Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-caed-1_06-cv-00046/USCOURTS-caed-1_06-cv-00046-8/pdf.json

Nature of Suit Code: 870
Nature of Suit: Tax Suits
Cause of Action: 26:6703 IRS: Refund of Tax Penalty

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IN THE UNITED STATES DISTRICT COURT

FOR THE EASTERN DISTRICT OF CALIFORNIA

HARGROVE & COSTANZO and CASE NO. CV-F-06-046 LJO DLB

RICHARD H. HARGROVE 

Plaintiffs, O R D E R O N C O U N T E R C L A I M

DEFENDANTS’ MOTION TO DISMISS

SECOND COUNTERCLAIM (Doc. 53)

vs.

UNITED STATES OF AMERICA, et al.,

Defendants,

and

UNITED STATES OF AMERICA,

Counterclaim Plaintiff,

vs.

HARGROVE and COSTANZO, RICHARD

H. HARGROVE, NEIL COSTANZO, and 

HARGROVE & COSTANZO, 

PROFESSIONAL CORPORATION,

Counterclaim Defendants.

 / 

I. INTRODUCTION

This is an action to dismiss a Second Amended Counterclaim (“SAC”) filed by the United States

of America (“the Government”) which seeks to bring to judgment and enforce a tax penalty assessed

against Counterclaim Defendants in the amount of $1,875,717, plus interest. The Government’s claims

to collect the liability, based on California Corporations Code §§16306(a) and 16307 and a successorentity theory, are properly pleaded and are not subject to dismissal as a matter of law. Further, the

underlying claim is not “illegal” and/or “void” and accepting the Government’s pleadings as true, a

proper assessment was made. Therefore, the motion to dismiss is DENIED in full. 

II. BACKGROUND

From 1996 through 2000, Hargrove & Costanzo (“the Partnership”) operated as a general

partnership law practice in Fresno, California. During that time, the Partnership acted as bond counsel

for eighteen bond issues individually described in the SAC. In a bond opinion letter signed by Richard

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Hargrove for each bond issuance, the Partnership represented that each of the bonds was a qualified taxexempt government bond. The Partnership stopped doing business as a partnership on December 31,

2000. On January 1, 2001, Hargrove & Costanzo, Professional Corporation (“the Corporation”) was

formed.

Based on the Government’s belief that the Partnership made tax-related statements which its

lawyers knew or should have known were false in conjunction with the 18 bond issuances, a delegate

for the Secretary of the Treasury made an assessment against the Partnership for a penalty pursuant to

Internal Revenue Code §6700 (“Section 6700") in the amount of $1,944,717 on May 16, 2005. The

assessment was based on 100% of the gross income derived by the Partnership for its participation in

the issuance of the bonds. The Partnership and Mr. Hargrove paid a portion of the penalty ($19,000) and

initiated this action for a refund on January 12, 2006, challenging the assessment of the tax penalty by

the Internal Revenue Service (“IRS”). 

The Government filed its SAC against the partnership, Mr. Hargrove, Neil Costanzo, and the

Corporation on June 1, 2007, which includes three claims for relief. First, the Government seeks to

reduce assessment of the tax penalty to judgment against the Partnership in the amount of $1,875,717,

plus interest. Second, the Government seeks to hold Mr. Costanzo and Mr. Hargrove jointly and

severally liable for the Partnership’s obligation pursuant to California Corporations Code §16306(a).

Third, the Government seeks to hold the Corporation jointly and severally liable for the Partnership’s

tax obligation based on the successor entity doctrine. Counterclaim Defendants filed this motion to

dismiss the SAC on June 20, 2007. (Doc. 53). The Government filed an opposition on August 5, 2007.

(Doc. 54) Defendants filed an untimely reply on August 17, 2007. (Doc. 55) Having considered the

moving, opposition, and reply papers, as well as the Court’s file, this Court vacates the August 23, 2007

hearing pursuant to Local Rule 78-230(h) and issues the following order. 

///

III. ANALYSIS

A. Standards of Review

1. Fed. R. Civ. P. 12(b)(6)

Federal Rule of Civil Procedure 12(b)(6) provides that a court may dismiss a complaint “for

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failure to state a claim upon which relief can be granted.” In considering a motion to dismiss for failure

to state a claim, the court must accept as true the allegations of the complaint in question, construe the

pleading in the light most favorable to the party opposing the motion, and resolve all doubts in the

pleader's favor. Jenkins v. McKeithen, 395 U.S. 411, 421, reh'g denied, 396 U.S. 869 (1969); Hospital

Bldg. Co. v. Trustees of Rex Hospital, 425 U.S. 738, 740 (1976). 

