Source: https://procedurallytaxing.com/category/flora/
Timestamp: 2019-04-18 22:39:06+00:00

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The case of Bedrosian v. United States, No. 17-3525, __ F.3d __, 2018 U.S. App. LEXIS 36146 (3rd Cir. Dec. 21, 2018) marks the possible jurisdictional cross-over of the Flora rule from the tax code into the broader reaches of the United States Code. This is not good news for individuals seeking to contest the application of the FBAR penalty – the penalty at issue in this case – or other liabilities with ties to taxes. For a discussion of the case and links to several of the documents filed in the case, look at the blog post by Jack Townsend. In addition to Jack’s excellent post which you should read for a fuller understanding of the issue here, I wish to acknowledge the assistance of Carl Smith and Christine Speidel in writing this post. While we regularly circulate the posts prior to publication, I reached out with a special request for help on this one due to my lack of knowledge about the technical workings of the FBAR provisions.
The Secretary has implemented this statute through various regulations, including 31 C.F.R. § 1010.350, which specifies that certain United States persons must annually file a Report with the IRS. Covered persons must file it by June 30 each year for foreign accounts exceeding $10,000 in the prior calendar year. 31 C.F.R. § 1010.306(c). The authority to enforce the FBAR requirement has been delegated to the Commissioner of Internal Revenue. Id. § 1010.810(g); see also Internal Revenue Manual § 4.26.1, Ex. 4.26.1-3 (U.S. Dep’t of Treasury Memorandum of Agreement and 4 Delegation of Authority for Enforcement of FBAR Requirements).
The civil penalties for a FBAR violation are in 31 U.S.C. § 5321(a)(5). The maximum penalty for a non-willful violation is $10,000. Id. § 5321(a)(5)(B)(i). By contrast, the maximum penalty for a willful violation is the greater of $100,000 or 50% of the balance in the unreported foreign account at the time of the violation. Id. § 5321(a)(5)(C)(i).
The amount of the penalty imposed on individuals who the IRS determines willfully violated the provision makes the FBAR penalty potentially similar to the IRC 6707 penalty at issue in United States v. Larson, __ F.3d __ (2nd Cir. 2018) which we discussed here and here. The IRS assessed a willful FBAR violation penalty against Mr. Bedrosian of $975,789. While that is only a small fraction of the amount assessed against Mr. Larson and “only” 50% of the amount in the foreign bank account for the year he failed to report the account, this amount still presents a high bar for entry into court to litigate the correctness of the application of the penalty.
To understand how Mr. Bedrosian came to be in front of the Third Circuit, a short review of FBAR assessment and collection procedures may be helpful. When the IRS determines that someone has failed to properly report a foreign bank account, it does not send a notice of deficiency for this Title 31 violation. It makes a summary assessment. The “person” (not “taxpayer”) is given the opportunity to go to appeals before FBAR assessment. See IRM 4.26.17.4.6 (01-01-2007) Closing the FBAR Case Unagreed. See also IRM 4.26.17.4.7 (01-01-2007) Closing the FBAR Case Appealed, and IRM 8.11.6 FBAR Penalties (appeals procedures). There are also special procedures for FBAR examinations.
Not surprisingly, the IRM reflects in several ways the government’s position that FBAR penalties are not tax penalties subject to Title 26 requirements and norms. For example, Form 2848 can only be used to appoint a representative for an FBAR exam if there is a related income tax examination. If there is not, a representative must provide a general POA valid under state law. See IRM 4.26.8.2.
The collection process for FBAR cases does not follow the normal IRS practice for collection either. For a detailed discussion of collection of an FBAR penalty you might review the slide program to which Jack Townsend mentions. The program was presented at the May, 2018 ABA Tax Section meeting.
[IRS] Collection is not delegated any enforcement authority with respect to FBAR penalties. … The Bureau of Fiscal Service (BFS), formerly Financial Management Service (FMS), which is a bureau of the Department of the Treasury, is responsible for collecting all non-tax debts. This includes FBAR penalties.
IRM 5.21.6, Foreign Financial Account Reporting. There is nothing in the IRM about BFS collection procedures or requirements.
One might wonder if FBAR penalties can be compromised. The IRS position is that FBAR assessments cannot be compromised through the Offer in Compromise program “because the assessment is based on Title 31 violations and IRC § 7122 allows the IRS to compromise only Title 26 liabilities.” IRM 5.8.1.9.6 (05-05-2017). The Third Circuit, however, rejects this simple and clear distinction.
Mr. Bedrosian decided to pay 1% of the assessed liability, or $9,757, and bring a suit for recovery of that amount in district court under the Little Tucker Act. The Tucker Act (28 U.S.C. sec. 1491(a)(1)) allows the Court of Federal Claims to hear suits against the United States founded upon a contract, the constitution, or a statute, without limitation as to amount. The Little Tucker Act (28 U.S.C. sec. 1346(a)(2)) allows similar suits in district court, but only where the amount involved does not exceed $10,000. Flora held that a tax refund suit under 28 U.S.C. sec. 1346(a)(1) (i.e., not the Little Tucker Act) can only be brought in the district court or the Court of Federal Claims after full payment of the tax in dispute. Section 1346(a)(1) applies to suits brought for refund “under the internal -revenue laws”. Neither party brought up the Flora rule as a jurisdictional hurdle here. The Department of Justice counterclaimed for the balance of the liability rather than moving to dismiss the case for lack of jurisdiction, as it did in Larson, because it believed that the district court had jurisdiction to hear the case under the Little Tucker Act. The district court did not raise Flora as a possible jurisdictional bar to the litigation. The Flora issue emerged, sua sponte, from the Third Circuit at oral argument. The court asked the parties to submit letter memoranda on the district court jurisdictional issue after the oral argument occurred. Jack Townsend’s post linked in the first paragraph above provides the links to the memoranda submitted to the Third Circuit on this issue.
The parties’ argument that Bedrosian’s claim is not within the tax refund statute is premised on the notion that the phrase “internal-revenue laws” in 28 U.S.C. § 1346(a)(1) refers only to laws codified in Title 26 of the U.S. Code. But that argument does not follow the statutory history of the tax refund statute, which suggests that “internal-revenue laws” are defined by their function and not their placement in the U.S. Code. See Wyodak Res. Dev. Corp. v. United States, 637 F.3d 1127, 1134 (10th Cir. 2011). The argument also ignores the Tax Court’s rejection of the proposition that “internal revenue laws are limited to laws codified in [T]itle 26.” See Whistleblower 21276–13W v. Comm’r, 147 T.C. 121, 130 & n.13 (2016) (noting that “the IRS itself acknowledges that tax laws may be found outside title 26”). We also observe, by analogy, that claims brought by taxpayers to recover penalties assessed under 26 U.S.C. § 6038(b) for failing to report holdings of foreign companies—a statute nearly identical to the FBAR statute, except addressing foreign business holdings rather than foreign bank accounts—are brought under the tax refund statute, 28 U.S.C. § 1346(a)(1). See Dewees v. United States, 2017 WL 8185850, at *1 (Fed. Cir. Nov. 3, 2017). Also, allowing a taxpayer to seek recovery of a FBAR penalty under the Little Tucker Act permits that person to seek a ruling on that penalty in federal district court without first paying the entire penalty, as Bedrosian did here by paying just under the $10,000 Little Tucker Act threshold. This violates a first principle of tax litigation in federal district court—“pay first and litigate later.” Flora v. United States, 362 U.S. 145, 164 (1960). We are inclined to believe the initial claim of Bedrosian was within the scope of 28 U.S.C. § 1346(a)(1) and thus did not supply the District Court with jurisdiction at all because he did not pay the full penalty before filing suit, as would be required to establish jurisdiction under subsection (a)(1). See Flora, 362 U.S. at 176–77. But given the procedural posture of this case, we leave a definitive holding on this issue for another day.
