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Fast Track Settlements for Collection Cases

Late last year the IRS issued guidance on Fast Track settlement procedures for collection cases.  The goal of the process is to provide resolution of disputed issues within 30-40 calendar days.  Generally, issues involving an offer-in-comprise or trust fund recovery penalties can be brought before an Appeals mediator.  The new program is called SB/SE Fast Track Mediation- Collection (FTMC) and should provide a meaningful avenue to resolve differences.  Ultimate settlement authority continues to reside with Collections and not with IRS Appeals.  See guidance at Rev. Proc 2016-57.

Thouron v. United States: Third Circuit Holds Reliance on Counsel may Relieve Penalties for Late Payment of Taxes.

In Thouron v. United States, No. 13-1603 (3d Cir. May 13, 2014) the Court of Appeals for the Third Circuit held that reliance on tax advice may establish a reasonable cause defense to failure to pay penalties.  (Slip. Op. at 9.) 

This case arises out of estate taxes originally due in 2007.  In his will, the decedent appointed a friend as executor of the estate and the friend hired a tax attorney to advise the estate on tax matters.  Relying on the advice of the attorney, the estate timely filed an extension for time to file the estate return and remitted a partial payment, but did not file for an extension to pay the remainder of the tax due.  The estate claimed its attorney advised it that the extension to pay was not due until the return was filed and that the tax due would be deferred under I.R.C. section 6166 because the bulk of the estate’s assets were illiquid.  The estate further claimed that the attorney advised it that no penalty would be imposed.  The IRS assessed the mandatory penalties of I.R.C. section 6651 and the estate filed a refund claim in district court asserting reasonable cause and reliance on its tax expert as a penalty defense.

The district court for the District of Pennsylvania held that reliance on the tax adviser was not reasonable cause for the late payment of the estate taxes and granted summary judgment in the government’s favor.  To support its conclusion, the lower court relied heavily on United States v. Boyle, 469 U.S. 241 (1985), a Supreme Court decision holding an estate could not rely on its attorney for the ministerial task of timely filing a return.  The district court read Boyle to preclude any finding of reasonable cause based on reliance on an expert or other agent in failure-to-file and failure-to-pay cases.

The Third Circuit reversed and remanded.  The court first established that the holding of Boyle, though a late-filing case, was applicable to failure-to-pay cases because of the similarity in the language in the statutes.  The Third Circuit held, however, that the district court misapplied Boyle to the facts at issue.  Distinguishing Boyle because it involved reliance on an adviser for merely the ministerial task of filing, the court noted the distinction drawn in Boyle between relying on an expert’s clerical action and relying on the expert’s advice: “taxpayers may rely on the advice of an expert but may not, for purposes of completing their statutory duty, rely on an agent to perform the task of filing and paying.”  (Slip. Op. at 9).

Ultimately, the Third Circuit held there was a material question as to whether the estate relied on the advice of counsel in not paying the tax due and remanded the case for that factual determination.  The court noted that the estate must also show either an inability to pay or undue hardship from paying at the deadline.  The court offered no insight as to how the estate can make such showing.

Another Instance Where Relying on a Tax Expert Does Not Excuse Penalties Imposed On A Taxpayer

Although it seems reasonable for a taxpayer to assume that by soliciting the advice or services of a tax expert the taxpayer would be insulated from any tax penalties stemming from a mistake made by the tax expert, unfortunately, case law does not always support that assumption.  Specifically, the Ninth Circuit recently ruled that a taxpayer was liable for a penalty for filing a late estate tax return even though the taxpayer relied on a certified public accountant (CPA), who incorrectly advised him about the extended filing deadline.  See Knappe v. United States, 713 F.3d 1164 (9th Cir. 2013).

