FAQ Disclaimers: Balancing the Need for Guidance and Taxpayer Reliance on FAQs

Today we follow up on Alice G. Abreu and Richard K. Greenstein‘s post discussing the recent NTA blog on IRS FAQ with some additional thoughts from guest blogger James Creech. As yesterday’s post noted, IRS FAQs have grown more important since the coronavirus hit, as the IRS responded to the urgent need for a high volume of guidance by increasing its use of website FAQs in place of IRB guidance.

While IRS FAQs are particularly voluminous and consequential right now, recent observations build on years of criticism. For example, in 2012 Robert Horwitz and Annette Nellen authored a policy paper for the State Bar of California’s Taxation Section. This paper recounts the evolution of the IRS’s use of website FAQs and proposes solutions to concerns, including “(1) the lack of transparency, (2) the lack of accountability, (3) the lack of input by the public, (4) the difficulty in finding specific FAQs on the IRS website, (5) whether FAQs are binding on IRS personnel, and (6) the extent to which FAQs can be relied upon by taxpayers and tax practitioners.” I recommend reading this paper not only for the history of IRS website FAQs but for the authors’ proposals to address these concerns without scrapping the practice or reducing its utility as a quick method of communication to taxpayers.

Former NTA Nina Olson also addressed IRS FAQ in reports to Congress and in Congressional testimony, as discussed and linked in this 2017 blog post.

In addition to her recent blog post discussed yesterday, NTA Erin Collins addressed FAQ in several sections of her 2021 Objectives Report to Congress. The report discusses the pros and cons of informal guidance “in the face of widespread closures of core IRS functions as well as the enactment of the FFCRA and CARES Act,” and notes that by June 10, the IRS had issued 273 FAQ relating to pandemic tax relief. That number has continued to grow in the last four weeks. Due to the uncertainties facing taxpayers, the NTA argues that “if the IRS continues issuing and relying on FAQs, the regulations under IRC § 6662 need to be amended to clarify that FAQs can be used to establish reasonable cause for relief from the accuracy-related penalty.” I wholeheartedly agree. Christine

The IRS has routinely used FAQs as a way inform the public about some of the nuances of tax administration. However as part of the COVID-19 FAQs something new has emerged. The IRS has started to put disclaimers at the beginning of some recently issued FAQs. For example the preamble to the Employee Retention Credit FAQs states:

This FAQ is not included in the Internal Revenue Bulletin, and therefore may not be relied upon as legal authority. This means that the information cannot be used to support a legal argument in a court case.

and the preamble to the COVID Opportunity Zone FAQs states:

These Q&As do not constitute legal authority and may not be relied upon as such. They do not amend, modify or add to the Income Tax Regulations or any other legal authority.

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As discussed in some detail in a previous post by Monte Jackel, these disclaimers are necessary because of the lack of weight given to these otherwise official sounding pronouncements. Technically speaking, FAQs are considered unpublished guidance because they are not printed in the Internal Revenue Bulletin like Notices and Revenue Rulings. They are not binding on the IRS. They are not binding on the taxpayer and cannot be used by a taxpayer as substantial authority when taking a legal position or penalty protection. FAQs are subject to change at any time (which is why practitioners should print any on point FAQs instead of bookmarking the webpage) and are frequently revised based upon real world feedback.

Yet despite these limitations, FAQs have real value because they allow the IRS to push out guidance faster without the worry of unintended consequences. For taxpayers they can offer some comfort that their interpretation of how to approach a murky situation is not at odds with the IRS’s approach. The trouble is that for many taxpayers there is no recognizable difference between FAQs published on IRS.gov and a Notice (published in the Internal Revenue Bulletin) done in FAQ format and also published on IRS.gov.

While including disclaimers on some of the COVID guidance is a good start, it is a little disappointing that the disclaimers are not uniform and are not part of every set of FAQs regardless of when they were issued. Recognizing, of course that this is not the right time for the IRS to start new projects, even the COVID specific FAQs are haphazard. Surprisingly the FAQs regarding the Economic Impact Payments (at the time this article was written) do not have a disclaimer. This is despite the target audience being individual taxpayers who may be less able to parse statutory language when compared to sophisticated opportunity zone investors.

For an FAQ disclaimer to be effective for all taxpayers it should be written in plain English in a manner understandable to all taxpayers. The Employee Retention Credit disclaimer for example does not make it clear that the FAQs are not binding on the IRS. Unless the reader knows the importance of publication in the Internal Revenue Bulletin, the statement that the FAQs “cannot be used to support a legal argument in a court case” could seem to indicate that a taxpayer could cite to the FAQ during an administrative dispute regarding the credit.

A better disclaimer might read “These FAQs are informational purposes only and are subject to change at any time. Taxpayers cannot rely on these FAQs as the official position of the IRS and cannot be cited as legal authority. FAQs do not change the Internal Revenue Code or Treasury Regulations. For more information on FAQs click here”

Effective FAQs are an important element of agency communication and like it or not they are here to stay. However getting them right means not only drafting answers that reflect the law but giving taxpayers the tools to understand exactly what they can and cannot rely on.

NTA Blog Post On “Protecting the Rights of Taxpayers Who Rely on FAQs” Is Timely and Welcome, But Doesn’t Go Far Enough

We welcome first time guest bloggers Alice G.  Abreu and Richard K. Greenstein, both Professors of Law at Temple’s Beasley School of Law in Philadelphia.  They offer their reactions to the recent blogpost in which the National Taxpayer Advocate, Erin Collins, addresses the issue of taxpayer reliance on frequently asked questions (FAQs) and makes several recommendations. The issue of taxpayer reliance on FAQs specifically, and subregulatory guidance more generally, is not new, but it has received increased attention given the accelerated pace of tax legislation in response to the COVID-19 pandemic and the IRS’s need to provide prompt guidance. Professors Abreu and Greenstein have spoken and are writing on the subject and here they not only offer their reactions to National Taxpayer Advocate’s recent post but also their own recommendations.

We have touched on this issue before here with an excellent post in May by Monte Jackel and PT Contributor Nina Olson blogged on this topic when she was the National Taxpayer Advocate.  Keith

Kudos to NTA Erin Collins for taking on the issue of taxpayer reliance on IRS written guidance.  Her blogpost, released on July 7, is spot-on in identifying an important problem.  We particularly liked that she began by framing the issue clearly and persuasively: she described the plight of a taxpayer who goes to the IRS website for guidance on the deductibility of a particular item, finds a Frequently Asked Question (FAQ) on point, and takes the deduction, only to be audited and denied the deduction because the IRS changed its position, and is subjected to the 20 percent accuracy related penalty to boot. To make matters worse, the taxpayer can no longer access the FAQ because the IRS has removed it from its website, and no archive of removed FAQs exists.

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We agree with NTA Collins that “[i]f the Taxpayer Bill of Rights is to be given meaning, this scenario violates ‘The Right to Informed’ and ‘The Right to a Fair and Just Tax System.’”  We also emphatically agree that “[i]t is neither fair nor reasonable for the government to impose a penalty against a taxpayer who follows information the government provides on its website.” But we think that by focusing on the penalty, NTA Collins understates the unfairness faced by the taxpayer in this scenario.  Of course it is unfair for a taxpayer to be penalized for doing what the IRS itself said she could do, in a document specifically intended to guide taxpayer actions. And it is also unfair for the IRS to take down the document so that the taxpayer cannot offer it in support of a claim that she had “reasonable cause” for the position that resulted in the alleged underpayment, as provided by IRC § 6664(c)(1), which should allow her to avoid the penalty without reaching the question of whether the FAQ constitutes substantial authority for the taxpayer’s position. Indeed, removing an FAQ from the IRS website after a taxpayer has relied on it may also violate the taxpayer’s “Right to Challenge the IRS’s Position and Be Heard” because the IRS is thereby interfering with the taxpayer’s ability to provide adequate documentation for her position.  We therefore heartily endorse the NTA’s recommendation that the IRS create and maintain an archive of all FAQs issued.

But the unfairness depicted in the opening scenario of the NTA’s blogpost is far deeper than the post acknowledges. The core unfairness is that by refusing to stand by the positions it takes in written guidance intended for the specific purpose of informing taxpayers, the IRS is disrespecting the taxpayer’s reasonable reliance. And respect for the reliance interest is at the core of justice. Outside of the tax law, respect for reliance has led to the development of entirely new theories of obligation, such as promissory estoppel.  As we have previously noted, by refusing to stand by its written statements the IRS is behaving like the Peanuts character Lucy:  Lucy tormented Charlie Brown by repeatedly offering to hold a football for him to kick, only to pull it away just as he was going to kick it, which sent him up in the air and caused him to end up lying flat on his back. The IRS should not behave like Lucy, and taxpayers deserve to be treated better than Charlie Brown.