Having raised Flora as a possible jurisdictional defect to the suit, the Third Circuit decides that because the IRS filed a counterclaim the district court (and it) clearly have jurisdiction to hear the case. It decides not to make a definitive ruling on the application of Flora to FBAR cases. Maybe no other court will take the bait and after a few faltering footsteps on land the idea of applying Flora to provisions outside of Title 26 will head back to the swamp not to emerge again. Still, Bedrosian raises the specter of the extension of Flora yet again to matters never intended by the Supreme Court or anyone else when that Court ruled 5-4 on the shaky legal basis presented 60 years ago. Let’s hope that Bedrosian does not signal a new expansion of a doctrine that needs to be contracted and not expanded.
In assessing the inquiry performed by the District Court, we first consider its holding that the proper standard for willfulness is “the one used in other civil contexts—that is, a defendant has willfully violated [31 U.S.C. § 5314] when he either knowingly or recklessly fails to file [a] FBAR.” (Op. at 7.) We agree. Though “willfulness” may have many meanings, general consensus among courts is that, in the civil context, the term “often denotes that which is intentional, or knowing, or voluntary, as distinguished from accidental, and that it is employed to characterize conduct marked by careless disregard whether or not one has the right so to act.” Wehr v. Burroughs Corp., 619 F.2d 276, 281 (3d Cir. 1980) (quoting United States v. Illinois Central R.R., 303 U.S. 239, 242–43 (1938)) (internal quotation marks omitted). In particular, where “willfulness” is an element of civil liability, “we have generally taken it to cover not only knowing violations of a standard, but reckless ones as well.” Fuges v. Sw. Fin. Servs., Ltd., 707 F.3d 241, 248 (3d Cir. 2012) (quoting Safeco Ins. Co. of Am. v. Burr, 551 U.S. 47, 57 (2007)). We thus join our District Court colleague in holding that the usual civil standard of willfulness applies for civil penalties under the FBAR statute.
This is an important case for those practicing in the FBAR area. The Flora issue raises the possibility of expansion in a way that could make it much more difficult for individuals challenging an FBAR assessment. The discussion of willfulness provides some clarity that litigants may find useful.
Update: Can District Courts Hear Innocent Spouse Refund Suits?
This is an update on two cases discussed by Keith in a recent post. The post primarily discussed the case of Chandler v. United States, 2018 U.S. Dist. LEXIS 174482 (N.D. Tex. Sept. 17, 2018) (magistrate opinion), adopted by judge at 2018 U.S. Dist. LEXIS 173880 (N.D. Tex. Oct. 9, 2018). Chandler was a district court suit in which an individual sought a refund for overpaying her equitable share of taxes on a joint return, taking into account innocent spouse relief under section 6015(f). In Chandler, the district court granted a DOJ motion to dismiss for lack of jurisdiction, holding that only the Tax Court could hear suits involving innocent spouse relief. Keith wondered whether there would be an appeal of this ruling of first impression with respect to innocent spouse refund suit jurisdiction.
In his post, Keith also mentioned the existence of a similar innocent spouse refund suit under section 6015(f) pending in the district court for the District of Oregon, Hockin v. United States, Docket No. 3:17-CV-1926. In that case, a similar DOJ motion to dismiss for lack of jurisdiction was pending, arguing that district courts cannot hear refund suits involving innocent spouse relief.
The update, in a nutshell, is that Chandler was not appealed, but Hockin has been set up as a test case, where nearly all the filings are in and linked to below.
Both under the original innocent spouse provision (section 6013(e), which existed from 1971 to 1998) and the current innocent spouse provision (section 6015, enacted in 1998), the district courts and the Court of Federal Claims had occasionally, and without objection from the DOJ, entertained suits for refund filed solely on the grounds that a taxpayer paid more than was required after the application of the innocent provisions.
Although the DOJ had apparently never done so before in any innocent spouse refund suit going back all the way to the 1970s and 1980s, in the summer of 2018, DOJ trial division lawyers in both Chandler and Hockin submitted motions to dismiss for lack of jurisdiction, arguing that, because Congress in 1998 enacted a stand-alone innocent spouse Tax Court action at section 6015(e) in which the Tax Court can find an overpayment under section 6015(b) or (f), the Tax Court is the sole court in which innocent spouse refund suits can now be filed (i.e., via section 6015(e)), and so neither the district courts nor the Court of Federal Claims has jurisdiction to entertain innocent spouse refund suits. The DOJ motions acknowledged only one rare exception to this position: Where there was a pending refund suit in a district court or the Court of Federal Claims (presumably on other issues) at a time when a taxpayer also filed a suit in the Tax Court under section 6015(e), the statute provides that the Tax Court innocent spouse suit should be transferred over to the court hearing the refund suit. Section 6015(e)(3).
In July, Keith and I were alerted to the existence of the motion in Hockin – but not the one in Chandler – by pro bono counsel for Ms. Hockin, J. Scott Moede, the Chief Deputy City Attorney of the Portland, Oregon Office of the City Attorney. Mr. Moede had taken on the Hockin case in his role as a regular voluteer with the Lewis & Clark Low-Income Taxpayer Clinic in Portland. That clinic suggested that Mr. Moede contact the Harvard Federal Tax Clinic because of the Harvard clinic’s interest in innocent spouse cases.
Working with summer students, in August, Keith and I put together a draft of a proposed amicus memorandum for Hockin arguing that the DOJ position was both ahistorical and contrary to the 1998 and 2000 legislative history of section 6015(e) that seemed to make clear that Congress enacted section 6015(e) to be added on top of all existing avenues for judicial review of innocent spouse issues, not to repeal or replace any prior avenues for judicial review.
Further, in the draft memorandum, we pointed out that the Trial Section’s motion in Hockin took a position directly contrary to the position that the DOJ Appellate Section had taken in three cases that the Harvard clinic had recently litigated. In those three cases, the DOJ Appellate Section urged the appellate courts not to worry about holding that a person who filed a late Tax Court suit under section 6015(e) must have her suit dismissed for lack of jurisdiction. The DOJ Appellate Section said that such a taxpayer could always still get judicial review of the IRS’ decision to deny innocent spouse relief by paying the tax in full, filing a refund claim, and suing for a refund in the district court or the Court of Federal Claims.
In both Hockin and Chandler, the taxpayers received a notice of determination denying innocent spouse relief, but did not try to petition the Tax Court within the 90 days provided under section 6015(e). Rather, after later making either partial (Chandler) or full (Hockin) payment, the taxpayers filed refund claims and brought refund suits in district court that were timely under the rules of sections 6511(a) and 6532(a) (though, for Hockin, the lookback rules of section 6511(b) limit the amount of the refund to only a portion of what Ms. Hockin paid). Thus, except for the full payment (Flora) rule problem in Chandler, the taxpayers had done exactly what the Appellate Section said they should do to get judicial review of innocent spouse relief rulings other than through section 6015(e).
In August, we sent a draft copy of the memorandum to the DOJ attorney in Hockin and asked whether the DOJ would object to a motion by the Harvard clinic to file it. This draft memorandum apparently triggered the DOJ’s desire to explore mediation in the case. So, the case was assigned to a magistrate for mediation, and further filings on the motion (including the amicus motion) were postponed.
