Source: https://procedurallytaxing.com/tag/andy-grewal/
Timestamp: 2019-04-19 08:43:20+00:00

Document:
Today we welcome back a prior contributor to PT, Professor Andy Grewal, Associate Professor at University of Iowa College of Law. Andy often provides strong commentary on complicated and technical areas of the Code. Today’s post is no different, and is a combination of prior posts Professor Grewal wrote for Yale’s great regulatory blog Notice and Comment. In the post, Andy discusses the recent proposed regulations on management fee waiver transactions in private equity funds, and, specifically, provisions he argues are invalid because the timing under the regulations contradicts the clear statutory language. This is an incredibly hot topic among tax practitioners and the finance industry, and Andy raises interesting concerns that could impact the regulations generally. Steve.
In response to considerable public outcry, the Treasury and IRS recently issued proposed regulations on management fee waiver transactions (PT comment: for more information on management fee waiver transactions, see Prof. Grewal’s article, Mixing Management Fee Waivers with Mayo). Practitioner comments have focused heavily on whether the regulation’s various factors properly follow those described in the legislative history of Section 707(a)(2)(A).
This post examines a largely overlooked provision of the regulations that, if finalized, would plainly contradict the governing statute. It then considers how any challenge to that provision might arise and how any such challenge might lead to a broad invalidation of the Section 707(a)(2)(A) regulations.
Under the proposed fee waiver regulations, an allocation to a private equity firm regarding its waiver interest (the additional profits interest received in exchange for waiving a fee) may be treated as a payment to an outsider, generating ordinary income, rather than as an allocation of partnership long-term capital gain. The IRS’s approach here is generally sound, but a provision in the regulations, Prop. Reg. 1.707-2(b)(i), departs from the statute on an important timing issue.
such allocation and distribution shall be treated as a transaction described in [Section 707(a)(1)].
As the bolded language shows, the statute contemplates regulations that apply outsider treatment when there has been both an “allocation and distribution.” The statute uses that phrase 3 times, and Section 707(a)(2)(A)(iii) hammers that point home — the allocation and distribution must be “viewed together” to determine if it’s appropriate to take the transaction outside of the partner-partnership framework.
For the IRS, this apparently creates administrative problems, because a partnership might allocate income to a partner in one year, but any related distribution may take place in a later taxable year. Citing these administrative problems, the proposed regulations nix the statute’s distribution requirement. Under Prop. Reg. 1.707-2(b)(i), the transaction is tested “at the time the arrangement is entered into.” So, under the regulation, an income allocation may be recharacterized without regard to any related distribution.
As a pure textual matter, the regulation does not comply with the statute. The statutory language requires an “allocation and distribution” that are “viewed together.” If the IRS focuses on only the allocation and attempts to alter its tax consequences, without considering the related distribution, it has exceeded the regulatory authority granted by Section 707(a)(2)(A). The IRS cannot “view together” two parts of a transaction, as required by the statute, if it looks at only one part. Under Step One of the familiar Chevron framework, Prop. Reg. 1.707-2(b)(i), if finalized, will fail.
The IRS might offer rejoinders to this conclusion. For example, it might make a policy-based argument and say it’s unfair to delay the determination of tax consequences until a distribution is made, especially in light of the apparent administrative problems associated with a wait-and-see approach.
However, it’s just as easy to imagine that Congress wanted to limit the IRS’s authority to circumstances where a distribution occurs soon after any partnership allocation is made. After all, if a partner and partnership are using the distributive share regime as a mere funnel for payments, with the intention of avoiding capitalization requirements or of converting the character of a payment, one would expect that a distribution will occur soon after the related allocation. If instead a distribution occurs, say, 10 years after an allocation, that would be a fairly strong sign that the allocation/distribution were not used as a device to funnel payments. In other words, it’s quite easy to see why the temporal relationship between the allocation and distribution are relevant to whether a transaction should be moved to the Section 707(a)(1) framework. Congress, in fact, was principally concerned with relatively simple transactions when it enacted Section 707(a)(2)(A), not complex fee waiver transactions.
This is not to say that Congress’s policy in enacting Section 707(a)(2)(A) was the best one. Maybe the statute should be amended such that it extends regulatory authority when “an allocation and a reasonably anticipated distribution, viewed together” show that the parties acted as strangers. However, those are not the words that Congress has chosen. And any pure policy arguments supporting the negation of the distribution requirement can just as easily be matched with a policy argument emphasizing the insights yielded by viewing an allocation and distribution together.
To find some statutory support for its approach, the IRS refers to the underlying policies of Section 704(b). Under that statute, an allocation generally must have “substantial economic effect” to be respected. The relevant regulations contemplate that an allocation to a partner will enjoy “economic effect” when the partner essentially enjoys the benefit or bears the burden associated with an allocation of income or loss. See Treas. Reg. 1.704-1(b)(2)(ii)(a). Thus, it’s not enough to nominally allocate income to the partner — the partnership must increase his capital account as a result of the allocation and must make distributions consistent with the balance in that account. See Treas. Reg. 1.704-1(b)(2)(ii)(b)(2). In other words, an income allocation comes with some “distribution rights,” via the capital account maintenance rules.
The proposed regulations seize on these distribution rights to negate the statute’s distribution requirement. That is, “the Treasury Department and the IRS believe that a premise of section 704(b) is that an income allocation correlates with an increased distribution right, justifying the assumption that an arrangement that provides for an income allocation should be treated as also providing for an associated distribution for purposes of applying section 707(a)(2)(A).” 80 Fed. Reg. 43652, 43654 (July 23, 2015).