In Knappe, the taxpayer was named as the executor of an estate.  Because the taxpayer had no prior experience serving as an executor or filing an estate tax return, the taxpayer enlisted the help of a CPA.  The CPA correctly informed the taxpayer that the deadline for filing the estate tax return was nine months after the decedent’s date of death.  In need of additional time to prepare the return, the taxpayer sought advice from the CPA about requesting an extension of the filing deadline from the IRS.  The CPA mistakenly told the taxpayer that he could obtain a 12-month extension of both the filing and payment deadlines.  Acting on the erroneous advice, the taxpayer filed the estate tax return several months late and the IRS assessed a 20% late filing penalty, amounting to $196,414.60.

The taxpayer argued that his reliance on the CPA constituted “ordinary business care and prudence” such that the taxpayer had an apt defense to the penalty—the failure was due to reasonable cause and not due to willful neglect.  The Ninth Circuit, however, disagreed.

The Ninth Circuit addressed the familiar Supreme Court case, Boyle, which involved a taxpayer who delegated the task of filing a tax return to an expert, only to have the expert file the return late.  Boyle v. United States, 469 U.S. 241 (1985).  In contrast to Boyle, the taxpayer here did not delegate the task of filing the return to an expert.  Rather, the taxpayer personally filed the return after the actual deadline, but within the time that the CPA erroneously told him was available.  In fact, the Supreme Court in Boyle expressly declined to address the precise question posed in Knappe.

In Boyle, the Supreme Court drew a sharp distinction between substantive tax advice, on which taxpayers may reasonably rely, and non-substantive tax advice, on which taxpayers may not rely.  The Supreme Court explained that determining the filing date for a tax return is a non-substantive matter.  Although determining the date for a filing extension is different from simply determining a filing deadline, the Ninth Circuit found that it was not different enough.  That is, similar to the question of the determining the filing deadline of a tax return, the question of when the estate tax return was due once an extension had been obtained is also a non-substantive question.  Accordingly, the Ninth Circuit concluded that the taxpayer did not exercise ordinary business care and prudence when he relied on the CPA’s advice regarding the extended deadline.

Interestingly, the Ninth Circuit cited another tax case that treated the question of whether multiple filing extensions were available to the taxpayer as a substantive question, thus, absolving the taxpayer of tax penalties.  It seems there’s a very fine line separating substantive tax advice from non-substantive tax advice.

SCOTUS Struggles with TEFRA Jurisdiction: Oral Arguments in United States v. Woods

On October 9, 2013, the U.S. Supreme Court heard oral arguments in United States v. Woods, 471 Fed. Appx. 320 (5th Cir. 2012), cert. granted, 133 S. Ct. 1632 (Mar. 25, 2013) (No. 12-562).  The original question presented to the Court by petitioner was whether the 40% gross valuation misstatement penalty applies to transactions that lack economic substance.  When the Court granted the certiorari petition, however, it expressly asked the parties to brief and argue the additional question of whether the district court had jurisdiction in the case under I.R.C. section 6226 to consider the substantial valuation misstatement penalty at issue.  And it was this jurisdictional question that dominated oral argument before the Court.

Both the parties and the Court focused on the statutory language granting a court jurisdiction at the partnership level.  Specifically, I.R.C. section 6226(f) grants a court jurisdiction to determine “all partnership items . . . and the applicability of any penalty . . . which relates to an adjustment to a partnership item.”  Justice Kagan attempted to narrow the issue to whether the penalty was directly or indirectly “related to” a partnership item, and accused both parties of adding something to the statute: the taxpayer requiring the penalty “directly” relate, and the government asking the Court to read the statute to include any penalties “indirectly” relating to a partnership item.  Counsel for the taxpayer-Respondent explained that Congress separately defined an “affected item”, which includes outside basis, and could have explicitly expanded the statute to include penalties related to the partnership item and affected items, but it did not.  Respondent later reminded the Court that tax penalties are strictly construed in favor of the taxpayer and that any ambiguity must be resolved in the taxpayer’s favor.

