Can You Put a Price on Political Influence? Designated Orders, February 24 – 28, 2020

We don’t usually introduce designated order posts because the team of authors is a part of PT team.  I am making an exception here because I have been following the case that Caleb discusses since he was in law school.  I have written several posts about this taxpayer because he received a tremendous amount of ink from the Philadelphia Inquirer when I was teaching at Villanova.  So, I followed his political demise and criminal trial over a long period of time in my local press.  Then, after following the long arc of the criminal case the matter moved into its tax phase resulting in a jeopardy assessment followed by what must be the slowest jeopardy determination ever. 

This is one of the first cases I blogged back when we started in 2013.  Imagine a jeopardy assessment case where the IRS makes the rare determination of the need to move past the normal assessment process of notice of deficiency followed by a Tax Court hearing in order to quickly make an assessment, file notices of federal tax lien and preserve the government’s position in the taxpayer’s assets.  This is a jeopardy case the IRS took four years to put together.  Now imagine it’s almost seven years after the IRS finally put its jeopardy case together (that’s eleven years after starting to work on the jeopardy case!) and the Tax Court has just denied summary judgment.  The trial and the decision on the liability remain in the future.  That the Tax Court now has its most efficient jurist on the case provides some hope for an outcome before the case reaches an age where it would enter middle school.  I am curious what has happened to the taxpayer’s assets after the district court declined to allow the jeopardy assessment.  If you want to read more about this remarkably slow moving case and my thoughts about the case from several years ago, read the posts here, here, here and here, before starting Caleb’s excellent explanation of the designated order the court entered last month.  Keith

There were three designated orders the week of February 24, 2020, but one stole the show: an order pertaining to former Pennsylvania state Senator Vincent J. Fumo (here). (The remaining two orders can be found here and here.)

Aside from the natural allure of political intrigue (one may fairly say, corruption), the Fumo order was particularly compelling because of its discussion of “collateral estoppel.” For those who remember “collateral estoppel” as something learned in a first-year Civil Procedure course, briefly re-learned for the bar, and then filed away in their brain under “never useful again: going into tax law,” this order may change your mind. Procedurally Taxing has definitely raised the issue before in numerous contexts (see here, here, and here).

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To understand how collateral estoppel plays out in this case, one must first understand the nature of Mr. Fumo and his previous run-ins with the law. For those unfamiliar with the workings of Pennsylvania state politics, a quick google search will bring up numerous stories of varying length and detail on the rise and fall of Mr. Fumo in the halls of political power. At the apex of his power, he certainly seemed to carry a lot of influence. 

And then came the fall. Charges of defrauding both the Pennsylvania State Senate and the non-profit Citizens Alliance for Better Neighborhoods. Mr. Fumo harmed both of these parties in numerous ways, including using their money and services for personal purposes (rather than the public interest purposes he presumably presented). But he also made sure these parties spread the wealth (in self-serving ways), by ensuring payment of “excessive salaries to employees who were promoted solely because of loyalty to [Mr. Fumo].” The Feds brought an indictment with 139 different counts, of which Mr. Fumo was convicted of 137. 

When you have that many indictments, with that powerful a person, you can all-but guarantee there is going to be a lot of litigation. And this case is no exception. For those with Westlaw access, a look at the “history” tab in U.S. v. Fumo gives a taste with 17 separate entries from the district court and court of appeals (3 of which principally concern a party related to the Fumo matter, the aide who destroyed email evidence.). For our purposes, the court decisions that matter most pertained to money, including: (1) a finding that Mr. Fumo had to pay restitution, and (2) a finding against issuing a forfeiture judgment of the property “derived from proceeds traceable to the commission” of the offenses.

As it turns out, the IRS thinks that the first court finding entitles them to summary judgment and Mr. Fumo thinks that the second issue entitles him to summary judgment, both on theories of collateral estoppel. Cross motions ensue, both of which are denied. Let’s see why.

Judge Lauber neatly lays out the test for the application of collateral estoppel in Tax Court: (1) final judgment by court of competent jurisdiction, (2) identical issues from suits, (3) the assertion of collateral estoppel can only be asserted against parties to the prior judgment, (4) the parties must have actually litigated the issues, which were “essential” to the prior decision, and (5) the controlling facts and applicable rules need to be unchanged from the prior litigation. See Atkinson v. C.I.R., T.C. Memo. 2012-226. Oh, and if there are any special circumstances that warrant it, the Court can decide against applying collateral estoppel. 

So where does that go awry here? Let’s start with the easier of the two motions: Mr. Fumo’s.

To Mr. Fumo’s mind, the summary judgment in his favor is appropriate because the IRS is collaterally estopped “by the District Court’s decision not to enter a judgment of forfeiture, from asserting that petitioner received gross income.” Pretty simple, really: if the District Court already ruled I don’t have gross income, you can’t argue I have a deficiency based on omitted income. But is that what the District Court really said in its denial of forfeiture?

Judge Lauber focuses on the “identical issues” prong in dooming this motion. Is the inability to find “proceeds traceable to” specific criminal actions the same as saying there is an inability to find “income” as defined by the Internal Revenue Code? Not quite. One (proceeds) is fairly narrow and demanding, whereas the other (gross income) is extremely broad. The U.S. suit lost its motion for a judgment of forfeiture because they couldn’t sufficiently link specific property to the criminal acts. It is doubtful that the District Court found (or even considered) whether Mr. Fumo’s criminal activity had resulted in “accessions to wealth, clearly realized, over which [Mr. Fumo has] complete dominion.” Commissioner v. Glenshaw Glass Co. 348 U.S. 426 (1955).

Petitioner’s summary judgment motion denied. What about the IRS’s summary judgment motion? This one is a bit less of an easy call.

The IRS really wants collateral estoppel to apply in two ways: (1) to preclude Mr. Fumo from relitigating the fact that he misappropriated benefits from his victims, and (2) to preclude Mr. Fumo from relitigating that the misappropriations constitute taxable benefits as a matter of law.

One of these is a far heavier lift than the other. Or maybe they both are heavy lifts, and it really just depends on exactly what the IRS wants to do with the preclusion. Judge Lauber agrees that “collateral estoppel will prevent [Mr. Fumo] from relitigating numerous facts that were indisputably litigated and resolved against him in the criminal case.” But exactly what facts, and more importantly what legal conclusions they bring about, are not as well defined at the moment. Particularly, the Tax Court is wary of using collateral estoppel (at this point) to get to the heart of what the IRS is asking: preclusion from disputing “the amounts of unreported income[.]” Because ultimately, for summary judgment to make sense here, the IRS would be looking for a knock-out blow: preclusion on issue that the proceeds were taxable, and preclusion on the amount of the proceeds. But do they have enough in the District and Appellate Court records to get there?

Probably not. One overarching issue is Mr. Fumo’s particular brand of corruption. This isn’t a politician just taking bags of money under the table. This is a politician using his influence for personal benefit, often through jobs and salaries that went to other people (loyal to him, of course). The tax consequence of theft or embezzlement is usually straightforward, and the restitution judgments usually align one-to-one with the taxable income. 

Beyond that, the amount of Mr. Fumo’s benefit (to say nothing of his taxable benefit) was clouded even in the deciding courts, because there was a co-defendant. The court of appeals originally suggested up to 96% culpability to Mr. Fumo. The district court, however, ended up at 75% culpability for the restitution award (originally, they only found 50%). How the IRS came to the numbers on their Notice of Deficiency from the restitution award isn’t immediately clear either. The court ordered restitution in the amount of $4,083,802 and the IRS ultimately determined unreported income of $2,133,956, and later amended their answer to increase the amount to $2,304,364. Lots of moving parts and not a lot of science to the numbers, as far as this admittedly poor mathematician can tell. (The IRS says they changed the numbers based on a “different averaging computation,” but that honestly sounds like “fancier guess-work” to me.)

Ultimately, however, the biggest issue remains the nature of the benefits and how inappropriate it is for a summary judgment motion. Judge Lauber sums it up: “there may be disputes of material fact as to whether petitioner derived a dollar-for-dollar benefit from the additional salary received by employees for whom he secured promotions for higher positions.” And where there is a (genuine) dispute of material fact, summary judgment does not result. Collateral estoppel is sure to apply in this case on some (probably many) facts, but at this point not enough to pin-point the amount of taxable income -which is never what the District Court was concerned with in the first place. Assuming Mr. Fumo did not candidly report some of his ill-gotten gains on his tax return, he will owe something: exactly how much, however, may well require yet another trial.

Tax Litigation in the Discovery Phase – Business Records and Responding to Discovery Requests: Designated Orders 2/17/20 to 2/21/20

The week I reviewed for February included three orders.  The first order is a routine look at Collection Due Process.  The next two bring a theme of discovery in Tax Court.  The second order is about authentication of foreign bank records in Tax Court.  The third looks at how the Tax Court reviews discovery requests and responses.

Routine Collection Due Process

Docket No. 25954-17 L, Gary L. Shaw v. C.I.R., Order and Decision available here.

Overall, this order deals with a common theme for Collection Due Process cases in the Tax Court.  The petitioner did not file the requested income tax returns (tax years 2012 and 2016-2018).  While he requested an Offer in Compromise and checked the box for “I Cannot Pay Balance,” he did not submit either of the requested forms (656 or 433-A).  The judge found that because the petitioner was not compliant, the rejection of his proposed collection alternatives was justified and the Appeals Office did not abuse their discretion.