Then, in September and October, the magistrate and district court judge, respectively, issued rulings in Chandler granting the DOJ’s motion to dismiss for lack of jurisdiction. That is how Keith, Mr. Moede, and I learned of the existence of the Chandler case presenting the identical jurisdictional issue. Although Ms. Chandler was represented by counsel, that counsel had filed no papers in response to the DOJ motion to dismiss in her case. Naturally, this led to the magistrate and judge in Chandler relying entirely on the DOJ’s arguments and citations in ruling for the DOJ.
In his recent post on Chandler, Keith raised the question whether the Chandler district judge ruling would be appealed to the Fifth Circuit. The first piece of news in this update is that Ms. Chandler decided not to appeal. Frankly, give the Flora full payment problem in the case, I think an appeal on the issue of whether the district court otherwise would have had jurisdiction would have been pointless.
But, the second piece of news is that, in November, mediation failed in the Hockin case. So, Hockin is now set up as a possible appellate test case, depending on the district court’s ruling.
The DOJ has now not objected to the Harvard clinic’s filing of an amicus memorandum in Hockin. That memorandum was filed on November 26.
On December, 21, Ms. Hockin (through Mr. Moede) filed her response to the DOJ motion. In her response, Ms. Hockin argued not only that the district court had jurisdiction over section 6015 innocent spouse relief refund suits, but also that she had raised in her refund claim two additional arguments: that she had never filed a joint return for the year and that the IRS should be bound to give her innocent spouse relief for the year because it had given her such relief for the immediately-following taxable year. As noted in the Harvard memorandum, the “no joint return” argument has been considered in district court refund lawsuits even predating the enactment of the first innocent spouse provision in 1971.
The DOJ will be allowed to file a reply by January 11.
On February 5, oral argument on the motion will be heard before a magistrate who was not involved in the mediation. Ms. Hockin has agreed to have this magistrate decide the jurisdictional motion without the involvement of a district court judge, but the DOJ has not yet similarly consented. If the DOJ does the same, and the magistrate dismisses the case, this would allow a direct appeal from the magistrate to the Ninth Circuit. If the DOJ does not consent, the magistrate’s ruling will have to be reviewed by a district court judge before a party could appeal any adverse ruling to the Ninth Circuit.
You can find here for Hockin, the DOJ’s motion, the Harvard clinic’s amicus memorandum, and Ms. Hockin’s response.
Finally, you may be aware of the recent amendment of 28 U.S.C. section 1631 that allows district courts and the Court of Federal Claims to transfer to the Tax Court suits improperly filed in the former courts. That amendment would not help Ms. Hockin, since her district courts suit was filed long after the 90-day period to file a Tax Court suit under section 6015(e) expired. So, her case, if transferred, would have to be dismissed by the Tax Court for lack of jurisdiction because the suit was untimely filed in the district court for purposes of the Tax Court’s stand-alone innocent spouse case jurisdictional grant. For Ms. Hockin, her only chance now for getting a refund attributable to the innocent spouse provisions is for the courts to agree that district courts have jurisdiction to consider innocent spouse refund suits.
Carl Smith’s earlier post on Larson v United States discussed Larson’s argument that the Flora rule should not apply to immediately assessable civil penalties under Section 6707. Larson also argued that the absence of prepayment judicial review violated his 5th Amendment procedural due process rights.
I will briefly describe the procedural due process issue and the Second Circuit’s resolution of the issue in favor of the government.
The Second Circuit disagreed in a fairly brief discussion of the issue, and in so doing reminds us that while courts have pushed back on tax exceptionalism in many areas, when it comes to viewing the adequacy of IRS procedures in a due process framework tax is different.
At its heart, the protections associated with procedural due process, notice and hearing, are about minimizing the risk of the government making a mistake and depriving a person of a protected interest—in this case property. In finding that the process adequate, the Larson opinion leaned on caselaw that had its pedigree in 17thcentury England which had established that when assessing and collecting taxes the sovereign is entitled to rely on summary pre-payment and assessment procedures backstopped by the right to post payment judicial review.
That case law was based on the notion that potentially interposing a hostile judiciary between the taxpayer and the fisc was just too risky; taxes, after all, are the lifeblood of the government, and if the government makes a mistake in assessing a tax, a taxpayer can get justice by bringing a refund suit.
Of course, in our modern tax system, Congress has repeatedly stepped in and provided statutory protection to allow prepayment review in many cases. The US Tax Court exists in large part to soften the impact of the lack of meaningful due process protections associated with a determination of liability. The ability to pay a divisible portion of a tax and sue for refund, as well as CDP’s opportunity to challenge a liability in certain circumstances, all soften the blow of the exceptional view of tax cases.
As Carl mentioned the 6707 penalty is not divisible, and we have discussed the limits of CDP providing a forum for challenging the penalty.
This brings us to Larson’s constitutional challenge. As Larson and others have argued, much has happened since the Supreme Court first blessed the assess first pay later constitutionality of the US tax system in the latter part of the 19thand early part of the 20thcentury. A number of meaningful Supreme Court cases, such as Goldberg v Kelly, provided that in most instances, the norm should be more defined pre-deprivation review. Most creditors are no longer entitled to rely on post payment judicial protections to ensure that a debtor’s interests are protected. In Mathews v Eldridge, the Supreme Court instructed courts to consider three factors when faced with a due process claim: (1) “the private interest that will be affected by the official action”; (2) “the risk of an erroneous deprivation of such interest through the procedures used, and the probable value, if any, of additional or substitute procedural safeguards”; and (3) “the Government’s interest, including the function involved and the fiscal and administrative burdens that the additional or substitute procedural requirement would entail.
In concluding that Larson did not have a successful procedural due process claim, the court did acknowledge that the Mathews factors were instructive and did in fact apply those factors to Larson’s facts. That is more than some courts have done with tax cases, where some opinions state that since the time of King Charles the sovereign is entitled to rely on summary assessment procedures, and leave it at that.
Larson’s interest is not insignificant; the IRS has imposed onerous penalties that Larson claims he cannot pay. But, as we previously noted, the IRS Office of Appeals review resulted in a substantial reduction of Larson’s penalties. No review is perfect and Larson offers no record‐based criticism of how the appeal was conducted. We are satisfied that the current procedures effectively reduced the risk of an erroneous deprivation and gave Larson a meaningful opportunity to present his case. Indeed, the Seventh Circuit recently observed that the IRS Office of Appeals “is an independent bureau of the IRS charged with impartially resolving disputes between the government and taxpayers,” and that “Congress has determined that hearings before this office constitute significant protections for taxpayers.” Our Country Home Enters., Inc., 855 F.3d at 789. Lastly, the governmental interest here is singularly significant due to the careful structuring of the tax system and the Government’s “substantial interest in protecting the public purse.” Flora II, 362 U.S. at 175. Considering all three factors, our Mathewsanalysis weighs in the Government’s favor. Therefore, application of the full‐payment rule to Larson’s § 6707 penalties does not result in a violation of Larson’s due process rights.
The opinion leans heavily on Appeals’ role, both in terms of how Congress has emphasized Appeals’ importance to the tax system (an issue front and center in the Facebook litigation we have discussed) and how Appeals reduced the penalties at issue in the case by $100 million. The opinion heavily weighs the government’s interest without thinking on a more granular level as to what the government interest is. For example, what is the government’s interest in summary process for this penalty? What additional burdens or risks would the government face by allowing for judicial review of the penalty? I also would have liked to have seen a more robust discussion of the individual’s interest and a bit more on the structural deficiencies with Appeals as a resolution forum relative to a judicial forum.