Under the basic rule, a motion to dismiss for failure to state a claim should granted “only if it is

clear that no relief could be granted under any set of facts that could be proved consistent with the

allegations" Hishon v. King & Spalding, 467 U.S. 69, 73 (1984), citing Conley v. Gibson, 355 U.S. 41,

45-46 (1957); Yamaguchi v. U.S. Dept. of the Air Force, 109 F.3d 1475, 1481 (9th Cir. 1997). Although

courts assume the facts alleged as true, courts do not “assume the truth of legal conclusions merely

because they are cast in the form of factual allegations.” Western Mining Council v. Watt, 643 F.2d 618,

624 (9th Cir. 1981). Dismissal is appropriate “only if it is clear that no relief could be granted under any

set of facts that could be proven consistent with the allegations.” McClinchy v. Shell Chem. Co., 845

F.2d 802, 810 (9th Cir. 1988)(citation omitted).

Plaintiffs filed the answer to the second amended complaint and the motion to dismiss pursuant

to Fed. R. Civ. P. 12(b)(6) on the same day. On the docket, the motion to dismiss appears after the

answer. Pursuant to Rule 12(b), a motion to dismiss for failure to state a claim upon which relief can

be granted must be made before pleading if a further pleading is permitted. Fed. R. Civ. P. 12(b)

(emphasis added). A motion to dismiss is timely only if filed before the answer. Aetna Life Ins. Co. v.

Alla Medical Services, Inc., 855 F.2d 1470, 1474 (9th Cir. 1988). 

2. Fed. R. Civ. P. 12 (c)

When a Rule 12(b)6) motion to dismiss for failure to state a claim upon which relief can be

granted is filed after an answer is filed, a court may deny the motion to dismiss as untimely, or the court

may consider the Rule 12(b)(6) motion to dismiss as a motion for judgment on the pleadings pursuant

to Federal Rule of Civil Procedure 12 (c). Aldabe v. Aldabe, 616 F.2d 1089, 1093 (9th Cir. 1980).

Federal Rule of Civil Procedure 12(h)(2) states that a motion to dismiss for failure to state a claim may

be made in a motion for judgment on the pleadings pursuant to Rule 12 (c). In Aldabe v. Aldabe, 616

F.2d 1089,1093 (9th Cir. 1980), the Ninth Circuit reasoned

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Rule 12(h)(2) specifically authorizes use of the latter motion to raise the defense of

failure to state a claim. Because it is only after the pleadings are closed that the motion

for judgment on the pleadings is authorized Rule 12(c)Rule 12(h)(2) should be read as

allowing a motion for judgment on the pleadings, raising the defense of failure to state

a claim, even after an answer has been filed. Under that interpretation, Rules 12(c) and

12(h)(2) together constitute a qualification of Rule 12(b)(6). 

A motion for judgment on the pleadings pursuant to Fed. R. Civ. P. 12 (c) “is properly granted

when, taking all the allegations in the pleadings as true, the moving party is entitled to judgment as a

matter of law.” Nelson v. City of Irvine, 143 F.3d 1196, 1200 (9th Cir. 1998). A dismissal on the

pleadings for failure to state a claim is proper only if “the movant clearly establishes that no material

issue of fact remains to be resolved and that he is entitled to judgment as a matter of law.” McGlinchy

v. Shell Chemical Co., 845 F.2d 802, 810 (9th Cir. 1988) (citing Doleman v. Meiji Mut. Life Ins. Co.,

727 F.2d 1480, 1482 (9th Cir. 1984). But, when a Rule 12 (c) is used to raise a defense for failure to

state a claim, “the motion for judgment on the pleadings faces the same test as a motion under Rule

12(b)(6).” McGlinchy, 845 F.2d 802, 810. That is, dismissal is proper “only if it is clear that no relief

could be granted under any set of facts that could be proven consistent with the allegations.” Id. (quoting

Hishon v. King & Spalding, 467 U.S. 69, 73, 104 S. Ct. 2229 (1984)). 

B. Joint and Several Liability of Individual Partners

Count II of the SAC states a cause of action against Mr. Hargrove and Mr. Costanzo in their

individual capacities. There is no dispute that Mr. Hargrove and Mr. Costanzo made up the Partnership

of Hargrove & Costanzo. The Government assessed a tax penalty against the Partnership, which is now

defunct, and seeks to enforce the assessment against the individual partners. The issue presented is

whether the tax penalty assessed against the Partnership may be enforced against the partners under

California law.