If repeating this helps out someone with their Collection Due Process case, I will say again that in order to advance with the IRS procedurally it is necessary to provide them the paperwork they request.

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Foreign Bank Records

Docket No. 13531-18, George S. Harrington v. C.I.R., Order available here.

At issue in this case is whether Mr. Harrington is liable for deficiencies and fraud penalties due to his alleged receipt of unreported income during 2005-2010.  The IRS filed a motion in limine in order to seek admission into evidence of business records from the United Bank of Switzerland (UBS) to prove the truth of the matters asserted.  Mr. Harrington objected on grounds of hearsay and authentication.

Now, dealing with low income Kansas taxpayers does not mean I regularly focus on Swiss bank accounts so I found it interesting to learn about interactions between the United States and Swiss governments.  In 2009, the U.S. Department of Justice came to an agreement with the Swiss government concerning “accounts of interest” held by U.S. citizens and residents.  Pursuant to the agreement, the IRS submitted to the Swiss government, under the bilateral tax treaty between the two nations, a request for information concerning specific accounts they believed that U.S. taxpayers owned.  The Swiss government directed UBS to turn over to the IRS information in UBS files concerning bank-only accounts, custody accounts in which securities or other investment assets were held, and offshore nominee accounts beneficially owned indirectly by U.S. persons.  The Swiss Federal Office of Justice was to oversee UBS’ compliance with those commitments.  The U.S. Competent Authority received from the Swiss government information concerning numerous U.S. taxpayers.

Regarding Mr. Harrington, the IRS received 844 pages of information concerning UBS accounts in September 2011.  That material included bank records, investment account statements, letters, emails between Mr. Harrington and UBS bankers, summaries of telephone calls, and documentation concerning entities through which assets were held.

Were the UBS documents business records?  They were 844 Bates-numbered pages accompanied by a “Certification of Business Records” by legal counsel for UBS.  The certification states the records were made at or near the time of occurrence of the matters set forth by people with knowledge of those matters, they were kept in the course of UBS regularly conducted business activity, and were “made by the said business activity as a regular practice.”  The legal counsel signed under penalty of perjury.  The court admitted the documents into evidence as self-authenticating foreign business records.

Mr. Harrington argues that legal counsel cannot certify the UBS records were business records because she is not as the Federal Rules of Evidence state a “custodian of records or other qualified witness.”  The Court points out that the requirement for a qualified witness is to be familiar with the record-keeping procedures of the organization.  Legal counsel for UBS meets that requirement.

Mr. Harrington argues against the records as being part of UBS regularly conducted business activity and questions the admissibility of emails, letters, third party communications, and summaries of client contacts.  The Court notes that UBS performed client services beyond those in connection with checking accounts.  The bank helped to create trusts, corporations, and other entities to hold client investments, solicited client goals for investments, and attempted to manage the investments in order to meet those goals.  The Court finds it consistent that the bank retained records of communication with clients in their business activity.

Mr. Harrington argued that email is informal and less trustworthy than other business records.  The Court noted that it would be normal for UBS to communicate by email with their clients in the United States and around the world.

Finally, Mr. Harrington argued that the 844 pages produced also referred to additional documents.  Since UBS produced to the IRS all documents they could locate in their files pursuant to the U.S.-Swiss agreement and under supervision of the Swiss Federal Office of Justice, the Court did not see why that was problematic.  Mr. Harrington could explain why that was so or produce further documents into evidence, but he did not.

The Court granted the IRS motion in limine admitting into evidence the foreign business records.

Discovery Requests and Responses

Docket Nos. 13382-17, 13385-17, 13387-17, Adrian D. Smith & Nancy W. Smith, et al., v. C.I.R., Order available here.

To begin with, this order is 38 pages, which is at greater length than the average designated order (for example, the other two this week were 4 pages each).  The nature of these consolidated cases is not discussed in the order because it focuses on discovery requests from the IRS to the petitioners and how responsive the petitioners’ responses have been.  Since the order is lengthy, I tried to summarize as best I could to provide the procedural issues without listing items that are more important to the parties of the case.

Basically, the IRS has sent to the petitioners several sets of interrogatories and requests for production of documents.  The IRS later submitted a report to the Court stating that the petitioners have not been responsive to specific interrogatories and requests for production of documents.  Based on those failures, the IRS seeks an order imposing sanctions against the petitioners.

In reviewing the specific interrogatory responses, the Court finds that the response to one is satisfactory while the responses to the other three are unsatisfactory.  In reviewing the specific responses to the requests for production of documents, the Court finds that the two responses in question are unsatisfactory.

There is lengthy discussion regarding the details and analysis of the responses to those four specific interrogatories and two specific requests for production of documents.  The petitioners relied on Tax Court Rule 71(e) regarding sufficiency of business records to answer interrogatories.  The Court finds their reliance on Rule 71(e) inadequate.  As an example regarding interrogatory one, it is unsatisfactory because requests regarding years 2008, 2009, and 2010 received business records concerning 2007 and 2008 (but did not provide information on 2009 and 2010).  Another example is that the response regarding contractors for the second interrogatory is not complete or adequate.  Basically, partially responsive is not responsive.

The Court also notes additional litigation that involved the petitioners where the courts imposed sanctions because the petitioners were not compliant concerning orders regarding discover requests (CRA Holdings US, Inc. v. United States and United States v. Quebe).

Turning to the requests for production of documents, the Court does not find either sufficiently responsive.  With regard to the second response, the Court finds it was not in good faith.  This is because the petitioners responded first with 12 pages.  Their supplemental answer references over 25,000 pages of previously produced documents.  The Court that the response was not in good faith.  As a result, the Court partially grants sanctions.

At the end of this designated order, there are 4 pages mainly made up of the 16 individual paragraphs regarding the specific court orders in this case.  The range of court orders includes deadlines and other miscellaneous orders.  The sanctions granted with regard to the 12 pages produced by the petitioners are that the petitioners may not introduce at trial extrinsic evidence as to whether the alleged research conducted under the six sample contracts was “funded research.”

Overall, this order provides a thorough examination of whether specific discovery requests in Tax Court are responsive or not.  The order would be worth reviewing by anyone wanting to learn more on the subject.

From Redactions to Reasonable Cause: Designated Orders 1/20/20 to 1/24/20

This week in review for January brought a group of orders with no common theme.  Two orders concern incorrect filings by petitioners, another deals with the Court’s jurisdiction for a petition, one is based on the statute of limitations in a TEFRA proceeding, and the final one is a bench opinion dealing with a taxpayer’s reasonable cause and good faith for a substantial understatement penalty.

Petitioners Needing Filing Help

Docket No. 19551-19S, Eric Bukhman & Marina Bukhman v. C.I.R., Order available here.

To begin with, I want to continue to give support for the Tax Court’s assistance with petitioners.  Many of the petitioners are pro se and need assistance with filing matters.  The Court is quite patient with them and helps them through matters.  One example is the Bukhmans.  They filed their petition without signatures.  Chief Judge Foley gave them until February 14 to ratify the petition by submitting their signatures to the Court.  The Clerk of the Court even provides them a tailored form to ratify their petition.  In fact, they did so on February 5.

Docket No. 11485-17S, Charles Easterwood & Ann M. Easterwood v. C.I.R., Order available here.

That does not explain what happened with the Easterwoods.  They are represented by counsel so there is no excuse about being pro se.  In fact, the Court directed the IRS to respond to its order.  Instead, petitioners’ counsel responded.  Included in the response was a copy of the Notice of Deficiency that did not have the taxpayer identification numbers redacted.  In the order, the response from petitioners’ counsel was stricken and the IRS was ordered they no longer needed to respond.  Caleb Smith wrote about the subsequent order directing petitioners’ counsel to refile the response with proper redactions.

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I am going to take a moment to examine proper Tax Court filing.  Certainly, making sure the petitioners sign the petition is an obvious first step.  However, petitioners and counsel do not always think about redacting.  It is necessary to review the documents thoroughly because the IRS likes to put social security numbers on nearly every page.  Additionally, it is worth looking at the bar codes to see if the taxpayer’s number is embedded within the barcode number.  Next, do not forget about the scannable bar codes or QR codes that the IRS uses.  Is the taxpayer’s information included there?  I am not sure.  I do not want my client’s information to be publicly available so I redact all of those items.  Yes, I feel like I am using whiteout at the level of a conspiracy theorist, but at least I am actively protecting my client.

Let me take another moment here to speak to the IRS.  Since they are in charge of drafting these documents that then need to be filed with Tax Court, is it possible to change the specific forms such as the Notice of Deficiency that give taxpayers the ability to petition Tax Court?  By removing the taxpayer identification numbers, there would no longer be the need for pro se taxpayers or counsel to redact forms.  There would also no longer be the problem for the Tax Court to decide how to grant access to forms that may or may not have been correctly redacted when filed.  I am suggesting that the solution to this issue for petitioners and the Tax Court could start at the source.  Just saying.

Missing the Mark

Docket No. 8400-19, Laurence Harvey Edelson v. C.I.R., Order of Dismissal for Lack of Jurisdiction available here.

Mr. Edelson filed a petition with the Tax Court on May 23, 2019, alleging he never received a notice of deficiency for tax years 2005-2008 and 2010-2017.  He also stated he never received a notice of determination for those same years.  He did not attach any documents with his petition.