We therefore believe that the IRS, which itself adopted the Taxpayer Bill of Rights even before Congress made it a part of IRC § 7803(a)(3) in 2015, should change its position and respect taxpayer reliance on written guidance, whether that guidance is included in the Internal Revenue Bulletin or in publications, instructions to forms, FAQs, or other written guidance.  Respecting reliance operationalizes the taxpayer’s right to be informed as well as the right to a fair and just tax system because respecting reliance is at the core of justice and due process.

We understand the IRS’s need for nimbleness in issuing guidance in the face of recently enacted and immediately effective legislation, and we agree with NTA Collins that “[b]ecause FAQ’s aren’t subject to thorough review, Treasury and the IRS may later decide some of them are wrong and change them.” Indeed, we believe that similar concerns apply to much subregulatory guidance, and we think it salutary for the IRS to remain open to alternative interpretations of legislative language and to change its position in light of further reflection and discussion. As Stanley Fish noted over three decades ago, “No text reads itself.” Stanley Fish, Consequences, 11 Critical Inquiry 433, 446 (1985) (“The semantic meaning of the text does not announce itself; it must be decided upon, that is, interpreted . . . . In short, no text reads itself . . . .”). The susceptibility of provisions of the Internal Revenue Code to reinterpretation is ongoing.

But neither the IRS’s need for nimbleness in issuing guidance nor its understandable desire for precision, which NTA Collins noted, require that it refuse to stand by the positions it takes in published documents it issues for the specific purpose of guiding taxpayer behavior. The IRS is entitled to change its position, but until it announces that it has done so it should stand by that position, and not assert a different position against taxpayers who have reasonably relied on its publicly issued written statement. While we agree with NTA Collins that FAQs and other written documents intended for taxpayer guidance should constitute substantial authority for penalty relief purposes, we don’t think her recommendation to classify FAQs as “’Internal Revenue Service information’” under Treasury Regulation § 1.6662-4(d)(3)(iii),” goes far enough. The IRS should stand by its all of its written, publicly announced, positions until it announces that it has changed positions, and it should do so for all purposes, not just for penalty protection. In other words, the IRS should apply the changed position prospectively only and not apply it to any taxpayer who has reasonably relied.

Moreover, the IRS’s inclusion of a non-reliance disclaimer in some FAQs, like many courts’ assertion that “[i]t is hornbook law that informal publications all the way up to revenue rulings are simply guides to taxpayers, and a taxpayer relies on them at his peril,” Caterpillar Tractor Co. v. United States, 218 Ct. Cl. 517 (1978) (citing, Carpenter v. United States, 495 F.2d 175 (5th Cir. 1974)), while arguably well intentioned, only serves to undermine the agency’s legitimacy.  As NTA Collins pithily observed, “Why should taxpayers even bother reading and following FAQs if they can’t rely on them and if the IRS can change its position at any time and assess both tax and penalties?” The same question can be asked with respect to publications and instructions to forms.

We publicly expressed our views on taxpayers’ right to rely on statements in IRS written guidance in May, 2019, at the 4th International Taxpayer Rights Conference in Minneapolis when we participated in a panel discussion at a session on “The Virtues of Tax Authority Advice.” A recording of that panel discussion is available here and archived materials from the Conference can be found here. (Information on future International Taxpayer Rights Conferences to be held in Pretoria, South Africa, and Athens Greece, can be found here.) Our Conference presentation is now a draft article which we expect to be able to post on SSRN in a few weeks; its working title is Stand by your Words: Operationalizing Taxpayer Right to be Informed. In addition to fleshing out the positions articulated here and explaining why the change in the IRS’s stance on taxpayer reliance should not result in weaponizing IRS written guidance, we also argue that if the IRS persists in behaving as depicted by the opening scenario of the NTA’s blog, courts should apply the doctrine of equitable estoppel to protect taxpayers from harm.  We recognize that asserting equitable estoppel against the government is extraordinarily difficult, but, again, we believe that enactment of the TBOR and its adoption by the IRS provide a basis for a change in the status quo.

When Do We Have to File and Pay Our Federal Taxes This Year?

Today we welcome back guest poster Tom Greenaway. Tom is a principal in KPMG’s Tax Controversy Services practice. He discusses the issue of 7508A and this year’s tax deadlines.

Most years, the due dates for federal tax filings and payments are obvious. This year, the answers are not so clear, especially as disruption caused by the COVID-19 pandemic continues to spread through the summer.

As some practitioners noted early this spring, this year is different for two reasons: COVID-19 and Congress. COVID-19 has created, among other things, an ongoing nationwide disaster. And Congress, late last year, passed a law shielding qualified taxpayers against tax deadlines until 60 days after the last incident in a presidentially-declared disaster area

In this post, we focus again on the potential technical “60-day rolling shield” defense to tax deadlines provided by section 7508A(d) of the Internal Revenue Code. As applied to the pandemic, this position has been embraced by the American Bar Association Tax Section and the IRS National Taxpayer Advocate. Taxpayers facing significant financial hardships—and their advisors—should consider the merits of this position before reaching for their checkbooks on July 15, the extended due date set by IRS. The ability to use the funds for other purposes, delinquency penalties, and interest hang in the balance.

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Background: How Hard Can It Be To Figure Out Tax Deadlines?

IRS computers automatically assess delinquency penalties on late-filed returns and late-paid taxes. These penalties can be substantial. They are, however, subject to reasonable cause relief for taxpayers who exercise ordinary business care and prudence. Outside the context of IRS administrative waiver provisions (like first-time abate), it is hard to obtain reasonable cause relief for delinquency penalties, especially when claiming reasonable reliance on professional advice.

As the Supreme Court noted in the 1985 Boyle case: “The Government has millions of taxpayers to monitor, and our system of self-assessment in the initial calculation of a tax simply cannot work on any basis other than one of strict filing standards. Any less rigid standard would risk encouraging a lax attitude toward filing dates. Prompt payment of taxes is imperative to the Government, which should not have to assume the burden of unnecessary ad hoc determinations.” All well and good.

Here’s the punchline from Boyle: “It requires no special training or effort to ascertain a deadline and make sure that it is met.” In Boyle, the Court rejected an executor’s claimed reliance on an attorney to prepare and timely file an estate tax return to avoid delinquency penalties. The Court established a bright-line general rule, holding that that the failure to timely file could not be excused by the taxpayer’s reliance on an agent to establish reasonable cause for a late filing. The Court allowed, however, that this general rule would not apply in “a very narrow range of situations.”

In particular, Boyle explicitly declined to resolve the circuit split as to whether a taxpayer demonstrates reasonable cause sufficient to avoid delinquency penalties when, in reliance on the advice of an accountant or attorney, the taxpayer files a return after the actual due date but within the time the advisor erroneously thought was available. Before and after Boyle, the Tax Court and some circuit courts consistently have held that erroneous professional advice with respect to a tax deadline constitutes reasonable cause if such reliance was reasonable under the circumstances.

This Year: Pretty Hard

This year, there is a legitimate question about when federal tax returns must be filed and federal tax liabilities paid. In short, this year we may have fallen into one of those narrow situations anticipated by—and expressly reserved in—the Supreme Court’s Boyle opinion.

As noted above, in late 2019 Congress amended the Internal Revenue Code section that gives Treasury authority to postpone tax deadlines by reason of presidentially declared disasters. In a nutshell, new section 7508A(d) extends the postponement period for any qualified taxpayer 60 days after the “latest incident date” specified in the presidentially declared disaster declaration, “in the same manner as a period specified under subsection (a).” Section (d) applies in addition to any other postponement period provided by IRS and Treasury under subsection (a).

Every FEMA Major Disaster Declaration with respect to COVID-19 lists January 20, 2020 as the start date of the “Incident Period.” On March 13, 2020, the President issued an emergency declaration under the Stafford Act in response to COVID-19. The Emergency Declaration instructed the Secretary of the Treasury “to provide relief from tax deadlines to Americans who have been adversely affected by the COVID-19 emergency, as appropriate, pursuant to 26 U.S.C. 7508A(a).” IRS and Treasury invoked section 7508A(a) by issuing Notice 2020-23 and other guidance postponing tax filing and payment deadlines until July 15 for all affected taxpayers. Neither the President nor IRS mentioned section 7508A(d) in the declaration or guidance, and IRS didn’t say on which day the Incident Period started: January 20, March 13, or some other date.