Counterclaim defendants argue that “ aspects of the statute compel the determination that section

6700, by its terms, does not impose liability without fault, or vicarious or imputed liability on anyone.”

Mot. Dismiss SAC, p.10. Specifically, Counterclaim Defendants argue that the scienter requirement of

Section 6700 does not allow vicarious imputation of liability to innocent partners of the partnership.

This argument illustrates Counterclaim Defendants’ “mistaken understanding of the function and nature

of an assessment as identical to the initiation of a formal collection action against any person or entity

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Enforcement of the assessment against the individual partners is contingent on the Government successfully 1

reducing its federal tax assessment against the Partnership to judgment.

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who might be liable for payment of a debt.” United States v. Galletti, 541 U.S. 114, 121-22 (2004).

 In this action, the Government seeks to recover from the partners the amount previously assessed

against the Partnership in May 2005. “Once a tax has been properly assessed, nothing in the Code

requires the IRS to duplicate its efforts by separately assessing the same tax against individuals or

entities who are not the actual taxpayers but are, by reason of state law, liable for payment of the

taxpayer’s debt.” Id. at 123. Under California law, a partnership and its general partners are separate

entities. See Cal. Corp. Code §16201. However, once the IRS assessed the tax penalty against the

Partnership, the partners became jointly and severally liable for the tax liabilities of the Partnership

pursuant to Cal. Corp. Code §16306(a). Specifically applicable to Section 6700, California Corporations

Code §16305(a) states that “a partnership is liable...for a penalty incurred, as a result of a wrongful act

or omission, or other actionable conduct of a partner.” (emphasis added) 

“The IRS contains no requirement that the Government must make separate assessments of a

single tax debt against persons or entities secondarily liable for that debt in order for [a collection

enforcement ] to apply to those persons or entities.” Galletti, 541 U.S. 114, 122. Accordingly, the

Government need not assert any allegations that Costanzo personally violated the Section 6700 and the

individual elements (including the scienter requirement) need not be reasserted against the individual

partners. Once the amount of liability has been established and judgment entered, the Government may 1

properly employ administrative enforcement methods to collect the tax penalty against the individual

partners pursuant to Cal. Corp. Code §16306(a). This counterclaim is one such administrative

enforcement method. Therefore, Counterclaim Defendants are not entitled to judgment as a matter of

law on this issue and the motion to dismiss this claim is denied. 

///

C. Successor Entity Liability 

Count III of the SAC states a cause of action against the Corporation in its capacity as the

successor entity to the Partnership. In California, a new entity assumes the liability of the old entity

when (1) there is an express or implied agreement of assumption, (2) the transaction amounts to a

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 This theory was born in the corporate setting, where the succession is from one corporation to another. Here, a

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corporation succeeded a partnership. Counterclaim defendants do not question the applicability of this concept and other

court decisions indicate that the application of the concept has grown past its original roots. See, e.g. McGranahan v. Bell

(In re Bell), 1991 Bankr. LEXIS1743 (E.D. Cal.1991) (applying successor-entity liability in a partnership-corporation

succession).

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consolidation or merger of the two entities, (3) the purchasing corporation is a mere continuation of the

seller, or (4) the transfer of assets to the purchaser is for the fraudulent purpose of escaping liability for

the old entity’s debts. Ray v. Alad Corp., 19 Cal. 3d 22, 28 (1977); Stoumbos v. Kilimnik, 988 F.2d 949,

962 (9th Cir. 1993), cert. denied, 510 U.S. 867 (1993). The basic premise underlying the theory is that 2

a business should not be allowed to defraud its creditors by simply changing its form. The theory

embraces and adopts several independent elements of various causes of action including alter ego,

fraudulent conveyance, consolidation or merger, piercing of the corporate veil, and continuation.

Economy Refining & Service Co. v. Royal Nat’l Bank, 20 Cal. App. 3d 434 (Cal. App. 1 Dist. 1971). st

California courts have developed several tests, including the “mere continuation test,” the “form of the

merger test,” and the “significant and identifiable part” test. See Certain Underwriters at Lloyd’s of

London v. Pacific Southwest Airlines, 786 F. Supp. 867 (C.D. Cal. 1992). 

The Government alleges that the Corporation is a mere continuation of the Partnership for the

following reasons: (1) the general partners in the partnership, Hargrove and Costanzo, are now

shareholders in the professional corporation; (2) the names of the partnership and corporation are the

same; (3)the location ofthe Partnership andCorporation are the same; (4) the two entities have the same

or substantially the same management; and (5) the professional corporation did not pay adequate

consideration for the partnership’s assets. While Counterclaim Defendants deny these allegations, the

Court must assume these well-plead facts as true for purposes of this motion. 