What is the history?  The IRS sent notices of deficiency for 2005 (on September 4, 2007), 2006 and 2007 (on May 25, 2011), and 2008 (on February 7, 2011).  There was a notice of determination for 2005 issued December 2008.  Mr. Edelson and the IRS agreed to an installment agreement for 2006-2008 tax years.  The IRS did not send notices of deficiency or notices of determination for 2010-2017.

The IRS filed a motion to dismiss for lack of jurisdiction because the 2005-2008 tax years were not timely and there were no notices of deficiency for the other years.  The Court granted the motion because they lacked jurisdiction for those tax years based on the reasons cited above.

Has the Statute of Limitations Run?

Docket No. 22295-16, 22296-16 (consolidated), Ramat Associates, Wil-Coser Associates, a Partner Other Than the Tax Matters Partner, et al., v. C.I.R., Order available here.

These consolidated cases are TEFRA cases that involve Ramat Associates (Ramat), a Delaware limited liability company.  By a Notice of Final Partnership Administrative Adjustment (FPAA), the IRS adjusted certain partnership items of Ramat’s for the 2006 tax year and determined an accuracy-related penalty.  By a second FPAA, the IRS did the same for the 2007 and 2008 tax years.

The petitioner moved for judgment on the pleadings in both consolidated cases and moved for partial summary judgment in docket # 22296-16 with respect to tax year 2008.  Both motions are based on the notion that the period of limitations has run for the assessment of taxes and penalties resulting from the adjustments made in the FPAAs.  The IRS objected.

Petitioner’s argument is based off IRC section 6229(a), which provides the period for assessing tax with regard to partnership and affected items shall not expire before three years after the later of the date on which the partnership return is filed or the last day for filing such return without regard to extensions.  Section 6229(d) tolls that period if, within the period, the IRS mails an FPAA to the partnership’s tax matters partner.

The IRS instead relies on IRC section 6501(a), saying section 6229 is not a stand-alone statute of limitations, but extends 6501(a) in certain circumstances.  Section 6501 controls the statute of limitations at the partner level for the assessment of any tax flowing from the adjustments in the case.  Section 6501(a) “provides, generally, that the amount of any tax imposed shall be assessed within three years after the return was filed, unless extended or another exception applies” while 6229(a) describes the minimum period for the assessment any tax attributable to partnership items.

The Court agrees with the IRS argument and states the IRS pled facts in sufficient detail to establish a genuine dispute as to a material question of fact whether the section 6501(a) period of limitations has lapsed for the assessment of any tax resulting from the adjustments in the FPAAs.  The Court denied both of the petitioner’s motions.

Penalties for the Taxpayer?

Docket No. 13072-18, Floyd X. Proctor v. C.I.R., Order of Service of Transcript available here.

In this bench opinion, Judge Gustafson examines a taxpayer’s reasonable cause and good faith to determine whether he should be liable for the penalties the IRS imposed.

The IRS issued a notice of deficiency to Mr. Proctor based on his adjustments to income and deductions reported on his Schedule C.  The IRS also assessed timely filing penalties and accuracy-related penalties.  The parties settled regarding the tax deficiencies, but still at issue before the court were the different penalties.

Mr. Proctor has a high school education and worked for the Department of Defense (“DOD”).  In 2011, he formed an LLC and bought a dump truck.  In 2014 and 2015 (the years at issue), he operated a trucking business in addition to his DOD employment.

The 2014 tax return was filed about 9 months late and the 2015 tax return about 11 months late.  Mr. Proctor takes responsibility for the late filings, saying he was not paying attention, was negligent, and he is not trying to get out of being at fault.

Mr. Proctor testified that he connected with a man named Mr. Charles who did similar work and advised him regarding tax filing for their occupation.  Mr. Proctor used Tax Act software for the two returns.  Mr. Proctor showed Mr. Charles the Forms 1099 issued and received, the cancelled checks, invoices, and receipts for trucking expenses.  Mr. Proctor did not realize he had not received all Forms 1099 for his trucking activity income (probably missing his snow-plowing income).  As a result, Mr. Proctor under-reported his income for those years.  Also, he reported expenses which he agreed by stipulation should be reduced.

Judge Gustafson is convinced that the deductions were not deliberately faked.  He is persuaded that Mr. Proctor believed he prepared his tax returns correctly, with serious and forthright efforts.  Accordingly, the judge believes Mr. Proctor did his reasonable best to prepare a correct tax return.

When the IRS examined Mr. Proctor’s returns, he provided bank statements and other financial information.  The IRS informed him that his returns were in error.  Mr. Proctor hired an accountant who prepared profit and loss statements for the trucking business.  After those statements were supplied to the IRS, the IRS prepared the statutory notice of deficiency.  Before communicating the penalty determination to Mr. Proctor, the individual who made that determination obtained written approval from his immediate supervisor.

In reviewing the case, Judge Gustafson finds that Mr. Proctor is liable for the section 6651(a)(1) timely filing penalty since Mr. Proctor admits his lateness was due to his neglect.

Next, Judge Gustafson turns to the accuracy-related penalty for Mr. Proctor.  As a reminder, the 6662(a) penalty is an accuracy-related penalty of 20 percent of the portion of the underpayment attributable to the taxpayer’s negligence or disregard of rules and regulations.

Is his understatement substantial?  Yes, it meets the requirement of exceeding $5,000 and it exceeds by more than 10% the tax liability Mr. Proctor should have reported on his return.

Regarding negligence, that means there must be a “failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return.”  Negligence was not addressed based on the review of reasonable cause below.

For the IRS burden of production, they met their burden because the understatements were substantial and there was compliance with the supervisory approval requirements of section 6751(b).

Section 6664(c)(1) provides that no penalty shall be imposed under sections 6662 or 6663 regarding an underpayment if shown there was reasonable cause and the taxpayer acted in good faith regarding that underpayment.  Those are based on facts and circumstances, including “the experience, knowledge, and education of the taxpayer” (26 C.F.R. sec. 1.6664-4(b)(1)).  For experience, the judge states Mr. Proctor had no experience in keeping books or filing returns for a business.  For knowledge, he had little help in return preparation.  Mr. Proctor had modest education.

For determining reasonable cause, “the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability” (id).  Judge Gustafson holds that Mr. Proctor made a serious and good-faith effort to comply with his tax filing requirement and report his correct liability.

Judge Gustafson held that Mr. Proctor had reasonable cause and showed good faith so he was not liable for the accuracy-related penalty.

In my view, this was a fair decision for Mr. Proctor.  He received some relief regarding the accuracy-related penalty due to his situation, yet still owed the penalty due to his late filing.  He also had the tax due in his settlement with the IRS.  Sounds like the definition of a compromise to me.

The Costs of Being Too Clever By Half: Designated Orders, January 27 – 31, 2020 Part 2 of 2

In my previous post I provided some in-depth coverage on the designated order stemming from Zhang v. C.I.R. about the definition of a prior “opportunity” to dispute the underlying tax. It is an issue that I would very much like to see raised in more appellate courts, as we in the tax community continue to develop the case law around Collection Due Process. The remaining designated orders from that week do not raise such substantive issues, but nonetheless provide important lessons. Foremost among them, the potential consequences of being “too clever by half” in your tax positions.

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Being Too Clever By Half in with Your Business: Paying Yourself So You Have Income, But No Corresponding Deduction. Provitola, et. al. v. C.I.R., Dkt. # 12357-16 and 16168-17 (order found here)

The Provitola case provides us with a fact situation that could have easily been pulled from a law school exam. At its simplest, petitioner husband has two businesses: one as a lawyer, and one as an inventor. With regards to the inventing business, Mr. Provitola has a B.S. in physics, seven patents, experience in patent law, and an LLC that plans on selling some sort of TV enhancing product. Well, actually Mr. Provitola doesn’t have an LLC: his wife is the sole owner (very little information is provided about her background). Mr. Provitola does, however, have an S-Corp for his law practice which he is the sole owner of, so he isn’t completely missing out on the ownership game.

And, in fact, the legal business Mr. Provitola owns appears to be the more profitable (or at least more active) one. His wife’s LLC was created in 2007, but through 2012 remained pretty much dormant: no expenses or receipts to report. Then, in late 2013, something went off in the mind of Mr. Provitola: he had actually been providing legal services to his wife’s LLC since 2009. In fact, he was due $12,000 per year for those services and sent a bill to his wife’s LLC for $60,000. 

I am happy to say this did not cause marital discord. In fact, the LLC paid $36,000 of the amount owed to Mr. Provitola from its (just created) capital account. The arrangement seemed so happy, in fact, that they basically repeated it in 2014.

Maybe the couple was fine with this arrangement because of how it shaked out on their joint tax return. You might be inclined to see it as a wash: Mr. Provitola has taxable income, whereas his wife has a corresponding deduction. But in fact it worked out a little better for the couple than that, because Mr. Provitola’s business had enough other expenses to pretty much completely offset the income. So really, his business continued to have $0 income and his wife still has a large net operating loss. Quite the fortuitous circumstance, it would seem.

Were this a law school exam, this is where the prompt would be: “Imagine the Provitola’s return is audited and ends up going to Court. You are the IRS attorney: what arguments would you raise for why the Provitola’s should not be allowed to deduct the expenses paid by the LLC?”