The IRS might nonetheless argue that when Congress referred to an “allocation” in Section 707(a)(2)(A), it was speaking of sham allocations, and not those that enjoy substantial economic effect. But that wouldn’t make much sense. If an allocation lacks substantial economic effect, it will not be respected under Section 704(b) in the first instance, and the parties’ attempt to manipulate the allocation rules would already be defeated, without regard to Section 707(a)(2)(A). Thus, the statute’s references to a “distribution” and to viewing the transactions “together” add further elements to the statute which the IRS must honor.
Prop. Reg. 1.707-2(b)(i) may reflect a good policy (a debatable point), but it does not square with the law. In recharacterizing any income allocated to a private equity firm’s waiver interest, the regulation should be re-drafted such that it follows the statutory requirements and views together the allocation and the related distribution. The IRS will continue to enjoy the authority to recharacterize allocations and distributions on waiver interests — the issue here relates to when to make the relevant determinations, not whether to do so. And if, as expected, private equity firms quickly receive distributions on their waiver interests, then the administrative problems might be negligible. If distributions are severely delayed and the IRS still wishes to act under Section 707(a)(2)(A), it should request authority from Congress. Its current regulation, if made final, reflects an invalid interpretation of the existing statute.
Any allegation of a regulation’s invalidity usually comes with some uncertainty, given the generally deferential framework employed by courts in examining agency rulemaking. But here, the IRS has taken an eraser to statutory language. Perhaps some on the Tax Court would uphold the regulation under a strong purposive approach, but that tribunal has gone through somewhat of a renaissance in the administrative law area, as evidenced by the Altera decision. Thus, the Tax Court may very well view Prop. Reg. 1.707-2(b)(i) through the same lens that the Supreme Court and the circuit courts would view it. Under their approach to statutory interpretation, they do not bless an agency’s rewrite of a statute especially where, as here, following the plain language is consistent with the statutory structure and is supported by plausible policy concerns.
The regulations thus seem poised for a challenge. The Preamble to the proposed regulations acknowledges that some “distributions may be subject to independent risk,” and taxpayers who face risky distributions may scoff at the premature re-characterization of their income allocations. Additionally, two comment letters raise concerns with Prop. Reg. 1.707-2(b)(i), so presumably some taxpayers will be adversely affected. See Comments of the Tax Section of the Connecticut Bar Association (Oct. 8, 2015); Comments of the Tax Section of the New York State Bar Association (Nov. 13, 2015).
Although the invalidation of a regulation always raises a significant issue, the stakes could be far higher if the private equity industry mounts a pre-enforcement challenge to the regulations. The IRS apparently believes it must eliminate the statute’s “distribution” and “view[ing] together” requirements to make the regulations administratively workable. Consequently, Prop. Treas. Reg. 1.707-2(b)(i) might not be severable from the remainder of the regulations. If that is so, a successful challenge to the final version of Prop. Treas. Reg. 1.707-2(b)(i) could lead to the invalidation of all the Section 707(a)(2)(A) regulations.
To address this issue, the IRS might include a severability provision in its fee waiver regulations, stating that if a court invalidates Prop. Treas. Reg. 1.707-2(b)(i), it should not bring down the rest of the regulations. But the effect of such provisions remains uncertain, as detailed in a new article by recent Yale Law School graduate Charles Tyler and by former Yale Law School Professor Donald Elliott found here.
Of course, taxpayers usually very wisely avoid pre-enforcement challenges to Treasury regulations, especially given the difficulties associated with standing. Thus, a deficiency or refund action reflects the most natural and likely forum through which to invalidate Prop. Treas. 1.707-2(b)(i).
Nonetheless, the private equity industry seems unusually well-coordinated, even aggressive, when it comes to preserving their tax benefits. Additionally, the legal fees associated with a pre-enforcement challenge reflect an exceptionally tiny fraction of the industry’s income, and the benefits of a victory would be considerable. Consequently, the possibility of a pre-enforcement challenge might be explored. See generally, Patrick J. Smith, Challenges to Tax Regulations: The APA and the Anti-Injunction Act, 147 Tax Notes 915 (2015). Any related litigation would involve procedural and severability issues that are as uncertain as they are fascinating.
It took more than 7 months from the close of oral arguments, but the D.C. Circuit finally issued its decision in Petaluma FX v. Commissioner. The unusually long wait shouldn’t be surprising, given that the case involved some open questions of tax and administrative law, which I’ve discussed here and here. However, the long wait for guidance was apparently for naught, because the D.C. Circuit resolved the case through a strange reading of a TEFRA regulation’s effective-date provision. In doing so, the court avoided the broad questions raised in Petaluma’s brief, but it unwittingly stepped into a thicket of issues related to Treasury’s authority to issue retroactive regulations.
In Petaluma, the taxpayers argued that the Tax Court lacked jurisdiction over its sham partnership. Although Section 6233 grants the Treasury the authority to issue regulations extending TEFRA to sham partnerships, Petaluma argued that the relevant regulations (Temp. Regs. 301.6233-1) failed to comply with the APA’s notice and comment requirements. Those regulations, issued in 1987, remained on the books until they were finalized in 2001, after the tax year at issue in the case.
The government did not meaningfully dispute that the temporary regulations governed the jurisdictional question. However, it argued that the regulations satisfied the APA. To determine the validity of the temporary regulations, the D.C. Circuit thus had to explore the relationship between tax and administrative law.
But in a surprise move, the D.C. avoided that task. It concluded, contrary to both parties, that the 2001 final regulations applied retroactively to Petaluma’s 2000 tax year, making the taxpayers’ procedural challenges to the temporary regulations irrelevant. Petaluma had to prove some defect in the final regulations, but it had not done so. The D.C. Circuit’s prior opinion in Petaluma held that the temporary regulation controlled the controversy and the government was on board with that view, so Petaluma understandably never presented a challenge to the final regulations.
