TEFRA + LCU = Confusion, Part 3

In today’s post Bob Probasco concludes his three-part series on General Mills and the intersection of TEFRA and “hot interest.” Part One can be found here. Part Two, here. Christine

In Part 1, I described the decision by the Court of the Appeals for the Federal Circuit in General Mills, Inc. v. United States, 957 F.3d 1275 (Fed. Cir. 2020), aff’g 123 Fed. Cl. 576. (2015).  The taxpayer’s refund suit sought recovery of $6 million of excessive underpayment interest, but the court dismissed the case based on a jurisdiction issue from a special TEFRA provision.  I thought that the court made a crucial assumption, never clearly stated, as to the conceptual framework for adjustments resulting from a TEFRA proceeding.  Part 2 explained why an alternative framework, which would have supported the taxpayer’s position instead of the government’s, is not only possible but perhaps the best way to think about these issues.  Because the court dismissed the case for lack of jurisdiction, based on the TEFRA provision, we didn’t get a decision regarding the merits issue, concerning whether the IRS has assessed too much interest.  It’s an issue that I had never dealt with before and I think the IRS’s position may be wrong.  That’s what today’s post, Part 3, is about.

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Background

The case involved two sets of tax returns and audits: those for the General Mills (“GMI”) corporate tax returns and those for partnership tax returns for General Mills Cereals, LLC (“Cereals”).  Various members of the GMI consolidated group were partners in Cereals, so the partnership tax returns – and any audit adjustments – for Cereals flowed through to GMI.  The IRS audited the 2002-2003 tax returns (both corporate and partnership) and later the 2004-2006 tax returns (same).  Although there are some slight differences between the audits for those two periods, for simplicity I will focus on the 2002-2003 tax returns.

Audits began for both GMI and Cereals in 2005 for these years.  The IRS issued a 30-day letter for the GMI audit on June 15, 2007, asserting proposed deficiencies of more than $143 million for 2002 and almost $83 million for 2003.  The partners in Cereals entered into settlement agreements in July 2010.  On August 27, 2010, the IRS issued a document described as a “notice of computational adjustment” to GMI, identifying additional underpayments, resulting from the Cereals audit, of about $16 million for 2002 and more than $33 million for 2003.

The IRS assessed additional taxes, penalties, and interest resulting from the Cereals audit in September 2010.  GMI paid all outstanding balances for these years, including interest, on April 11, 2011.  The IRS sent GMI detailed interest computation schedules for these years, apparently for the first time, on April 18, 2011 and April 20, 2011.  The schedules reflected that the IRS began charging a higher underpayment interest on July 15, 2007.  GMI filed refund claims on March 28, 2013, arguing that the interest IRS accrued and assessed was almost $6 million too high.  GMI then filed this refund suit on January 30, 2014.

The Basis for GMI’s Refund Claim – LCU Interest The interest rate for large corporate underpayments (LCU) is governed by section 6621(c), as supplemented by Treas. Reg. § 301.6621-3, which increases the normal underpayment interest rate by 2% for a corporate taxpayer’s underpayments that exceed $100,000.  It was enacted in 1990, as part of the Omnibus Budget Reconciliation Act, and has typically been referred to by practitioners ever since as “hot interest.”  There are two key concepts in determining whether, and when, to apply hot interest: the “threshold underpayment” and the “applicable date.”

Threshold Underpayment

Whether hot interest applies is not, oddly enough, determined by comparing the underpayment balance to $100,000.  The regulation establishes a “threshold underpayment,” a term of art that appears only here.  Hot interest applies if that amount, rather than the underpayment balance, exceeds the $100,000 statutory requirement.  The threshold underpayment is defined as the correct amount of tax (excluding penalties and accumulated interest) less all payments made by the last date prescribed for payment.  Thus, it appears to be a cumulative amount rather than the result of a particular transaction such as an audit.  (But see below regarding “applicable date.”)  Once hot interest is triggered, the higher interest rate would apply to the entire underpayment balance going forward, including interest and penalties and any amounts subsequently assessed.  Under the IRS interpretation, hot interest would apply even if the actual underpayment balance declines below the $100,000 threshold as a result of payments.

The existence of a threshold underpayment is determined only when there is an assessment, not merely because of a proposed deficiency.  (Contrast the determination of the “applicable date” discussed below.)  If the taxpayer receives a 30-day letter or a notice of deficiency for $110,000 but the amount is reduced to $90,000 prior to assessment, the threshold underpayment is only $90,000 and hot interest does not apply.  But even if an amount greater than $100,000 is originally assessed, the regulation states that hot interest will not apply if a subsequent judicial determination reduces the tax liability (and therefore the threshold underpayment) below $100,000.

The regulation doesn’t specifically address whether a subsequent administrative determination reducing the tax liability (e.g., an abatement resulting from a refund claim) would reduce the threshold underpayment, potentially below $100,000.  Based on the definition of the threshold underpayment in the Code, it should – but I haven’t run across a ruling on this specific question.  The IRS has challenged whether an abatement reduces the threshold underpayment but to my knowledge only in the specific context of an NOL carryback.  The IRS lost, in Med James, Inc. v. Commissioner, 121 T.C. 147 (2003), but in that case the reduction from an NOL carryback was asserted as a counterclaim in a deficiency proceeding.  If the abatement had been granted in an administrative determination, the taxpayer might have had to pay and file a refund claim/suit to address the hot interest issue.

Determining the amount of the threshold underpayment is complicated enough that the IRS can easily make mistakes.  But if you look at the amounts above, it’s clear that GMI met the threshold underpayment requirement.  That is only one part of the answer, though.  To determine whether/when hot interest applies, the IRS also must determine the applicable date. 

Applicable Date

Interest on underpayments generally runs from “last date prescribed for payment,” typically the unextended return due date.  The higher rate for hot interest only applies “for periods after the applicable date.”  For assessments subject to deficiency proceedings, the applicable date is 30 days after the earlier of a “letter of proposed deficiency which allows the taxpayer an opportunity for administrative review in the Internal Revenue Service Office of Appeals” (i.e., a 30-day letter) or the notice of deficiency.  That’s section 6621(c)(2)(A).

Section 6621(c)(2)(B)(i) is a special rule that applies to tax assessments not subject to the deficiency procedures; for such underpayments, the applicable date is 30 days after a letter or notice of the assessment or proposed assessment.  This would apply to certain taxes other than income tax.  This category also would include two common situations involving income tax: amounts shown on the original return but not paid on or before the last date prescribed for payment, and summary assessments for “mathematical or clerical errors.”

Although not explicitly addressed in the Code, the regulation includes within the scope of section 6621(c)(2)(B)(i) “underpayments attributable, in whole or in part, to a partnership item.”  For those, the applicable date would be the 30th day after the first letter or notice that notifies the taxpayer of an assessment of the tax.

The Code also identifies three exceptions under which a letter or notice that otherwise qualifies would not establish an applicable date and start hot interest running:

  • A 30-day letter or notice of deficiency that is withdrawn.
  • A 30-day letter or notice of deficiency for which the taxpayer pays the amount in full within 30 days after the letter or notice is sent.
  • Any letter or notice involving “small amounts,” that is, an amount that is not greater than $100,000 (as with threshold underpayment, excluding penalties and interest). 

As with threshold underpayments, the proper determination of the applicable date may be complicated and subject to error.  GMI believed that the IRS applied the law incorrectly and charged hot interest when it should not have.

IRS application and GMI’s argument

Interest at the normal underpayment interest rates generally (with some common caveats) begins as of the filing due date, without regard to extensions, rather than when the IRS made the assessments.  But the increased interest rate for hot interest starts only on the applicable date. What does that mean when there are multiple assessments, including adjustments flowing through from TEFRA audits?

The IRS position apparently is that hot interest starts, for the entire underpayment balance, as of the first applicable date for any component of that underpayment balance.  As noted above, GMI’s corporate audit resulted in a 30-day letter issued on June 15, 2007.  So the IRS interest calculations increased the interest rate starting on July 15, 2007, one month later, for the entire underpayment balance, including that attributable to the computational adjustments from the TEFRA audit.

GMI, on the other hand, read sections 6621(c)(2)(A) and (B)(i) as bifurcating the underpayments for these tax periods.  The portion of the underpayment attributable to the corporate audit and the portion of the underpayment attributable to the TEFRA audit would have separate applicable dates.  Hot interest for the portion of the underpayment attributable to the corporate audit might start as of July 15, 2007.  But the first letter or notice that notified GMI of an assessment of tax from the TEFRA audit was issued on August 27, 2010.  So hot interest for that portion of the underpayment shouldn’t start until September 26, 2010, more than three years later than the applicable date the IRS used. 