The real-life IRS attorney was (somewhat) bound by the SNOD’s rationale, since they didn’t raise alternative arguments in their answer (see Tax Court Rule 36) to the petition. (I’d note that the real-life IRS attorney also made some strained evidentiary arguments that were dismissed in a previous designated order here.) With regards to the SNOD, the IRS took the boilerplate position that the expenses were disallowed because the Provitolas (1) did not establish the expenses were paid/incurred in the years at issue, plus (2) it was not proven that the expenses were ordinary/necessary. In other words, the expenses didn’t in fact happen (as a matter of timing or reality), and even if they did they weren’t statutorily allowable under IRC 162

But the IRS attorney fleshed these positions out a bit (one may say, changed them) as litigation went on. Before Judge Buch, the argument became: (1) the LLC isn’t even a real business at all, so everything having to do with it is a fiction, and (2) even if it was a business, the payments it made were non-deductible start-up expenses. Judge Buch calls these the “substance over form” and “start-up expenditures” arguments, respectively. Query whether the change in argument should result in a burden shift, and what that even entails -see Professor Camp’s article here. For my money, I’d say both arguments fall within the original, extremely broad and vague rationales of the SNOD. A fictitious entity only makes fictitious payments, which would seem to be the equivalent of saying “expenses were not paid/incurred” in tax years at issue. And capitalized start-up expenses are, by definition, not ordinary and necessary under IRC 162 -arguably, a core component of the ordinary and necessary test is to determine whether it must be deducted or capitalized. See C.I.R. v. Tellier, 383 U.S. 687, 689-90 (1966).

Judge Buch resolves this case with a bench opinion, so the correctness or incorrectness of the IRS’s arguments was clear enough without the need for post-trial briefing. With regards to the first argument, Judge Buch finds that the LLC is, in fact, a business under the two-prong test of Bertoli v. C.I.R., 103 T.C. 501 (1994). The LLC was, in fact, created for a business purpose (to sell/market the technology, and the business did carry on that business activity (the facts show a website was created, though not made public, and about a thousand units were actually manufactured, even if none were yet sold). So the “not a real business” argument is going to fail. Good news for the Provitolas!

Or maybe not.

In fact, this is (probably unwittingly) bad news for the Provitolas. Judge Buch notes that if it were true that the LLC was not really a business and all the transactions would be disregarded and there would not be corresponding income to Mr. Provitola’s law firm: the income and deductions would vanish (what I originally would have thought to be the correct outcome, but is not the position taken on the SNOD). But that’s not what happens here. And what happens here is much worse for the Provitolas. 

Since it is, in fact a business, the substance of the payments to Mr. Provitola are respected. But as law students learn in Fed Income Tax I, not every expense is immediately deductible. Some, including “start-up expenses,” must (generally) be capitalized. The question is whether expenses (1) incurred for a business that has not made its website public, (2) had not generated any revenue, and (3) had not even really appeared to have marketed its products at the time of the expense are “start up expenses” or expenses for a going concern. The conclusion reached appears to be an easy one: these are definitely non-deductible start up expenses. (Note that in some circumstances you can deduct start-up expenses under IRC 195, but that there are time-limits and phasing rules for taking that deduction. Professor Camp covers some other niceties with that code section here)

So what does that mean? Effectively, Mr. Provitola has income that he (and his wife) paid him, but no offsetting deduction. Worst of both worlds. Oh, and the Court upheld an IRC 6662 penalty on both years for substantial understatement of tax, in part because Mr. Provitola is an attorney (and admitted to the US Tax Court) so he should have known better.

A somewhat convoluted set of transactions that resulted in the worst possible tax consequences. By “creating” income without creating a corresponding deduction the Provitolas were too clever by half.

Remaining Orders (Quick Hits):

Si v. C.I.R., Dkt. # 18748-18 (order found here

I briefly mentioned a previous order from this case, where the petitioner argued that the Tax Court had no jurisdiction because the SNOD was improperly addressed. The “Tax Court has no jurisdiction” argument won’t fly when you file a timely petition, regardless of where the IRS sent the Notice of Deficiency. So, by anxiously filing their petition on time to raise this procedural argument, the petitioner was too clever by half.

This order makes it a bit clearer to me why the petitioner would be in a hurry to raise that argument: on the merits (the usual substantiation of expenses issue) their case was quite weak. 

Wright v. C.I.R., Dkt. # 21509-18 (order found here)

Rather than the petitioner being too clever by half, here the offending party is Congress. Specifically, the drafters of code section 6015(e)(7). That section was intended to clarify the standard and scope of review in Innocent Spouse cases -an issue that years ago was contentious, but since had been resolved through case law. See Carl’s post here. It is also questionable that it really helps taxpayers at all (interesting outcome, given that it was part of the “Taxpayer First Act.” See posts here and here.

In any event, rather than clarify it has led to a slew of questions from practitioners, the Court, and the IRS. Basically, any and all affected parties. This order stems from Judge Gale asking the IRS for some clarification on how the provision will apply and being unsatisfied with their answer (petitioner appears to not really address the issue at all). It’s almost as if Congress may have benefitted from asking practitioners in the tax community about this provision before enacting it…

Easterwood v. C.I.R., Dkt. # 11485-17S (order found here)

I’m not even going to try to fit the final order under the “too clever by half” theme: it is a page of Judge Leyden lightly admonishing a practitioner for (1) failing to redact, and (2) submitting something illegible. If someone wants to try to fit that order with the week’s theme I’ve selected, your suggestions are welcome in the comment section.

Missed Opportunities… And What Does “Opportunity” Even Mean (to Congress)? Designated Orders, January 27 – 31, 2020 Part 1 of 2

For many, the New Year is a time of opportunity: the power of a new beginning and clean-slate to help us move towards our goals. I’ll admit that I am someone who makes New Year’s resolutions and several months later struggles to remember exactly what they were. In such instances I’ve missed the opportunity to change -to strike when the iron is hot. This post is all about what happens when you fail to act on an opportunity, and what “opportunity” really means… at least in the context of IRC 6330(c)(2)(B). In addressing that issue we will focus entirely on one (very important) designated order from Judge Gustafson in the case of Zhang v. C.I.R., Dkt # 4956-19L (order found here). Because I found this order so important I wanted to devote all of the post to it -Part 2, released later, will cover the remaining orders of the week.

read more…

Because of the procedural posture of the order granting an IRS summary judgment motion, it is a little difficult to parse the facts (i.e. the reality) from the “facts” (i.e. what Judge Gustafson assumes, without deciding, to be true) of the Zhang case. But the “facts” certainly paint a pretty unfair picture for the taxpayer. 

Mr. Zhang runs a restaurant where, not surprisingly, customers pay with credit cards. Credit card companies love these arrangements, since they get transaction fees from the vendor. Consumers (if they don’t carry a balance) love this arrangement because they usually get points or miles. The IRS (probably) also loves this arrangement, because it makes for a paper-trail: specifically, the issuance of Form 1099-K from the credit card processors. (The only people really missing out are those that pay with cash, since the vendor usually passes on the transaction fees to the customer in the form of higher prices. Interesting take found here.)

The paper trail of the Form 1099-K is the root of the problem in this case. Mr. Zhang operates the restaurant through a C-Corporation. Generally, the income from the business (including those reflected on the Form 1099-K) should be reported on the C-Corporation’s return. And that is exactly what Mr. Zhang did: he reported the income on the business’s tax returns, rather than his personal returns. However, the issuers of the Form 1099-K appear to have listed Mr. Zhang (not the C-Corporation) as the recipient of the income… You can probably guess what happens next.

The IRS information matching system (Automated Underreporter, or AUR) prompted the IRS to take a second look at the return.  Mr. Zhang never responded to any of the letters, and attests that he never received the ensuing SNOD (more on that later) so the deficiency was assessed basically through default.

The facts, at this point, are essentially that Mr. Zhang shouldn’t owe the tax the IRS assessed. Judge Gustafson goes so far as to say that the IRS “incorrectly concluded that these payments were unreported income of Mr. Zhang.” 

Thank goodness Congress created Collection Due Process in the 98 RRA. Without it, not only could the IRS levy without judicial review, but Mr. Zhang wouldn’t be able to argue in Court that he doesn’t owe the tax without fully paying it first. Instead, the IRS first had to issue a “Notice of Intent to Levy” giving Mr. Zhang the right to a Collection Due Process (CDP) hearing, which Mr. Zhang dutifully (and timely) requested. 

And here, reader, is where we begin to learn the meaning and value of “opportunity.” Because Mr. Zhang claims he never actually received an SNOD, he would like to use the CDP hearing to dispute the underlying tax. And, assuming that Mr. Zhang did not actually receive the SNOD, he is well within his right to raise that issue. See Kuykendall v. C.I.R., 129 T.C. No. 9 (2007).

Under IRC 6330(c)(2)(B) there appear to be two (conjunctive?) conditions a taxpayer must satisfy to have the right to argue the underlying liability. To wit, a person “may also raise at the hearing challenges to the existence or amount of the underlying tax liability for any tax period if [1] the person did not receive any statutory notice of deficiency for such tax liability or [2] did not otherwise have an opportunity to dispute such tax liability.” (I’ve added the bracketed numbers to make this track a little easier.) From what we know, Mr. Zhang did not actually receive the SNOD and didn’t “otherwise have an opportunity” at this point. Keep that second component in the back of your mind.

To the extent that a CDP hearing actually took place (being extremely informal as they are, it is sometimes difficult to pin-down their moment of consummation), IRS Appeals did not appear to consider the underlying tax issue. They also did not properly schedule a telephonic hearing with the taxpayer in the first place. Judge Gustafson goes so far as to say, based on the (assumed) facts, IRS Appeals “abused its discretion in the handling of Mr. Zhang’s” CDP hearing.