While some may argue that Congress did not contemplate ongoing disasters (such as the COVID-19 outbreak) when enacting subsection (d), the provision by its terms is not limited to time-limited disasters such as tornados, hurricanes, or floods.

In March, the IRS issued a tolerably terse statement for use in a Wall Street Journal article: “The President’s March 13 Stafford Act declaration didn’t automatically trigger the full range of filing relief.” Since then, IRS and Treasury have gone mute on the question as to why, in their view, section 7508A(d) does not add a rolling 60-day tail onto the end of the relief Treasury provided under section 7508A(a).

Interested groups have asked IRS for more time, but last week the IRS Commissioner testified to the Senate Finance Committee that IRS anticipates no shift from its current position that July 15 is the final payment deadline for postponed payments. “Protecting the revenue” is always a dubious rationale for IRS enforcement priorities, see Rev. Proc. 64-22, and it seems even more so in the current environment. To be clear, the Commissioner assured the Senate Finance Committee that IRS will “exercise discretion on the back end,” but it is better to build a technical basis before taking a tax position rather than depend on the discretion of the IRS afterwards.

Conclusion

Practitioners and academics continue to discuss the merits of the 60-day rolling shield position. Most taxpayers with no liquidity issues or appetite for picking a fight with IRS will pay their outstanding taxes on or before July 15. And IRS offers many payment plans and alternative arrangements to qualifying taxpayers.

Most taxpayers do not plan into fights with the IRS, and taxpayers and practitioners should not take the 60-day rolling shield position as an opportunistic way to circumvent the postponed due dates. Nevertheless, the position might be proven correct in time.

Taxpayers in dire straits may want to work with their professional tax advisor to consider whether they may further postpone their tax filing and tax payment obligations this year. The first building blocks in any such position would rely on more well-established grounds for reasonable cause relief, such as “undue hardship.”  But the 60-day rolling shield position deserves serious consideration as well. Even if the 60-day rolling shield position is not sustained, obtaining competent professional advice before July 15 may mitigate the downside risk of delinquency penalties for taxpayers who rely on that advice in good faith.

The following information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax advisor. This article represents the views of the author(s) only, and does not necessarily represent the views or professional advice of KPMG LLP.

The Tide Keeps Going Out, Carrying Overpayment Interest Suits Away from District Courts

We welcome back regular guest blogger Bob Probasco. Bob is the director of the Low Income tax Clinic at Texas A&M University School of Law. Prior to starting the clinic at Texas A&M, Bob had a long a varied career in different tax positions. Before law school, he spent more than twenty years in various accounting and business positions, including with one of the “Big Four” CPA firms and Mobil Oil Corporation. After law school and a year clerking with Judge Lindsay of the Northern District of Texas, he practiced tax law with the Dallas office of Thompson & Knight. He left T&K in 2014 and started a solo practice before switching to full time academia. Keith

We return to the jurisdictional dispute over taxpayer stand-alone suits claiming additional overpayment interest in excess of $10,000.  The latest development, a decision on July 2nd by the Federal Circuit in Bank of America v. United States, docket number 19-2357, continues a trend that I’ve been following for two years now.  Until recently, the only decision on this issue at the Circuit Court level was E.W. Scripps Co. v. United States, 420 F.3d 589 (6th Cir. 2005), which concluded that district courts can hear such claims.  For years, most lower courts followed the Sixth Circuit.  But recently the tide turned.  Here’s a timeline of recent cases illustrating the change.

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First, the lower courts follow Scripps and agree that district courts have jurisdiction over these claims:

  • October 31, 2016:  The Southern District of New York follows Scripps in Pfizer, Inc. v. United States, 118 A.F.T.R.2d (RIA) 2016-6405 (S.D.N.Y. 2016) and decides it has subject matter jurisdiction.  On May 12, 2017, the court dismissed the case for lack of jurisdiction for failure to timely file the refund suit.  Prior discussion here.  The taxpayer appeals.
  • July 1, 2019:  The Western District of North Carolina follows Scripps in Bank of America Corp. v. United States, 2019 U.S. Dist. LEXIS 109238, 2019 WL 2745856 (W.D.N.C. 2019), and denies the motion to transfer the case to the Court of Federal Claims.  Prior discussion here.  The government appeals.
  • August 30, 2019:  In the Southern District of Florida, the magistrate judge’s report and recommendation in Paresky v. United States, 2019 U.S. Dist. Lexis 149629, 2019 WL 4888689 (S.D. Fla. 2019) follows Scripps.  The magistrate judge concludes that the court has subject matter jurisdiction but recommends dismissal in part for failure to file timely refund claims. Prior discussion here.

And then a break, with cases now holding that only the Court of Federal Claims, not district courts, have jurisdiction over these claims:

  • September 16, 2019: The Second Circuit reverses the S.D.N.Y., in Pfizer, Inc. v. United States, 939 F.3d 173 (2d Cir. 2019) and concludes there is no subject matter jurisdiction.  Prior discussion here.  The court transfers the case to the Court of Federal Claims, docket number 19-1803. Plaintiff files a motion for summary judgment on April 30, 2020.
  • October 7, 2019:  The District of Colorado agrees with Pfizer, in Estate of Culver v. United States, 2019 U.S. Dist. LEXIS 173235, 2019 WL 4930225 (D. Colo. 2019).  The court transfers the case to the Court of Federal Claims, docket number 19-1941.
  • October 21, 2019:  In the Southern District of Florida, the district court judge in Paresky v. United States declines to adopt the magistrate judge’s report and recommendation and follows Pfizer, dismissing the case for lack of subject matter jurisdiction.  Prior discussion here.  The taxpayers appeal.
  • July 2, 2020:  The Federal Circuit agrees with Pfizer and reverses the WDNC, in Bank of America Corp. v. United States. It remands the case to the WDNC, to sever some of the claims and transfer them to the Court of Federal Claims.

So now we have the Sixth Circuit holding that district courts have jurisdiction over such suits while the Second and Federal Circuits disagree, with one more circuit court considering the issue.  Mr. and Mrs. Paresky’s case is currently pending in the Eleventh Circuit, docket number 19-14589.  Appellants filed their primary brief on May 27, 2020.  The government’s brief is due on July 27, 2020.

When only one circuit court has ruled on a difficult issue, district courts – even in other circuits – tend to follow that decision.  But once another circuit court disagrees, the better analysis tends to win out and lower courts change direction.  It’s possible that the magistrate judge in Paresky, and the district court in Bank of America, would have reached a different conclusion if they were deciding after Pfizer.  My guess is that the Eleventh Circuit will agree with the Second and Federal Circuits on this issue.  This is still a small sample size, but I suspect the tide has turned decisively.

Caveat:  Bank of America lost in the Federal Circuit but has a strong incentive (see below) to seek review by the Supreme Court.  Similarly, the government may want a ruling by the Supreme Court to overturn Scripps once and for all.  With a circuit split, and if both parties ask the Supreme Court to hear the case – well, the Court hates tax cases but might take this one.  If so, all bets are off.

How did we get here?

Before I get into the court’s decision, a brief reminder why Bank of America, appealed from the Western District of North Carolina, wound up in the Federal Circuit instead of the Fourth Circuit. The government had moved to dismiss the case, or in the alternative to transfer it to the Court of Federal Claims, on the basis that the district court did not have jurisdiction for such cases. The district court denied both alternatives, as the court concluded it had jurisdiction. However, if a district court issues an interlocutory order “granting or denying, in whole or in part, a motion to transfer an action to the United States Court of Federal Claims,” a party can make an interlocutory appeal and the Federal Circuit has exclusive jurisdiction. 28 U.S.C. § 1292(d)(4). The government could have done the same in Pfizer, when the district court ruled against it on the first motion to dismiss for lack of subject matter jurisdiction, but it chose not to do so. In the second motion to dismiss, based on failure to timely file the refund suit, the government did not request transfer, so Pfizer’s appeal was to the Second Circuit.