 The characteristics of a mere continuation are present–there was a direct sale from the

predecessor to the successor, there is continuity of employees and principals, and the business location

and assets have remained essentially the same. Maloney v. Am. Pharm. Co., 207 Cal. App. 3d 282, 289

(1988). The Government alleged on information and belief that the Corporation did not pay adequate

consideration from the partnership’s assets; however, it is the Government’s burden to prove this

foundation. Id. This question of fact is determined at a later stage of this litigation. For purposes of this

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motion, accepting all allegations to be true and considering that if the Government proves these facts

to be true, the Court finds that the elements of the mere continuation theory exist. Accordingly, the

motion to dismiss this claim is denied. 

D. Constitutional Issues Raised3

1. Excessive Fines

Mr. Costanzo and the Corporation assert that enforcement of the tax penalty against them as

“innocent parties” would violate the Eighth Amendment prohibition against excessive fines. A fine is

unconstitutionally excessive if (1) the payment to the government constitutes punishment for an offense

and (2) the payment is grossly disproportionate to the gravity of the defendants’ offense. United States

v. Mackby, 261 F.3d 821, 830 (9 Cir. 2001). Thus, an excessive fines analysis involves two steps: (1) th

whetherthe Excessive Fines Clause applies, and (2) if, so, whetherthe fine is “excessive.” United States

v. Bajakajian, 524 U.S. 321, 334, 118 S.Ct. 2028 (1998), cited in Engquist v. Oregon Dept. of

Agriculture, 478 F.3d 985, 1006 (9th Cir. 2007).

 The first prong of this test requires that the excessive fines clause be applied to government

actions that are intended to punish. Engquist, 478 F.3d 985, 1006. Costanzo and the Corporation argue

that “imposing a penalty or fine as punishment on a person or entity which has done nothing

sanctionable under the statute and solely by application of a rule of civil vicarious liability or agency

law does not serve to advance deterrent effect. Interpreting this statute in any manner which imposes

punishment on innocent persons or entities creates a significant constitutional problem.” Mot. Dismiss

SAC, 14. They conclude that an “imputed penalty cannot [sic] necessarily violates [sic] the excessive

fines provision of the Constitution when the person sought to be held vicariously liable is not guilty of

any offense.” Id. at 15. This argument illustrates Counterclaim Defendants’ misunderstanding of the

current action.

The derivative claims are not intended to punish either Costanzo or the Corporation. As

Counterclaim Defendants assert, the “purposes of deterrence and punishment are not fulfilled by making

an innocent violator pay civil penalties or incur additional. As previously discussed, the Government

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does not seek to assess a new penalty against these Counterclaim Defendants under the statute in this

action. Rather, the Government seeks to enforce a penalty already assessed against the Partnership.

attorneys fees.” United States v. Winchester Municipal Utils., 944 F.2d 301, 304 (6th Cir. 1991). These

obligations are defined in the California law described above, not Section 6700. 

Furthermore, Counterclaim defendants have not proved as a matter of law that Section 6700 is

a punishment. The Government argues that as applied in this case, Section 6700 serves the “remedial

goal of reimbursing the government for the costs in investigating tax fraud and for possible lost tax

revenue.” Reiserer v. United States, 479 F.3d 1160, 1164 (9th Cir. 2007). Because the penalty itself

is not a punishment and because the derivative claims are not intended to punish Costanzo or the

Corporation, the excessive fines arguments must fail. 

2. Due Process

Mr. Costanzo and the Corporation claim that enforcement of the tax penalty against them would

violate their due process rights. Statutes or regulations that permit monetary penalties against persons

who violate them must provide fair warning ofthe conduct that is prohibited or that is required and must

provide a reasonably clear standard of culpability to circumscribe the discretion of the enforcing

authority and its agents. Montgomery Ward & Co. v. FTC, 691 F.2d 1322 (9th Cir. 1982). Costanzo

and the Corporation argue that although Section 6700 “plainly gives notice to those who actually

engaged in the prohibited conduct,” they “would need to be clairvoyant to conclude that mere association

with a person violating the statute could lead to the imposition of a penalty.” Mot. Dismiss SAC, 15.