In other words, the Court essentially says that based on the assumed facts this was a pretty poor hearing, and a pretty poor opportunity to argue your underlying tax. I’d argue based on the facts assumed by the Court that it wasn’t really a CDP hearing at all -and why I’d argue that will make a lot more sense by the end of this post. 

But for now, it is critical to note that the underlying tax argument (indeed, no argument) was not raised with the Tax Court after this CDP “hearing.” The IRS issued a Notice of Determination upholding the levy, and Mr. Zhang did not respond.

Failing to exercise your right to judicial review when the IRS abuses its discretion is a textbook “missed opportunity.” And it is a costly one in this case. 

It isn’t clear whether the IRS ever followed through on the levy, but they did later issue a Notice of Federal Tax Lien (NFTL) for the same tax year. And with an NFTL comes essentially the same CDP hearing rights, albeit under IRC 6320

Mr. Zhang again timely requests a CDP hearing, and again raises the underlying tax issue. And if it was an abuse of discretion not to consider it before surely it is now, right?

Wrong.

Now it doesn’t even matter if Mr. Zhang “actually received” the SNOD because of the second clause in IRC 6330(c)(2)(B): you can’t argue if you “otherwise have an opportunity to dispute such liability.” And that “opportunity to dispute” was precisely the first CDP hearing… So IRS Appeals again doesn’t entertain the argument about the underlying liability, but this time on the grounds that he already had an opportunity to do so.

This time, however, Mr. Zhang isn’t taking “can’t argue underlying tax liability” for an answer. He petitions the tax court. If only he had done so with the first hearing…

Judge Gustafson feels for Mr. Zhang (“If the facts assumed here are correct, then Mr. Zhang’s situation is very sympathetic,”) but this is not a court of equity and being sympathetic isn’t enough. Mr. Zhang should have petitioned the court after the first hearing where the IRS presumably abused its discretion by not entertaining his argument about the underlying liability. That was his prior opportunity: when you raise the issue, you better follow through. Now, hoping to return to it, he is barred by the language of IRC 6330(c)(2)(B): what was once an abuse of discretion in the first hearing under the first clause of that provision has now morphed into Appeals correctly applying the law.

Summary judgment to the IRS.

There is a lot going on here, such that I cannot help playing arm-chair lawyer. My biggest qualm is with the quality of the “opportunity” Mr. Zhang received. I think the Court and the Treasury Regulations have really stacked the deck against taxpayers in a way that Congress and even the statute as written do not require.

If Mr. Zhang were to argue that the first hearing never really took place (as I suggested), since there was no phone call (it isn’t clear what else happened) might that be a way out? It would be an uphill battle for sure. The Treasury Regulations go so far as to say that simply receiving the CDP Levy notice is enough to preclude arguing the underlying tax at a later CDP lien hearing… whether you act on it or not. See Treas. Reg. 301.6320-1(e)(3), A-E7. The Tax Court appears to take no issue with that Treasury Regulation definition of prior “opportunity” (see, e.g. Nichols v. C.I.R., T.C. Memo. 2007-5). So maybe no dice on that argument… or maybe it has some life in a different iteration (that I will conclude this post with).

Let’s consider just how bad or ethereal an “opportunity” to dispute the tax can be for it to still be an opportunity. In this case, the assumed facts are that the taxpayer raised the issue, was told by the IRS that they couldn’t raise the issue, and then when they tried to raise it again were told they already had the “opportunity” to do so. Note that IRC 6330(c)(4) specifically lists out what issues are “precluded” from being raised: those that were “raised and considered under a previous hearing” (emphasis added) is the first one listed. To me, the underlying liability was certainly raised, but just as certainly not considered. I’ll talk more about why I think that matters from an administrative law perspective, but I’d note that this designated order did not rely on IRC 6330(c)(4) to reach its conclusion: the underlying liability was “precluded” from being reviewed under IRC 6330(c)(2). 

Intentionally or otherwise, the case law and treasury regulations have turned “prior opportunity” into a landmine-strewn DMZ for taxpayers: the moment you step foot towards the Office of Appeals, you better tread lightly. We have already seen that if you raise the underlying liability with Appeals, even though you have no route to Court at that time, you may be barred from raising the liability at a later CDP hearing under the “prior opportunity” rationale. See Keith’s post here for an excellent review (Note that we’re still waiting on Tax Court to rule on the proposed opinion, which was assigned to Judge Goeke on 11/13/2019.)

A lesson used to be “wait to take the first step.” That is, instead of submitting audit reconsideration and going to Appeals, wait until the CDP hearing. This is obviously a poor use of judicial and administrative resources, but one that I feel practitioners have to keep in mind given the IRS (and Court’s) interpretation of the Treasury Regulations. With Zhang v. C.I.R. one can fairly add “once you’ve taken that first step, you better run with it all the way to Tax Court.” It wasn’t that he failed to insist on his administrative rights when given the chance (e.g. ignoring the first notice of intent to levy, which somehow “precludes” raising the issue later), but that he didn’t insist on his judicial rights to enforce the opportunity he was denied. When Mr. Zhang paused after his first step he stranded himself in no-man’s-land.  

Finally, this case brings up interesting Taxpayer Bill of Rights and -of course- potential administrative law questions. I submit to you the following thought experiment: Assuming the Tax Court gets it right (i.e. the first CDP hearing was an opportunity to dispute the tax), might it nonetheless be an abuse of discretion for the IRS Appeals officer to fail to consider the underlying liability? 

Consider the Treasury Regulations first, which provide in relevant part that “In the Appeals officer’s sole discretion, [they] may consider the existence or amount of the underlying tax liability, or such other precluded issues, at the same time as the CDP hearing.” Treas. Reg. 301.6320-1(e)(3), A-E11. However, the Treasury Regulation goes on to clarify “Any determination, however, made by the Appeals officer with respect to such a precluded issue shall not be treated as part of the Notice of Determination issued by the Appeals officer and will not be subject to any judicial review.” Id. In other words, Appeals can be nice and review the underlying liability when it is otherwise precluded, but their decision to do so (or not do so) can never, ever, be questioned. I take issue both with the Regulation’s definition of the underlying liability as “precluded” in those circumstances, and its attempt to limit the Tax Court’s review (one may say, the Tax Court’s jurisdiction).

First, query whether a regulation can limit the jurisdiction of the Tax Court to review a discretionary act, especially where Congress has specifically granted that Court jurisdiction. That, to me, is the admin law question. As a matter of judicial deference to such a regulation, Carl has written here. You might retort: “it isn’t a really a “discretionary” act that the regulation is forbidding review of: Congress precluded review of the underlying liability in those instances.” I think that is dead-wrong, and a huge problem that the Tax Court and Treasury Regulations have created on their own. 

I read IRC 6330(c)(2) as a list of the issues a taxpayer has the right to raise. If the taxpayer’s situation doesn’t meet the requirements therein, they don’t have the right to raise the issue, but that isn’t to say it can’t be raised altogether (i.e. that it is precluded), only that it is discretionary. This reading, I believe, is bolstered by the fact that just two paragraphs down (6330)(c)(4)) Congress does, in fact, list out what issues cannot be raised under the helpful heading “Certain issues precluded.” Unless the underlying tax was already litigated, or “raised and considered” in a prior CDP hearing (again, emphasis added) it is not a precluded issue. And if it isn’t a precluded issue, and the IRS has the discretion to consider the issue, then I find it odd that the Court is precluded from reviewing that exercise of discretion solely because the agency has essentially shielded itself from review through the issuance of a regulation. I rarely invoke the Constitution in my tax practice, but that seems like a separation of powers issue to me.

Now, let’s talk TBOR. Imagine, as is nearly the case here, an IRS Appeals officer says, “I know you probably don’t owe the tax, but you missed your chance to argue it so we’re going to uphold the lien/levy. The Regulations provide that it is in my sole discretion whether to look at the underlying tax or not, and I’ve decided not to because I don’t have to.” Could TBOR provide a statutory basis for saying this is an abuse of discretion? After all, doesn’t TBOR ensure that the IRS employees should act in accord with the right to “pay no more than the correct amount of tax” (IRC 7803(a)(3)(C))? What is the point of that “right” if not to keep the IRS from collecting more tax than is due based on technicalities? 

Again, it is possible that all of the “facts” here make this case seem a lot worse than the reality. But that is the beauty of the posture of this case, and how it illuminates the legal issues that I, for one, would love to see worked out in a precedential case. 

A Drama in Three Acts: Designated Orders Jan. 13 – 17 (Part Three of Three)

Part Three: Accardi and the IRM

In the previous post on the Orienter designated order we saw petitioners try to argue for abuse of discretion on the grounds that IRS Appeals didn’t follow the IRM in rejecting the Offer in Compromise. Judge Holmes found that IRS Appeals did, in fact, follow the IRM, but in the order opens up a whole other can of worms for practitioners to fuss over: is verifying that the IRM has been followed part of the mandate in IRC 6330(c)(1) that appeals verify “the requirements of any applicable law or administrative procedure” [emphasis added] have been met. In other words, is the IRM part of administrative procedure? This is a hairy and very important topic. I’d expect nothing less from Judge Holmes than to bring administrative law issues to the front. Let’s take a look.