Statutory interpretation

The jurisdictional provision at issue in these cases is 28 U.S.C. § 1346(a)(1). It has no dollar limitation. That’s the statute we rely on when filing tax refund suits, so I think of it as “tax refund jurisdiction.”  The taxpayers in these cases argued that it also covers stand-alone suits for overpayment interest, although technically those are not refund suits.  The alternative jurisdictional provision for district courts, the “little Tucker Act” at § 1346(a)(2), provides jurisdiction for any claim against the United States “founded either upon the Constitution, or any Act of Congress, or any regulation of an executive department . . . .” but is limited to claims of $10,000 or less.  The comparable jurisdictional statute for the Court of Federal Claims, § 1491(a)(1), has no such limitation.  So, if § 1346(a)(1) covers stand-alone suits for overpayment interest, taxpayers can bring suit in either district court or the CFC.  If it doesn’t, and the claim exceeds $10,000, the only option is the CFC.

Here’s what § 1346(a)(1) says, with the relevant language italicized:

Any civil action against the United States for the recovery of any internal-revenue tax alleged to have been erroneously or illegally assessed or collected, or any penalty claimed to have been collected without authority or any sum alleged to have been excessive or in any manner wrongfully collected under the internal-revenue laws

The language is very similar to Section 7422(a), which sets forth requirements for tax refund suits.  Because those requirements – exhaustion of administrative remedies and a shorter statute of limitations than for the little Tucker Act – have frequently been held not applicable to these stand-alone overpayment interest suits, the government argues that § 1346(a)(1) doesn’t apply to such suits either.

Overpayment interest doesn’t fall within the first two categories because it is neither tax nor penalty.  But Scripps interpreted the third category, “any sum alleged to have been excessive,” as broad enough to cover overpayment interest suits.  After all, the Supreme Court had stated in Flora v. United States, 362 U.S. 145, 149 (1960): “One obvious example of such a ‘sum’ is interest.”  Scripps concluded that the amount was “excessive” if you looked at how much the government retained rather than collected and, more importantly, focused on the entire balance of the account rather just individual components such as the overpayment interest.  (I provided an illustration of this last point here.)  The comparison to section 7422(a) was inapt because section 7422(a) includes a qualifying header (“No suit prior to filing claim for refund”); § 1346(a)(1) does not and therefore could include both refund suits and “non-refund” suits.

Both the Second Circuit and the Federal Circuit disagreed completely with that analysis.  The comment in Flora, in context, referred to underpayment interest (which is assessed and collected) rather than overpayment interest (which is paid out).  The structure of § 1346(a)(1), including the first two categories in the list, and the use of the present-perfect tense “have been” made it clear that it referred to amounts that had been previously paid to, or collected by, the IRS.  And the statutory language mattered much more than the header for section 7422(a) versus lack of such for § 1346(a)(1).

Legislative history

Both parties in Bank of America also pointed the court to legislative history in support of their positions.  In its opening brief, the government pointed out that the final version of the provision was understood by courts to establish a narrow exception to the $10,000 limitation for “little Tucker Act” claims – only for tax refund claims.  The government also focused on the Supreme Court’s discussions of the legislative history in Flora v. United States, 357 U.S. 63 (1958), and Flora v. United States, 362 U.S. 145 (1960).

Here is a summary of the arguments in the taxpayer’s brief: 

  • The predecessor statutes to § 1346(a)(1) were designed to eliminate several distinctions and inequities.  For example, the earlier provisions (a) for district court jurisdiction, requiring suing the Collector and could not brought after he died; and (b) for Court of Claims jurisdiction, did not allow for awarding interest.  Thus, in some instances, a taxpayer would have no way to recover overpayment interest.  In a floor statement introducing an amendment to the Revenue Act of 1921, a Senator noted those issues and stated that the amendment was intended to eliminate the problems.
  • The Assistant Chief Counsel of the Bureau of Internal Revenue represented, in a 1953 Senate subcommittee hearing, his opinion that the language of § 1346(a)(1) already covered stand-alone overpayment interest suits.
  • In connection with that same hearing, Treasury later provided by letter a list of several cases in district court involving stand-alone claims for interest.    

In its reply brief, the government took issue with the taxpayer’s arguments based on legislative history:

  • The Senator who introduced amendments to the Revenue Act of 1921 was concerned about tax refund claims, on which overpayment interest might be paid, rather than stand-alone claims for overpayment interest.
  • It was not entirely clear that the Assistant Chief Counsel’s statement at the 1953 Senate subcommittee hearing concerned stand-alone claims for overpayment interest.  In any event, a witness from the ABA testifying at the same hearing disagreed with the Assistant Chief Counsel’s opinion that the existing statute covered stand-alone claims. 
  • None of the 14 cases listed on the letter from Treasury of district court litigation concerned jurisdiction under § 1346(a)(1) for stand-alone claims of overpayment interest, the issue in Bank of America.  Only six cases involved overpayment interest at all, of which: (a) two declined to exercise jurisdiction; (b) two didn’t question jurisdiction; and (c) two were based on different jurisdictional provisions and involved claims under $10,000.

This brief summary doesn’t do the arguments justice, of course.  For those interested in more details, I suggest a review of the parties’ briefs, which provide a detailed history of the evolution of the jurisdictional provisions.  I was impressed by the thoroughness of both sides’ work, scratching and clawing for anything they could find or infer in support of their respective positions.  They did the best possible with what little was out there.

I count myself among those who consider legislative history relevant in interpreting ambiguous statutes, and a good tax lawyer (or judge) can find ambiguity in almost anything if they want to.  Even so, I considered these examples unlikely to persuade a court that had not already decided for other reasons.  I went back and looked at some of the original sources when reading the district court decision and they didn’t persuade me in either direction.  The Federal Circuit didn’t seem impressed either.

Impact on Bank of America

When I originally looked at the case, I thought that “most” of Bank of America’s claim would be eliminated if it lost in the Federal Circuit.  The third amended complaint was for $163 million, of which $141 million related to interest netting.  The interest netting claims seemed particularly vulnerable if Bank of America had to litigate in the CFC (see below), based on a cursory review of the complaint.  Now that I’ve reviewed the motion to dismiss more carefully, it appears that “most” overstated the potential impact on Bank of America, although it’s still significant.

The benefits of interest netting – the section 6621(d) adjustments to eliminate the interest rate differential – can be effected two ways.  The government can pay additional overpayment interest to bring that rate up to the underpayment interest rate, or it can refund underpayment interest to bring that rate down to the overpayment interest rate. 

Over $95 million of the benefit from interest netting came from years in which the adjustments were for reductions/refund of underpayment interest. A claim for refund of excessive underpayment interest clearly fits with § 1346(a)(1); under section 6601(e)(1), underpayment interest is treated as tax, except that it is not subject to deficiency procedures. 

Thus, there would be no basis for transferring those claims to the CFC.  (There were small amounts of overpayment interest in those years, presumably interest on the claimed refund of underpayment interest rather than directly from interest netting.  That overpayment interest would not be a disallowed stand-alone claim for overpayment interest; it would be permitted under ancillary jurisdiction.)  The government sought to transfer only $67 million of the total complaint amount to the CFC, of which only $44 million involved interest netting.  Assuming that the non-interest netting claims are not at a particular disadvantage in the CFC, Bank of America’s loss from the Federal Circuit’s decision may be only $44 million, or even less.  Well, to the taxpayer losing the claim, “only” is an inappropriate adverb; that’s still a lot of money.

Interest netting

Most taxpayers are perfectly willing to litigate interest cases in the CFC.  The CFC judges tend to have more experience with interest issues and most large interest cases are litigated there instead of district courts. In fact, Bank of America has another interest netting case pending there now. Taxpayers tend to bring substantial stand-alone interest cases in district court only to: (a) take advantage of favorable precedent in that circuit; or (b) avoid unfavorable precedent in the Federal Circuit.  Pfizer was an example of the former.  It wanted to rely on a favorable precedent, Doolin v. United States, 918 F.2d 15 (2d Cir. 1990).  It won’t necessarily lose its case elsewhere; it might persuade the CFC to reach the same decision as the Second Circuit did in Doolin.  Based on the complaint, I suspect Bank of America is an example of the latter, in this case trying to avoid an unfavorable precedent regarding interest netting, Wells Fargo & Co. v. United States, 827 F.3d 1026 (Fed. Cir. 2016).  (Prior discussion here.) 