Again, the claims against Mr. Costanzo and the Corporation are not based on the federal tax

statute. Instead, the claims against these parties derive from the instant action, based on California

corporations, agency law, and the successor-entity theory. Mr. Costanzo and the Corporation have

asserted no facts to show that they were not provided proper notice in the instant action. Further, they

have been afforded an opportunity to defend themselves, as exemplified by this motion. Therefore, the

notice requirement of due process has been satisfied and this claim fails.

D. Underlying Tax Penalty Assessment

1. False allegations

Throughout this motion to dismiss, and in the untimely reply, Counterclaim Defendants argue

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that the underlying tax penalty is null and void because it is based on false allegations. In making this

argument, Counterclaim Defendants ignored the law’s mandate that in this motion, all well-pleaded

allegations are assumed to be true. Therefore, the arguments advanced on the grounds that the

allegations are false shall not be considered here.

2. Assessment of Penalty

Section 6700 provides that an imposition of a penalty will be made against a “person” who (1)

organizes (or assists in the organization of) any plan or arrangement or who participates in the sale of

an interest in a plan or arrangement and (2) makes or furnishes a statement with respect to the

allowability of anydeduction or credit, the excludability of any income, or the securing of any tax benefit

by reason of holding an interest in the entity or participating in the plan or arrangement (3) which the

person knows or has reason to know is false or fraudulent as to any material matter. Under Section

6700, a promoter of an abusive tax shelter “shall pay, with respect to each [proscribed] activity..., a

penalty: in the amount of the lesser of $1000 or 100% of the gross income derived by that promoter. 26

U.S.C.§ 6700(a).

Counterclaim defendants argue that the underlying penalty is void, because (1) there is no factual

premise to the calculation of the penalty, (2) the calculations are based on “naked assumptions,” (3) it

was erroneously calculated because it was not annualized, and (4) the Government used the wrong

calculation. The first two argumentsignore this Court’sstandard ofreview, which is to assume all wellplead facts by the Government as true. Further, Counterclaim Defendants raise issues outside of the

pleadings by relying on information contained in the Revenue Agent’s Report and correspondence,

which was not mentioned by the United States in the SAC. The Court will not consider these issues

outside the scope of the pleadings.

 The Court must determine the proper method of calculation for the Section 6700 penalty.

Counterclaim defendants argue that the penalty assessed is illegal, because the Government may only

assess a penalty no greater than a total of $1000. The Government interprets the statute to read that bond

counsel is liable for either the less of $1000 per sale of each bond or the total sum of the gross income

derived. Under this calculation, the Government believes that the total sum of the income derived, over

$1.8 million, is lesser than a charge of $1000 for each sale of each of the 18 bonds. 

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 Section 6700 was amended in 1989 and again in 2004. For purposes of this action, Section 6700

as it applied during the years of 1990 through 2003 is applicable. Prior to the 1989 amendments, there

was a split in the case law over how the $1000 penaltywas calculated. Some courts held that the penalty

was only $1000, while others held that it was $1000 per sale. Bond v. United States, 872 F.2d 898, 900

(9th Cir. 1989). The 1989 Amendment clarified that the penalty was $1000 per sale, unless the gross

income was less, and that it applied to direct or indirect sales. A provision of the Omnibus Budget

Reconciliation Act of 1989, P.L. 101-239, Sec. 7734(a)(3), reprinted in 1989 U.S.C.C.A.N. 1906, 1397,

substituted the following language into Section 6700(a)(2): 

with respect to each activity described...a penalty equal to $1,000, or if the person

establishes that it is lesser, 100 percent of the gross income derived by such person from

such activity. For purposes of the preceding sentence, activities described in paragraph

(1)(A)...shall be treated as a separate activity and participation in each sale described

in paragraph (1)(B) shall be so treated. (emphasis added)

From the plain language of this statute, the Court finds the proper penalty is the lesser of either 100

percent of the income derived from the activity described or $1000 for each separate activity and sale

described. 

At this stage, the Court does not have sufficient undisputed, proven, or stipulated facts to

determine the proper calculation for the penalty. The IRS made an assessment pursuant to the Code and

based on its investigation. This Court will determine whether the penalty amount is too high or too low

after the production of evidence. Counterclaim Defendants’ challenge to the penalty amount does not

warrant dismissal of this claim. Accordingly, the motion to dismiss is denied.

 

IV. CONCLUSION

For the foregoing reasons the Counterclaim Defendants’ motion to dismissis DENIED in full and

the August 23, 2007 hearing is VACATED. 

IT IS SO ORDERED.

Dated: August 21, 2007 /s/ Lawrence J. O'Neill 

b9ed48 UNITED STATES DISTRICT JUDGE

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