacked the necessary mutuality.  As such it violated the language of the plan in this case.

While the bankruptcy court decides that the IRS should not have offset the debt owed by the debtor against the post-petition refund, it also determines that it does not have the power to order the IRS to turn over the refund in the current proceeding.  It suggests that the debtor initiate a BC 505 proceeding to determine the correct amount of the refund and through that process obtain the refund it seeks.  The case provides a useful reminder of the impact of bankruptcy on the ability of the IRS to offset and also the special provisions of chapter 12.

Given the pressure that the pandemic places on farmers, not to mention the pressure that U.S. trade policy has placed on them, chapter 12 may become more prominent in the near future.  Be aware that it has provisions for farmers quite different that those applying to debtors in other chapters.  Approach any chapter 12 case with caution to get to know the lay of the land.

ABA Tax Section Law Student Challenge

The ABA Tax Section is beginning its planning for this year’s Law Student Tax Challenge and is looking for law school faculty who would be interested in providing feedback to the drafting committee. The commitment is not burdensome and is really important in helping ensure that the problems are pitched at the right level for students!

The general experience has been that law school faculty have a good feel for the level of difficulty that is appropriate, and that even after one or two years in practice, tax lawyers may not realize how much they have learned in practice since they graduated from law school.

If you are interested in helping out on this — or would just like to learn more — please contact Diane Ring  (ringdi@bc.edu).

If you want to know more about the law student challenge, here is a link describing this year’s winners, the challenge itself and winners from past years.  The first year I taught in a law school I was a visiting professor at the University of Arizona with about 12 years of experience as a Chief Counsel attorney.  I will never forget the shock of reading the exams after that semester and realizing how little I seemed to have imparted to my students.  I spoke shortly thereafter to one of my former law school professors who said reading the exams could be an existential experience that made you question your existence.  I mention this only to reinforce Diane’s point that working with students really does give you a sense of what is realistic to expect from them.  While it’s always nice to be surprised, remembering their limitations, as well as your own as a professor, is helpful.  I encourage you to assist in this project.  The students who participate are always excited at the challenge.

Litigation of Tax Liability After Restitution Order

It has now been a decade since Congress began allowing the IRS to make restitution based assessments.  This area of the law is still in the growing phase.  We have blogged about issues regarding restitution based assessments here, here, here, here, here and here if you want more background on this.  The Saltzman-Book treatise also covers this topic extensively at ¶ 10.01[2][e] (addressing assessments generally) and ¶ 12.05[14][e][vi] (addressing criminal penalties) along with a stand-alone chapter on restitution based assessments at ¶ 12.06[5][a].

The recent case of Le v. Commissioner, T.C. Memo 2020-17 brings us back to the issues presented in a deficiency case following a restitution based assessment.  As is essentially required in these cases one of the petitioners, here the husband, Dung T. Le, was criminally prosecuted giving rise to a restitution order.  He was convicted of tax evasion under IRC 7201 pursuant to a plea agreement for the year 2006.  The prosecution occurred for the years 2004, 2005 and 2006 following an indictment on March 20, 2013. 

Because the criminal investigation process is slow, because the IRS defers civil action until the completion of the criminal aspects of the case conclude and because this case took four years to resolve in the Tax Court we discuss a case today involving years prior to the birth of around 30% of the world’s population.  The length of a case going through the criminal tax process provides the greatest reason for allowing assessment of some of the tax following the restitution phase of the criminal case.  As we will see, however, that assessment marks the beginning rather than the end of the assessment process in a case such as this.

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In connection with Petitioner Le’s plea agreement, he also agreed to pay restitution of $33,332 for 2006.  He paid that amount.  After he paid the restitution, the IRS finished the examination of the couple’s returns it had begun prior to the criminal case.  The examination resulted in a notice of deficiency for 2004, 2005 and 2006 in the amounts of $31,944, $44,178 and $40,706, respectively.  The IRS also asserted fraud penalties for each of the years.

Petitioner Le argued that the doctrine of collateral estoppel barred respondent from relitigating his 2006 liability since the criminal court determined the amount of his liability in the restitution order.  He loses this argument which came as no surprise.  The Court held that the order for criminal restitution did not comprise an essential part of the criminal conviction and was not an element of the conviction.  The Court also pointed out that the law is well settled that a restitution order has no effect on the authority of the IRS to determine a taxpayer’s correct civil tax liability citing Morse v. Commissioner, 419 F.3d 829, 833-835 (8th Cir. 2005).

After swatting away the argument that the restitution order in any way stopped the IRS from pursuing the correct liability in a follow up civil proceeding, the Court then marched through all of the reasons that he owed the additional tax.  That the taxpayer wanted to go through this after declining to go through it for criminal tax purposes surprises me but apparently he thought a sufficient chance existed that the IRS would not put on its proof to cause the creation of an opinion detailing the many ways in which he cheated on his federal taxes.  The Court also had little trouble finding that Mr. Le deserved to have the fraud penalty apply.

So, this case shows in a simple, straightforward manner the ability of the IRS to pursue civil assessment of additional taxes after making a restitution based assessment.  It offers very little, if anything, new.

Two other aspects of the case deserve quick mention.  First, the Court finds that Mr. Le’s wife does not owe the accuracy related penalty.  The fact that the IRS asserted the accuracy related penalty against Mrs. Tran also surprises me since I would have expected the government to know better.  Aside from hoping that the IRS attorneys read our blog posts explaining that if it cannot prove fraud against the spouse the Court can impose no lesser included penalties against her, because doing so would create an impermissible stacking of penalties as set out in Said v. Commissioner, T.C. Memo 2003-148, aff’d 112 F. App’x 608 (9th Cir. 2004), I hope that government attorneys know the law.  Seems like someone should have caught this argument unless the IRS seeks to change the law in which case perhaps we will see an appeal.  This is the second opinion within six months in which the IRS attorneys have made an argument that appears contrary to both the regulation, Treas. Reg. 1.6662-2(c), and the IRM, IRM 20.1.5.3.3.1 No Stacking Provision (12-13-2016).  Either the review of the IRS attorneys is lax or a change in position is afoot.

Second, the case contains an order sealing part of the record.  The order is unusual and its language caused me to read this passage a few times: “Pursuant to the Court’s Order dated July 10, 2018, portions of the exhibits were not properly redacted in accordance with Tax Court Rule 27(a), and the exhibits were not marked in accordance with Tax Court Rule 91(b).”  After reading the prior order, I came to understand this language as an odd way to refer back to an earlier order requiring redaction. 

Next the Court determines that since the material was not properly redacted, it is going to seal it.  It appears the Court sealed the record sua sponte.  Nothing in the order makes clear how the sealing of the record here meets the criteria for sealing discussed eloquently in a post by Sean Akins.  In its order dated July 10, 2018, the Court pointed out to the parties that they failed to properly redact documents in the stipulation in accordance with the Tax Court rules.  I am troubled that the remedy for failing to properly redact material in a stipulation, in which both parties were represented by counsel, would be to deny the public the right to the material in order to prevent the public from seeing material the parties were required to redact rather than to order the parties a second time to redact the material properly and resubmit it. 

It is quite possible that I am missing something in the order or outside of the order that drives the decision, but the order itself leaves me quite puzzled.  I doubt that any non-party cares what was in the stipulated documents, but if a non-party did care, it seems to me that non-party should have a right to see the documents following appropriate procedures without having to go through the lengthy and difficult process to unseal the record.  Counsel to the parties in this case could have been sanctioned for failing to follow the redaction rules and the prior specific order of the Court. The sanction instead falls on the person with a lawful right to see the records of the case.