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One may be excused for wondering if the question of the “value” of the IRM hasn’t already been fully established. After all, it is “a well-settled principle that the Internal Revenue Manual does not have the force of law, is not binding on the IRS, and confers no rights on taxpayers.” See, for example, my coverage of the Lecour v. C.I.R. order here  or, more precisely, footnote 16 in Thompson v. C.I.R. 140 T.C. No. 4 (2013). So how does Judge Holmes find some daylight in the issue of whether the IRM creates some sort of obligation upon the IRS visa IRC 6330(c)(1)?

The answer is part due to an administrative law principle called the “Accardi Doctrine” (sometimes alternatively referred to as the Accardi “Principle” if you are scrambling to look it up in law review articles). Doctrine or principle, it is named after the Supreme Court case of United States ex. rel. Accardi v. Shaughnessy, 347 U.S. 260 (1954). That case, which may look both deceptively short and inconsequential to tax (it stems from a writ of habeus corpus), has largely come to stand for the proposition that agencies have to follow their own rules or face having their actions invalidated for abuse of discretion… though exactly which “rules” matter is something of an unsettled question. Is it just notice and comment regulations that Accardi cares about? Is it just for “legislative” regulations (which may or may not be the same question phrased differently)?

The Second Circuit interprets the Accardi doctrine as applying to those rules “promulgated by a federal agency, which regulated the rights and interests of others” as being “controlling on the agency.” Montilla v. INS, 926 F.2d 162, 166 (2nd Cir. 1992). As relevant to the question of whether this is only applicable to “notice and comment” regulations, the Second Circuit in Montilla gives a (blissfully) clear answer: it applies even “where the internal procedures are possibly more rigorous than otherwise would be required and even though the procedural requirement has not yet been published in the federal register.”

So we have the opening, at least in cases appealable to the Second Circuit, that “sub-regulatory” guidance (i.e. guidance that isn’t published in the Federal Register) may nonetheless be binding on the IRS under Accardi. But does this trickle all the way down to the IRM? Maybe, and maybe not (or at least not through Accardi). Judge Holmes doesn’t need to directly answer the Accardi doctrine question here, because he finds that IRS Appeals followed the IRM in any case.

Still, I promise to you, there are lessons to be learned from these unanswered questions that directly touch on the value of the IRM. Those lessons can best be learned by splitting the issue in two: (1) how the Tax Court views Accardi’s application to the IRM, and (2) how the Tax Court applies IRC 6330(c)(1)’s definition of “administrative procedures” to the IRM.

Starting with the Tax Court’s view of Accardi and administrative law, it may come as little surprise that Accardi has been infrequently discussed in earlier cases. Administrative law issues being raised in Tax Court has certainly gained steam in recent years, but it is still something of a rarity, and especially with earlier cases. In fact, when I searched Westlaw for Tax Court cases citing to Accardi I found only five -many of them with basically no discussion of the doctrine.

One of the cases that I believe gives a pretty good indication of the Tax Court’s thoughts on Accardi and the IRM is Capitol Federal Sav. & Loan Ass’n & Subsidiary v. C.I.R., 96 T.C. 204 (1991). In that case, the Court notes that “[a]gencies are not required, at the risk of invalidation of their actions, to follow all of their rules.” OK, so not all rules matter the same. There are different tiers. And what rules may the agency “not follow” without necessarily invalidating their actions? Those that are “general statements of policy and rules governing internal agency operations or ‘housekeeping’ matters, which do not have the force and effect of law.” These would include the IRM and are not “binding” on the agency in the Accardi mold.

In fact, the Supreme Court has (almost) weighed in on that issue in U.S. v. Caceres, 440 U.S. 741 (1979). Though Caceres is a (criminal) tax case that directly implicates the IRM, it doesn’t conclusively answer the question of how Accardi applies to the IRM. The defendant in Caceres wanted evidence of bribery suppressed because the IRS agent procured it without properly following IRM procedures (which the Court maddeningly refers to as “regulations” throughout the opinion). The Court ends up allowing the evidence despite failure to follow the IRM… but notes explicitly that this “is not an APA case.” In other words, it is not looking at whether to invalidate an agency action, but whether a constitutional right was violated. Not quite the same things. And we are really just concerned with whether an agency action should be found arbitrary and capricious, not whether our constitutional rights are (directly) violated.

I take the Tax Court’s attitude in Capital Federal Savings to be that Accardi only applies to legislative regulations, which are those that are meant to carry the force of law (and generally published in the federal register). Unless your Circuit has said something different, the Tax Court is unlikely to treat sub-regulatory guidance as equivalent to a legislative regulation, and thus unlikely to be binding on the IRS through Accardi. This holds especially true if the guidance is purely internal like the IRM. 

Nonetheless, even if Accardi doesn’t apply that doesn’t mean that failure to follow subregulatory guidance can’t lead to a finding of “abuse of discretion.” if the IRS “fails to observe self-imposed limits upon the exercise of his discretion, provided he has invited reliance upon such limitations.” Capital Federal Savings at 217. Accardi might not get you much traction with the Tax Court (though to be sure, you should look to what your Court of Appeals has said on the topic), but that doesn’t mean you still shouldn’t point to sub-regulatory guidance when arguing about abuse of discretion. Indeed, that is generally your best (or only) indication of how the IRS is supposed to exercise their discretion in the first place.

So the IRM and Accardi probably don’t mix. What about the IRM and IRC 6330(c)(1) reference to “administrative procedures?” Here we may actually get somewhere with the Tax Court…

The focal point of this issue is not Accardi, but a different case cited by Judge Holmes (also authored by Judge Holmes): Trout v. C.I.R., 131 T.C. 239 -specifically Judge Marvel’s concurrence. With this analysis we move from the general to the specific: Accardi as a general doctrine about what rules agencies must follow (for my money, only legislative rules), and Trout as what a specific statute requires of the IRS in conducting CDP hearings. Really, it all hinges on the definition of what may be considered “any applicable […] administrative procedure.”

Trout was all about what procedures the IRS must follow when an OIC defaults, which can happen in any number of ways (failing to file and pay on time for the next five years, being among the more common). The IRS usually doesn’t rip up an OIC the moment these events occur, but rather gives the Offeror a chance to cure. Indeed, the IRM generally provides that numerous letters be sent in those instances before terminating the OIC. Just search “potential default” in IRM 5.19.7 to see for yourselves. The lead opinion in Trout addresses the issue mostly from contract law principles of material breach. Judge Marvel, and some later cases, however, put a stronger emphasis on the IRM and what responsibilities the IRS has emanating therefrom.

Judge Marvel is well-aware of the Court’s position that the IRM “do[es] not have the force or effect of law.” But if anything carries the force of law, it is a statute -and here we have a statute that explicitly compels IRS Appeals to verify that “any applicable law or administrative procedure have been met.” IRC 6330(c)(1). Again, any applicable administrative procedure. Might that broad language include the IRM? IRS Chief Counsel seems to have thought so. Judge Marvel notes that Chief Counsel Notice CC-2009-019 provides for IRC 6330(c)(1) that “The requirements the appeals officer is verifying are those things that the Code, Treasury Regulations, and the IRM require the Service to do before collection can take place.” [Emphasis added.] If the IRS’s own attorneys seem to think Appeals needs to verify the IRM was followed, who would argue against them?

In putting the IRM in play, Judge Marvel also puts the spotlight on an issue I have frequently had with IRS Notice of Determinations: the boilerplate recitation that Appeals “has determined that all legal and procedural requirements are concluded to have been met.” This, to me, is fertile ground that practitioners should be looking at whenever they are working with CDP cases: what review has Appeals really done, and have they documented it at all in the administrative file? Judge Marvel’s concurrence was joined by seven other judges, five of whom still sit as judges or senior judges. I do think this line of argument may well find a more receptive audience in the Tax Court than Accardi may. The Court is already willing to use the IRM as a yardstick for determining the IRS’s exercise of discretion (see Moore v. C.I.R., T.C. Memo. 2019-129, for one example). I don’t think it’s asking too much of Appeals to have them actually look at what happened leading up to collection: not every IRM violation should mean that it would be an abuse of discretion to sustain a levy. But failing to look at all, when Congress directs you to, certainly is.

Only not in this case, because as far as we can tell all IRM provisions were followed.

And so our trilogy covering the designated orders for the week of January 13 comes to an end. But as the credits roll, and for the sake of completeness, here are the other orders for the week of January 13 – 17 (and one bonus order)…

Other Orders: “Quick Hits”

Richlin v. C.I.R., Dkt. # 16301-16L (order here)

If you have questions about Treas. Reg. 1.6654-2(e)(5)(ii)(A) and whether you are entitled to the crediting of some payments from an ex (now deceased), this order may just be the thing you’re looking for.

Ramat Associates ,Wil-Coser Associates, A Partner Other than the Tax matters Partner, Et. Al v. C.I.R., Dkt. # 22295-16 (order here)

If you’d like to know about the standards for a motion to strike, this order just may be the thing you’re looking for.

Johnson v. C.I.R., Dkt. # 7249-19L (order here).

If you want to see the IRS get a pretty standard motion for summary judgment correct with Judge Gustafson, this order just may be the thing you’re looking for.

Bonus: Si v. C.I.R., Dkt. # 18748-18 (order here)

This order is actually from the week before the one I am covering, but it was the only one from that week and didn’t warrant a full post. It is an interesting look at the perils of trying to catch the IRS in a potential foot-fault of not sending the SNOD to the correct last known address… which backfires if you actually receive the SNOD with time to petition the Court (as this petitioner clearly did, since they filed a timely petition and then a motion to dismiss for lack of jurisdiction).