On the merits, Respondent’s counsel focused on Congress’ intent and the context of the statute, arguing that the statute deals with a different situation than the one before the Court: the statute addresses a misstatement of value, not an entirely disallowed transaction.  Respondent explained the distinction by analogy, “if I donate a painting that I say that is worth $1 million to a church and I put that on my return, but, in fact, it turns out that I didn’t donate the painting, I may have committed a fraud . . . but I haven’t made a valuation misstatement, nor have I misstated my basis.”  As multiple Justices recognized, Congress enacted a new statute in 2010 to directly address that problem, in a noneconomic substance penalty.  See I.R.C. § 7701(o).  Both parties before the Court agreed that the noneconomic substance penalty would apply to the current case had that penalty been on the books at the time of the transaction.

Neither advocate had much time to argue the merits of the case, and, interestingly, the Justices asked few questions during those parts of the arguments.  On the other hand, questions from the bench commanded the jurisdictional arguments.  While tax practitioners may be hoping for a decisive answer to the question on the merits, it is possible the Court will issue a more narrow ruling that it lacks jurisdiction in this case to answer that question.  Of course, predictions based on oral arguments alone are like writing in the wind and the running water.  It is difficult to predict whether the Justices will rule on the merits of the case, much less what that ruling may be.

Adam Pierson, a member of Dentons’ Litigation practice, co-authored this article.

Jurisdiction to Dispute Penalties: Partner v. Partnership-Level Proceedings

The U.S. Supreme Court recently heard oral arguments in United States v. Woods, 471 Fed. Appx. 320 (5th Cir. 2012), cert. granted, 133 S. Ct. 1632 (Mar. 25, 2013) (No. 12-562).  In addition to the heavily-disputed circuit split regarding the gross misstatement penalties, the Court may rule on a complicated jurisdictional question implicated in TEFRA partnership proceedings.  Although neither party nor the lower courts raised the issue, the Court directed the parties, without further detail, to brief and argue whether the district court had jurisdiction under I.R.C. § 6226 to consider the substantial misstatement penalty for an underpayment “attributable to” an overstatement of basis.  Accordingly, the Court may address the issue of whether penalties related to the overstatement of outside basis must be resolved in a partnership proceeding or must be raised in a subsequent partner-level claim.  It is possible that the Supreme Court may resolve the Woods case on jurisdictional grounds, without addressing the substantive circuit split on whether the 40% gross valuation misstatement penalty applies to transactions that lack economic substance, though most believe that it will also address the circuit split on the gross valuation misstatement penalty.

In either event, the fact that the Supreme Court directed the parties to brief and argue the jurisdictional issue is a pointed reminder that the TEFRA partnership audit procedures are outdated and in desperate need of a fix.  In fact, TEFRA jurisdictional issues have generated huge amounts of litigation about partnership tax procedure, often without addressing the underlying merits of a tax dispute.  So the Supreme Court’s guidance in Woods on TEFRA jurisdiction may have far reaching impact and either confirm or cast doubt on a whole series of ad hoc TEFRA procedural decisions over the past ten years.

In Woods, the particular TEFRA partnership procedures at issue involves penalties.  When TEFRA was originally enacted, penalties were not partnership items and had to be resolved in individual partner-level proceedings after the completion of the partnership audit and any resulting tax litigation.  In 1997, congress amended TEFRA to provide that penalties are determined at the partnership level without reclassifying penalties as partnership items.  As a result, significant confusion arose as to whether all or only a portion of the penalty issues (e.g., everything except the reasonable cause defense to penalties as this is specific to an individual partner’s state of mind) can be determined in a partnership proceeding.  Also, significant issues arose as to whether a court has jurisdiction in a partnership  proceeding over penalties if the underlying adjustment resulting in a partner-level underpayment of tax is itself not a partnership item.

Many courts have found that the reasonable cause defense to penalties is jurisdictionally appropriate at the partnership level when the defense involves the conduct and state of mind of the partnership’s managing member or when the defense is not personal to the partners or dependent on their separate returns.  Where the penalties imposed require a determination of non-partnership items, however, courts have found the defense properly raised at the partner level.  Thus, several courts have found no jurisdiction in a partnership-level proceeding when the penalties related to the outside bases of the individual partners because outside bases are generally not partnership items and must determined at the partner level.  It is this last point that the Supreme Court in Woods has focused its jurisdictional analysis on, even though the parties to the case did not raise jurisdictional questions.