To be sure, due process is not a one size fits all analysis. And as a comment to Carl’s post notes perhaps Larson is not the most sympathetic of taxpayers. Yet, over time, our tax system has changed to reflect an increased sense that taxpayers should have the right to challenge an IRS assessment without having to full pay the liability. Congress has also added significant civil penalties that are immediately assessable; that progression has been piecemeal and could stand to use some reform that might also consider the procedural aspects of challenging those penalties.
Norms with respect to individual protections and taxpayer rights are changing as well. Perhaps the appropriate remedy here is a statutory fix to CDP that would allow for Tax Court review of the penalty and possible refund of any amount paid in a CDP proceeding. That would more closely align collection due process with the 5thAmendment notion of due process.
In Flora v. United States, 357 U.S. 63 (1958) (“Flora I”), and, again, in an expanded opinion at 362 U.S. 145 (1960) (“Flora II”), the Supreme Court held that a jurisdictional predicate to a district court or Court of Federal Claims suit under 28 U.S.C. § 1346(a)(1) for refund of an income tax deficiency is full payment of the tax deficiency. In oral argument in a later Supreme Court case, Laing v. United States, 423 U.S. 161 (1976), the Solicitor General’s office made clear its position that Flora’s full payment requirement only applies where the taxpayer could have, instead, petitioned the Tax Court to contest the deficiency prepayment, but chose not to. A recent opinion, Larson v. United States, 2018 U.S. App. LEXIS 10418 (2d Cir., Apr. 25, 2018), involved a tax shelter promoter penalty assessed under section 6707 – one of the many “assessable” penalties that Congress has enacted since Flora that may be assessed without first allowing prepayment review in Tax Court through a notice of deficiency. In Larson, the DOJ argued contrary to what the SG’s office did in Laing, and the Second Circuit accepted this changed position – holding that the Florafull payment requirement also applies to assessable penalties for which there is no possibility of Tax Court prepayment review through deficiency procedures.
The facts of Larson were as follows: Larson was criminally convicted in connection with promoting several tax shelters. The IRS later decided to impose assessable penalties under section 6707 for the promoters’ failure to file the necessary form under section 6111 (Form 8918) with the Office of Tax Shelter Analysis in Ogden, Utah alerting the IRS to the shelters. Under section 6707 at the time (though not currently), the penalty under section 6707 was calculated as 1% of “the aggregate amount [that taxpayers] invested in such tax shelter”.
The IRS proposed to assess penalties of $160 million on a collection of promoters (including Larson), jointly and severally. This means that the “aggregate amount invested”, according to the IRS, was $16 billion.
Appeals did not agree with Larson’s argument for lowering the penalties to $7 million, though it did give him credit for the penalties already paid by other promoters, reducing what Larson owed to about $60 million.
Larson paid $1.4 million toward the penalties, filed a refund claim, and then sued for a refund in the district court of the Southern District of New York. It is not clear why he paid $1.4 million, but it appears that he thought the section 6707 penalty was “divisible”, and that $1.4 million was enough payment of a divisible tax to give the court jurisdiction. In a footnote in Flora II, the Supreme Court said that full payment would not be required if a divisible tax was involved — a footnote that many people take advantage of with respect to section 6672 responsible person penalties (which have been held to be divisible).
In his suit, Larson argued that he had made a sufficient jurisdictional payment to commence suit, but that, even if he did not, the court had alternative jurisdiction under the Administrative Procedure Act, mandamus, Due Process, and because the size of the penalty violated the Eight Amendment’s excessive fines clause.
Unfortunately for Larson, shortly after he commenced his suit, the Federal Circuit held in Diversified Group Inc. v. United States, 841 F.3d 975 (Fed. Cir. 2016), that the section 6707 penalty was not divisible, so Flora IIrequired full payment in order to commence a refund suit. The district court in Larson cited and followed Diversified Group, also rejecting all the other bases for jurisdiction that Larson alleged. Larson v. United States, 2016 U.S. Dist. LEXIS 179314 (SDNY 2016). Stephen did a prior post on both Diversified and the Larson district court opinion.
This post will not address the other grounds alleged for jurisdiction, but Les will be doing a later post on at least one of those other grounds.
In his Second Circuit Appeal, Larson repeated all of his arguments for why the district court had jurisdiction, but abandoned his argument that section 6707 penalties are divisible. Rather, Larson’s main argument was now that Flora II did not require full payment in a case like section 6707 penalties where no prepayment review was available in the Tax Court through a notice of deficiency. Larson also argued that he couldn’t afford to pay the roughly $60 million left to make full payment, so requiring him to make full payment would leave him without a practical remedy for judicial review.
Flora II expanded upon the opinion in Flora Iand corrected a significant misstatement in the earlier opinion. Hereafter, I will discuss only Flora II. In Flora II, the IRS had sent the taxpayer a notice of deficiency for income tax. He did not file a Tax Court petition, but rather paid part of the deficiency, filed a refund claim, and brought suit for refund in district court. The Supreme Court held that a jurisdictional predicate to a refund suit under 28 U.S.C. § 1346(a)(1) is full payment of the tax. But, the way it got to this holding was curious.
The statute being interpreted first appeared in the Revenue Act of 1921. But, the court found that, even though there were statutory antecedents, with regard to whether full payment is required for a refund suit, the actual “statutory language . . . is inconclusive and legislative history . . . is irrelevant”. Flora II, 362 U.S. at 152.
The establishment of the Board of Tax Appeals in 1924, which allowed taxpayers to contest deficiencies without prepayment, seemed to be done with the assumption that the Board was needed because refund suits concerning deficiencies otherwise required full payment.
In 1935, Congress amended the Declaratory Judgment Act (28 U.S.C. § 2201) to prohibit declaratory judgments “with respect to taxes”. The Court noted that if full payment were not required, then nothing would stop a taxpayer from paying $1, filing a refund claim, and suing for a refund. The latter would effectively be a suit for a declaratory judgment.
The adoption of section 7422(e), which provides that, if a refund lawsuit is underway when the taxpayer receives a notice of deficiency for the same taxable year, the taxpayer may either continue the suit in district court or move it to the Tax Court, but not litigate simultaneously in both courts.The Court concluded that the logic of not requiring full payment for a refund suit would be that a taxpayer could simultaneously conduct a deficiency suit in the Tax Court and a refund suit in the district court – a situation that section 7422(e) does not contemplate.
A word should also be said about the argument that requiring taxpayers to pay the full assessments before bringing suits will subject some of them to great hardship. This contention seems to ignore entirely the right of the taxpayer to appeal the deficiency to the Tax Court without paying a cent. If he permits his time for filing such an appeal to expire, he can hardly complain that he has been unjustly treated, for he is in precisely the same position as any other person who is barred by a statute of limitations.
362 U.S. at 175 (footnote omitted).
Laing v. United States, 423 U.S. 161(1976), involved income tax termination and jeopardy assessments under section 6851 and 6861 at a time when those sections did not state that the IRS must issue a notice of deficiency in connection with making such assessments. The IRS had made such an assessment and argued that it was not required to issue a notice of deficiency before or after the assessment.
What this Court held in Flora was that under general circumstances a taxpayer cannot bring a refund suit until he has paid the full amount of the assessment. In reaching that decision, the Court painstakingly went through the legislative history in connection with the creation of the Board of Tax Appeals, and there were indications going both ways as to what Congress really intended. But I think that the really operative portion of the Chief Justice’[s] opinion in Flora was the fact that there the taxpayer had another remedy. He could have gone to the Tax Court, and that made all the difference in Flora . . . .
For those interested, attached are all the briefs filed in Larson: the appellant’s brief, the appellee’s brief, the reply brief(which contains the entire Laing oral argument transcript as an addendum), and an amicus brieffiled by the tax clinics at Harvard and Georgia State. I believe that Keith will be doing a further post about what the amicus brief discussed.
