I recently blogged on the Eleventh Circuit’s decision in In re Shek rejecting First, Fifth and Tenth Circuit precedent that a late return filed two years or more before bankruptcy is not discharged.  Today I am blogging on another recent bankruptcy case, In re Harold, 2020 WL 709866 (B. Ct. M.D. Mich. 2/12/2020), which addressed whether the debtor, Patricia Harold, attempted to evade or defeat tax, thus making otherwise dischargeable taxes not dischargeable under Bankruptcy Code §523(a)(1)(C).

The debtor was a successful obstetrician-gynecologist in Detroit.  She had a professional corporation that was a member of an LLC with another obstetrician-gynecologist.  She owed taxes for 2004-2012 and 2014.  The taxes for 2012 and 2014 were not dischargeable as priority taxes and the taxes for 2008 and 2010 were not dischargeable because the returns were filed late and less than two years before she filed for bankruptcy.  The question before the bankruptcy court was whether the taxes for the remaining years were not dischargeable under Bankruptcy Code 523(a)(1)(C).  That section provides that a tax is not discharged “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.”

The case was complicated by its procedural posture: the IRS was the debtor’s largest creditor.  It had obtained orders that the Estate had no interest in the debtor’s residence and lifting the stay to allow it to bring a district court action to foreclose its tax liens.

The debtor’s husband had been convicted of bank and tax fraud and lost his CPA license.  They had a son and a daughter.  Her husband to handle all tax matters.  The debtor was the main income earner in the family.  During the years for which she did not pay tax her average gross receipts from her practice were more than $500,000 and her net income ranged between $170,000 and over $350,000.  Their returns for the years in issue were often filed late and the tax shown due was not paid.

The debtor and her husband entered into an installment agreement with the IRS that they defaulted on.  During this period the debtor and her husband maintained “a comfortable, even affluent, lifestyle.  They purchased a new home in 2005 under a land sale contract before they sold their existing home; they ended up making monthly mortgage payments on two homes until the bank foreclosed on the first home in 2009.  Devout Catholics, they sent their children to Catholic grade schools, high schools and universities and spent over $325,000 on their children’s private schooling while their tax obligations went unpaid.  They took a number of family vacations and personal trips, and leased “high-end” autos that cost between $600 and $800 a month, including Lexuses, Cadillacs and  Jaguar.

In 2016, the debtor filed a chapter 7 bankruptcy to deal with her tax debt.  While the bankruptcy and IRS foreclosure suit were pending, a client of the debtor’s husband “purchased” their home and purportedly leased it back to them.  The debtor admitted this was done to avoid foreclosure by the IRS. The debtor did not disclose this to her attorneys, the IRS, the district court or the bankruptcy court until after the IRS moved to appoint a receiver to sell the property.  At the trial in bankruptcy court, she could produce no lease agreements, rent checks or other documents supporting her claim that she and her husband were renting the property

The bankruptcy court was in the Sixth Circuit.  Beginning with In re Toti, 24 F. 3rd 806 (1994), the Sixth Circuit developed a two-part test to determine whether a debtor attempted to evade or defeat tax.  The first part focuses on the debtor’s conduct: did the debtor engage in affirmative acts to avoid assessment or payment of tax.  The second part focused on mental state: did the debtor know of the duty to pay tax and voluntarily and intentionally violate that duty.  The mere failure to pay tax for a number of years was not enough to prove an attempt to evade or defeat.

The bankruptcy court held that the debtor attempted to evade or defeat tax.  The bankruptcy court found that the IRS proved the taxpayer engaged in affirmative acts to avoid payment of tax: she had a substantial income, yet consistently failed to pay the tax, instead spending large sums on non-discretionary items, including vacations, cars and her private schools for her children.  The IRS also proved the taxpayer had the requisite mental state: she knew she owed the tax but voluntarily and intentionally decided to pay substantial sums for non-discretionary items, including her children’s private schooling, rather than pay the tax and let her husband handle tax matters even though he had been convicted of tax fraud.  Finally, after filing for bankruptcy, she entered into the purported sale and lease back of her home to keep the IRS from foreclosing.

The Sixth Circuit conduct test focuses on the taxpayer’s lifestyle.  The Ninth Circuit in Hawkins v. FTB, 769 F. 3rd 662 (9th Cir. 2014), rejected the test used by the Sixth Circuit and other circuits and held that to prove an attempt to evade or defeat the taxing agency must show that the debtor acted with the specific intent to evade or defeat the tax and that profligate spending while knowing tax wasn’t paid was insufficient.  The Ninth Circuit distinguished cases decided by other circuits, noting that in each one the taxpayer engaged in conduct, such as transferring assets to nominees, that could support a finding of specific intent.  So while Dr. Harold’s spending on her kids’ schooling would not have been relevant, the sale and lease back transaction may have been sufficient in the Ninth Circuit to support a finding of an attempt to evade or defeat.