My new article in Bloomberg BNA,“Petaluma Takes a Bizarre Turn,” explains the flaws in the court’s analysis. In brief, the D.C. Circuit failed to heed the final regulation’s preamble and applied a strange construction to its effective-date provision. The preamble plainly states that the final regulations “apply to unified partnership proceedings with respect to partnership taxable years beginning on or after October 4, 2001” and, for prior years, taxpayers “are directed to the temporary regulations.” T.D. 8965, 66 F.R. 50541, 50544 (Oct. 4, 2001). This leaves no doubt about the Treasury’s intention to issue the final regulations prospectively, but the D.C. Circuit did not even cite the preamble.
The body of the regulation seemingly parrots the preamble, saying first that the final regulations apply to future tax years and then saying that taxpayers should look to the temporary regulations for prior years. See Reg. 301.6233-1(d) (“This section is applicable to partnership taxable years beginning on or after October 4, 2001. For years beginning prior to October 4, 2001, see § 301.6233-1T contained in 26 CFR part 1, revised April 1, 2001.”). However, the D.C. Circuit read the second sentence as incorporating the temporary regulations into the final regulations via cross-reference. As detailed in my BNA article, that interpretation suffers from a technical flaw.
The temporary regulations, not the final regulations, should have controlled the controversy, and the court’s contrary and erroneous holding stemmed from its inquisitorial approach. When a court independently raises a dispositive issue after oral arguments and never seeks briefing on that issue, mistakes are inevitable.
Petaluma leaves one wondering why the court would take such unusual steps to resolve the case. The D.C. Circuit might have believed that its reading of Final Reg. 301.6233-1(d) allowed it to avoid some of the fundamental questions raised in Petaluma’s brief, but its holding actually implicates complex issues of administrative law. The court held that the final regulation applies retroactively to “all tax years,” Slip Op. at 14, but it made no mention of the special issues raised by this retroactivity.
As my BNA article explains, the court’s facile extension of the final regulations to prior tax years raises serious concerns. Although the Treasury may generally enjoy the authority to issue retroactive regulations, the issues are far more complex where, as here, the governing statute is not self-executing and where the final regulations purportedly cure defects in prior regulations. However, these special issues received no attention from the court.
In dismissing the taxpayers’ challenge, the D.C. Circuit emphasized that, upon publishing the final regulations, the Treasury removed the temporary regulations from the books. In the court’s view, this established that those regulations were of “no continuing significance” and were “no-longer-operative.” Slip Op. at 15. The temporary regulations enjoyed force only because they were cross-referenced in the final regulations.
This strange analysis could create massive problems for the government. In Petaluma, the dismissal of the temporary regulations did not hurt the IRS because the final regulations allegedly incorporated the otherwise-defunct temporary ones. But there are various final regulations that remove and replace temporary regulations, and the body of those final regulations might not always contain alleged cross-references of the type seen in Reg. 301.6233-1(d). Rather, the Treasury may cross reference temporary regulations only in the Preamble of the final regulations.
In these circumstances, a final regulation’s removal of temporary regulations could nullify the effect of the temporary regulations for prior tax years. That is, if temporary regulations were in effect from, say, 2008 to 2010, and final regulations are issued in 2011, taxpayers who are engaged in disputes concerning their 2008-2010 tax years can legitimately argue that the temporary regulations no longer apply. After all, the Treasury will likely have removed the temporary regulations from the books, and Petaluma is quite clear about the consequences of such removal.
Taxpayers should thus closely examine any temporary regulations that have been replaced by final regulations, especially when the governing, taxpayer-adverse statute depends for its effect on regulations. In this situation, the removal of the temporary regulations would retroactively eliminate the IRS’s ability to enforce the statute, unless the temporary regulations are cross-referenced in the body of the final regulations.
I don’t think this is a terribly sensible result because in legal drafting, it’s quite common to remove provisions even though they remain effective. When amending the tax code, for example, Congress routinely replaces a particular section or subsection. Yet no one seriously suggests that that removal renders the section or subsection ineffective in disputes over prior tax years. Nonetheless, Petaluma clearly gives enterprising taxpayers some ability to disregard temporary regulations, at least in litigation that might end up in the D.C. Circuit. I would not recommend planning a transaction under this approach, but once a matter has reached the dispute stage, it makes sense to deny the effect of any adverse temporary regulations that have been scrapped from the books and for which no final regulation makes a cross-reference.
Petaluma should also provide some measure of encouragement for taxpayers who wish to present arguments along the lines of those contained in the taxpayers’ brief. That is, rather than go through the gymnastics with the final regulations, the court could have simply rejected the challenge to the temporary regulations. The court’s decision not to do so reflects some acknowledgement regarding the seriousness of those challenges. In other words, taxpayer challenges to temporary regulations remain viable in the D.C. Circuit, except where they have been subsequently removed by final regulations in circumstances similar to those in Petaluma.
The court also left the door open to challenges regarding Reg. 1.6662-5(g), which extends the gross valuation misstatement penalty to zero-basis circumstances. I explained the defects in that regulation here and also debated my conclusions with attorney Michael Schler in Tax Notes. During oral arguments, the D.C. Circuit seemed hostile to the taxpayers’ arguments, but rather than reject them, the court deemed the arguments waived. Petaluma thus adopted a cautious approach and reserves on the validity of Reg. 1.6662-5(g). Slip Op. at 18.