The majority in Laing held that the IRS was required to send a notice of deficiency, so it did not reach the issue of whether Flora II required full payment for a refund suit in the absence of the possibility of receiving a notice of deficiency.
This passage demonstrates that the full-payment rule applies only where a deficiency has been noticed, that is, only where the taxpayer has access to the Tax Court for redetermination prior to payment. This is the thrust of the ruling in Flora, which was concerned with the possibility, otherwise, of splitting actions between, and overlapping jurisdiction of, the Tax Court and the district court. Where, as here, in these terminated period situations, there is no deficiency and no consequent right of access to the Tax Court, there is and can be no requirement of full payment in order to institute a refund suit.
423 U.S. at 208-209 (citation omitted).
While it is true that Flora I and Flora II acknowledge the existence and availability of Tax Court review, see Flora I, 357 U.S. at 75–76; Flora II, 362 U.S. at 175, Tax Court availability was not essential to the Supreme Court’s conclusion in either opinion. The basis of the Flora decisions is that when Congress enacted § 1346(a)(1) it understood the statute to require full‐payment to maintain “the harmony of our carefully structured twentieth century system of tax litigation,” not that the full‐payment rule only applies when Tax Court review is available. Flora II, 362 U.S. at 176–77.
The Larson court did not acknowledge that the government had changed position as to the applicability of the full payment rule between Laingto Larson. The Larson court did quote Justice Blackmun’s statements from his dissent in Laing, but noted: “Justice Blackmun’s view did not garner majority support. No subsequent majority of the Supreme Court has adopted that understanding of the statute.” Slip op. at 12 n.8.
We close with a final thought. The notion that a taxpayer can be assessed a penalty of $61 million or more without any judicial review unless he first pays the penalty in full seems troubling, particularly where, as Larson alleges here, the taxpayer is unable to do so. But, “[w]hile the Flora rule may result in economic hardship in some cases, it is Congress’ responsibility to amend the law.” Rocovich v. United States, 933 F.2d 991, 995 (Fed. Cir. 1991).
The most surprising thing about the Larson opinion, to me, is that this issue of Flora’s application to assessable penalties has not been litigated before – i.e., until about 60 years later. But, then most assessable penalties are either severable, require only 15% payment to commence suit, or are rather nominal in amount, so there were few in a position to argue that a full payment requirement to commence an assessable penalty refund suit was neither required by Flora II nor economically practicable.
The second most surprising thing is that both Flora II and Larson defend their statutory interpretation exclusively by reference to understandings of later Congresses when legislating. I have always read that one is not to pay much attention to what later Congresses think a statute means.
But, ultimately, I was not surprised at the Larson ruling, and I don’t think Keith was either. I refer people to my statutory proposal made some years ago: “Let the Poor Sue for a Refund Without Full Payment”, Tax Notes Today, 2009 TNT 191-4 (Oct. 6, 2009). Although my proposal was designed primarily for the poor, it would help Larson (assuming that he gets himself on an installment agreement or in currently not collectible status first). The opinion in Larson just underscores the need for a legislative fix.
As we move into tax season, it is worth remembering that IRS has a significant arsenal of civil and criminal penalties to address misbehaving preparers. I recently came across a federal district court case, Bailey v. United States that discussed an exception to the Flora full payment rule for preparers subject to penalties for preparing tax returns or refund claims that have understatements stemming from unreasonable positions or willful/reckless conduct. For preparers, that penalty can be fairly sizeable, as under Section 6694 the amount of the penalty is the greater of $1,000 for each return or refund claim ($5,000 if the understatement is due to willful or reckless conduct) or 50% (75% for willful/reckless conduct) of the income derived by the tax return preparer with respect to the return or claim for refund.
These penalties are not subject to the deficiency procedures, meaning that if IRS examines a preparer and determines that the preparer’s conduct in preparing the return or refund claim warrants a penalty, the preparer will generally have to pursue a refund suit to guarantee judicial review of the penalty. (I’ll skip the CDP discussion on this, a topic we also have discussed, which turns on whether a preparer has previously had an opportunity to dispute the penalty through its rights to have Appeals consider the matter).
We have often discussed the Flora rule, which requires full payment to ensure jurisdiction for a refund suit. Flora presents a considerable barrier, especially for moderate income persons subject to the penalty but also stemming from the fact that some civil penalties, including the variety of penalties preparers are subject to, can be very significant; Keith has written about that before here, suggesting perhaps it is time to rethink Flora in light of the impact and potential unfairness of requiring full payment to get a court to review the Service’s penalty determination.
Bailey implicates an implicit statutory exception to Flora for the 6694 penalties. IRS asserted $70,000 in penalties due to what IRS felt was his willful or reckless conduct. As per Section 6694(c)(1), if a preparer pays at least 15% of the Section 6694 penalty within 30 days of IRS making notice and demand, the preparer can stay collection and file a refund claim. Section 6694(c)(2) also provides that if a preparer fails to file suit in district court within the earlier of (1) 30 days after the Service denies his claim for refund or 30 days of the expiration of 6 months after the day on which he filed the claim for refund, then paragraph (1) of Section 6694(c) no longer applies. That suggests that a preparer can avoid the full payment rule; to that end see note 1 of the 2016 Bailey opinion, discussing the logical Flora implication of Section 6694(c)(2).
In Bailey, the preparer paid $10,500, or 15 percent of the penalty within 30 days of the IRS notice. He filed a refund claim on March 28, 2014. At the time of the suit, IRS did not deny the claim. Thirty days after the expiration of 6 months (and a day) from the time he filed his claim was October 29, 2014. Bailey filed his refund suit in district court on November 12, 2014. That filing was two weeks late, and he no longer was eligible to take advantage of the exception to Flora.
Because the preparer missed the deadline, the district court granted the government’s motion to dismiss the suit. The failure to comply with the time requirements in Section 6694(c)(2) meant that absent the preparer’s full payment of the penalty, the district court did not have subject matter jurisdiction over the suit. Because the dismissal was without prejudice, the preparer could cure his error by fully paying the balance and refiling his complaint.
Instead of full paying, the preparer filed another action in federal court in 2017; this time, the suit alleged personal misconduct among IRS employees; in light of a motion to dismiss the preparer filed a motion to substitute the US as a party to the suit and restated his allegations that his conduct did not warrant a penalty. In November of last year the court dismissed that suit.
So Flora is not an option.
In the below post, we will discuss the somewhat recent holdings in Diversified Group v. United States and Larson v. United States, two cases dealing with whether or not promoter penalties under Section 6707 are divisible for refund claim purposes. An interesting issue, and one that may require a tweak to the law from Congress.
In September of 2015, Keith wrote about Diversified Group Inc. v United States, where the Court of Federal Claims held that shelter promoter penalties imposed under Section 6707 were not divisible, and therefore the promoter could not pay the penalty imposed on just one investor (this case was decided based on prior versions of Section 6111 and 6707, but the underlying concepts are still valid). In November, the Court of Appeals for the Federal Circuit affirmed the Court of Federal Claims; the opinion can be found here.
As explained by Keith and in the opinion, in general, a taxpayer can only sue for a refund in a district court after the amount of tax has been paid in full. SCOTUS created an important exception to this rule in Flora v. US, where it indicated an excise tax may be divisible based on each taxable transaction or event, allowing full payment to occur with a small amount of tax. Under Section 6707, certain promoters who fail to file required returns, or do so with a false or incomplete return, regarding reportable transactions are subject to penalties. The penalty then imposed was 1% of the aggregate investment amount (now the penalty is $50,000 for each transaction, or, if relating to a listed transaction, it is the greater of $200k or 50% of the gross income derived by the advisor (increased to 75% if the failure is intentional)). The promoter paid a portion related to one transaction and sued for refund, and the IRS objected. The lower court determined the penalty was not divisible, and was related to the singular act of failing to report the promoting of the tax shelter (and not the imposition of the amount on the 192 clients separate transactions).