I think GMI’s position is certainly a reasonable interpretation.  The Code is, as almost always, ambiguous and the drafters may not even have considered this situation.  GMI’s particular situation, an assessment resulting from a corporate audit followed by an assessment resulting from a TEFRA audit, is not explicitly addressed anywhere in the 4-1/2 pages of regulations either.  There are six examples in the regulations, but none involve this situation.  Indeed, none of the examples even involve a partnership adjustment.

GMI pointed out that section 6621(c)(2)(A) already uses a “the earlier of” comparison between a 30-day letter and a notice of deficiency for which no 30-day letter was issued.  If Congress didn’t want to bifurcate the underpayments in a situation like GMI’s, why not simply include the provision regarding non-deficiency proceedings as 6621(c)(2)(A)(iii) instead of 6621(c)(B)(i)?  

I think it would be possible to carry the argument even further, arguing that hot interest applies only at the level of individual components of the underpayment balance, rather than the entire balance.  Other interest provisions apparently work that way, e.g., the “restricted interest” provisions in sections 6601(c) and 6611(e).  The references in section 6621(c) to letters or notices arising from specific adjustments, rather than to the entire underpayment balance, are very similar to the restricted interest provisions.  That arguably suggests the same approach of applying the special rule to components rather than the entire balance.

That interpretation could also be inferred from the exception in section 6621(c)(B)(iii), under which a letter or notice for a deficiency or assessment less than $100,000 does not start hot interest running.  Before that provision was added in 1997, hot interest would be triggered when the threshold underpayment from two or three separate transactions exceeded $100,000.  That’s reflected in Treas. Reg. § 301.6621-3(d), Example 2, which has not been revised to be consistent with the Code provision as amended in 1997.  What’s the purpose of section 6621(c)(B)(iii)?  Maybe it reflects a determination that hot interest should be applied only to individual transactions over $100,000, rather than a cumulative balance.  And maybe that implies that the applicable date should be determined separately for each of those transactions.

Further support is available from the exception in section 6621(c)(B)(ii), under which a letter or notice for which the taxpayer pays the amount in full within 30 days does not start hot interest running.  That looks very much like an incentive for quick payment, doesn’t it?  But if hot interest applies at the level of the entire underpayment balance rather than individual transactions, the incentive starts looking strange.  There is an extra incentive to pay quickly for the first deficiency/assessment that triggers hot interest, but that extra incentive goes away for the second, third, etc. deficiency/assessment.  Why would that be the case? I don’t recall ever seeing this issue before the Federal Circuit’s decision came out.  The case was filed in the Court of Federal Claims in 2014, and that court ruled in 2015, but I missed those at the time.  To my knowledge, this issue has not been addressed in any other cases.  (If anyone has seen it elsewhere, please let me know!)  So I was eager to see the court’s analysis.  Alas, there was none.  The case was dismissed for lack of jurisdiction, so we’re still waiting for the courts to rule on this issue.

TEFRA + LCU = Confusion, Part 2

In Part Two of this three-part series, Bob Probasco examines the dissenting view in the recent General Mills case out of the Federal Circuit. Part One can be found here. Christine

In Part 1, I described the decision by the Court of the Appeals for the Federal Circuit in General Mills, Inc. v. United States, 957 F.3d 1275 (Fed. Cir. 2020), aff’g 123 Fed. Cl. 576 (2015). The parties’ briefs on appeal can be read here: Opening Brief, Answer, and Appellant’s Reply. The taxpayer’s refund suit sought recovery of $6 million of excessive underpayment interest, but the court dismissed the case based on a jurisdiction issue from a special TEFRA provision.  I thought that the court made a crucial assumption, never clearly stated, as to the conceptual framework for adjustments resulting from a TEFRA proceeding. 

Part 2 explains why an alternative framework, that would have supported the taxpayer’s position instead of the government’s, is not only possible but perhaps the best way to think about these issues.  This case involved the intersection of TEFRA and the complex interest provisions of the Code.  The combination is messy. 

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Brief Recap of the Facts and the Majority’s Position The case involved partnership audits and adjustments for partnership tax returns for General Mills Cereals, LLC (“Cereals”).  Different members of the General Mills (GMI) consolidated group were partners in Cereals, so the tax returns—and any audit adjustments—for Cereals flowed through to GMI.  The IRS audited the 2002-2003 tax returns (both corporate and partnership) and later the 2004-2006 tax returns (same).  Although there are some slight differences between the audits for those two periods, for simplicity I will focus on the 2002-2003 tax returns.

Audits began for Cereals in 2005 for these years.  The partners in Cereals entered into settlement agreements in July 2010.  On August 27, 2010, the IRS issued a “notice of computational adjustment” to GMI, identifying additional underpayments resulting from the Cereals audit, of about $16 million for 2002 and more than $33 million for 2003. 

The IRS assessed additional taxes, penalties, and interest resulting from the Cereals audit in September 2010.  GMI paid all outstanding balances for these years, including interest, on April 11, 2011.  The IRS sent GMI detailed interest computation schedules for these years, apparently for the first time, on April 18, 2011 and April 20, 2011.  The schedules reflected that the IRS began charging a higher underpayment interest rate (“hot interest”) on July 15, 2007.  GMI filed refund claims on March 28, 2013, arguing that the higher interest rate should not have started until September 26, 2010.  It then filed this refund suit on January 30, 2014.

The government argued, and the majority agreed, that the relevant statute of limitations for such refund claims was the six-month period specified in section 6230(c)(2) for challenging erroneous computational adjustments rather than the two-year limitation period of section 6511.  As a result, the refund claims were filed untimely, and the case was dismissed for lack of jurisdiction.

The Dissent

The Federal Circuit’s decision was 2-1.  Judge Newman dissented and would have reversed the dismissal for lack of jurisdiction.  She thought section 6511, rather than 6230(c), applied to these refund claims.  Section 6231(a)(6) defines a computational adjustment as “the change in the tax liability of a partner which properly reflects the treatment under this subchapter of a partnership item.”  She concluded that the “payment of interest is not a ‘tax liability.’”  Further, “partnership item” should not be construed so “‘broadly as to cover claims that depend on the unique circumstances of an individual partner.’” (quoting Prochorenko v. United States, 243 F.3d 1359 (Fed. Cir. 2001)).  Thus, the refund claims were not correcting errors in computational adjustments of a partnership item; they were for refund of an overpayment of interest, to which the two-year limitation period in section 6511 apply.

Judge Newman found no hint in the TEFRA legislative history of any Congressional intent to truncate the two-year limitations period in section 6511.  She also quoted a 2001 Supreme Court case:  “[I]n cases such as this one, in which the complex statutory and regulatory scheme lends itself to any number of interpretations, we should be inclined to rely on the traditional canon that construes revenue-raising laws against their drafter.”

Possible Confusion Regarding the Conceptual Framework?

As I read the majority opinion and the applicable Code sections, it occurred to me that the analysis—as well as the regulation that defined resulting interest as a computational adjustment—rested in part on an assumption about the governing framework.  Specifically, the IRS, DOJ, and Court seem to think of adjustments to the partners’ returns as falling into two categories only:

  • Computational adjustments for which deficiency proceedings are required.  This encompasses (a) those for which partner-level determination are not necessary as well as (b) those for penalties, additions to tax, and additional amounts. 
  • Computational adjustments for which deficiency proceedings are not required.  This encompasses those for which partner-level determinations are not necessary. 

That seems consistent with the structure of former section 6230.  Section 6230(a)(2)(A) provides circumstances under which deficiency procedures apply and section 6230(a)(1) effectively is “everything else.”

The government puts interest in the second category, even though partner-level determinations are necessary.  (They certainly were in this case because the interest computations depended on information that was not part of the TEFRA proceedings.  The notice, and therefore applicable date used by the IRS, were part of the corporate audit.)  The decision to put interest into the second category perhaps was because interest doesn’t fit into the first category, which “shall apply to any deficiency attributable to . . ..”  Interest is not a tax liability and therefore is not included in the definition of deficiency and therefore does not fall within section 6230(a)(2)(A).  Where else can it be?  Only section 6230(a)(1).

But that is only the case if assessments of additional interest are computational adjustments.  The dissent concluded that interest assessments don’t fit within the definition of a computational adjustment.  An alternative framework would be that adjustments to partners’ returns, resulting from a partnership-level proceeding, fall into three categories:

  • Computational adjustments for which deficiency proceedings are required.  This encompasses (a) those for which partner-level determination are not necessary as well as (b) those for penalties, additions to tax, and additional amounts. 
  • Computational adjustments for which deficiency proceedings are required.  This encompasses (a) those for which partner-level determination are not necessary as well as (b) those for penalties, additions to tax, and additional amounts. 
  • Computational adjustments for which deficiency proceedings are required.  This encompasses (a) those for which partner-level determination are not necessary as well as (b) those for penalties, additions to tax, and additional amounts. 