It’s unclear whether Petaluma will provide the last word on the Section 6233 temporary regulations. The taxpayers still have time to petition for a rehearing, but it’s unknown to me whether they intend to do so. Petaluma suffers from faulty legal analysis, so perhaps the court will be receptive to correcting its mistake. Nonetheless, the D.C. Circuit almost always leaves its panel decisions undisturbed. Thus, a petition for panel rehearing or an en banc petition would face uphill battles. However, I’m aware of at least one other circuit that is considering a challenge to the Section 6233 regulations and may blog about it as the case develops.
In part four of his series on Tax Court opinions and their precedential value, or lack thereof, Professor Grewal discusses the opinions that the Tax Court issues in Small Tax cases. The taxpayer must elect Small Tax case status. Neither the Tax Court nor the IRS imposes this status upon a taxpayer no matter how small the matter may be in terms of dollars at issue. Small Tax cases generally make up about half of the Tax Court’s docket. The Tax Court only began publishing Summary opinions about 15 years ago. Prior to that time only the individual taxpayer in the case, the IRS and the Court knew of the outcome of specific cases and finding prior summary opinions was practically impossible.
In my prior posts (found here, here, and here) on my recent article, The Un-Precedented Tax Court, I covered some issues related to Memo opinions and Bench opinions. Here, I want to discuss constitutional and practical concerns related to Summary or “S” opinions, which are issued in connection with small cases decided under Section 7463.
Because S opinions relate only to small cases, this might make them seem unimportant, at least for those concerned principally with big-dollar cases or regular cases. However, S opinions raise what’s probably the most profound and difficult constitutional issue covered in my article: Does Congress enjoy the power to deny precedential effect to a class of judicial opinions?
In establishing the S procedures, Congress mandated that S opinions “not be treated as precedent in any other case.” See Section 7463(b). Under this provision, the Tax Court cannot make precedent in a small case, nor can any court treat S opinion as precedent.
On its face, Section 7463(b) is an odd provision. Historically, courts have fashioned rules related to precedent, and stare decisis seems like a doctrine governed exclusively by the judicial power. Why should Congress have any say in telling courts how to use their prior expositions? Congress can of course always amend the underlying law, but its intrusion into the decisional process of course triggers separation of powers concerns.
In my article, I discuss different Supreme Court authorities on this subject, although none squarely address the constitutionality of Section 7463(b). The statute appears unique in the U.S. Code. I’m not aware of any other circumstance where Congress has attempted to deny precedential effect to an entire class of judicial decisions.
Constitutional issues aside, S opinions also raise some practical difficulties. It’s a bit strange to pretend that a judicial opinion does not exist, and the Tax Court has danced around whether Section 7463(b) displaces issue preclusion doctrines, with one recent opinion simply noting that the matter remains “controversial.” The statute would not appear to bar the application of res judicata doctrines (whether to treat an opinion as precedent is an issue separate from its effect on the particular parties in the case), but the nonprecedential nature of S opinions, along with the lack of appeal opportunities, has made the Tax Court act cautiously in this area.
Unlike Memo opinions, which the Tax Court routinely cites and relies on, S opinions rarely receive attention in judicial opinions. In this way, S opinions cause less confusion than Memo opinions, for which taxpayers receive mixed signals. However, the near-blanket ignoring of S opinions raises its own problems.
Sometimes, an S case will deal with issues of first impression, and taxpayers may wonder whether they can really ignore the related S opinion. After all, like Division or Memo opinions, S opinions enjoy review from the Chief Judge and, when entered, reflect a “decision of the court” under Section 7459. Can a taxpayer really ignore an S opinion’s detailed exposition of a legal issue, like that contained in Cutts v. Commissioner, T.C. Summary Opinion 2004-8 (dealing with a complex Section 7872 issue and acknowledging that court had “dropped the ball” by allowing case to be decided under S procedures).
Also, like other opinions, S opinions can be searched via legal databases. One would guess that, if an S opinion provides a helpful exposition, a judge will review that opinion if it is brought to his or her attention, whether by parties or by court staff. In these circumstances, a conflict arises between Section 7463(b) and the common judicial practice of describing the legal authorities that influence the court’s decision.
My article concludes that Congress should repeal Section 7463(b) and explores some potential counterarguments to that proposal. Failing a legislative repeal, we may eventually see cases similar to those related to unpublished appellate opinions. That is, because S cases sometimes raise issues of first impression and decide things in taxpayer-favorable way, a subsequent taxpayer might argue that the Tax Court is constitutionally bound to follow the prior S opinion. Any such litigation would be fun to watch.
In part three of his series on Tax Court cases and precedent, guest blogger Andy Grewal looks at bench opinions. I wrote about bench opinions in a post earlier this year and I expanded on the information provided in the post by writing an article published in the Journal of Tax Practice and Procedure. Like the memorandum opinions discussed in Andy’s second post, bench opinions do not create precedent. Unlike memorandum opinions, bench opinions can result from regular or small cases. For example, in my research of 222 bench opinions issued from 6/1/2011 to 1/1/2013, 92 cases were small cases and 130 were not.
Setting aside the issue of precedent, it makes good sense to me for the Tax Court to issue bench opinions in routine type cases. It allows the parties to quickly learn the outcome and move on. Bench opinions in small cases make perfect sense because both bench opinions and small case (summary) opinions by statute do not carry the weight of precedent. To encourage more bench opinions in small cases, the Tax Court could change its rules to allow judges to issue bench opinions within some relatively short specified time after the close of the trial session. The current rules can make it difficult to use this quick resolution method because of the requirement that the opinion be issued before the session ends. Unless the judge of a small trial calendar has down time during the session, issuing a bench opinion will prove very difficult and it may not make sense to stay in a remote location and hold a session open just to issue a bench opinion. Bench opinions in regular cases can also provide quick feedback on routine cases but for the reasons Andy discusses, may need more oversight.