A Drama in Three Acts: Designated Orders Jan. 13 – 17 (Part Two of Three)

Today we leave the familiarity of Graev and move into AJAC and administrative law. Without further ado I present:

Part Two: What to Expect When You’re Expecting A Better Deal from Appeals

Some of the most important designated orders are the ones that deal with common situations and fairly unremarkable facts, but raise arguments that rarely make it into published opinions. The order we will be discussing in Orienter v. C.I.R., Dkt. # 20004-13L (order here) is a perfect example. Though I (obviously) appreciate anyone reading my synopsis and analysis of the order, I strongly commend any practitioner that works in tax controversy (and especially collection) to read the order for themselves as well. It is that substantive and that worthwhile.

It is also fairly easy to digest. In just 16 (incorrectly numbered) pages Judge Holmes lays out four discrete issues I will focus on and three more that I won’t. The issues that I believe warrant additional detail are:

  1. How does the Court review the rejection of a multiple-year Offer in Compromise when the Court only has jurisdiction over some of the years contained in the Offer?
  2. How do the IRS “Appeals Judicial Approach and Culture” (AJAC) rules and procedures limit Appeals’ review of the record compiled by the Centralized Offer in Compromise (COIC)?
  3. Does the IRM or any other authority give taxpayers a way to accept an (initially rejected) Offer amount from COIC if the taxpayers end up doing even worse with Appeals?
  4. Is the IRM a source of “administrative procedure” such that a violation of it would be a violation of IRC 6330(c)(1) (that the requirement of “any applicable law or administrative procedure” be met)?

I’ve been at an ABA Tax Section meeting where Judge Holmes said that he would recommend studying administrative law to anyone considering going into tax. These are all interesting questions that bring us to the crossroads of administrative and tax law… Let’s see what Judge Holmes thinks about them.

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To set the scene, Judge Holmes describes matters as getting “complicated” for the taxpayers, though I found this case represent a fairly typical scenario for taxpayers filing an Offer in Compromise. This doesn’t mean that the situation isn’t complicated, only that it isn’t particularly unusual. The main complicating factors were (1) the Orienters had more tax debts they wished to settle than just the years at issue in the CDP Notice, and (2) the Orienters sent their Offer to the IRC COIC unit, rather than to the IRS Appeals Office working the case. Since IRS Appeals really just forwards the Offer to COIC in any case, so long as you let Appeals know that you submitted an Offer it shouldn’t really affect your CDP hearing -other than likely to have it postponed until COIC reaches a preliminary determination. These two factors (multiple years at issue, and especially multiple “levels” of IRS review of the Offer) are what bring us to the interesting legal issues.

Issue One: How does the Court review the rejection of a multiple-year Offer in Compromise when the Court only has jurisdiction over some of the years contained in the Offer?

As we have been told once or twice before, the Tax Court is a court of “limited jurisdiction.” In a CDP case, jurisdiction is limited only to those years that were a part of the CDP hearing (and consequently, those on the Notice of Determination). The CDP hearing and Notice of Determination was strictly for the 2004 tax year, but the Offer was for 2002 – 2005 tax debts. Should the Tax Court only consider the jurisdictional year and ignore the other years, even though those years clearly matter to the Notice of Determination?

I’m not sure what that would really look like, since in filing an Offer you are essentially wrapping all of your tax debts into one liability and arguing your inability to pay that one liability. You can’t really just look at one year in reaching a determination of ability to pay, because you need to look at the tax debt as a whole. Luckily, I don’t have to spend much time thinking about what such limited review would look like because, as Judge Holmes notes, there is already numerous cases (though none that are technically precedential: see post here) on point that allow the Tax Court to consider the full debt (i.e. non-jurisdictional years) in reaching a determination of abuse of discretion for the jurisdictional year.

Should practitioners find themselves dealing with a similar strain of “jurisdictional trap” in CDP hearings, I’d commend them to read this order for the cases cited, and particularly the case of Sullivan v. C.I.R., 97 T.C.M. 1010 (2009) (apologies, couldn’t find a link) that Judge Holmes highlights. While I’ve never had the IRS try to argue that the Tax Court is barred from even considering non-jurisdictional years, the Court’s reasoning in Sullivan for when and why such years can be considered may be helpful, because it brings up the statutory language which could be relevant for far more than just rejected Offers. The most relevant section of Sullivan is:

“This Court is disabled from halting the IRS’s collection of [non-jurisdictional] liabilities, but it is not disabled from knowing about them. In determining whether the rejection of the OICs and the collection […] is appropriate, this Court is authorized (as the Appeals officer was required) to consider ‘any relevant issue relating to … the proposed levy.’ Sec. 6330(c)(2)(A), (d).”

So, as to Issue One, we have a fairly uncontroversial (though helpful and clarifying) answer: the Tax Court can consider the other non-jurisdictional years in order to determine if there was an abuse of discretion for the jurisdictional year in the Offer.

Issue Two: How do the IRS “Appeals Judicial Approach and Culture” (AJAC) rules and procedures limit Appeals’ review of the record compiled by the Centralized Offer in Compromise (COIC)?

It is with Issue Two, I believe, where things start to get slightly away from the ordinary CDP Offer. The Orienters Offer was originally for $25,000. IRS COIC preliminarily recommended rejection of the Offer, but that they might consider it if the amount was bumped up to $65,860 -the amount COIC calculated as the “Reasonable Collection Potential” (RCP). This was unacceptable to the Orienters, so they decided to try their luck with Appeals.

And it does not appear that their luck improved.

In fact, IRS Appeals determined that the RCP was closer to $200,000, and sustained the rejection of the $25,000 Offer, finding that even the special circumstances of the Orienters (who appear to have health problems) would not warrant accepting either the $25,000 or the $65,860 proposed by COIC. The Orienters, now fearing that they had perhaps made the wrong decision in not accepting the $65,860 Offer, tried to have the case sent back to COIC so they could accept that proposal. But they were stymied: IRS Appeals said the case could not be transferred. Eventually, a Notice of Determination reflecting this was issued.

This all comes down to what your options are when IRS Appeals seems to take a harder line than the originating function. Here, the Orienters want to argue that IRS Appeals is essentially barred from behaving as they did, or at least that their behavior is an “abuse of discretion” because it goes against the IRM vis a vis the “AJAC” rules.

Put broadly, AJAC is meant to have Appeals review cases more like a reviewing Court (i.e. limited to specific issues before it, rather than looking for or raising new ones). To the Orienters, this means Appeals was only supposed to review whether enough information was provided to warrant acceptance of an Offer less than $65,860 -not to re-work the Offer or raise new issues. The IRM provides that “[g]enerally, Appeals will sustain a rejection only under the same basis for which the offer was rejected.” (IRM 8.23.4.3(2).) But the basis of the rejection by Appeals was not the same as the basis of rejection by COIC. And so the IRS Appeals officer went against the AJAC principles embodied in the IRM, and thus abused its discretion.

The IRS, however, frames the issue a bit differently: the only issue was whether the Offer of $25,000 should be accepted or the levy sustained. Oh, and the IRS Appeals officer did follow the relevant IRM provisions (for example, 8.22.7.10.6) in either case.

Judge Holmes sees the issue as hinging on what the meaning of the phrase “same basis” is in this context. If IRS Appeals did reject on “the same basis” as COIC, then there isn’t really an issue because IRS Appeals followed the IRM (more on what the consequence to not following the IRM could be in the next post, since it brings up some really interesting admin law points).

So what was is the “basis” for rejection at issue here? Judge Holmes thinks it would be too narrow to define the issue in the way the Orienters want. The question is simply whether an Offer should be accepted for $25,000  i.e. the Offer put forth and rejected. This amount was admittedly less than the RCP, and the discount was arrived at on the grounds of “special circumstances” (always difficult to quantify in exact dollars). When IRS Appeals reviewed the file and recalculated the RCP, Appeals wasn’t “raising new issues” but really just determining if they believed the $25,000 offer should actually be accepted (if Appeals didn’t take a second look at RCP, it isn’t immediately clear what they would be doing in Appeals to begin with). In finding that RCP + Special Circumstances did not equal $25,000 Offer, they were rejecting on the same basis as COIC -even if they reached a different amount they thought may be reasonable.

Thus, we conclude Issue Two: No AJAC violation. So no abuse of discretion on those grounds. On to the largely related Issue Three…

Issue Three: Does the IRM or any other authority give taxpayers a way to accept an (initially rejected) Offer amount from COIC if the taxpayers end up doing even worse with Appeals?

So maybe IRS Appeals didn’t violate AJAC. But is there another way the Orienters can get back to that (now-enticing) COIC number of $65,680? Let’s look a little bit more at how that number was memorialized, to understand what legal meaning it may carry.

When COIC proposes a rejection of an Offer, it will send a few spreadsheets walking through its calculation of RCP and, usually, a page of boilerplate about how they “considered” special circumstances but that they didn’t warrant accepting the Offer proposed. Sometimes when special circumstances are raised and considered the IRS may “suggest” an alternative Offer amount they may be willing to accept. Such appears to be the case with the Orienters. The question is how much “value” that suggestion of $65,680 holds.

There are a long line of cases that essentially treat Offers under contact principles. Which seems to make sense, since (1) it is loaded with contractual terms governing performance (e.g. filing and paying on time for five years), and (2) it is literally called an Offer in Compromise, with offer and acceptance being fundamental to the formation of a contract.