In that case, the six-month period in section 6230(c)(2) only applies to the first two categories.  The third falls under the two-year period of section 6511 for normal refund claims.

This certainly seems as though it could have been what Congress intended.  Before TEFRA, we just had deficiency procedures and interest was not subject to those; it was just assessed after tax was assessed.  Did Congress intend partnership proceedings and computational adjustments to only address the same types of adjustments that deficiency proceedings covered—underlying tax, penalties, additions to tax, and additional amounts?  And then rely on the existing process for assessing interest, which is to simply assess it and require the taxpayer to pay and file a refund claim?  I haven’t done a deep dive into the legislative history, but that seems very plausible to me.  It’s also arguably the best interpretation under the definition of a computational adjustment quoted above in the discussion of the dissent.

There is a technical argument to the contrary that could support the majority’s position. 

  • Section 6601(e)(1) says that references to “tax” shall be deemed also to refer to interest, except for such references in subchapter B of chapter 63 (sections 6211-6216). 
  • So “tax” in section 6230(a)(2)(A) would include interest, but that section doesn’t mention “tax,” it refers to “deficiency”. 
  • And the reference to “tax” in section 6211(a), defining “deficiency,” doesn’t include interest.  Therefore, interest is not part of a deficiency. 

Thus, interest is included in the definition of a computational adjustment in section 6231(a)(6), which has a direct reference to “tax.”  But section 6230(a)(2)(A) has only an indirect reference (through section 6211) to tax, so interest is not included to the category of computational adjustments for which a deficiency proceeding is appropriate. 

But that’s highly technical and formal.  Common sense would say that—for purposes of the TEFRA provisions—if interest is not included in a deficiency for purposes of section 6230(a)(2)(A), it shouldn’t be included in a change to tax liability for the definition of computational adjustment in section 6231(a)(6).

The Court of Federal Claims opinion addressed this question, whether interest is incorporated in the definition of a computational adjustment, in more detail than the Federal Circuit’s decision.  The CFC didn’t rely entirely on the regulation and in fact suggested that would be insufficient by itself.  It cited several cases, some of which addressed a former version of section 6621(c), which increased the interest rate for “tax-motivated transactions” (TMT); the CFC, along with other courts, considered TMT interest analogous to hot interest.  But those cases never addressed the definition of computational adjustment, other than in the regulation.

For example, in N.C.F. Energy Partners v. Commissioner, 89 T.C. 741 (1987), the partnership sought to challenge penalties and TMT interest in its proceeding, although they were not asserted in the final notice of partnership administrative adjustment.  The IRS moved to dismiss those portions of the case for lack of jurisdiction.  The court concluded that additional findings of fact with respect to individual partners would be required, so those issues should not be addressed in the partnership proceeding.  The court did not directly interpret the definition of a computational adjustment, although it seemed to suggest that TMT interest would be addressed in a deficiency proceeding.

In White v. Commissioner, 95 T.C. 209 (1990), the IRS issued a notice of deficiency including TMT interest after the conclusion of the partnership proceeding.  The IRS moved to dismiss the interest determination from the deficiency proceeding.  The court agreed, 13-2 in a reviewed opinion.  That case, however, turned on the question of whether interest was included in a “deficiency.”  The court did not address how a later assessment of interest should be handled, as a computational adjustment or just a normal assessment of interest.

In Pen Coal Corp. v. Commissioner, 107 T.C. 249 (1996), the notices of deficiency had included tax, penalties, additions to tax, and additional amounts and had also determined that hot interest applied, without determining the amount.  The IRS sought to strike the interest determinations from the deficiency proceeding.  The court agreed, following White, but again did not interpret section 6231(a)(6).

Finally, in Olson v. United States, 172 F.3d 1311 (Fed. Cir. 1999), the taxpayers filed refund suits in the Court of Federal Claim.  They argued that various assessments (including TMT interest) resulting from a settlement of a partnership proceeding were invalid because they had received no notices of deficiency.  The CFC granted the government’s motion for summary judgement, concluding that notices of deficiency were not required and noting that no other basis for the refund was asserted.  The Federal Circuit agreed.  There was a brief reference to interest being included in the definition of a computational adjustment, but that mentioned only the regulation with no interpretation of the applicable Code section. 

Practical Considerations

The regulation stating that interest is included in a computational adjustment may have been influenced by an assumption—possibly shared by the DOJ and court—that interest computations are generally straight-forward and easy to verify.  If so, it might seem simplest to include interest in a computational adjustment not subject to deficiency procedures.  As with the allocation of the previously determined change in the underlying tax, errors would be rare but easily detected.  A computational adjustment, even with the abbreviated period within which to file a refund claim, would be a reasonable compromise.

However, while interest calculations for most taxpayers are indeed straight-forward and easy to verify, that is often not the case with large businesses who may have multiple changes to tax liability implicating several different issues of interest calculation.  Sometimes the law is not clear; other times the law is clear, but errors occur frequently.  Specialist firms provide taxpayers with reviews of interest computations to identify potential problems.  That process, however, can take a long time.

This also means that an abbreviated period within which to file refund claims relating to interest is not a good idea from a policy perspective.  The description in the Federal Circuit’s decision suggests that by the time GMI received the April 2011 interest computation schedules it had all the necessary information to identify the basis for a refund claim based on when hot interest rates should apply.  But that was more than six months after the August 2010 notice that the CFC considered the initial notice of computational adjustment.  It was even more than six months after the assessment of interest in September 2010.  I defy anyone to look at a lump sum assessment of interest for a large corporate taxpayer and be able to determine how that amount was calculated.

Even if the Federal Circuit decided that the April 2011 schedules were the initial notice of computational adjustment with respect to interest, six months is still not a lot of time within which to file a comprehensive refund claim covering all interest errors that might have been contained in those computations.  Rushing to file a refund claim based only on the issue concerning hot interest might have risked forfeiting claims based on other issues.

Thus, even if the correct legal determination were that the six-month period to file refund claims applied to computational adjustments relating to interest, it seems like a bad policy choice.

Conclusion  

Between the dissent, the alternative framework for classifying adjustments arising from a TEFRA proceeding, and the practical considerations, there seems to be at least a reasonable argument that interest should not be included in the definition of computational adjustments and not subject to the accelerated refund claim provisions of section 6230(c).  But that’s now what the regulation the IRS wrote say—and challenging the validity of the regulation would be difficult—and that’s not what the Federal Circuit decided.

This concludes the discussion of the TEFRA jurisdictional issue.  Part 3 addresses the substantive issue: exactly when the higher hot interest rate should have started.  It’s a complicated issue in these specific circumstances and, to my knowledge, has not yet been ruled on by any court.

TEFRA + LCU = Confusion, Part 1

We welcome back guest blogger Bob Probasco for a three-part series inspired by the Federal Circuit’s recent 2-1 decision tossing General Mills’ refund claim as untimely under TEFRA, although the claim would have been timely under the standard timeframes of section 6511. Part 1 sets the stage and examines the majority’s reasoning. Christine

On April 23, 2020, the Court of the Appeals for the Federal Circuit issued its decision in General Mills, Inc. v. United States, 957 F.3d 1275 (Fed. Cir. 2020), aff’g 123 Fed. Cl. 576 (2015).  The taxpayer’s refund suit sought recovery of $6 million of excessive underpayment interest it had paid to the IRS.  The court ruled for the government and dismissed the case.  It’s an unusual case, with aspects I had never dealt with before, so I thought Procedurally Taxing readers might enjoy it.  Fair warning, though: the TEFRA partnership audit procedures are complicated, as are the “large corporate underpayment” (LCU interest, or “hot interest”) provisions of the Code.  When they intersect, turbulence is likely.

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The Facts

The case involved two sets of tax returns and audits: those for the General Mills (“GMI”) corporate tax returns and those for partnership tax returns for General Mills Cereals, LLC (“Cereals”).  Different members of the GMI consolidated group were partners in Cereals, so the tax returns—and any audit adjustments—for Cereals flowed through to GMI.  The IRS audited the 2002-2003 tax returns (both corporate and partnership) and later the 2004-2006 tax returns (same).  Although there are some slight differences between the audits for those two periods, for simplicity I will focus on the 2002-2003 tax returns.