After being directed to brief the issue, the taxpayers in Woods rely heavily on Tax Court decisions Jade Trading and Petaluma to argue that the district court lacked jurisdiction to impose the penalty because it relates to a nonpartnership item, i.e., the partner-by-partner determination of the partners’ outside (or tax) bases in the partnership interests.  See Petaluma FX Partners LLC v. Comm’r, 591 F.3d 649, 655-56 (D.C. Cir. 2010), on remand 135 T.C. 366; Jade Trading v. United States, 80 Fed. Cl. 11, 60 (2007), aff’d in part and vacated in part, 598 F.3d 1372 (Fed. Cir. 2010).  In contrast, the government argued that the district court had jurisdiction to impose the penalty because the issue was a partnership item.  Interestingly, the government previously conceded that its argument was wrong.  See Brief for Respondents, United States v. Woods, 133 S. Ct. 1632, 2013 WL 3816999, *21-24 (July 19, 2013) (citing Logan Trust v. Comm’r, No. 12-1148 (D.C. Cir. Oct. 25, 2012) (“We agree that outside basis is an affected item, not a partnership item . . .”)).

Hopefully, the Supreme Court’s jurisdictional decision in Woods clarifies—instead of further confuses—TEFRA jurisdictional rules.  Given the current political environment in Washington, D.C., it is unlikely that congress would take up a statutory fix to TEFRA, much less agree on what that fix should look like.  The current case-by-case, and often conflicting, judicial resolution of TEFRA issues is maddening to lawyers, judges, and especially taxpayers who simply want the merits of their tax cases decided.

Did the Tax Court Enforce Retroactive Penalties?

Taxpayers and practitioners alike were unsettled by recent language from a Tax Court opinion suggesting that retroactive penalties may be enforced.  See Soni v. Comm’r, T.C. Memo. 2013-30.   In Soni, the Tax Court summarily stated “[t]his Court has decided previously that taxpayers may be liable for a penalty arising from a transaction entered into before the penalty was enacted.”  Id. at *8.  In support, the Court cited Patin v. Comm’r, 88 T.C. 1086, 1127 n.34 (1987), aff’d without published opinion, 865 F.2d 1264 (5th Cir. 1989), and aff’d without published opinion sub nom. Hatheway v. Comm’r, 865 F.2d 186 (4th Cir. 1988), and aff’d sub nom. Skeen v. Comm’r, 864 F.2d 93 (9th Cir. 1989), and aff’d sub nom. Gomberg v. Comm’r, 868 F.2d 865 (6th Cir. 1989) (all available through major commercial case reporting services); McGehee Family Clinic, P.A. v. Comm’r, T.C. Memo. 2010-202, slip op. at 6.

Retroactive penalties conflict with Congress’ express recognition that taxpayers, as a general matter, should not be penalized if their tax return filing position is successfully challenged by the IRS if—at the time the return was originally filed—the taxpayer took the position reasonably and in good faith.  The primary exception to this fundamental proposition is the new and arguably strict liability penalty for transactions lacking economic substance.  Some would argue, and the IRS routinely does in fact argue, that if a transaction lacked economic substance, it necessarily was not entered into reasonably and in good faith.  Obviously, we disagree with this argument given the ever-shifting and vague economic substance doctrine.  Nonetheless, what to make of Soni and the cases it relied upon?

A close review of the facts and holding of Soni reveals that the Tax Court did not impose retroactive penalties.  In summary, the court enforced penalties arising from transactions entered into before the transaction was subject to penalty—not before the penalty was enacted.  This is a fine, but significant, distinction.