Wells Fargo involved interest netting claims between separate corporations that had merged.  The Federal Circuit decided that, in such contexts, interest netting is only permitted if the period of overlap (an underpayment balance for one period and an overpayment balance for another period) began after the date of the merger. Here’s an illustration:

Company A had a $2.5 million underpayment balance for its 2008 tax year outstanding from 3/15/2009.  Company B had a $2 million overpayment balance for its 2011 tax year outstanding from 3/15/2012.  If the balances were still outstanding until paid/refunded on 12/1/2016, there was a $2 million overlap from 3/15/2012 (when the second balance began) until 12/1/2016 (when both balances ended).  During that overlap period, there was an interest rate differential; corporations earned from 1% to 4.5% less on overpayments than they paid on underpayments, and in this scenario the difference would more likely be 4.5% than 1%. 

If the companies merged in 2010, $2 million of the respective balances could be netted to avoid that differential, for the entire period from 3/15/2012 to 12/1/2016.  But if the companies merged in 2013, under Wells Fargo those balances could not be netted at all.  I think a better interpretation of the law would allow interest netting for part of the overlap period, starting from the date of the merger.  But the CFC will rule based on Wells Fargo, not based on my interpretation.

As noted above, Bank of America’s claims that will now wind up in the CFC include $44 million of interest netting benefits.  I don’t know if the entire $44 million will be denied based on Wells Fargo.  But (a) those claims involve Merrill Lynch’s tax years 1987, 1990, 1991, 1999, 2002, 2003, 2005, 2006, and 2007 tax years; and (b) Merrill Lynch merged with Bank of America on October 1, 2013.  I didn’t try to review the interest computations attached to the motion to dismiss, but I anticipate Bank of America stands to lose the vast majority of the $44 million.  Worth a cert petition to the Supreme Court?

Impact elsewhere?

The above discussion concerns how this case impacts Bank of America and more broadly other companies that might prefer to bring stand-alone overpayment interest suits in district court.  That doesn’t mean the impact of this line of cases is limited to overpayment interest.  Pfizer and Bank of America identified a certain type of claim that arises under the Internal Revenue Code but is not a tax refund claim for purposes of jurisdiction.  This distinction might affect not only the available forum, which is what I’ve been focusing on here, but also other issues. For example, a “non-refund claim” under the little Tucker Act will not be subject to the requirement to exhaust administrative remedies and will have a different statute of limitation.

Are there other examples of “non-refund claims” arising under the Code?There may well be, and Carl Smith pointed out one prominent recent example that cited Pfizer. On June 19, 2020, the district court of Maryland decided in R.V. v. Mnuchin, 2020 U.S. Dist. LEXIS 107420 (D. Md. 2020), that the government had waived its sovereign immunity with respect to the CARES Act economic impact payments (EIPs).  The plaintiffs claimed jurisdiction under, among others, the little Tucker Act, § 1346(a)(2).  That jurisdiction requires a separate “money-mandating” statute, for which the plaintiffs pointed to section 6428.  The government argued that section 6428 is a tax statute; any challenge to the denial of a credit falls within the jurisdiction of § 1346(a)(1) instead of § 1346(a)(2) and is subject to the restrictions of section 7422.  The plaintiffs’ failure to exhaust administrative remedies was fatal to their claim. 

The court dismissed the government’s motion to dismiss without prejudice.  It stated: “The Government argues that 26 U.S.C. § 6428 is not a money-mandating statute because it is a tax statute.  True.  But the two are not mutually exclusive.”  It cited Pfizer for that proposition.  To put it another way, a tax statute authorizes refund claims, but it also may authorize claims that are not “tax refund claims” for purposes of § 1346(a)(1) and not subject to section 7422 but are money-mandating provisions sufficient to support a Tucker Act claim.

The Advance Premium Tax Credit under the Affordable Care Act would likely be another “non-refund claim.” As with the EIPs, it is reconciled on the taxpayer’s tax return, but it is paid in advance pursuant to a clear money-mandating statute. Michelle Drumbl points out that the U.S. at one time had an advance earned income credit and other countries currently have similar advance credits. If Congress ever enacted her proposal for a transition to periodic payments rather than when the tax return is filed, that would likely also qualify as a “non-refund claim.”

What about refundable credits that are not paid in advance? That might be a harder argument to make; it’s not clear whether there is a money-mandating provision other than section 6402(a), working with section 6401(b)(1). But “hard” doesn’t always mean “impossible.” I haven’t researched enough to know whether a taxpayer has ever tried filing suit for payment of refundable credits based on the little Tucker Act instead of § 1346(a)(1). It might be the only route for recovery for a taxpayer who filed a return claiming a refund (based on a refundable credit) more than three years after the due date. The six-year statute of limitations for a little Tucker Act suit might avoid the problem of the “look back” limitation of section 6511(b)(2). It might be worth a try if you have a client with the right facts.

After all, ten months ago we weren’t sure the government would convince a court that stand-alone overpayment interest suits are “non-refund claims” for which district court jurisdiction is only available under the little Tucker Act. Now, the government has won in the Second and Federal Circuits and seems to have momentum heading into the Eleventh Circuit.

Postscript

While I was working on this post, Jack Townsend posted on his blog concerning the Federal Circuit’s decision in Bank of America.  Jack’s observations are always worth reading.

ACA Penalty Notices May Not Meet Section 6751(b) Requirements

We welcome back guest blogger Rochelle Hodes.  Rochelle is a Principal in Washington National Tax at Crowe LLP and was previously Associate Tax Legislative Counsel with Treasury. As we prepare to gear back up for IRS enforcement activity, she provides a timely discussion of the ever popular IRC 6751(b) and another way it may help your client when the IRS seeks to penalize.  Keith

Section 6751(b)(1) generally provides that no penalty can be assessed unless the initial determination of such assessment is personally approved in writing by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.  Written supervisory approval is not required to impose a penalty under Section 6651, 6654, or 6655.  Written supervisory approval also is not required to impose a penalty that is automatically calculated through electronic means. 

Section 6751(b) has been covered many times in the Procedurally Taxing blog. Generally, the Tax Court will not sustain the IRS’s assertion of a penalty if the IRS cannot demonstrate that written supervisory approval is not obtained prior to the initial determination of assessment of the penalty.  The latest in this line of cases is Kroner v. Commissioner, T.C. Memo. 2020-73 (June 1, 2020), which further fine-tunes earlier holdings regarding when the initial determination of the penalty is made. 

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Prior to Kroner, the Tax Court ruled in Clay v. Commissioner, 152 T.C. 223, 249 (2019), blogged here, and Belair Woods, LLC v. Commissioner, 154 T.C. ___ (Jan. 6, 2020), blogged here, that the initial determination is the date on which the IRS formally communicates to the taxpayer Examination’s determination to assert a penalty and notifies the taxpayer of their right to appeal that determination.  In Clay, that court held that the initial determination was the date that the IRS issued the revenue agent’s report (RAR) and the 30-day letter. In Belair, the court held that the initial determination was the date that the IRS issued the 60-day letter, which in the case of a TEFRA partnership is the notice that communicates Examination’s determination that penalties should be imposed and notifies the taxpayer of their right to go to Appeals. 

In Kroner, the IRS issued a Letter 915, which is an examination report transmittal, to notify the taxpayer that Examination is proposing penalties and that the taxpayer has a right to go to Appeals.  Later, the IRS sent the taxpayer an RAR and a 30-day letter.  The written supervisory approval for penalties was issued after the Letter 915 was sent and before the RAR and 30-day letter were sent.  The Tax Court held that regardless of what the IRS calls the notice that provides the taxpayer with its determination of penalties and notification of the right to go to Appeals and regardless of the IRS’s intent, the initial determination for purposes of section 6751(b) is the first time examination determines that it will assert the penalty and notifies the taxpayer that they have a right to appeal that determination.  In Kroner, the court held that this occurred when the IRS issued the Letter 915.  Accordingly, written supervisory approval was issued after the initial determination for purposes of section 6751(b), and the penalty was not sustained.

On May 20, 2020, the IRS issued an immediately effective interim IRM 20.1.1.2.3.1 on the timing of supervisory approval:

For all penalties subject to section 6751(b)(1), written supervisory approval required under section 6751(b)(1) must be obtained prior to issuing any written communication of penalties to a taxpayer that offers the taxpayer an opportunity to sign an agreement or consent to assessment or proposal of the penalty.

Not long before Kroner was decided and the interim IRM guidance above was released, I had a client who received an IRS form letter, Form 5005-A (Rev 7-2018), imposing immediately assessable information reporting penalties under section 6721 and section 6722 for 2017 for failure to timely file Forms 1094-C and 1095-C.  This letter is one of several form letters that are being issued under the IRS’s ACA employer compliance initiative. Under section 6056, employers are required to file and furnish these ACA-related forms to report offers of health coverage. 