In this case, the Orienter’s would like to characterize that $65,680 as a counter-offer, which they are free to accept. Judge Holmes is not buying this: the COIC letter (which usually states “rejection”) was only that -a rejection. It was not a counteroffer, because “a mere inquiry regarding the possibility of different terms […] is ordinarily not a counter-offer.” Restatement (Second) of Contracts Sec. 39 (1981). In Judge Holmes’ words, the “$65,860 was never on the table – it wasn’t even in the oven.”

Further, even if the Orienters were able to characterize the rejection letter as a counter-offer (I believe the language of the letter said COIC “could not even consider an Offer of less than $65,680” which certainly makes it seem like a suggestion, and not a set term), they would probably not prevail on contract grounds. And that is because, lest we forget, the Orienters pretty clearly rejected the supposed counter-offer by going to Appeals. And once you reject, you can’t just “go back” now that you regret it.

So, no luck to the Orienters on trying to find some sort of authority for their proposition that they should be allowed to accept the “counter-offer” of $65,680. But does that mean the Orienter’s are doomed? Tune in for part three where we will look at one final (and very interesting) line of argument that explicitly puts administrative law and the IRM in the crosshairs.

A Drama in Three Acts: Designated Orders Jan. 13 – 17 (Part One of Three)

Sometimes I think the Tax Court Judges like giving me extra work by putting really substantive and interesting issues in designated orders. The week of January 13, 2020 was certainly one of those weeks. So much so, that it warrants (at least) three posts on two orders. Let’s start with our familiar friends (Graev and petitioners failing to prosecute) before moving on to new ones (the Accardi doctrine).

Part One: Tax Court, the Commitment to Getting the Right Tax… And Graev. Meyers v. C.I.R., Dkt. # 8453-19 (order here)

On a cold, winter’s eve I recently watched the critically-acclaimed “Marriage Story” on Netflix. Perhaps because I am unmarried and don’t have kids, what I found most compelling about the film was the portrayal of the family law attorneys -specifically, how incredibly different and adversarial their dynamic is from my own experience in tax. I finished the movie feeling uplifted… about my choice to go into tax law. The Meyers bench opinion was a similarly uplifting story: a reaffirmation that the Tax Court (and generally IRS Counsel) care mostly about getting the right amount of tax, and not simply the most amount of tax.

Of course, since this blog focuses on tax rather than romance (and only rarely the twain shall meet), my post will be on the interesting procedural aspects that arise. Luckily, this case provides a few such lessons that are worth taking a look at.

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“Meyers Story” features a husband and wife in deficiency proceedings for, shall we say, “unlikely” deductions that the IRS disallowed. I will note a few of them for the sake of levity: (1) that 94% of their home was a “home office”, (2) that the husband’s remarkably unprofitable model airplane “business” was not subject to the hobby-loss limits, and (3) that his purchase of model airplanes were ALSO deductible advertising expenses for his (again, remarkably unprofitable) real estate “business.” These are but a few of the many improper deductions at play. Somehow, the case went to trial.

And that is where things get procedurally interesting. For this is not the time-worn tale of taxpayers filing a petition and then just moving on in their life. No, petitioners took many more steps than to simply “file-and-forget.” In fact, they almost saw the case to completion. They filed stipulations with the Court. They even showed up to Court and testified… but only for half of the trial.

Because of the numerous issues that had to be hammered out, the trial was set to span two days. The wife was able to wrap up her part on day one, which was helpful since she appears to work a fairly lucrative (six figure) job. The husband, on the other hand (whose sources of income are less clear) only had time on day-one to finish direct questioning: that is, to give his own testimony. He was set to come back on day two to face cross-examination. After reading the tea-leaves, however, Mr. Meyers decided against facing IRS questioning: in his opinion Judge Gustafson had “already made up his mind -it’s going to be a waste of time.” This was expressed in an email to IRS counsel before the second day of trial. The Court called Mr. Meyers and left a message explaining that he was required to show up to Court, but Mr. Meyers ignored it. Accordingly, the IRS moved that the case be dismissed for failure to prosecute and for the imposition of an IRC 6673 penalty.

So what is Judge Gustafson to do? Grant both motions and leave it at that? To appreciate the dilemma(s) facing Judge Gustafson, let’s look at what is supposed to happen when a case is dismissed for failure to prosecute.

Tax Court Rule 123(b) provides that when a case is dismissed for failure to properly prosecute the court may enter a decision against the petitioner. But can that decision (for our purposes, the deficiency amount) be whatever the Court wants? Does it have to be what the IRS wants, and if so is that simply the amount on the Notice of Deficiency?

The statute on point provides guidance, but some wiggle-room. IRC 7459(d) provides that the Court’s dismissal of a case (other than for lack of jurisdiction) “shall be considered as its decision that the deficiency is the amount determined by the Secretary.”

I think that could reasonably be read as “dismissal = affirming whatever is in the Notice of Deficiency” since that would appear to be the IRS determination that led to the case being brought. The code section doesn’t specifically direct that outcome -arguably, “the amount determined by the Secretary” could be more than the Notice of Deficiency if new issues were raised in the Answer, though that gets into hairy “presumption of correctness” issues not at play in Meyers.

However, more often the Tax Court and IRS are willing to enter a decision for an amount less than the Notice of Deficiency when a case is dismissed. As Judge Gustafson notes, “it is the frequent practice of this Court -often at the instance of the Commissioner to dismiss a case for failure to prosecute but to enter a decision in a deficiency amount smaller than what appears in the SNOD.”  Usually, this happens when the IRS has conceded some issues, but, Judge Gustafson notes, that isn’t the only circumstance: “we prefer […] to enter a decision based on the facts demonstrated by the evidence rather than as a punishment.” In other words, even when you have a bad actor that doesn’t prosecute their case and the IRS is standing by the SNOD the Court wants the right amount of tax when there is reason to believe the SNOD may be off.

Getting the right amount of tax rather than the most amount of tax… My eyes aren’t teary, I just have winter allergies.

Of course, the Tax Court does not take lightly the petitioner’s failure to prosecute. Judge Gustafson calls the failure to appear for cross “a most serious offense against the process” in our adversarial system, and does not wish to “reward[] the petitioner for his non-appearance.” But again, that isn’t enough to “punish” the taxpayer with an amount of tax that may be incorrect, so Judge Gustafson walks through the merits as if the case had been seen through to fruition.

Because a lot of the issues come down to the credibility of evidence, and because the petitioners have proven themselves to be extraordinarily non-credible (a little more on that in a moment), the vast majority of deductions are denied. Some deductions, however, are more mechanical. Judge Gustafson has no problem completely disallowing the ridiculous home office deductions, but notes that since 94% of the home mortgage interest payments were attributed to this (i.e. deducted on Schedule C), the petitioners should likely get that foregone 94% as an itemized deduction (i.e. deducted on Schedule A instead).

In sum, the SNOD was likely correct to disallow (almost) all the deductions, but it still didn’t quite get the right amount of tax after that. So we arrive at the procedural fix: what I’d style as a “conditionally” granted motion to dismiss. The IRS’s motion to dismiss is granted but only to the “extent of undertaking to enter decision in amounts of tax deficiencies smaller than those determined in the SNOD[.]” In other words, the case is dismissed, and a decision will be entered, but in an amount determined under Rule 155.

Everything appears to be neatly wrapped up. Except that there were two motions at play, and we have only resolved the motion to dismiss. What about the motion to impose sanctions under IRC 6673?

On the merits of the penalty, there is more to this than just the petitioner failing to show up for day two and taking egregious deductions. Petitioner husband pretty obviously created a fake receipt (one may say, committed fraud on the Court) for a charitable deduction from Habitat for Humanity, by altering the date to make it fall within the tax year at issue. Judge Gustafson doesn’t use the word “fraud,” but instead concludes that the husband “deliberately concocted a non-authentic receipt and tried to make the Commissioner and the Court assume it was authentic.” Fraud-lite, you may say.

Let’s just assume that the behavior and absurdity of the deductions are enough on the merits to warrant a penalty under IRC 6673. Are there any other hurdles that the IRS must clear?

Why yes, there (apparently) is: our old friend Graev and IRC 6751. Like any good story, this provided an unexpected twist. Although the penalty is proposed by motion, orally, at trial, Judge Gustafson finds that it would (likely) need written supervisory approval first. The IRS attorney had, in fact, asked their supervisor about the possibility of moving for an IRC 6673 penalty via email. But the supervisory response was simply “Print these for the court, please.” Cryptic, and apparently not enough to demonstrate approval.

The tax world has been abuzz recently with published opinions on IRC 6751. Procedurally Taxing has covered some here and here. Here, again, we have a designated order as bellwether for an emerging issue: none of the cases have ruled on whether written supervisory approval is needed in this context (i.e. a motion for court sanctions at trial). I fully anticipate that this order will result in either the IRS changing their procedures for such motions, or (less likely, in my opinion) litigating the issue.

Is that the end of the Myers saga? Not quite. In one final twist, we are reminded that the Court could impose the penalties sua sponte (perhaps “nudged” by the IRS motion). And the Court has (conveniently) found that it does not need written supervisory approval for imposing such penalties. See Williams v. C.I.R., 151 T.C. No. 1 (2018).

But in this instance Judge Gustafson decides to let them off with a warning and an indication that the Court may not be so forgiving in the future. A tantalizing cliff-hanger for the possibility of a sequel…