Division and Memo opinions each follow the procedures described in Sections 7459 and 7460. Those provisions generally require that, for each Tax Court proceeding, a judge issue a report (i.e., a draft opinion) and provide that report to the Chief Judge. Unless the Chief Judge determines that the entire court should review it, the draft opinion leads to a “decision of the Tax Court.” Consequently, each opinion type (Division or Memo) goes through a statutorily mandated review process and each carries the weight of the Tax Court’s decisional authority, not merely that of a single judge.
The final sentence of Section 7459(b), added in 1982, provides an exception from these general procedural requirements. Under the provision, statutory requirements will be “met if findings of fact or opinion are stated orally and recorded in the transcript of the proceedings,” subject to any limitations the Tax Court prescribes. Under Tax Court Rule 152(a), a judge may, “in the exercise of discretion,” issue a so-called oral or Bench opinion if she is “satisfied as to the factual conclusions to be reached in the case and that the law to be applied thereto is clear.” Although they may be appealed, Bench opinions, unlike Division or Memo opinions, do not receive further review from the Chief Judge. Instead, the authoring judge will read the opinion into the record prior to the close of the relevant trial session and promptly send transcripts to the parties.
Bench opinions apparently have not given rise to the same level of controversy as Memo opinions. The case law reflects some occasions where a judge may have incorrectly decided a case via the streamlined Bench opinion process, but these circumstances seem rare. Also, Tax Court Rule 152(c) flatly denies precedential status to Bench opinions, and this substantially limits taxpayer confusion as compared to Memo opinions, regarding which taxpayers must grapple with various conflicting statements. Perhaps most importantly, Bench opinions historically have not been published or posted online. Opinions can’t cause a lot of confusion if no one can find them.
Expanded search capabilities for Tax Court opinions could change this. The court’s website now allows users to search recent Bench opinions. It’s possible that a litigant will find a favorable opinion and rely on it, notwithstanding the prohibitions contained in the Tax Court rules.
Bench opinions, however, seem qualitatively different from Division or Memo opinions. The latter opinions follow a statutory review process and eventually lead to a “decision of the court.” Bench opinions do not actually follow any review process and, though they reflect a decision of the Tax Court, they are only deemed to satisfy the Section 7459 and 7460 procedural requirements. They thus seem roughly analogous to opinions issued by federal district judges, which do not establish any “law of the district.” Consequently, even if the Constitution mandates the precedential effect of Division or Memo opinions, it seems unlikely that that mandate would apply to Bench opinions.
Putting constitutional issues aside, functional concerns militate against the precedential status of Bench opinions. Sections 7459 and 7460 establish procedures under which the Tax Court will “decide all cases uniformly, regardless of where, in its nationwide jurisdiction, they may arise.” Lawrence v. C.I.R., 27 T.C. 713, 718 (1957). The statutory review provisions, which might independently establish a stare decisis requirement, do not apply to Bench opinions, which were authorized only recently. If those opinions nonetheless bound the entire court, it’s hard to see how uniformity could be achieved.
That’s not to say that Bench opinions raise no concerns. In a recent article, Keith Fogg surveyed more than 200 such opinions and found that their use varied widely among Tax Court judges. One judge disposed of 60 cases via Bench opinion, employing them more than twice as frequently as any other judge, but several judges rarely issued them.
Given the breadth of Rule 152, under which a judge can issue a review-free Bench opinion in almost any case, some further guidance on Bench opinions would be helpful. As it stands now, the Rule leaves the decision to issue an opinion solely within the discretion of the authoring judge. Given their new accessibility, the significance of Bench opinions will likely rise, especially if practitioners uncover prior decisions addressing key issues. However, these concerns remain speculative, and practitioner feedback would be helpful on these issues.
In this post on my article, The Un-Precedented Tax Court, I want to discuss some constitutional and practical concerns over the Tax Court’s treatment of Memo opinions.
As most of the readers of this blog are no doubt aware, Tax Court opinions come in various forms. After hearing a case, a Tax Court judge will send her draft opinion to the Chief Judge, who ultimately decides whether a given opinion will be a Division opinion (cited as “T.C.”) or instead a Memorandum opinion (cited as “T.C. Memo”). Division opinions are considered binding precedent, whereas Memo opinions are frequently dismissed as nonprecedential. See, e.g., Nico v. C.I.R., 67 T.C. 647, 654 (1977)). Consequently, the Tax Court essentially chooses which of its opinions will bind it under the principles of stare decisis.
Fairly recently, the federal appellate courts and scholars engaged in a heated debate over the constitutionality of this practice. Numerous circuit courts had adopted rules that prohibited citation to their unpublished opinions and also denied them any precedential value. The Eighth Circuit declared its own such rule unconstitutional, deciding that allowing judges to pick and choose which cases to follow was offensive to the judicial power conferred under Article III. Others took a more functional view, concluding that if every unpublished opinion established precedent, judges would find it impossible to effectively discharge their duties. Eventually, the Judicial Conference stepped in and abolished rules prohibiting citation to unpublished opinions, but a debate rages on regarding their precedential value.
It’s somewhat surprising that that debate hasn’t drawn in the tax community, especially because it was a tax case that triggered the appellate firestorm. The Eighth Circuit’s case related to a technical tax issue — whether the court was bound to follow a prior decision regarding the statute of limitations and refund claims. However, commentary on Memo opinions generally focuses on their precedential value, not on whether it’s constitutional in the first instance for the Tax Court to decide whether it wants to be bound by a decision. Because I side with those who argue that the “judicial power” mandates principles of stare decisis, I would like to see the debate reach Memo opinions.