Audits began for both GMI and Cereals in 2005 for these years.  The IRS issued a 30-day letter for the GMI audit on June 15, 2007, asserting proposed deficiencies of more than $143 million for 2002 and almost $83 million for 2003.  The partners in Cereals entered into settlement agreements in July 2010.  On August 27, 2010, the IRS issued a “notice of computational adjustment” to GMI, identifying additional underpayments, resulting from the Cereals audit, of about $16 million for 2002 and more than $33 million for 2003. 

The IRS assessed additional taxes, penalties, and interest resulting from the Cereals audit in September 2010.  GMI paid all outstanding balances for these years, including interest, on April 11, 2011.  The IRS sent GMI detailed interest computation schedules for these years, apparently for the first time, on April 18, 2011 and April 20, 2011.  The schedules reflected that the IRS began charging a higher underpayment interest rate (“hot interest”) on July 15, 2007.  GMI filed refund claims on March 28, 2013, arguing that the higher interest rate should not have begun until September 26, 2010.  As a result, the IRS had accrued almost $6 million too much interest.  GMI then filed this refund suit on January 30, 2014.

The “hot interest” issue underlying the claim is intriguing and I was looking forward to reading the court’s analysis of it.  But the opinion focuses instead on the jurisdictional TEFRA provision that formed the basis of the government’s motion to dismiss.  I’ll have more discussion of the hot interest issue in Part 3.  But because the taxpayer lost on the jurisdictional issue, we will have to wait for another day for a court decision on the merits issue.

The Jurisdictional Question—TEFRA Computational Adjustments

Framework

A preliminary reminder:  the TEFRA provisions—Subtitle F, Chapter 63, Subchapter C—were stricken and replaced with a new regime for partnership audits, by the Bipartisan Budget Act of 2015.  References herein to specific Code sections are to the TEFRA versions, not the BBA versions.

As we all remember, TEFRA established unified partnership audit proceedings, with special rules for assessments of partners based on any resulting adjustments to the partnership tax return.  The changes to the partners’ tax liabilities to reflect the partnership adjustments are called “computational adjustments,” section 6231(a)(6).  Computational adjustments were initially understood as falling into two categories, depending on whether a partner-level determination was required.  If no such partner-level determination was required, the IRS simply assessed any additional amounts due.  (Mechanical applications, such as recalculating an itemized deduction for medical expenses, were not considered “determinations.”)  If a partner-level determination was necessary, the IRS had to issue a notice of deficiency, providing an opportunity for judicial review. 

The two categories became three with the Taxpayer Relief Act of 1997.  Penalties had been identified as a problem.  There might be necessary partner-level determinations to address penalty defenses.  Litigating those defenses (including defenses by indirect partners) in a partnership-level proceeding was not considered feasible but removing all penalties to deficiency proceedings was not an ideal approach either.  Thus, whether a penalty generally applied would be resolved in a partnership-level proceeding.  The IRS could then proceed to assessment without a deficiency proceeding, requiring partners to raise partner-level defenses in a refund claim/suit.  So the categories were:

  • Adjustments for which a partner-level determination was not required (immediate assessment allowed).
  • Adjustments for which a partner-level determination was required, other than penalties, additions to tax, and additional amounts (deficiency proceeding required).
  • Adjustments for penalties, additions to tax, and additional amounts (immediate assessment allowed).

Those were specified in section 6230(a).  Although that section didn’t address interest, the IRS did, by regulation.  Treas. Reg. § 301.6231(a)(6)-1(b) provides that a “computational adjustment includes any interest due with respect to any underpayment or overpayment of tax attributable to adjustments to reflect properly the treatment of partnership items.”  The IRS treats such adjustments of interest as computational adjustments that can be assessed immediately.

Claims Arising Out of Erroneous Computations

For computational adjustments that are assessed directly and cannot be challenged in a deficiency proceeding in Tax Court, section 6230(c) provides an opportunity for challenge.  The taxpayer may file a refund claim for erroneous computations that:

  • Are necessary to apply the results of a settlement, final partnership administrative adjustment (if not challenged in Tax Court), or a Tax Court decision challenging the FPAA. 
  • Impose any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item.

These refund claims “shall be filed within 6 months after the day on which the Secretary mails the notice of computational adjustment to the partner.”  Thereafter, a refund suit can be brought within the period specified in section 6532(b) for refund suits.  And section 6511(g) provides that section 6230(c) applies, rather than section 6511, with respect to tax attributable to partnership items.

I’ve actually never dealt with a section 6230(c) refund claim before and perhaps others haven’t either.  This case was a good reminder of the different limitation period.  But it’s particularly fascinating because of a quirk introducing when dealing with interest resulting from a TEFRA proceeding.

Application in GMI’s Case

The Notices GMI Received

Let’s start with the communications at the conclusion of the Cereals (partnership) audit, as those were relevant to the basis for the motion to dismiss.  The IRS and GMI executed a settlement agreement on July 27, 2010.  It addressed “any deficiency attributable to partnership items, penalties, additions to tax, and additional amounts that relate to adjustments to partnership items, as set forth in the attached Schedule of Adjustments (plus any interest provided by law.)”  The same “any interest provided by law” language also appeared elsewhere in the settlement agreement, but there was no reference to hot interest or even the amount of interest that would result.

On August 27, 2010, the IRS sent a cover letter with Form 5278, Statement—Income Tax Changes.”  That form included a line for “Balance due or (Overpayment) excluding interest and penalties” with a corresponding dollar amount.  No amount was shown for interest, but the cover letter stated that the IRS “will adjust your account and figure the interest.”  Still no reference to hot interest.  The IRS assessed the tax deficiencies plus interest (including hot interest) on September 3, 2010, but no schedule showing how the amount of interest had been computed was sent to GMI at this time. 

On April 18, 2011, the IRS sent GMI an interest computation schedule for each of the four years, showing that hot interest began running on June 15, 2007—the date of the notice of proposed deficiency for the corporate audit.  The IRS sent another interest computation schedule for one of the years on April 20, 2011.

GMI paid the additional taxes and interest (including hot interest) on April 11, 2011.  It then filed refund claims on March 28, 2013, within the traditional two-year period after the payment in section 6511, and then this refund suit.  The government filed a motion to dismiss, arguing that the six-month period of section 6230(c) applied and therefore the refund claims were filed too late.

The Majority Opinion

GMI’s attorneys did a very professional, thorough job of identifying arguments that the refund claims were timely.  The majority opinion in the Federal Circuit shot them all down.

The notices received did not qualify as “computational adjustments.”  The majority’s response: Treas. Reg. § 301.6231(a)(6)-1(b) specifically included interest in the scope of computational adjustments and GMI did not challenge the validity of the regulation.  The Court of Federal Claims also cited several cases, including the Tax Court and other Circuit Courts, that it concluded supported the conclusion that interest is a computational adjustment.

However, I think (and the dissent may have agreed) the validity of the regulation is not clear.  And I don’t find the cases cited by the Court of Federal Claims very persuasive either.  Stay tuned for further discussion in Part 2.

Refund claims for “computational adjustments” only cover computation errors, not the legal error that GMI alleged.  The majority relied on the fact that section 6230(b) addressed “mathematical and clerical errors appearing on partnership returns,” implying that section 6230(c) must refer to a different class of errors.  It also cited a Seventh Circuit that reached the same conclusion, for the same reason. 

This isn’t entirely persuasive either.  An alternative, and to my mind more persuasive, distinction would be that section 6230(b) concerns mathematical or clerical errors on the partnership return while section 6230(c) concerns errors in a computational adjustment to make the partner’s return consistent with a substantive adjustment to the partnership return in a TEFRA proceeding.  Two entirely different things, aren’t they?  And most direct assessments (other than interest) without deficiency proceedings can only be challenged based on: (a) mathematical errors in allocating the change in tax liability; or (b) partner-specific penalty defenses.

The section 6230(c) refund claim provision applies only to adjustments necessary to apply the settlement, but the partnership audit and settlement did not address how hot interest should be computed.  GMI pointed out that (a) the partnership settlement agreements did not cover any aspect of how interest would be computed and (b) a global settlement agreement had explicitly carved out any implication that GMI had agreed to interest computations.  The court’s response focused on the boilerplate language “any interest provided by law.” 

I don’t consider this persuasive either.  Can you imagine a settlement agreement concerning the underlying tax liability that, instead of identifying the specific adjustments, said “any adjustments to income or expenses provided by law”?   Of course not.  That’s not a “settlement” in any normal sense of the word.  Similar boilerplate language about interest abounds in tax controversy but I’ve always considered that as intended simply to avoid any implication, by omission, that the parties had agreed that interest would not apply.  I don’t think boilerplate language like that has ever been interpreted to mean that the parties had settled on the resulting computation.  The fact that interest was “clearly contemplated” doesn’t mean that it was settled.