In Soni, the taxpayers engaged in a certain transaction beginning in 2001.  In a revenue ruling issued three years later, the IRS “listed” the transaction as an abusive tax shelter, arguably putting the taxpayer on notice that the transaction could not be entered into in good faith. (Obviously, this line of reasoning ignores the fact that the IRS has “delisted” certain transactions that it previously considered abusive.)  Even after the transaction was listed, the taxpayer continued to engaged in it.  For the taxable year ending after the revenue ruling was effective, the IRS sought to impose a penalty under I.R.C. section 6662A (for understatements with respect to reportable transactions) on the taxpayers for engaging in the listed transaction at issue.

Part of the taxpayers’ defense to the penalty was that they relied upon a favorable IRS determination letter issued in 2002, before the revenue ruling was issued.  In upholding the penalty, the court found that the revenue ruling should have put the taxpayers on notice that they could no longer rely upon such determination letter and that the transaction was now a listed transaction—“[i]gnorance of the law is no excuse for noncompliance with the applicable law.”  Id. at *10.

None of the cases cited by the court in Soni (listed above) actually applied penalties retroactively or stand for the proposition that a penalty can be applied prior to the enactment of the penalty statute.  In fact, in McGehee, the court explicitly stated that the penalty was not being applied retroactively and was applicable only to tax years ended after the date of enactment of the penalty at issue.  See McGehee, T.C. Memo. 2010-202.  So, despite the loose language in Soni, the Tax Court did not open the floodgates to retroactive penalties.

The Eighth Circuit Weighs in on Whether Outside Basis is an Affected Item at the Partner Level

As a part of the continuing TEFRA partnership audit proceeding litigation saga, the Eighth Circuit in Thompson v. Comm’r, (No. 12-1725) (Sept. 9, 2013), weighed in on the question of whether outside basis can be decided at the partnership level, or whether it is an affected item that must be determined subsequently at the partner level.  In Thompson, after partnership-level proceedings involving a SON-of-BOSS transaction were decided in favor of the government, the IRS issued a notice of deficiency to the partners explaining several adjustments made to their individual returns and imposing a 40% accuracy-related penalty.  When the taxpayers filed a petition in Tax Court to challenge the notice of deficiency, the IRS moved to dismiss for lack of jurisdiction and argued that the notice was issued in error and that the deficiency procedures of I.R.C. § 6230(a)(1) were inapplicable.  The Tax Court agreed with the IRS and dismissed the partners’ petition.  Writing for the majority, Judge Wherry held that computing the partners’ deficiency arising from the adjustments finalized in the partnership-proceeding did not require any partner-level determinations since the partnership activities “constituted an economic sham” that “foreclosed [the partners] from claiming any loss on liquidating a partnership interest in a disregarded partnership.”  On appeal, the Eighth Circuit reversed, holding that the Tax Court erred in determining that it lacked jurisdiction over the petition.

The Eighth Circuit’s focus, interestingly, was on whether the Tax Court actually made a determination of the partners’ outside basis in the partnership-level proceeding.  The Eighth Circuit held that because the Tax Court did not determine the partners’ outside basis in the partnership, the notice deficiency procedures were applicable and the Tax Court had jurisdiction to consider the taxpayers’ petition.  But, as Judge Gruender noted in his concurring opinion, the question is not whether the Tax Court made the determination; Judge Gruender argued that the Tax Court did in fact make a determination that the partners’ outside basis in the partnership was zero, but that this determination must be “determined at the partner level.”

In holding the Tax Court had jurisdiction, the Eighth Circuit agreed with other circuits to have addressed the question, citing Jade Trading, LLC v. United States, 598 F.3d 1372 (Fed. Cir. 2010) and Petaluma FX Partners, LLC v. Comm’r, 591 F.3d 649 (D.C. Cir. 2010).

The United States Supreme Court may rule on this issue in United States v. Woods, 471 Fed. Appx. 320 (5th Cir. 2012), cert. granted, 133 S. Ct. 1632 (Mar. 25, 2013) (No. 12-562), where, on its own initiative, the Court directed the parties to brief and argue whether the district court had jurisdiction to consider the substantial misstatement penalty for an underpayment “attributable to” an overstatement of basis.