The appellate court affirmed that the singular act of failing to report the shelter was what occurred to impose the penalty. Further, it reviewed the applicable language, finding the Code viewed the shelters in the aggregate (not individually) for determining if the penalty was applied, and Section 6111 required disclosure the day on which the shelter was initially offered, and did not relate to each investor buying in. Providing more evidence it was the initial failure and not each purchase of the shelter.
While feeling sorry for someone who promotes an egregious tax shelter scheme requires a great deal of effort, I think parties should have the opportunity to litigate the imposition of a tax or penalty without full payment. The Court of Federal Claims decision rests on firm ground, yet barring someone against whom the IRS assesses a penalty, any penalty, from disputing that penalty in court without paying over $24 million seems inappropriate. Maybe tax shelter promoters have access to that kind of money but most parties do not.
Keith’s post also discusses the potential for CDP as an avenue for a merit review by the courts, which is not without issues. If readers have not previously reviewed that aspect of Keith’s prior post, I would encourage them to do so.
The Diversified holding was followed by Larson v. United States, which was decided by the District Court for the Southern District of New York on December 28th. Larson is continued fallout from the KPMG tax shelter case from the mid-2000s. Mr. Larson paid a fraction of the $63.4MM Section 6707 penalty related to one transaction (the overall penalty was initially a $160.2MM penalty, but others paid portions of it). He argued that the partial payment was valid under Flora. The Southern District came to the same conclusion as the Federal Circuit.
Jack Townsend wrote up the case on his Federal Tax Crimes Blog here, where he summarizes the holding and quotes the salient aspects of the case. At the end of the post, Jack highlights his takeaways from the case, which include similar contents to Keith’s thoughts on Diversified. Jack thinks, given the huge dollar amounts that can be involved, that there needs to be some prepayment or partial payment review, otherwise taxpayers could be inappropriately precluded from litigating the merits. Mr. Larson attempted to make similar arguments in his case, based on the APA and the Constitution, which the Southern District did not agree with. These are discussed below.
Jack also highlights an APA challenge raised by Mr. Larson. Larson argued for judicial review under the APA claiming the denial of his refund claim was arbitrary, capricious, and an abuse of the IRS discretion. The Court found this argument lacking, stating “an existing review procedure will…bar a duplicative APA claim so long as it provides adequate redress. Clark City Bancorp. v. US Dept. of Treasury, 2014 WL 5140004 (DDC Sept. 19, 2014)”. The “existing review procedure” here was the full payment of the claimed amount due, and the request for review of a refund denial in the district court. Jack’s post highlights other language summarizing this holding.
There are various other interesting arguments made in this case. For instance, Mr. Larson argued the fines under Section 6707 violate the 8th Amendment of the Constitution (excessive fine, not cruel and unusual punishment, although if I told my wife I owed a fine of that amount I am certain it would result in cruel and unusual punishment). The Court questioned whether it had jurisdiction to review the matter, but eventually determined that didn’t matter, as Larson failed to state a claim.
Sticking with long shot Constitutional challenges, Mr. Larson also argued that his due process rights under the Fifth Amendment would be violated by the penalty under Section 6707 if it was not divisible because the imposition of the full payment rule would preclude him from being able to pay and therefore from being able to have a review. The Court rejected this argument, stating courts have consistently held that the inability to pay penalties has never been determined to be a due process violation (citing to various cases, including the recent case of his one-time co-defendant, Robert Pfaff, 117 AFTR2d 2016-981 (D. Colo. 2016)). I understand if this was not the rule, everyone would claim inability to pay, and it is possible that much lower fine amounts would clog the courts. Here, however, the fine was $63MM! I think less than .1% of the population would ever be able to pay that.
I have no further insight beyond what Jack and Keith stated. For the most part, the people arguing these cases have violated the tax law, and done so knowing full well that the areas they were flirting with had substantial penalties. They did this for significant financial gain. But, the penalties can easily be many times more than the assets of the individual, making it impossible for full payment, and there should be some way for the merits to be litigated. This will likely require a legislative change, although I am uncertain who is going to advocate for the tax shelter promoters.
Summary Opinions — For the last time.
This could be our last Summary Opinions. Moving forward, similar posts and content will be found in the grab bags. This SumOp covers items from March that weren’t otherwise written about. There are a few bankruptcy holdings of note, an interesting mitigation case, an interesting carryback Flora issue, and a handful of other important items.
Near and dear to our heart, the IRS has issued regulations and additional guidance regarding litigation cost awards under Section 7430, including information regarding awards to pro bono representatives. The Journal of Accountancy has a summary found here.
The Bankruptcy Court for the Southern District of Florida in In Re Robles has dismissed a taxpayer/debtor’s request to have the Court determine his post-petition tax obligations, as authorized under 11 USC 505, finding it lacked jurisdiction because the IRS had already conceded the claim was untimely, and, even if not the case, the estate was insolvent, and no payment would pass to the IRS. Just a delay tactic? Maybe not. There is significant procedural history to this case, and this 505 motion was left undecided for considerable time as there was some question about whether post-petition years would generate losses that could be carried back against tax debts, which would generate more money for creditors. This became moot, so the Court stated it lacked jurisdiction; however, the taxpayer still wanted the determination to show tax losses, which he could then carryforward to future years (“establishing those losses will further his ‘fresh start’”). The Court held that since the tax losses did not impact the estate it no longer a “matter arising under title 11, or [was] a matter arising in or related to a case under title 11”, which are required under the statutes.
You can get credit for taxes paid in Cuba.
The Tax Court in Best v. Comm’r has imposed $20,000 in excess litigation costs on an attorney representing clients in a CDP case. The Court, highlighting the difference in various courts regarding the level of conduct needed, held the attorney was “unreasonable and vexations” and multiplied the proceedings. Because the appeal in this case could have gone to the Ninth Circuit or the DC Circuit, it looked to the more stringent “bad faith” requirements of the Ninth Circuit. The predominate issue with the attorney Donald MacPherson’s conduct appears to have been the raising of stated frivolous positions repeatedly, which the Court found to be in bad faith.
And, Donald MacPherson calls himself the “Courtroom Commando”, and he is apparently willing to go to battle with the IRS, even when his position may not be great…and the Service and courts have told him his position was frivolous. Great tenacity, but also expensive. In May v. Commissioner, the Tax Court sanctioned him another seven grand.
The Northern District of Ohio granted the government’s motion for summary judgement in WRK Rarities, LLC v. United States, where a successor entity to the taxpayer attempted to argue a wrongful levy under Section 7426 for the predecessor’s tax obligation. The Court found the successor was completely the alter ego of the predecessor, and therefore levy was appropriate, and dismissal on summary judgement was proper.
I’m not sure there is too much of importance in Costello v. Comm’r, but it is a mitigation case. Those don’t come up all that frequently. The mitigation provisions are found in Sections 1311 to 1314 and allow relief from the statute of limitations on assessment (for the Service) and on refunds (for taxpayers) in certain specific situations defined in the Code. This is a confusing area, made more confusing by case law that isn’t exactly uniformly applied. The new chapter 5 of SaltzBook will have some heavily revised content in this area, and I should have a longer post soon touching on mitigation and demutualization in the near future. In Costello, the IRS sought to assess tax in a closed year where refunds had been issued to a trustee and a beneficiary on the same income, resulting in no income tax being paid. Section 1312(5) allows mitigation in this situation dealing with a trust and beneficiary. There were two interesting aspects of this case, including whether the parties were sufficiently still related parties where the trust was subsequently wound down, and whether amending a return in response to an IRS audit was the taxpayer taking a position.