My article also raises various practical concerns over Memo opinions. Although they are nominally nonprecedential, the Tax Court routinely cites Memo opinions and sometimes expressly cites them for their precedential value. Taxpayers frequently do the same thing.
Constitutional or not, Memo opinions sow confusion in the tax law. Even appellate courts adopt inconsistent approaches, with the Fifth Circuit, for example, saying that it would give Memo opinions some weight even though the Tax Court itself apparently doesn’t, and the D.C. Circuit expressly dismissing a Memo opinion that was completely on point.
I would prefer that the Tax Court abandon the “nonprecedential” pretense and simply treat Memo opinions the same way as Division opinions. My article discusses various potential objections to that proposal, which I’ll touch on in a later post.
I’d like to thank Keith Fogg for generously inviting me to again share my research with the Procedurally Taxing community, through this first in a series of posts. The inimitable PT blog has helped create a bridge between scholars and practitioners, and I hope it many years of success, with perhaps Oliver Olsenultimately taking over operations. For those who haven’t been paying attention, Oliver is the newest addition to Stephen’s family, and I bet he will capably manage the million-dollar advertising sponsorships that this blog will surely enjoy, assuming Oliver’s artistic older sisterhas not already stolen the show.
Anyway, in my most recent article, “The Un-Precedented Tax Court”, I raise constitutional and practical objections to much of the Tax Court’s work. Although the court purportedly exercises the judicial power (more on that in a later post), most of its work product is not judge-like. That is, the Tax Court decides most of its cases as an administrative office would, without setting precedent. Even a complicated case is far more likely to be decided via a purportedly nonprecedential Memo opinion than via a precedential Division opinion. And the Tax Court also decides many S cases, with the related opinions (Summary opinions) lacking precedential value.
I think there are serious problems with this, which I’m going to detail over multiple posts. Because my concerns are already expressed in the formal article, I’m going to use these posts to address the issues in a more conversational way. I plan to cover various topics, including Memo Opinions, S opinions, Bench opinions, and of course Kuretski.
With this introductory post, I’d also like to solicit blog comments or emails from tax practitioners regarding their views on the weight given to Memo opinions. The article describes different approaches taken by different Tax Court judges, and I suspect that practitioners may also have different views on the subject. I’ll cover Memo opinions in further detail in my next post.
Petaluma v. Commissioner: TEFRA for Everyone?
I have previously written about the TEFRA issues of first impression raised in Petaluma FX Partners v. Commissioner, pending in the D.C. Circuit (Docket #12-1364). The taxpayers in that case argue that TEFRA procedures do not extend to their tax shelter controversy because their transaction involved a sham partnership, not a bona fide one. The various provisions of TEFRA, including the Section 6226(f) jurisdictional provision, explicitly refer to matters relating to a partnership, not a sham partnership. Section 6233 authorizes regulations extending TEFRA to sham partnerships, but the taxpayers argue that the relevant regulations were defectively issued.
Oral arguments held recently might have been expected to address the validity of the Section 6233 regulations. But the D.C. Circuit panel did not offer any questions to either party regarding procedural defects. Most of the argument time was spent sorting out an argument proffered by Judge Sri Srinivasan that would render the Section 6233 issue moot.
As best as I could tell from the sometimes-muffled audio recording, Judge Srinivasan believed that Section 6226(f) by itself established jurisdiction over sham partnerships, regardless of anything under Section 6233. That line of argument was apparently motivated by the Supreme Court’s holding in United States v. Woods, in which the Supreme Court held that Section 6226(f) establishes TEFRA jurisdiction to determine the applicability of the valuation misstatement penalty for the inflation of outside basis in a sham partnership.
Judge Srinivasan observed that Section 6226(f) established jurisdiction over the determination of partnership items, and he believed that a partnership item includes the determination that a partnership does not exist. Consequently, Section 6226(f) took the jurisdictional question “all the way home”; whether the Treasury properly promulgated regulations under Section 6233 was beside the point.
That argument enjoys some superficial appeal, and I understand how a judge would want to explore that question as he takes on the unenviable task of learning about TEFRA. It seems almost sadistic to require generalist judges to decide TEFRA-related issues, and we should thank the dedicated public servants who produce thoughtful opinions on the statute. However, Judge Srinivasan’s suggested argument does not comport with the TEFRA regime.
First, Section 6226(f) simply does not extend to sham partnerships. Under Section 6226(f), a court determines partnership items “of the partnership,” and the quoted language refers to an actual partnership, not a sham partnership. Section 6231(a)(1)(A) specifically defines “partnership” for TEFRA statutes by reference to Section 761(a)’s definition, which includes only bona fide partnerships. Consequently, Section 6226(f) presupposes the existence of a real partnership. If Section 761(a) actually reaches sham partnerships, we are all in a lot of trouble – that would invite abuse of Subchapter K.
Second, although Section 6226(f) allows the determination of partnership items, and the status of an entity reflects a partnership item, that does not provide backdoor jurisdiction for TEFRA jurisdiction over sham partnerships. A partnership item, under Section 6231(a)(3)’s definition, refers to an item “with respect to a partnership,” not an item with respect to a sham partnership. Consistent with the statute, the relevant regulations provide definitions of partnership items that presuppose the existence of a partnership. See Treas. Reg. § 301.6231(a)(3)-1. Section 6226(f) and 6231(a)(3) allow a TEFRA court to determine whether a partnership exists, as required by those statutes, but they do not establish further jurisdiction to determine items related to a sham partnership. This makes perfect sense, given that TEFRA originally did not apply to sham partnerships and that the Section 6231 regulations were drafted before Section 6233 came along. See 48 Fed. Reg. 1759 (1983) (proposed Jan. 14, 1983)(available upon request to PT).