Section 6511 also applies and is an alternative available to taxpayers.  Here, the court relied on the general principle that a narrower, specifically drawn statute pre-empts a broader provision.  That’s generally true, although it may not always apply. 

For policy reasons, the section 6230(c) refund claim provision should not apply to claims that are entirely due to a partner’s unique factual circumstances.  This seems one of GMI’s less persuasive arguments, and the court simply pointed out there was no authority to support this position.

Section 6230(c) only applies to refund claims that are attributable to partnership items and the “applicable date” that GMI was disputing is not a partnership item.  As with the preceding item, this was a difficult argument and the court disagreed that a “partnership item” was a general requirement for all these refund claims.  Although the court did not go into detail, there is a structural argument.  The only reference to “partnership item” in that provision is in section 6230(c)(1)(A)(i), which relates to a computational adjustment to make the partner’s return consistent with the partnership return.  That sounds very much like making the partner’s return consistent with the partnership return as filed.  By comparison, section 6230(c)(1)(A)(ii) addresses computational adjustments relating from a TEFRA audit—settlement, FPAA, or court decision.  Section 6230(c)(1)(A)(i) would cover GMI’s situation, and it does not mention “partnership item.”  Neither does section 6230(c)(2), which governs the refund claims, mention “partnership item.” 

The notices received by GMI did not provide adequate notification of the determination.  The Court of Federal Claims seemed to consider even the initial notice on July 27, 2010, to have provided adequate notification.  It relied on GMI’s acknowledgement that “interest is generally the type of item that is ‘implicit in a computation of tax with respect to settled items so that it need not be expressly computed or even identified in the notice of computational adjustment that applies to the settlement.’”  Interest may be straight-forward in other contexts but certainly was not here. 

However, the Federal Circuit relied instead on the interest computation schedules received in April 2011 as providing adequate notice.  From the court’s description, it appears those did make it clear that hot interest would be applied and what applicable date would apply.  GMI argued those were still insufficient because they didn’t mention the six-month limitation period in section 6230(c) or even that a jurisdictional period was being triggered.  In addition, the schedules didn’t mention the TEFRA proceeding or segregate interest arising from the corporate audit for that arising from the Cereals audit.  The court simply rejected those as not required elements of a notice of computational adjustment.

And so, the majority dismissed the case for lack of jurisdiction.  Unless/until the issue comes up in another circuit, that decision will stand.  But it’s not necessarily the correct decision.  In Part 2, I’ll briefly summarize the dissent and then add some further thoughts on how the framework applied by the majority is arguably not the best way to think about these types of adjustments.  A different conceptual framework could lead to a decision in the taxpayer’s favor.

The Validity of Near Duplicate Notices, Designated Orders: November 18 – 22, 2019

Five orders were designated during the week of November 18 – November 22, 2019 and the most interesting two are discussed below. The orders not discussed involve an unchallenged American Opportunity Tax Credit denial (here), a motion for failure to prosecute an absent petitioner (here), and a bench opinion involving frivolous returns and whether more than one section 6702(a)(1) penalty should apply (here).

Docket No. 11284-18, SNJ Limited, Ritchie N. Stevens & Julie A. Keene-Stevens, Partners other than the Tax Matters Partner v. CIR (Order Here)

In this first order the Court addresses the IRS’s motion to dismiss for lack of jurisdiction. This case is before the Court on notices of federal partnership administrative adjustment (“FPAA”), and the outcome of the IRS’s motion depends on whether the FPAAs are valid.  

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Validity is at issue because the two separate near duplicate sets of notices, for the same tax periods, were sent a few months apart from each other. Petitioners timely petitioned the Tax Court based on the date on the second set of notices, however, section 6223(f) states that only one FPAA can be valid (with some limited exceptions not applicable here) – which means that if the first set notices is valid, then the second is not and petitioners’ petition was not timely filed.

The notices pertain to 2006 and 2008. The first set was mailed in November of 2017 and the second in February of 2018. Petitioners oppose the IRS’s motion to dismiss by arguing that the first set of notices are not valid, because they were not sent to petitioners’ correct address.

In addition to that argument, but not specifically raised by petitioners, the Court considers whether the November notices are not valid by looking to the reason why the February set of notices covering the same periods were sent.

First, regarding petitioners’ address-related argument, the Court looks to section 6223(c)(1), which requires the IRS to send the FPAAs to the names and addresses listed on a partnership return. In this case, the partnership did not file returns for either year at issue. The IRS is obligated to use another address if it is provided in the manner specified in Treas. Reg. Sec. 6223(c)-1(b)(2) and (b)(3)(v), which is in a written statement signed by the person supplying it, and filed with the service center where the partnership return is filed.

Petitioners did not provide a new address in this manner, and instead, listed the allegedly incorrect address on unsigned returns provided during the examination. The IRS is permitted, though not required, to use the address provided on these unsigned returns pursuant to Treas. Reg. 301.6223(c)-1(f) and that is what it did. The IRS also sent a set of FPAAs (in November and February) to what it believed to be the Tax Matters Partner’s (“TMP”) address. Petitioners argue that address was not the TMP’s address. Petitioners, however, received the February FPAAs sent to that address because they were attached to their petition. As a result, the Court finds that the November FPAAs were not invalid as a result of being incorrectly addressed.

The Court then goes on to evaluate why a second set of FPAAs was even sent – was there an issue with the first set that calls into question its validity?

The IRS explains that it sent the second set of FPAAs out of an abundance of caution because an incorrect partnership name was used on a schedule attached to the November FPAAs. The correct partnership name was used on FPAAs themselves, the FPAAs and schedule listed the partnership’s correct EIN, and the adjustments reflected on the schedule appear to be based on information for the correct partnership. In other words, it was only the partnership name used on the schedule that was incorrect and nothing else, and as a result, the Court determines that doesn’t impact the validity of the November FPAAs. 

In making this determination the Court looks to Campbell v. CIR, 90 T.C. 110, 113-114 (1998), which upheld the validity of a notice of deficiency that named another taxpayer (and even listed amounts related to that other taxpayer) in an attached schedule. Although this case involves FPAAs, rather than a notice of deficiency the Court points out that “the standards governing the validity of an FPAA are less exacting than those governing the validity of a statutory notice of deficiency” and “for an FPAA to be valid it needs to only provide ‘minimal notice’ that the IRS has finally determined adjustments to the partnership return.”

The Court determines that even with the error the November FPAAs meet the “minimal notice” test and are valid. As a result, petitioners’ petition is not timely, the Court does not have jurisdiction, and the case is dismissed.

Docket No. 11229-15, Michael J. Hogan v. CIR (Order Here)

In this bench opinion the Court addresses the IRS’s motion for partial summary judgment on an interest abatement request related to petitioner’s 1994 and 1995 balances. It also addresses the IRS’s motion to compel, which I do not discuss. The years at issue do cause one to wonder why these balances still exist nearly 25 years later, but was the delay caused by an IRS ministerial act?

More information on the interest abatement request is found in an earlier order (here), but to summarize: the Form 843 was submitted in 2012 and requested abatement for interest accrued, according to petitioner, as a result of the returns being “put in a drawer by IRS/CID agent .  .  .” and “not filed by the IRS and processed until August 13, 2001.”  The petitioner never clearly stated the exact period for which he is requesting interest abatement.

The period referenced in the IRS’s motion for partial summary judgment in the earlier order was from the return due dates in 1995 and 1996 through when the original returns were filed in September 1997. The IRS was granted summary judgment with respect to that limited period because petitioner did not assert there was a delay caused by a ministerial act (or any genuine issue of material fact) for the 1995 – 1997 period.

It’s also relevant that in 1999 petitioner pled guilty to conspiring to defraud the government and tax evasion related to his 1994 and 1995 tax years. Pursuant to terms of the agreement, petitioner filed amended tax returns for those years in 2001.

The Court found that all of petitioner’s interest abatement related assertions are for the period after he filed his original returns in 1997, and it is (partially) that period which is addressed in this order. The IRS’s motion here requests that the Court grant summary judgment for the period from 1997 through November 21, 2000, which is the date both parties agree the criminal proceedings related to 1994 and 1995 terminated.

Relying on similar cases cited by the IRS (Badaracco v. CIR and Taylor v. CIR), which reference generally the IRS’s right to take more time evaluating cases that involve fraud or criminal proceedings, the Court decides petitioner is not entitled to interest abatement for the 1997 – 2000 period for either tax year and grants IRS’s motion for partial summary judgment.

The bench opinion doesn’t discuss whether periods after 2000 remain at issue in this case, but I assume they do since only a limited period is addressed by the IRS’s motion. Although the Court acknowledges that it is unclear, petitioner’s interest abatement request may include the interest accrued until at least 2012 when the Form 843 was submitted.