The Form 5005-A states that the taxpayer can agree with the penalty and pay it.  If the taxpayer disagrees, the letter states that the taxpayer will “have the opportunity to appeal the penalties after we send you a formal request for payment.” A Form 866-A, Explanation of Items, is attached explaining the basis for assertion of penalties.  The conclusion section states: “Subject to managerial approval, because the Employer failed to file Form(s) 1094-C and 1095-C and furnish Forms 1095-C as required pursuant to section 6056, the employer is subject to the penalties under IRC 6721 and IRC 6722 calculated above.”

The Letter 5005-A and Form 866-A are striking in three regards:  1) The letters clearly communicate Examination’s determination to impose the penalty; 2) the Letter 5005-A is less clear about the opportunity to go to appeals because it delays the opportunity until a formal request for payment is made, but there is clear notification that the right to go to Appeals exists and can be exercised; and 3) the Form 866-A takes the guess work out of whether there was supervisory approval—it states affirmatively that there has not yet been supervisory approval. 

Kroner makes it clear that the name or number of the form the IRS uses to communicate the determination and right to appeal is of no consequence.  As applied to the Letter 5005-A, there is a determination and arguably there is notification of the right to appeal, therefore, the date of this notice is the initial determination of the penalty.  Since according to the Form 866-A there was no supervisory approval before the date the Letter 5005-A was issued, the IRS has failed to satisfy section 6751(b) and the penalties should not apply. 

Even if the “notice of the right to go to Appeals” prong of Kroner is not satisfied, the Letter 5005-A clearly meets the standard for when supervisory approval is required under the interim IRM provisions because the taxpayer is provided the opportunity to agree with and pay the penalty.  While the interim IRM provisions were issued on May 20, 2020, they represent the IRS interpretation of how they should be complying with section 6751(b).  Therefore, failure to comply with the interim IRM provisions in the past should be a failure to comply with section 6751(b). 

IRS is currently sending penalty notices that were being held back due to the pandemic.  For penalties other than sections 6651, 6654, and 6655, practitioners should carefully review notices to evaluate whether section 6751(b) applies and if so, whether the letter is an initial determination required to be preceded by written supervisory approval.

Public Comment and LITCs: Bringing Client Voices To the Administrative Process

We welcome guest blogger Madeleine DeMeules who was a student of my clinic during the past semester.  She spent time this semester working on the Clinic’s brief to the 11th Circuit in an innocent spouse case, giving her a basis for reflecting on the process and offering some ideas to the IRS about its form.  The Clinic tries to comment on matters that impact low income taxpayers when the IRS offers the opportunity.  I was fortunate that Madeleine had the experience from her case work to provide several comments to the IRS we hope might improve the process.  Keith

The Harvard Federal Tax Clinic is a Low Income Tax Clinic (“LITC”), one of many such organizations nationwide that are sponsored by the IRS and work to serve low- and moderate-income taxpayers through individual representation as well as systemic policy work.

As a rising third-year law student with the Harvard Tax Clinic, I recently had the opportunity to work with our Clinic on an important piece of written advocacy on behalf of our clients. At the beginning of June, the Clinic submitted feedback to the IRS in response to its request for public comment on upcoming changes to IRS Form 8857. This is the form that taxpayers use to submit a request for innocent spouse relief under § 6015 of the Internal Revenue Code. In short, the innocent spouse provision of the tax code allows married taxpayers who have filed joint returns to seek relief from liability arising from the deceptive, improper, or otherwise inequitable behavior of a spouse. While there are many interesting facets to this particular type of IRS proceeding, a few in particular are worth mentioning:

  • First, the Internal Revenue Code phrases the innocent spouse provision in gender neutral language (i.e., referencing “individuals” and “spouses”). However, at least 90% of § 6015 litigants are women. See Stephanie McMahon, What Innocent Spouse Relief Says About Wives and the Rest of Us, 37 Harv. J.L. & Gender 141, 149 (2014).
  • Second, individuals who request innocent spouse relief may have experienced some form of abuse in their marriage, sometimes connected to the tax liability at issue.
  • Third, the Taxpayer Advocate Service—an independent organization that works from within the IRS to be a voice for taxpayers—has described innocent spouse relief as one of the most frequently litigated issues within the IRS as recently as 2017.

As any one of these points demonstrates, the stakes can be high in an innocent spouse case. Coupled with the difficulties of litigating complex tax issues pro se, these high stakes make innocent spouse cases an ideal issue for LITC clinics to assist clients with. Many clinics, including ours, make innocent spouse work an important part of their docket.  

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Significantly, LITC clinics may meet their clients at a variety of time points throughout a case. Sometimes clinics and clients encounter each other before a proceeding begins, and the clinic can help the client prepare their case from the initial filing of Form 8857. In other cases, a clinic might not meet their client until after administrative proceedings have begun, but before an appeal or Tax Court petition has been filed. From this spectrum of experience, then, clinics have the opportunity to observe and learn from their clients about what it is like to fill out IRS forms like 8857 without the aid of counsel. At seven pages long, Form 8857 is detailed; it goes without saying that completing it on one’s own is difficult. As a result, clinics are aware that the presence or absence of counsel at the outset of a case can influence a client’s eventual chances of success.  This is particularly important because of the changes to the Code last year which place additional emphasis on the administrative record.

In our recent comments to the IRS, the Clinic sought to summarize what we have learned from our clients in order to give the IRS specific suggestions about how it can improve Form 8857 for the range of taxpayers that encounter this form, and in particular for those clients that must proceed pro se because clinics are unable to reach them or do not have enough capacity. We suggested five changes, two of which are summarized below to illustrate the types of concerns that our clients have, and that we believe the IRS should account for as it updates Form 8857.

1. Form 8857 should include a voicemail contact permission.

The IRS sometimes calls taxpayers with questions after they submit Form 8857, but only during restricted business hours. Currently the IRS cannot leave voicemails, so taxpayers with irregular work schedules may be missing out on contacts with the IRS that could involve clarifying questions about their submission and potentially help their case. Low- and moderate-income individuals may juggle work schedules with changing shifts, or even multiple jobs. Adding a voicemail permission to Form 8857 is a simple change that should greatly increase the ability of all taxpayers to make contact with the IRS and participate fully in their case. 

2. Form 8857 should give taxpayers the option to identify as ESL and list their first or preferred language.

Currently, the IRS only offers Form 8857 in one translated format—Spanish—even though the agency has language resources, including phone interpretation, in over three hundred language and dialects. By collecting this information from taxpayers who wish to share it, the IRS will be better equipped to connect ESL taxpayers submitting Form 8857 with existing language resources. Additionally, the Clinic could find no published data about the language needs of the over 50,000 taxpayers annually who submit Form 8857. This addition to the form will allow the IRS to collect that data in a meaningful manner; at the Clinic, we hope that this data can be used in the future to make the case for translating Form 8857 into additional languages. 

While we at the Clinic of course hope that our comments will encourage the IRS to adopt the specific improvements we suggested, we also hope that the IRS appreciates the people and the perspectives that we sought to represent in this comment. In 2018, LITCs around the country served over 19,000 low-income taxpayers. By participating in public comments proceedings like these, our Clinic seeks to amplify the voices of the clients that we serve. We hope that the presence of their voices in the administrative process reminds that IRS that it serves these clients too.

Over the last two weeks, George Floyd’s death has reminded our country that society does not work the way it works by happenstance. Our society is the way it is because it is built on systems—systems of race, power, and privilege that are shaped by choices and constructed to produce specific results. The tax system is no exception: it directly influences how our society thinks about and interacts with pressing topics like healthcare, marriage, immigration, and income inequality. I am heartened that Harvard’s Clinic appreciates the importance of bringing as many voices as possible to the administrative process, so that as administrative agencies like the IRS continue to shape these systems, they do so with as much knowledge as possible about the needs of the people they serve.

In Altera Reply Brief, Taxpayer Doubles Down on Flawed Argument That the Government Changed Its Tune.

We welcome back guest bloggers Susan C. Morse and Stephen E. ShayThey bring us a further update on the efforts of the taxpayer in the Altera case to have the Supreme Court accept the case for argument.  Keith

Previously we blogged here (crossposted at Yale JREG Notice & Comment) about the government’s May 14 brief in opposition to the taxpayer’s petition for certiorari in Altera v. Commissioner. On June 1,  Altera replied to the government’s brief, as explained here by Chris Walker. The case has been distributed for a Supreme Court conference later in June.