Consistent with the statutory regime, guidance under Section 6231 indicates that sham partnership items become partnership items only via the Section 6233 regulations. In explaining the partnership item regulations, the Treasury acknowledged regulations under Section 6233 would provide the TEFRA “extension” to sham partnerships. T.D. 8082 (Apr. 18, 1986) (available upon request to PT). This is consistent with Section 6233’s purpose. Congress added Section 6233 because of the practical difficulties that would arise under existing statutes when a purported partnership turned out to be a sham, because the IRS or a court would suddenly realize that TEFRA could no longer apply.
The Section 6233 temporary regulations, if valid, establish TEFRA jurisdiction to determine items “which would be partnership items” if the entity weren’t a sham. See Temp. Reg. 301.6233-1T(a) & (b). So, even if one dismissed Section 6226(f)’s limitation to actual partnerships and dismissed the scope of partnership items under Section 6231(a)(3), the Section 6233 regulations remain necessary to establish TEFRA jurisdiction over a sham partnership. One simply cannot extend TEFRA to non-partnerships without the Section 6233 regulations.
The D.C. Circuit previously recognized the integral relationship between Section 6233 and the partnership item regulations. In an earlier opinion, the D.C. Circuit specifically acknowledged that the “jurisdiction . . . over this case is governed by Section 6233.” The court then relied on “Section 6233, its implementing regulations, and the regulations elucidating the meaning of ‘partnership item,’” to conclude that the partnership sham determination reflects a partnership item.
Judge Srinivasan seemed bothered that the Supreme Court in Woods made no reference to Section 6233, and he believed that that statute was not even on the “radar screen” in that case. But the Supreme Court’s review was limited to whether the gross valuation misstatement penalty for inflation of outside basis “relates to” a partnership item, not to whether TEFRA applied at all to sham partnerships. Also, Judge Srinivasan wondered why the government did not mention Section 6233 in its briefs in Woods. But of course it did. Its brief explicitly acknowledged that Section 6233 and its regulations extend TEFRA to sham partnerships. But the government cited the “more readily accessible regulations” rather than the temporary regulations, and the taxpayer missed the opportunity to present a procedural challenge.
The narrow briefing on the jurisdictional question in Woods should not be surprising. Both parties completely missed the jurisdictional issues at the district court and the circuit court level. Jurisdiction was first mentioned in a footnote in the government’s certiorari-stage reply brief, and the parties finally argued jurisdiction only when the Court, on its own, added that issue to the question presented in the government’s petition for certiorari.
Judge Srinivasan also thought it strange that administrative regulations, like those under Section 6233, could establish or deny a court’s jurisdiction over a taxpayer. But that improperly frames the issue. Of course courts enjoy jurisdiction to determine the tax liabilities of participants in a sham partnership. Any regulations simply go to whether jurisdiction must be exercised in a partnership-level proceeding or instead in a partner-level proceeding. Section 6233 does not allow the Treasury to arbitrarily determine the jurisdiction of Article III courts.
To her immense credit, the government’s attorney, Ms. Joan Oppenheimer, did not embrace Judge Srinivasan’s suggested argument, even though the court’s adoption of that argument would secure an IRS victory. Instead, Oppenheimer attempted to explain, consistent with the government’s brief, that Section 6233 reflects a necessary component to the extension of Section 6226(f) to sham partnerships. After some prodding, Oppenheimer acknowledged that she would not resist a holding along the lines suggested by Judge Srinivasan.
Perhaps she should have. If Judge Srinivasan’s suggested argument were accepted, then TEFRA would necessarily attach to sham partnerships, regardless of the discretion conferred by Section 6233. TEFRA jurisdiction would also extend to C corporations, REITs, trusts, and every other entity because, under Judge Srinivasan’s approach, partnership items include determinations over whether an entity is a partnership or instead a C corporation, REIT, trust and so on. In the long run, the Treasury would likely want to exercise its discretion under Section 6233 to determine the scope of entities that fall under TEFRA, and not allow Section 6226(f) to establish TEFRA procedures for every entity imaginable.
The most dangerous part of Judge Srinivasan’s suggested argument relates to the elimination of the partnership tax return requirement. That is, Section 6233 allows for the jurisdictional extension of TEFRA to sham partnerships and non-partnership entities only when a partnership tax return has been filed. Section 6226(f), however, contains no return limitation. Thus, if that statute independently establishes TEFRA jurisdiction over sham partnerships and non-partnership entities, the IRS can pull taxpayers into the TEFRA regime even when they never represented themselves as partnerships. Or perhaps taxpayers will seek strategic advantage and argue that the IRS failed to comply with TEFRA notice requirements under Section 6223 regarding their sham partnerships or non-partnerships. Simply put, holding that Section 6226(f) extends TEFRA jurisdiction to sham partnerships opens up the door to unending mischief. It’s thus no surprise that Congress used Section 6233 to make that extension, and it wisely conditioned TEFRA jurisdiction on the filing of a partnership tax return and the promulgation of regulations.