The First Circuit has joined all other Circuits in holding “that the taxpayer must comply with an IRS summons for documents he or she is required to keep under the [Bank Secrecy Act], where the IRS is investigating civilly the failure to pay taxes and the matter has not been referred for criminal prosecution,” and not allowing the taxpayer for invoking the Fifth Amendment. See US v. Chen. I can’t recall how many Circuit Courts have reviewed this matter, but it is at least five or six now.
The District Court for the District of Minnesota in McBrady v. United States has determined it lacks jurisdiction to review a refund claim for taxpayers who failed to timely file a refund request, and also had an interesting Flora holding regarding a credit carryback. The IRS never received the refund claim for 2009, which the taxpayer’s accountant and employee both testified was timely sent, but there was not USPS postmark or other proof of timely mailing, so Section 7502 requirements were not met. Following an audit, income was shifted from 2009 to other years, including 2008. This resulted in an outstanding liability that was not paid at the time the suit was filed, but the ’09 refund also generated credits that the taxpayer elected to apply to 2008. The taxpayers also sought a refund for 2008, arguing the full payment of the ’09 tax that created the ’08 credit should be viewed as “full payment”, which they compared to the extended deadline for refunds when credits are carried back. The Court did not find this persuasive, and stated full payment of the assessed amount of the ’08 tax was needed for the Court to have jurisdiction over the refund suite under Flora. Sorry, couldn’t find a free link.
The IRS lost a motion for summary judgement regarding prior opportunity to dispute employment taxes related to a worker reclassification that occurred in prior proceeding. The case is called Hampton Software Development, LLC v. Commissioner, which is an interesting name for the entity because the LLC operated an apartment complex. The IRS argued that during a preassessment conference determining the worker classification the taxpayer had the opportunity to dispute the liability, and was not now entitled to CDP review of the same. The Court stated the conference was not the opportunity, as the worker classification determination notice is what would have triggered the right under Section 6330(c)(2)(B), and such notice was not received by the taxpayer (there was a material question about whether the taxpayer was dodging the notice, but that was a fact question to be resolved later). The Hochman, Salkin blog has a good write up of this case, which can be found here.
The IRS has issued additional regulations under Section 6103 allowing disclosure of return information to the Census Bureau. This was requested so the Census could attempt to create more cost-efficient methods of conducting the census. I don’t trust the “Census”. Too much information, and it sounds really ominous. That is definitely the group in Big Brother that will start rounding up undesirables, and now they have my mortgage info.
The Service has issued Chief Counsel Notice 2016-007, which provides internal guidance on how the results of TEFRA unified partnership audit and litigation procedures should be applied in CDP Tax Court cases. The notice provides a fair amount of guidance, and worth a review if you work in this area.
More bankruptcy. The US Bankruptcy Court for the Eastern District of Virginia has held that exemption rights under section 522 of the BR Code supersede the IRS offset rights under section 533 of the BR Code and Section 6402. In In Re Copley, the Court directed the IRS to issue a refund to the estate after the IRS offset the refund with prepetition tax liabilities. The setoff was not found to violate the automatic stay, but the court found the IRS could not continue to hold funds that the taxpayer has already indicated it was applying an exemption to in the proceeding. There is a split among courts regarding the preservation of this setoff right for the IRS. Keith wrote about the offset program generally and the TIGTA’s recent critical report of the same last week, which can be found here.
The Court of Federal Claims decision in Diversified Group, Inc. v. United States continues the recent focus on what it takes to get into the door with a refund suit. (See recent posts on Flora rule here and here) The Court bars the door to a tax shelter promoter seeking to pay only a fraction of the penalty imposed under IRC 6707 for failing to register a tax shelter scheme. While feeling sorry for someone who promotes an egregious tax shelter scheme requires a great deal of effort, I think parties should have the opportunity to litigate the imposition of a tax or penalty without full payment. The Court of Federal Claims decision rests on firm ground, yet barring someone against whom the IRS assesses a penalty, any penalty, from disputing that penalty in court without paying over $24 million seems inappropriate. Maybe tax shelter promoters have access to that kind of money but most parties do not.
In this post I will explain the opinion but also connect the result with CDP and how the result in the trial court opinion possibly opens the door to litigating the merits of the penalty in a CDP proceeding.
Diversified Group, Inc. (DGI), a boutique merchant banking firm, and its president created a Son of Boss type shelter which they marketed between 1999 and 2002 to 193 clients seeking to evade or avoid their income tax liabilities. Around the Ides of March in 2002 the IRS notified DGI it was opening a 6707 penalty audit which later expanded to include the corporate president. A short eleven years later in May, 2013, the IRS sent a notice of proposed adjustment to each promoter informing them that it had determined they each owed $42 million as a penalty for failure to register the tax shelter. The promoters were given a chance to request a pre-assessment meeting with Appeals which they did not request. They later received notice that the penalty was reduced to $24 million because of payments by others. The penalty imposed resulted from “1 percent of the aggregate amount invested in [the] tax shelter” by their clients. The IRS provided them with charts showing the investment by each of the 193 clients.
The IRS assessed the penalty and sent notice and demand on February 21, 2014. Shortly thereafter each promoter made a payment to the IRS reflecting 1% of the aggregate investment by one client. (Note that the law on the computation of this penalty has changed since the year at issue though it would still produce a big number.) DGI paid $15,450 and the president paid $18,310 plus interest. With the payments, the promoters filed refund claims. The IRS denied these claims on April 10, 2014, less than 45 days after the claims were filed, advising the promoters that the “penalty is not assessed on each individual transaction, but instead assessed based on the aggregate amount invested in the tax shelter, or the aggregate amount of fees paid to promoters of the tax shelter…. Thus, [the] penalties are non-divisible and must be paid in full before commencing a refund suit.” The promoters filed suit three months later and the IRS immediately moved to dismiss the case. The opinion addresses that motion and sustains it.
The fight here centers on the concept of divisibility. The section 6707 penalty does not require the IRS to issue a notice of deficiency prior to assessment. For liabilities the IRS can assess without issuing a notice of deficiency, litigation concerning the correctness of the penalties normally occurs in the district courts or in the Court of Federal Claims though I will discuss some other options below that become available in the collection process or in bankruptcy. Under the Flora rule, the doors to the district courts or the Court of Federal Claims only open after a taxpayer fully pays the tax. To mitigate the difficulty created by this jurisdictional barrier, many of the types of taxes not subject to the deficiency procedures allow the taxpayer to pay a divisible portion of the overall assessment and then sue. The promoters sought to create a similar exception for the 6707 allowing them to pay only a portion of the penalty and get into court.
The Court of Federal Claims describes the promoter’s argument as “one that raises an issue of first impression, and that, if accepted, would carve out a new judicially created exception to the rule requiring full payment of the tax owed prior to filing suit in this court.” In arguing for divisibility of the penalty as a path to refund jurisdiction, the promoters relied heavily on two cases, Noske v. United States and Humphrey v. United States. Both of these cases dealt with the 6700 penalty for promoting abusive tax shelters and found that the penalty imposed by that section is divisible into each activity underlying the imposition of the penalty. Because of the location in the Code of the 6700 and 6707 penalties as neighbors and the goals of the two penalties to stop tax shelters, the promoters here argued for the adoption of a similar rule of divisibility with respect to 6707.