Sanctions, Converted Items Confusion and More, Designated Orders: October 14, 2019 – October 25, 2019

Only one order was designated during Patrick Thomas’s week, the week of October 14, 2019, and two during mine, the week of October 21, 2019. As a result, this is a joint post from Patrick and me covering both weeks. It begins with Patrick’s coverage of the one order designated during his week.

Docket  No. 12646-19, Brown v. C.I.R. (Order Here)

This short order displays the power of the Tax Court to sanction taxpayers who raise frivolous arguments or institute proceedings in the Court merely for purposes of delay. The Tax Court has a busy docket, handling approximately 25,000 new cases each year. Frivolous claims and proceedings instituted merely for purposes of delay clog that docket, at the expense of taxpayers who have legitimate disputes with the Service.

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This case deals with Petitioner’s 2008 federal income taxes—with a petition filed on July 9, 2019. Given that timing, Respondent unsurprisingly filed a motion to dismiss for lack of jurisdiction, presumably arguing that Petitioner failed to file the petition within 90 days of the notice of deficiency.

The Petitioner in Brown had previously filed three cases in the Tax Court. In Docket 7375-18, he failed to pay the Court’s filing fee, and the case was accordingly dismissed. In Docket 4754-19, he raised a constitutional challenge to paying the filing fee, which the Court swiftly disposed of; constitutional challenges to the payment of filing fees are rarely successful. And after all, if Petitioner had a financial inability to pay the fee, the Tax Court provides a remedy through the fee waiver application. 

Finally, in a case entitled “Estate of Ernest Richard Brown v. Commissioner”, at Docket 12335-11, the Court likewise dismissed the case due to failure to pay the fee and to properly prosecute the case.

Judge Carluzzo, in the present order in Docket 12646-19, notes that “a copy of the notice of deficiency [for 2008] is attached to the petition filed May 24, 2011,” but that in the present case, Petitioner denied ever receiving the notice. Accordingly, he regards that allegation as “patently false”.

Accordingly, Judge Carluzzo not only grants Respondent’s motion to dismiss, but also imposes a $500 penalty for the “frivolous pleading” in this case. I’m not sure if this low amount will dissuade Petitioner from continuing to challenge the liability. But as we’ve seen before, further frivolous proceedings will only lead to escalating penalties. And while the 6673 penalty is limited to $25,000, the penalty is imposed on any “proceedings” instituted before the Court—suggesting that the penalty could exceed $25,000 if Petitioner continues to file frivolous pleadings.

Docket Nos. 1143-05, 1144-05,1145-05, 1334-06,1335-06, 1504-06, 20673-09, 20674-09, 20675-09, 20676-09, 20677-09, 20678-09, 20679-09, 20680-09, 20681-09, David B. Greenburg, et. al. v. C.I.R. (Order Here)

This order involves a long-running consolidated, in-part TEFRA-related and in-part-deficiency-related case. It previously had orders designated during my week in September, which I didn’t specifically address, but now feel is unavoidable.

I must admit its significance is a bit lost on me – likely because it lives (somewhat) in the world of partnerships and TEFRA. 

The case was already heard, decided (the opinion is here) and is in the computation stage, but the petitioners moved the Court to dismiss the case for lack of jurisdiction in August and the Court addressed- and denied – the motion. This most recent order was filed in October and asks the Court to reconsider that denial. 

The October motion reiterates the arguments in the August motion, which seem to also be arguments that were addressed in the opinion (but with more focus on an issue with the partnership’s TEFRA election).

So what is it that petitioners keep arguing about? The IRS had sent notice to the petitioners about converting certain specified items into non-partnership items as result of a criminal investigation. This is permitted by section 6231(c)(1)(B). Once the items are converted, they are subject to deficiency proceedings rather than TEFRA proceedings because they are no longer considered to be partnership items.

Petitioners argue the Court does not have jurisdiction because the IRS asserted that certain items were converted items, when they were actually non-partnership items. This confuses the Court, because converted items are considered non-partnership items.

In other words, the crux of the petitioners argument is that a distinction should be made between “partnership items originally, but converted under TEFRA into nonpartnership items” and “items that aren’t converted into nonpartnership items by a converted items notice of deficiency because they are already nonpartnership items” and the Court doesn’t have proper jurisdiction over the latter.

The Court said it cannot make this jurisdictional distinction without some legal authority for doing so. It finds that it has jurisdiction over all of the items, even though the way in which the items became subject to the Court’s jurisdiction differed.

The Court acknowledges that the parties have preserved this issue for appeal (which is likely petitioners’ goal) and denies petitioners’ motion to dismiss yet again. 

Docket No. 17286-18, Michael Sestak v. CIR (Order Here)

In this order, Judge Buch holds the IRS to a high standard (ironically, its own) when applying the last known address rule.

Petitioner notified the IRS of his change of address when he began serving a five-year sentence in a federal prison – the only part that he did not communicate was his prison registration number, which is the number used to identify individual inmates. The IRS received this correspondence because petitioner also requested an abatement of failure to file penalties due to the reasonable cause of his imprisonment, which the IRS granted.

In addition to petitioner’s correspondence, a relative of petitioner sent a letter to the IRS that discussed petitioner’s prison sentence and included petitioner’s new address, this time with his prisoner registration number. The IRS retained this letter in its records.

Then the IRS sent petitioner a notice of deficiency to the address petitioner provided without the prisoner registration number. The petitioner never received the notice of deficiency and only became aware of it after he started receiving collection notices. A year and a half after the notice of deficiency was sent, petitioner petitioned the Tax Court.

IRS moves to dismiss the case for lack of jurisdiction because the petition was not timely filed, arguing that it reasonably relied on petitioner’s letter (which, again, did not list the prisoner registration number) when it sent the notice to petitioner’s last known address.

If the IRS does not exercise reasonable diligence and sends a notice of deficiency to an incorrect address, the notice of deficiency is deemed invalid. The Court addressed this issue more generally in Keeton v. Commissioner, holding that the IRS did not use the last known address when it knew the taxpayer was incarcerated and didn’t send the notice to the prison.

This order takes that decision one step further. The IRS was aware of the incarceration and sent the letter to the prison, but the Court still finds that that wasn’t enough.

Referencing the IRM (while acknowledging its non-precedential value), the Court states,

The Commissioner’s own manual gives instructions for mailing notices of deficiency to incarcerated taxpayers. The Internal Revenue Manual (IRM) states that the address on the notice of deficiency “should reference the prisoner locator number, if available.” The IRM provides a link to the Bureau of Prisons website where Service personnel may find prison locator numbers and addresses. The IRM thus states that a complete address for a prisoner contains the prisoner registration number and then provides a link to find that number. Therefore, the Commissioner knew he had an incomplete address for [petitioner] because the IRM stated that a prisoner address should contain the prisoner’s registration number.

The IRS asserts that it acted reasonably because the notice was sent by the Automated Underreporter System to the address on file. The Court finds that requirements under the last known address rule of section 6212(b) do not depend on which system the IRS uses to mail the notice and due diligence is required when the IRS is aware an address is incorrect or incomplete. The Court dismisses the case for lack of jurisdiction but not on the IRS’s proposed basis, but rather on the basis that the notice of deficiency was invalid since it was not sent to the taxpayer’s last known address.

Taxpayer Barred from Raising TEFRA Adjustments in Collection Due Process Hearing

The case of Davison v. Commissioner, T.C. Memo 2019-26 raises the issue of contesting the merits of adjustments contained in a Final Partnership Administrative Adjustment (FPAA). The Tax Court determines that Mr. Davidson cannot raise the merits of those issues which resulted in computational adjustments to his return. He argued that he never had a chance to raise those issues. Essentially, the court says too bad. He also sought to raise the issue of the penalty imposed on him due to the amount of the adjustments. The court signals that he might have been able to raise that issue had he done so when he made his Collection Due Process (CDP) request but having failed to raise the separate penalty issue when he submitted his request he could not do so during the Tax Court proceeding.

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Mr. Davison was a partner in a partnership that had an interest in two other partnerships. The IRS audited the partnerships he did not directly own and made adjustments. Those adjustments flowed through to his individual return through the partnership interest he did own. Although the IRS sent the FPAA regarding the adjustments to the tax matters partners of the two partnerships, no one petitioned the Tax Court.

Years later as the IRS began to collect from him Mr. Davison requested a CDP hearing and sought in the hearing to raise the issue of his underlying liability. The Settlement Officer in Appeals told him that he could not do so and he ultimately petitioned the Tax Court. In Tax Court he tried to raise the issue of the liability arguing that he had not previously had the opportunity to litigate the merits of the tax assessed against him. As with most things involving TEFRA, things get tricky.