Judge Srinivasan’s argument also raises problems because it contemplates that a sham partnership qualifies as a bona fide partnership under Section 6226(f) and, by extension, under Section 761(a). Any suggestion that a sham partnership qualifies as a real one threatens to open the door to abuse of the partnership tax regime. I do not mean to suggest that any reputable practitioner would allow her client to play games with Subchapter K simply because sham partnerships are recognized as bona fide partnerships under Sections 761(a) and 6226(f). But tax cheats come in two classes – those who simply hide their money under their mattresses (or in offshore accounts), and those who seize on some hyper-technicality to establish that “they are just beating the IRS at their own game.” Treating a sham partnership as a real partnership, even if only indirectly via a TEFRA ruling, potentially provides the protective rationalization needed for the second miscreant to justify his abuse.
Of course, as long as we are talking about general policies and not the command of the law, we must balance that potential for abuse against any ruling in favor of the taxpayers in Petaluma. The taxpayers in that case surely engaged in improper behavior. Maybe, if we are not concerned about applying statutes, it will be better for the court to adopt a creative argument that goes beyond TEFRA’s plain language and denies the taxpayer the right to present its jurisdictional challenge, so as to discourage improper behavior in the future.
In the end, it’s impossible to tell whether the D.C. Circuit will address the merits of the taxpayer’s challenge. On the one hand, the taxpayer’s argument goes to jurisdiction and is generally non-waivable. On the other hand, under Judge Srinivasan’s suggested line of analysis, the Section 6233 issue is non-jurisdictional and can be waived. But the government has itself waived Judge Srinivasan’s argument. So, to reject the taxpayer’s argument on waiver grounds, the court would have to use an argument that the government waived and is contrary to its briefs. That seems weird.
Ultimately, I hope that the D.C. Circuit addresses the validity of the Section 6233 regulations. Questions over how to address improper tax shelters should be left to Congress and the Treasury. The D.C. Circuit should simply focus on reaching the correct interpretation of the law.
Two weeks ago,in TEFRA Jurisdiction and Sham Partnerships-Again? I wrote about how the Supreme Court’s resolution of the jurisdictional issue in United States v. Woods might not have resolved the jurisdictional issue in Petaluma. Today, I want to discuss the merits issue and show how the Court’s opinion also leaves that issue open.
In Woods, the Court held that the Section 6662 gross valuation misstatement penalty applies when a partnership is disregarded under the economic substance doctrine and a partner’s outside basis is consequently reduced to zero. In so holding, the Court focused on whether the reduction of the basis was “attributable to” a valuation misstatement, as required to trigger the penalty. But the Court noted my argument (see pages 20-21 of my brief) that Treas. Reg. 1.6662-5(g), which extends the gross valuation misstatement penalty to zero basis circumstances, may be invalid. The taxpayer, however, chose not to embrace that argument, so the Court said it would assume the validity of the regulation for purposes of deciding the case.
In Petaluma, the taxpayer makes the argument that the Woods taxpayers did not. Petaluma squarely argues that the gross valuation misstatement penalty applies only when a taxpayer’s claimed basis is “400 percent or more” of the true basis, and the percent by which its claimed basis (about $25M) exceeds its true basis ($0) is undefined. Consequently, the statutory condition is not satisfied (“undefined” does not mean “400 percent or more”), and the Treasury regulation that simply treats zero basis circumstances as satisfying that standard is invalid.
Believe it or not, circuit precedent about “division by zero” actually supports the taxpayer’s position. See Lee’s Summit v. Surface Transp. Bd., 231 F. 3d 39, 41–42. But I’d like to skip the doctrinal analysis and address a more fundamental issue: When does a statute give rise to ambiguity such that an agency’s interpretation merits deference?
What type of fruit is a polar bear?
This question is nonsensical. A polar bear is an animal, and it makes no sense to classify it as any type of fruit.
But this question is not ambiguous. There are no interpretive choices between, for example, classifying a polar bear as a banana as opposed to a peach. And if Congress passed a statute taxing the sales of bananas and peaches, a Treasury regulation that treated a polar bear as either one would be invalid.
Is the claimed $25M basis 400 percent or more of the true $0 basis?
Maybe it’s harder to see than in the question about polar bears and fruits, but this question makes no sense and consequently leaves no room for Treasury rulemaking authority. To determine what percent one number is of another number, one must divide the first number by the second number. So, for example, 5 is 500 percent of 1, because 5/1=5.00, and 12 is 300 percent of 4, because 12/4 = 3.00. But in Petaluma, one must divide by zero ($25M/0) to apply the statutory formula, and that makes no sense. You can explain to someone what it means to divide a pizza into ten pieces, but how do you explain what it means to divide a pizza into zero pieces?
When a statute, as applied to a particular set of factual circumstances, makes no sense, an administrative agency does not enjoy the authority to re-write the statute to reach those circumstances. The Treasury can no more fit zero-basis circumstances into the valuation misstatement penalty regime than can it classify a polar bear as a fruit.
Too often, though, courts ignore this commonsense principle. Rather than ask whether a statute suffers from some ambiguity, a court will blandly acknowledge confusion over a statutory regime and approve of an agency’s rulemaking authority to address that confusion.
It would be far better for courts to focus on whether the relevant statutory language yields some interpretive choice for the agency. That is, an administrative agency enjoys authority to fill gaps within the statutes that it oversees, but it cannot re-write them to reach its preferred policy result.
Going back to Petaluma,readers should watch how the D.C. Circuit addresses the scope of the Treasury’s rulemaking authority. When it comes to administrative law matters, the D.C. Circuit stands in the shadow of only the Supreme Court, and the hypertechnical nature of the court’s inquiry should not hide the fundamental nature of the issues it will address.

References: v. 
 § 301
 v. 
 v. 
 v. 
 v. 
 v. 
 v. 
 § 301
 v. 
 v.