The Altera reply brief doubles down on an argument that the government brief has already persuasively dispatched: that Treasury gave the impression during the rulemaking process that comparability analysis – i.e., the analysis of comparable transactions between unrelated parties – was relevant to the determination of an arm’s length result under the transfer pricing regulation at issue, and that then the government changed its tune.

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First, some background to level-set for any new readers. In its cert petition, the taxpayer asked the Supreme Court to review a Ninth Circuit decision upholding a 2003 amendment to an existing tax regulation governing intra-group cost-sharing arrangements for the development of intangible property. (We submitted amicus briefs on behalf of the government to the Ninth Circuit in earlier stages of this litigation here (with coauthors Leandra Lederman and Clint Wallace), here and here.)

The regulation conditions the benefits of a qualified cost sharing arrangement, or QCSA, on including stock-based compensation deductions related to developing intangible property in the pool of costs to be shared. If this (and other) QCSA conditions are met, the cost-sharing party — typically an offshore subsidiary of a U.S. multinational firm — owns a share of the rights in intangible property, even though this intangible property is often developed within the United States. Allowing an offshore subsidiary to own a share of intangible property means that a U.S. multinational firm can attribute some profit from intangibles to the offshore subsidiary. This in turn means that the U.S. multinational firm can avoid paying U.S. corporate income tax on some of its profit.

Altera proposes that the Supreme Court should take this case because it is an opportunity to place limits on an inappropriate exercise of administrative agency power. The taxpayer’s cert petition argues that Treasury did not provide a reasoned explanation for the regulation as required under  State Farm, in light of evidence cited by commenters that unrelated parties to similar types of arrangements did not share stock-based compensation costs; that the government in litigation engaged in post hoc rationalization to defend the regulation, in violation of Chenery I; and that the Ninth Circuit accorded Chevron deference to a procedurally defective regulation.

The government in response observed that the taxpayer conflates the arm’s length standard with comparability analysis. It explained that the government has maintained a consistent argument throughout the rulemaking process and this litigation.  That is, the government has consistently maintained that the 2003 regulation’s rejection of comparability analysis as a means of determining an arm’s-length result in this limited context is consistent with both the “commensurate with income” language of the statute adopted in 1986 and the accompanying legislative history.

The core of Altera’s argument is that the government surprised taxpayers and tax advisers by making a “sea change in tax law without providing any notice of the change or opportunity to comment on it” (Reply Br. 1) and by taking a “new position” in litigation (Reply Br. 2) about the meaning of the arm’s length standard.  Altera’s reply brief states this claim in at least three ways. None hold up.

The first thing Altera claims is that “The arm’s length standard has a settled meaning: A transaction meets the arm’s length standard if it is consistent with evidence of how unrelated parties behave in comparable arm’s length transactions.” (Reply Br. 5) Altera may wish that this sentence stated doctrinal transfer pricing tax law, but it does not. As the government’s brief in opposition to the cert petition correctly explains, Altera’s statement conflates the arm’s length standard with comparability analysis. Comparability analysis is not a predicate for determining an arm’s length result. One clear indication of that reality is the residual profit split transfer pricing method contained in regulations promulgated in 1994.

The second claim Altera makes is that the government initially suggested that comparability analysis is relevant to the determination of an arm’s-length result under the regulation at issue in this case, but then changed its mind. This is also incorrect. As the government’s brief explains, Treasury promulgated the 2003 amendment to make explicit what it had consistently argued was implicit in the prior (1995) cost-sharing regulation: that QCSA stock-based compensation costs must be shared to produce an arm’s-length result, without regard to evidence of allegedly comparable transactions. And it consistently pointed to the commensurate-with-income language of the statute and the related legislative history to support its position. It referred to commensurate-with-income both in the 2002 Notice of Proposed Rulemaking and in the 2003 Preamble.

This government’s position in this regard has been at the heart of a longstanding and well-known disagreement between taxpayers and the government. In 2002, lawyers at Baker & McKenzie explained the already-long history, in a comment to the proposed regulations written on behalf of Software Finance and Tax Executives Council:

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. 

The third claim that Altera makes is that taxpayers did not realize that the government was promulgating a rule that did not rest on comparables and were caught by surprise. It writes that “none of the companies, industry groups, or tax professionals that participated in the rulemaking noticed” (Reply Br. 2) that the 2003 amendment made evidence of allegedly comparable uncontrolled transactions not determinative of an arm’s length result in this context. This claim also does not hold up.  Indeed, the amended regulation itself – in both its proposed and final form – unequivocally states that a QCSA will achieve an arm’s-length result “if, and only if,” the parties share all development-related costs (including stock-based compensation costs) in proportion to anticipated benefits.

In written submissions and at the 2002 hearing to consider the proposed regulation, commenters certainly realized that the regulation was not based on evidence of comparables. A representative for the American Electronics Association stated that the regulation identified an arm’s-length result “by fiat,” implicitly acknowledging that the government had rejected a comparables-based inquiry. A Fenwick & West partner explained that the regulation “deem[ed] a result to be arm’s length without providing any evidence.” A tax partner at PricewaterhouseCoopers noted the perception that the amendment “seem[s] contrary to the arm’s length standard as evidenced by actual transactions ….”  The rest of the regulatory record is consistent. Commenters understood. Taxpayers and tax advisers knew exactly what Treasury was doing.

Altera says it is making an administrative law argument, but it is really interested in a tax policy outcome. The asserted “immense prospective importance” (Reply Br. 4) is illusory. Even if the Court were to grant the petition and then hold that the 2003 amendment is procedurally defective, Treasury could simply re-promulgate the rule without substantive change but with a more detailed explanation. As for past tax years, Altera’s and similarly-situated companies’ financial statements have already incorporated the possibility that corporate income tax will be due based on compliance with the regulation. The real importance of the case for taxpayers lies in the hope that the Supreme Court goes beyond the administrative law issue and expresses a pro-taxpayer view as to the merits. But this tax issue is not presented.

Rather, the cert petition raises a procedural administrative law issue. It works for the taxpayer only if the government changed its tune. But to the contrary, the government has been singing the same tune for two decades or more.

The government did not surprise taxpayers and tax advisers with never-before-seen interpretations of the arm’s length standard. The government consistently explained that evidence of allegedly comparable transactions is not determinative of an arm’s-length result in this context. It consistently referred to the commensurate-with-income statutory language and legislative intent in support of its position. The government has been faithful to its argument and explanation since before the 2003 amendment and continuing through every stage of this litigation. There has been no surprise or change of course. Rather, this case involves the government making the same argument and explanation, over and over again. 

Global Pandemics and Economic Uncertainty: The Importance of Error-Correction Mechanisms in Crisis

Today’s guest post is from my colleague Orli Oren-Kolbinger, a Visiting Assistant Professor at Villanova University Charles Widger School of Law. In this post, Orli discusses problems with the tax law’s failure to allow taxpayers to unwind certain elections, including the inability to change filing status from filing jointly to separately. In this post and in her longer work in progress The Error Cost of Marriage Orli suggests ways to fix the problems associated with elections. Les

This blog post seeks to explain why the ability to correct tax election errors is especially important during times of global pandemic and economic uncertainty. Focusing on married taxpayers’ filing status election, I discuss the archaic and asymmetric error-correction rule that applies when married taxpayers seek to correct a tax election after the due date has passed. I conclude by offering a solution to this problem. The following is based on my recent work-in-progress The Error Cost of Marriage. I welcome any and all comments.

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A Brief Primer on Elections

United States taxpayers make many explicit elections each year. Clearly, from time to time taxpayers elect the less beneficial option to them. I refer to these inferior elections as Election Errors.” These errors may result in additional tax liability. As previously discussed here and here, taxpayers are unable to fix an election error with a superseding return after the due date for the election has passed. They can, however, file an amended return to fix some election errors using the error-correction mechanisms set forth in the Internal Revenue Code. Nonetheless, error-correction mechanisms that are available to a taxpayer in the Code are inconsistent and at times asymmetrically applied among similarly situated taxpayers.

In addition, tax elections are “sticky.” When taxpayers face an election they have already made in the past—e.g., filing status election married taxpayers are required to make every year—they maybe cautious or resistant to such a change. Taxpayers in this situation may also fail to consider the alternative election available to them, even if the alternative would make them better off.