This is not the first case involving this issue which does not surprise me given that two decades have passed since Collection Due Process came into existence; however, I had not noticed this issue before. I thought that perhaps others may not have noticed the issue since it does not arise with great frequency in litigation. The prior decisional law drives the outcome in this case.

The Court states:

In Hudspath v. Commissioner, T.C. Memo. 2005-83, aff’d, 177 F. App’x 326 (4th Cir. 2006), we addressed whether a taxpayer may contest his underlying income tax liability in a CDP case to the extent that this liability was based on computational adjustments resulting from a TEFRA proceeding. The case involved only income tax assessments for the taxpayer’s 1996 and 1997 taxable years that were attributable to computational adjustments resulting from two FPAAs. Those FPAAs had been the subject of a TEFRA proceeding that this Court ultimately dismissed for lack of jurisdiction. We held that pursuant to section 6330(c)(2)(B), the taxpayer was precluded from challenging the existence or amount of his 1996 and 1997 underlying income tax liabilities because he had had the opportunity, in the TEFRA proceeding, to challenge the partnership items that were reflected on the two FPAAs.

The instant case is indistinguishable from Hudspath. Pursuant to section 226(a) and (b), within 90 days of the mailing of an FPAA a tax matters partner may file a petition with this Court or other referenced Federal court for readjustment of the partnership items; and if the tax matters partner fails to file such a petition, any notice partner may file a petition for readjustment within 60 days after the 90-day period has closed. Here, the parties stipulated that on October 4 and 20, 2010, the IRS issued the Cedar Valley FPAA and the TARD Properties FPAA, but no petition was ever filed pursuant to this statutory prescription challenging either FPAA. These defaulted FPAAs then became binding and conclusive upon petitioner, allowing the IRS to make the computational adjustments to income that petitioner desires to place in dispute. See sec. 6230(c)(4); Genesis Oil & Gas, Ltd. v. Commissioner, 93 T.C. 562, 565-566 (1989). It is undisputed that petitioner’s income tax liability for 2005 was attributable solely to the computational adjustments resulting from the defaulted Cedar Valley FPAA and the defaulted TARD Properties FPAA. Accordingly, petitioner’s “earlier opportunity to dispute his liability” for income tax for 2005 was the opportunity to commence a TEFRA proceeding challenging the FPAAs upon their issuance.

Mr. Davison’s problem with this analysis stems from his lack of knowledge of the earlier opportunity to go to Tax Court. He complains that he never received notice of the FPAA and had no voice in whether the partnerships would file a Tax Court petition. He contends that he only learned about the FPAAs after the time to petition the Tax Court had passed. The IRS did not put on any evidence to contest his statement on this point – not that it was obligated to do so. There was also no indication that the IRS knew he was an indirect partner of the entities to which it issued the FPAAs. The court explained why this did not matter with respect to the issue of whether Mr. Davison could raise the underlying merits in the CDP case:

Under section 6223(h)(2), the tax matters partner of Six-D [this is the partnership in which Mr. Davison owned an interest] was required to forward copies of the Cedar Valley FPAA and the TARD Properties FPAA to petitioner. Furthermore, in any event, “[t]he failure of a tax matters partner, a pass-thru partner, the representative of a notice group, or any other representative of a partner to provide any notice or perform any act * * * [such as an appeal to an FPAA] does not affect the applicability of any proceeding or adjustment * * * to such partner.” Sec. 6230(f); Kimball v. Commissioner, T.C. Memo. 2008-78, slip op. at 9. Because petitioner indirectly held interests in Cedar Valley and TARD Properties and section 6223(c)(3) is of no avail here, the IRS was not required to provide him individual notice of the FPAAs.

Therefore, we find that petitioner had a prior opportunity to challenge his liability for income tax attributable to the computational adjustments resulting from the defaulted TARD Properties FPAA (as well as the defaulted Cedar Valley FPAA) and is precluded from challenging this liability in this case.

So, Mr. Davison does not have the opportunity to raise the merits of the partnership adjustments in his CDP case. While harsh, this result is the same result outside of CDP and is a feature of the way TEFRA operates with respect to certain affected items. The case does not discuss what possibilities of success Mr. Davison might have had if the court had allowed him to contest the underlying liabilities. It seems that the tax matters partners would have raised the issue if a meritorious case existed. He was removed from those partnerships and would likely have had a difficult time marshalling the evidence to contest the liabilities even if he had been given the opportunity.

In addition to contesting the underlying liability, Mr. Davison sought to contest the accuracy related penalty imposed upon him for one of the years because of the amount of the liability. The court noted that the partnership should also contest the penalty; however, the TEFRA rules that prevent him from contesting the partnership adjustments would not keep him from contesting the application of the penalty in a refund action after he paid the penalty. Unfortunately, he runs into another barrier.

Mr. Davison raised the penalty issue for the first time in his Tax Court petition having failed to mention it in his CDP request. The court stated:

We find that he did not properly raise this issue below and therefore is precluded from challenging his liability for the penalty in this proceeding.

This result flows directly from the CDP regs and serves as a reminder of the need to anticipate all arguments in submitting the Form 12153 at the beginning of the CDP case. The IRS should receive the opportunity to consider all issues the taxpayer seeks to raise as it considers the case during the administrative phase. The court does not want to see an issue for the first time that the taxpayer has failed to previously mention.

AJAC and the APA, Designated Orders 4/8/2019 – 4/12/19

Did the Appeals’ Judicial Approach and Culture (AJAC) Project turn conversations with Appeals into adjudications governed by the Administrative Procedure Act (APA) and subject to judicial review by the Tax Court? A petitioner in a designated order during the week of April 8, 2019 (Docket No. 18021-13, EZ Lube v. CIR (order here)) thinks so and Tax Court finds itself addressing its relationship with the APA yet again.

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I spent time reviewing the history of the APA’s relationship with the IRS as well as the somewhat recent Tax Court cases that have addressed it (including Ax and Altera). The argument put forth by petitioner in this designated order appears to be novel – but ultimately the Tax Court’s response is similar to its holding in Ax, with perhaps even more insistence on the Tax Court’s jurisdictional limitations.  

Most recently, the Ninth Circuit withdrew its decision in the appeal of Altera, and we wait to see if it decides again to overturn the Tax Court’s decision which held that the IRS violated the APA when issuing regulations under section 482. For the most recent PT update on the case, see Stu Bassin’s post here.

The case in which this order was designated is also appealable to the Ninth Circuit. Is petitioner teeing up another APA argument before the Ninth Circuit depending on what happens in Altera? That’s a stretch – since petitioner is asking the Court to treat a phone call with Appeals as a adjudication – but it is possible that something more is going on than what is conveyed in the order.

First, let me provide some background: Petitioner is an LLC taxed as TEFRA partnership; it filed bankruptcy in 2008 but then reorganized. Part of the reorganization involved the conversion of debt that Goldman Sachs (or entities controlled by it) had in the old partnership into a controlling equity interest in the new partnership.  After the reorganization, the partnership filed tax returns taking the position that the partnership was terminated on the date of the reorganization because more than 50% of the partnership interests had been ousted through what was in substance a foreclosure of the old partners’ interests. Accordingly, the old partners treated the reorganization as a deemed sale of their property and reported $22 million in gain.

Then, in 2011, reorganized EZ Lube filed an Administrative Adjustment Request (AAR) taking a position contrary to the former partners’ previously filed returns. The position taken in the AAR was that the partnership was not technically terminated, and instead the exchange of debt for equity created $80 million in cancelled debt income.

The IRS agreed with the AAR and issued a final partnership administrative adjustment (FPAA) reflecting that the partners’ originally filed returns were wrong. But one of the former partners liked the old characterization so in response to the FPAA, he petitioned the Tax Court.

In due course the case was assigned to Appeals and this is where things start to get messy. The Appeals officer stated, over the phone, that she agreed with the former partner. In other words, that the FPAA should be conceded. The Appeals Officer’s manager concurred but explained that they would need to consult with Appeals National Office before the agreement could be conveyed in a TEFRA settlement.  Appeals National Office did not agree with the Appeals Officer’s position, so the case did not settle.

Petitioner argues that the phone conversation with the Appeals Officer was a determination and should end the case. The basis for petitioner’s argument is that the IRS’s Appeals Judicial Approach and Culture initiative transformed Appeals to a quasi-judicial part of the IRS which listens to each side and then issues a decision (like a court) instead of negotiating settlements to end litigation.

The IRS does not dispute that the phone call occurred, nor does it dispute the substance of what the Appeals Officer said, but it does dispute that the phone call was a determination. The IRS acknowledges that AJAC may have changed how Appeals processes cases, but maintains it did not set up a system of informal agency adjudication followed by judicial review as those terms are commonly used in administrative law.  