So, is there anything the promoters can do, short of full payment, to obtain judicial review of the IRS determination that they owe over $24 million in penalties? What if they requested a CDP hearing following the filing of the inevitable notice of federal tax lien or a notice of intent to levy? Does CDP provide a path to consideration of the merits unavailable through the divisible payment refund process? It appears that they can litigate the merits of this penalty using the CDP process though the path to that answer may not be as clear as one might like and the answer appears to turn on whether the taxpayer has administratively requested penalty abatement after the assessment.
In Lewis v. Commissioner the Court held that the post-assessment opportunity to appeal the penalty determination administratively provides the taxpayer with all of the relief needed to prevent them from litigating the merits of the liability in a subsequent CDP hearing stating “Respondent argues that pursuant to section 6330(c)(2)(B) and section 301.6330-1(e)(3), QA-E2, Proceed. Admin. Regs., where a taxpayer has an opportunity for a conference with respondent’s Appeals Office before a collection action has begun, then the amount and existence of the underlying tax liability can neither be raised properly in a collection review hearing nor on appeal to this Court.” The decision is based on an interpretation of Treas. Reg. §301-6330-1(e)(3), Q&A-E2. Guest blogger Lavar Taylor wrote passionately on the incorrectness of the Court’s interpretation of the regulation.
The taxpayer in Lewis sought abatement of the penalty after assessment. The denial of the abatement request would have afforded him an opportunity to go to Appeals to discuss the denial. That opportunity was a post-assessment opportunity of the type described in the first sentence of Q&A-E2. When you make this type of appeal, no judicial remedy exists.
the regulation is a trap for the unwary. Taxpayers and unsophisticated representatives will generally be unaware that, by seeking an administrative review with the Office of Appeals of a penalty or other liability that can otherwise be challenged in a CDP appeal prior to submitting a CDP appeal, they are forfeiting their right to seek judicial review of the liability in the context of a CDP case.
Sophisticated taxpayers who wish to preserve their right to contest the liability in Tax Court in the context of a CDP case will simply refuse to submit a request for abatement of penalties prior to initiating a CDP appeal in response to the filing of a lien notice or the issuance of a notice of intent to levy.
The decision in Diversified Group states that the taxpayer chose not to go to Appeals to contest the penalty but that statement refers to a pre-assessment opportunity to go to Appeals. The decision is silent on whether the taxpayer has sought penalty abatement post-assessment. If not, it would appear that CDP would offer an opportunity to litigate this liability without first paying $24 million.
After Lewis a series of cases allow or discuss the ability to litigate the merits of a penalty in the CDP context. Because these cases do not discuss Lewis, they do not parse the Q&A in the regulation. It appears that either the IRS conceded jurisdiction because no post assessment request for abatement exits (although that is not clear from the cases) or the Lewis issue was simply overlooked. The first case in this alternative line is Williams v. Commissioner where a taxpayer sought to litigate his liability for an FBAR penalty. The Tax Court in dismissing the case for lack of jurisdiction because of the absence of a notice of deficiency or notice of determination also explored the CDP context. The discussion of the taxpayer’s ability to get in the Tax Court’s door in the CDP context is dicta and does not appear to address an issue raised by the taxpayer. The government did not raise the CDP issue. Because the collection options available to the government with respect to the FBAR penalty do not include filing a notice of federal tax lien or making a levy, CDP would never be an option for contesting this type of penalty and the Court went through the analysis to show that its doors were barred in the case before it and would always be shut to a determination on the merits of this type of penalty.
Next, a district court decision, harking back to the days when CDP cases could be heard in district court or Tax Court depending on the type of tax at issue, also addressed the issue in dicta. In D&M Painting, Corp. v. United States, the court indicated that taxpayers seeking an injunction to stop the IRS from collecting on an IRC 6707A penalty could not enjoin the IRS from collecting, in part, because they had the right to dispute the liability without paying first in a CDP hearing. The district court in D&M did not cite to Treas. Reg. §301-6330-1(e)(3), Q&A-E2.
Later that same year D&M is decided, the Tax Court looks at the possibility of CDP jurisdiction in another 6707A case. (There is a difference in the penalty between 6707 and 6707A; however, I cannot see how that difference would matter in the analysis here.) In Smith v. Commissioner, another regular T.C. opinion, the Tax Court says it does not have jurisdiction over 6707A cases in a deficiency proceeding similar to its finding in Williams regarding the FBAR penalty but, in dicta, states “we would presumably have jurisdiction to redetermine a liability challenge asserted by petitioners in a collection due process hearing.” The Court cites to Williams and to D&M. Again, no mention is made of the Lewis opinion or of the regulation and there is no indication, without going back and reading the documents filed by Chief Counsel’s office, that it agreed with or conceded this issue.
Yari v. Commissioner is another regular T.C. opinion in which the taxpayer seeks to contest the penalty in a CDP case. Taxpayer seeks to litigate the underlying 6707A penalty. The case was submitted fully stipulated and on the merits presented the issue of how to calculate the 6707A penalty. The Court states “the parties assume we have jurisdiction over the penalty issue in this case. But the Court has an independent obligation to determine whether it has jurisdiction.” So, Chief Counsel’s office did not raise the Lewis issue leading to the conclusion that no post-assessment abatement request occurred. The Court goes through an analysis concerning its jurisdiction citing to the Williams case and concluding that “Petitioner has not had an opportunity to dispute the amount of the penalty, and, consequently, we have jurisdiction to redetermine the amount of the penalty.” The Court cited to IRC 6330(c)(2)(B) but not to the underlying regulation. The use of the word opportunity raises the question of whether the taxpayer would always have the opportunity to make a post-assessment penalty abatement request and to appeal a denial and how that opportunity would color any decision.
Finally, in Gardner v. Commissioner `decided in August, 2015, the Court in a 6700 penalty case brought under the CDP provisions accepts the concession of Chief Counsel’s office that petitioner did not have a prior opportunity to contest the liability. What makes this case different from the other post Lewis cases is that the Appeals Officer during the CDP hearing “declined to discuss the underlying liability, stating that Mr. Gardner had had a prior opportunity to dispute it but he had not done so and therefore was not permitted to raise the issue at the section 6330 hearing.” One presumes from the concession by Counsel that the Appeals Officer may have misread the regulation and its application in Lewis to the facts of this case.
The IRS has not abandoned Lewis despite Lavar’s plea to them. Lewis and the regulation make it unclear without more information whether the promoters here may be able to get into court to contest the penalties through the CDP process since their post-assessment activity regarding penalty abatement is unknown.
Assuming the promoters cannot get into Tax Court through the CDP process, one final chance at a judicial hearing on the merits of the penalty exists. I do not know the financial circumstances of the promoters. Bankruptcy offers a possible avenue to litigate the liability without paying; however, it comes with potentially high costs in other respects. Section 505(a) of the Bankruptcy Code permits debtors to litigate the merits of their tax liability either in pre or post-assessment status. If one or both of the promoters files bankruptcy, the possibility of a judicial review of the penalty prior to paying it exists.
As I mentioned at the outset, the requirement that a taxpayer pay $24 million in order to obtain judicial review of an IRS penalty determination without going into bankruptcy seems wrong. Yet, I agree with the reasoning of the Federal Circuit concerning the divisibility of the 6707 penalty under the Flora analysis. I agree with Lavar that the CDP regulation should change and the result in Lewis should change to allow for determinations on the merits of the penalty whenever the person upon whom the penalty is imposed has no opportunity for judicial review without full payment. Another fix is to rethink Flora. Maybe it’s time to retool the way taxpayers get into court.

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