Taxpayer elections tend to be sticky during ordinary times, but even more so during times of economic and public health uncertainties. Consider your actions in regards to renewing your car insurance, reenrolling in employee benefits, or even ordering groceries online. You would probably prefer to avoid making significant changes to your previous elections as much as you can. This behavioral pattern can lead to errors, too, and is exacerbated during times of crises. Therefore, allowing taxpayers the option to correct an election error is a critical component of any decision-making process, including within the tax system.

The Inconsistent Approach to Fixing Election Errors

When looking to identify and classify error-correction mechanisms available to taxpayers in the Internal Revenue Code, the mechanisms available are inconsistent. Moreover, some benefit taxpayers and some do not. Hereinafter, I introduce three error-correction mechanisms that apply to married taxpayers’ filing status election. I then focus my analysis on the latter two.

Under one mechanism, the IRS initiates and corrects taxpayers’ errors for them without charging them of any fee to do so. For example, if a married taxpayer fails to file a tax return, the IRS automatically defaults them to “Married, Filing Separately” status (MFS) in the substitute return the IRS prepares.

Under a second mechanism, taxpayers can file an amended return to correct election errors. For example, married taxpayers are permitted to amend their filing status from MFS to “Married, Filing Jointly” (MFJ) after the due date for that tax year has passed, if they fulfill the requirements listed in IRC § 6013(b). When doing so, however, taxpayers produce an externality. It is an externality because the IRS now needs to reallocate resources to process an additional return for an already closed tax year only because the taxpayers previously elected an inferior alternative. Even so, the IRS does not charge a fee to process the amended return, despite its limited resources. As a result, taxpayers do not internalize the cost of correcting that election error. Moreover, this mechanism allows married taxpayers to receive a late tax refund—or at least a non-monetary or declaratory benefit (e.g., in the case of same-sex marriage)—for a closed tax year. Otherwise, taxpayers will not pursue it.  

Under a third mechanism, taxpayers are not permitted to correct their election errors.  For example, given the language of IRC § 6013(b) married taxpayers cannot change their filing status from MFJ to MFS, although the latter is the default filing status for married taxpayers. The only exceptions are “innocent spouse relief” under § 6015 and if the MFJ election is void (e.g., if the taxpayer is not eligible for this status), which are different scenarios than the one I refer to in this text.

The second and third mechanisms generate an “Asymmetric Error-Correction Rules (AECR).”

A Little History on Changing Filing Status Elections

When diving into the historical developments that led to the AECR, we find that from the introduction of joint filing in 1918 and until 1951, a taxpayer’s election of filing status was irrevocable. Meaning that married taxpayers could not change their filing status after the due date for filing the return has passed. However, in 1951, Congress enacted what is currently § 6013(b) [previously § 51(g)]. This provision permits taxpayers—under certain circumstances—to file joint returns after already having filed separate returns for a certain year. As reflected in the legislative history, the reasoning for the change was that “a proper election frequently requires informed tax knowledge not possessed by the average person.” Therefore, disallowing taxpayers to elect the MFJ status and maintain the MFS status “may result in substantially excessive taxes.” Congress did not address possible changes in the other direction, from MFJ back to the default of MFS.

Throughout the years, taxpayers have petitioned the Tax Court after the IRS denied their requests to change their filing status from MFJ to MFS. In Ladden v. Commissioner, 38 TC 530 (1962) as well as other cases, the Tax Court stated that although Congress has explicitly authorized spouses filing separately to change their filing status to filing jointly, such authorization does not mean that it implicitly allows the inverse.

These asymmetric limitations on changing married taxpayers’ filing status generate the aforementioned AECR. On the one hand, those who elected MFS status and later realized it was an inferior election, can correct it to MFJ without incurring a fee and enjoy any associated late benefits. On the other hand, those who elected MFJ status are not afforded the ability to correct the election to MFS status. This AECR is problematic for two main reasons. First, it has an adverse effect on horizontal equity. Similarly situated taxpayers are treated differently based on their ability to correct an election error. Second, it has an adverse effect on the administrability of the tax system. This is because the IRS needs to reallocate resources to process the amended return and it does not impose that cost on the taxpayers.

A Reminder As to Why All of This Matters—And Even More So Today

The U.S. tax system incentivizes married taxpayers to elect the MFJ status by generally offering monetary benefits to those who elect to do so. Such incentives include preferential tax rates and specific tax credits that are not available to married taxpayers filing separately. In addition, there are limitations on itemizing deductions for separate filers, e.g., allowing one spouse to elect to itemize their deductions only if the other spouse also elects to itemize.

Moreover, the U.S. tax system inherently frames the MFJ status as the preferred status for married taxpayers. As a matter of fact, 95% of married taxpayers elect the MFJ status. This means that a disproportionally large number of taxpayers in the U.S. are not able to correct filing status election errors. Because elections are sticky and because many believe MFJ is the only option for married taxpayers, taxpayers are unlikely to revisit a prior election despite a change in their financial circumstances. As a result, taxpayers may be unknowingly locked into an inferior election and are therefore not maximizing their tax benefits.

There are various scenarios in which MFS status is beneficial for a married couple. In general, if both spouses earn similar incomes, the incentive to file a joint return phases-out. A more specific scenario is when a taxpayer has itemized deductions that are dependent upon their adjusted gross income (AGI). For example, consider unreimbursed medical expenses, as defined in IRC § 213. Taxpayers can deduct a larger portion of their medical expenses if their AGI is smaller. Another example is IRC §67(a) miscellaneous itemized deductions, that are currently suspended. These depend on the taxpayer’s AGI, and the size of the benefit increases as AGI decreases.

Taxpayers’ AGI and unreimbursed medical expenses fluctuate over time. This point is especially true for some taxpayers in the current climate. During a pandemic that is coupled with an economic crisis, many married taxpayers are incurring income reductions and increased medical expenses of all sorts. If married taxpayers reelect the MFJ status for tax year 2020 solely because they have traditionally done so in the past, they are potentially creating a larger tax burden for themselves. Even if they realize they have made an election error, they will not be allowed to correct this error after the due date for filing their 2020 tax return has passed.

Another timely example is the recent Economic Impact Payment (EIP) benefit. In filing their 2019 return, low income married taxpayers may be better off maintaining MFS status if one spouse lacks an SSN. This is because the EIP is available to married taxpayers filing jointly only if both have an SSN.

A Solution to the Problem: The Pigouvian All Approach

In my opinion, there are three potential solutions for this overarching problem.

First, an “ALL” approach. To promote fairness, the current § 6013(b) error-correction rule should be expanded, allowing all married taxpayers to change their election from MFS to MFJ and from MFJ to MFS. In both cases, both spouses should agree to making the change. This is in comparison with the current error-correction rule that is available only to a fraction of married taxpayers. This has been the primary argument of taxpayers who have petitioned the Tax Court. Under this approach, however, taxpayers would still not internalize the administrative cost of processing the additional tax return(s). If so, the incentive to think through one’s election ex-ante diminishes. For this reason, this approach is insufficient.

Second, a “NOTHING” approach. This approach would prohibit married taxpayers from correcting a filing status election error from MFS to MFJ and from MFJ to MFS. On the one hand, this would eliminate the asymmetry created by § 6013(b), which as you may remember allows taxpayers in certain situations to switch their status from MFS to MFJ. This solution prioritizes the need for taxpayers to consider the possible ramifications of their filing election choice. On the other hand, this approach is also insufficient because humans make inferior elections and there should be at least some room for error correction.

Therefore, I propose a third approach, which I refer to as “A PIGOUVIAN ALL APPROACH.” This approach acknowledges and promotes both the fairness and administrability principles of tax policy. It is similar to the “ALL” approach, in the sense that the error-correction rule in § 6013(b) will apply to married taxpayers, whether their initial filing status election was MFS or MFJ. In addition, I propose to apply a processing fee that will be deducted from the potential refund the requesting taxpayer(s) is seeking. This way the party who made the error internalizes the administrative costs for correcting it. If the expected refund is lower than the fee, the taxpayer should refrain from correcting the error. In any case, this will increase the salience of the election even if the taxpayer will not correct it this time around.

To conclude, error-correction rules should be consistently applied to all taxpayers. Therefore, it is time to revisit this AECR after almost 70 years since its enactment have passed and the current crisis amplifies the need to do so. In my opinion, applying the existing error-correction rule more broadly combined with a processing fee would reflect better tax policy.