The Court tasks itself to answer the only question it sees fit for summary judgment, which is: what is the proper characterization of what the Appeals officer said?

The Court can decide, as it has in other cases, whether the parties actually reached a settlement by applying contract law and by making any subsidiary findings of fact. But petitioner argues that the call was not a settlement, it was a determination and the Court has jurisdiction to review such determinations.

This is where the Court insists on its jurisdictional limitations and goes on to review all the different code sections that grant it jurisdiction. It does not find anything in the Code that allows it to review determinations by Appeals in TEFRA, or deficiency, cases.

The petitioner agrees that nothing in the Code provides the Court with jurisdiction to review Appeals determinations in deficiency cases. Instead petitioner argues that the default rules of the APA give the Court jurisdiction, because the Appeals Officer was the presiding agency employee and she had the authority to make a recommended or initial decision as prescribed by 5 U.S.C. 554 and 557, and the Appeals Officer’s decision is subject to judicial review under 5 U.S.C. 702.

This is where the Tax Court revisits some of the arguments made in Ax – that the Internal Revenue Code assigns Tax Court jurisdiction. This arrangement is permissible under what the APA calls “special statutory review proceedings” under 5 U.S.C. 703. See Les’s post here and Stephanie Hoffer and Christopher J. Walker’s post here for more information.

If petitioner seeks review under default rules of the APA, the Court’s scope of review would be limited to the administrative record with an abuse of discretion standard. This creates two different standards for TEFRA cases, and the Court finds this impossible to reconcile.

The reality is that when a petitioner is unhappy with a decision made by Appeals in a docketed case, they can bring the case before the Court. It seems as though petitioner in this case is trying to treat a decision made by the Appeals Officer assigned to the case as something different than a decision made by Appeals National Office – but a decision has not been rendered until a decision document is issued and executed by both parties. The Court points out that phone calls can be a relevant fact in determining whether the parties have reached a settlement, but it doesn’t mean the Court has the jurisdiction to review phone calls. Petitioner says phone call itself is of jurisdictional importance, but if that’s the case, it is the District Court, not the Tax Court, that is the appropriate venue to review it.

Is this a situation where petitioner is unhappy because there was a glimmer of hope that the case would go his way which was ultimately destroyed by the National office? Or is something more going on here?  AJAC is called a project and caused changes to the IRM. It’s not a regulation or even guidance provided to taxpayers – rather it is a policy for IRS employees to follow and seems to be a permissible process and within the agency’s discretion to use. But it’s not even AJAC itself that petitioner seems to have a problem with, instead petitioner’s problem lies with the difference between the appeals officer’s position and the National Office’s position on the case.

The Court denies petitioner’s summary judgment motion and orders the parties to file a status report to identify any remaining issues and explain whether a trial will be necessary.

Other Orders Designated

There were no designated orders during the week of April 1, which is why there is no April post from Patrick. The Court seemingly got caught up during the following week and there were nine other orders designated during my week. In my opinion, they were less notable, but I’ve briefly summarized them here:

  • Docket No. 20237-16, Leon Max v. CIR (order here): the Court reviews the sufficiency of petitioner’s answers and objections on certain requests for admissions in a qualified research expenditure case.
  • Docket No. 24493-18, James H. Figueroa v. CIR (order here): the Court grants respondent’s motion to dismiss a pro se petitioner for failure to state a claim upon which relief can be granted.
  • Docket No. 5956-18, Rhonda Howard v. CIR (order here): the Court grants a motion to dismiss for failure to prosecute in a case with a nonresponsive petitioner.
  • Docket No. 12097-16, Trilogy, Inc & Subsidiaries v. CIR (order here): the Court grants petitioner’s motion in part to review the sufficiency of IRS’s responses to eight requests for admissions.
  • Docket No. 1092-18S, Pedro Manzueta v. CIR (order here): this is a bench opinion disallowing overstated schedule C deductions, dependency exemptions, the earned income credit, and the child tax credit.
  • Docket No. 13275-18S, Anthony S. Ventura & Suzanne M. Ventura v. CIR (order here): the Court grants a motion to dismiss for lack of jurisdiction due to a petition filed after 90 days.
  • Docket No. 14213-18L, Mohamed A. Hadid v. CIR (order here): a bench opinion finding no abuse of discretion and sustaining a levy in a case where the taxpayer proposed $30K/month installment agreement on condition that an NFTL not be filed, but the financial forms did not demonstrate that petitioner had the ability to pay that amount each month.
  • Docket No. 5323-18L, Percy Young v. CIR (order here): the Court grants respondent’s motion to dismiss in a CDP case where petitioner did not provide any information.
  • Docket No. 5323-18L, Ruben T. Varela v. CIR (order here): the Court denies petitioner’s motion for leave to file second amended petition.

Recent Tax Court Case Explores Tax Matter Partner SOL Extensions

TEFRA is still with us. Despite the coming launch of new partnership procedures in the Bipartisan Budget Act (BBA), TEFRA will remain relevant, as old cases work their way through the courts and also likely continuing to inform interpretations of many statutory holes in BBA. A recent Tax Court case, BCP Trading and Investments v Commissioner, explores whether alleged conflicts of interest taint what was an otherwise valid extension to the SOL on assessment.

I will skip the sordid details, but the case involves Son of Boss transactions implicating asset transfers to partnerships, with liabilities attaching to the assets in an effort to increase basis in the partnership and thus produce super sized partner tax losses. (Judge Holmes’ opinion describes the transactions for those who like that sort of thing).

The main procedural issue in the case involved claims that the consents to extend to the SOL on assessment that the tax matters partner (TMP) executed were invalid. The argument focused on how the TMP, Bolton, was under the influence of E&Y. E&Y was under criminal investigation for its role in structuring the transactions. That control, according to the argument, meant that the TMP had a conflict of interest, which invalidated the SOL extensions.

There is precedent for invalidating a TMP consent to extend the SOL. Transpac is a Second Circuit case which held that a TMP’s SOL extension did not have effect when IRS turned to a TMP who himself was under criminal investigation, when the partners individually would not extend the SOL.

The BCP Trading opinion (citations removed) describes Transpac further:

The TMP [in Transpac] s were, unsurprisingly, more receptive to the Commissioner’s request. They had “a powerful incentive to ingratiate themselves to the government,” and worked with the IRS in a criminal prosecution of the Transpac promoter because their immunity or suspended sentence depended on it. The TMPs signed the extensions right about the time they were especially trying to coax the government into granting them immunity or agreeing to lighter sentences.

The Second Circuit in Transpac held that the Commissioner couldn’t use these consents to bind the partners because he knew the TMPs had a strong incentive to cooperate with the government and had conflicting interests with the partners.

As BCP discusses, the issue is “very fact dependent.” The opinion distinguishes Transpac for two main reasons: 1) in BCP many of the individual partners did not turn IRS down in the face of individual requests to extend the SOL and 2) the TMP was not under criminal investigation when the IRS turned to him to sign the original extension.

BCP also argued that the E&Y role in the transactions should bring its actions into the lens as to whether the TMP had an impermissible conflict. One of the partnership employees, who started out working at the slippery sounding E&Y group with the acronym VIPER (which stood for Value Ideas Produce Extraordinary Results) went to BCP as a BCP employee to be a liaison with E&Y. BCP argued that the TMP was in effect controlled by the former E&Y/VIPER employee. The opinion gives that pretty short shrift, noting that the former E&Y employee left for messy reasons and that in any event the individual partners also signed consents to extend the SOL.

E&Y’s conduct, beyond its former employee’s role in the partnership, was not irrelevant to a related issue, however. BCP argued that the consents to extend were not valid because E&Y breached its fiduciary duty and exercised undue influence in getting the TMP to sign the consents. The opinion notes that while the consents to extend are not contracts (and should be treated as a waiver of a defense, rather than as a contract itself), contract principles are key to this inquiry. In light of those principles, the argument fell short, looking at contract principles to define undue influence:

Undue influence is unfair persuasion by a person who dominates a party or when, because of their relationship, a party justifiably assumes the person won’t do anything against his welfare.

It was here that the sophistication and extent of the partners’ other advisors worked against the undue influence argument. The opinion details the parade of high-profile advisors other than E&Y that were involved in looking over the shoulder of E&Y. In light of that, the opinion concludes that the evidence did not support a finding that E&Y manipulated the TMP to sign the consents to extend.

Conclusion

As we have discussed before it is difficult to argue against a signed consent to extend. The argument in BCP was a long shot, especially given the partners’ sophistication and the less than appealing atmosphere of a reviled tax shelter.