 

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

 

On February 19, 2020, the IRS issued IR-2020-34, which states the IRS “will step up efforts to visit high-income taxpayers who in prior years have failed to timely file one or more of their tax returns.” If the Commissioner of Internal Revenue Charles P. Rettig was speaking, he might say that high income taxpayers who have failed to file their federal tax returns should not complain –they have been given fair warning.
In September of 2019, Eric Hylton, the former deputy chief of IRS Criminal Investigation Division, became the SBSE Commissioner. He recently announced that SBSE would use data analytics to identify high-income non-filers. This data analytics also can be used to identify tax preparers who promote false tax returns, as well as businesses with large amounts of unpaid employment taxes.
Hylton’s goal is to integrate CI division analytics to his new role in SBSE, and he hopes data analysts from CI can work with Revenue Agents and Revenue Officers to develop new techniques that SBSE will use in its enforcement.
In Fiscal Year 2018, the IRS identified 73.4 million taxpayers that failed to file a tax return, including 10.6 million individuals and 62.8 million businesses. For Tax Year 2016, the most recent year estimated by the IRS, delinquencies associated with non-filers were approximately $37.5 billion, fertile ground for the deployment of tax resources and that is what the recent announcement is about: “IRS revenue officers across the country will increase face-to-face visits with high-income taxpayers who haven’t filed tax returns in 2018 or previous years.”
Failure to file tax returns can have severe consequences. IRC § 6651(a)(1) imposes substantial additions to tax for a failure to file a tax return. Moreover, fraud referrals from the IRS Collection Division have been increasing. There are potential criminal consequences as well: IRC § 7203 makes it a misdemeanor to failure to file; if convicted, a taxpayer can be fined up to $25,000 ($100,000 for corporations) in fines and up to 1 year in prison. Under IRC §7201, a willful failure to file, combined with affirmative acts of evasion, could lead to a potential felony conviction for tax evasion, which can result in up to 5 years in prison.
Taxpayers who have failed to file a tax return should immediately consider taking advantage of the IRS’s Voluntary Disclosure practice. Taxpayers who qualify have the opportunity to cooperate with the IRS to get into tax compliance while avoiding criminal investigation and prosecution for the failure to file a tax return.
The IRS announcement indicates that Revenue Officers will be visiting high-income non-filers who generally received income in excess of $100,000 during the tax year—and do not be surprised—Revenue Officer visits are usually unannounced. Ask for identification and treat them with professional courtesy and respect, but also immediately contact a competent tax professional. It’s a serous matter.
Steven Toscher is the Managing Principal of Hochman Salkin Toscher Perez P.C., where he has been specializing in civil and criminal tax litigation for more than 30 years. He is former Trial Attorney with the Tax Division of the U.S. Department of Justice.
Gary Markarian is an associate at Hochman Salkin Toscher Perez P.C., and a recent graduate of the joint JD/LL.M. Taxation program at Loyola Law School, Los Angeles.

Three types of tax debts are excepted from discharge in bankruptcy:

  • First, those entitled to priority under sec. 507(a) of the Bankruptcy Code. 11 U.S.C. Sec. 523(a)(1)(A).
  • Second, those with respect to which a return, if required, was not filed or was filed after it was last due and after two years before the date the bankruptcy petition was filed. 11 U.S.C. Sec. 523(a)(1)(B).
  • Third, those with respect to which the debtor filed a fraudulent return or attempted to evade or defeat the tax. 11 U.S.C. Sec. 523(a)(1)(C).

Two recent bankruptcy cases discuss whether the debtor’s tax debt was excepted from discharge under the second and third exceptions to discharge.   This blog will discuss In re Shek, 947 F.3d  770 (11th Cir. 2020),  a recent Eleventh Circuit decision addressing the second exception, and creates a split in the circuits.  I will soon post a blog discussing In re Harold, a district court case discussing the attempt to evade or defeat tax provision of the third exception.

First some background.  In 2005, Congress added a definition of “return” in a new paragraph at the end of subsection (a) of sec. 523.  That paragraph states that “For purposes of this subsection, the term ‘return’ means a return that satisfies the requirements of applicable non bankruptcy law (including applicable filing requirements).”  This so-called “hanging paragraph” further provides that “return” includes a return prepared under Internal Revenue Code (IRC) sec. 6020(a) or a written stipulation to a judgment entered by a non-bankruptcy tribunal but does not include a “substitute for return” under IRC sec. 6020(b).

Three circuit courts of appeal have held that the phrase “including applicable filing requirements” included the requirement that a return be filed by a specified date.  In re Fahey, 779 F.3d 1 (1st Cir. 2015); In re Mallo, 774 F.3d 1313 (10th Cir. 2014); In re McCoy, 666 F.3rd 925 (5th Cir. 2012).  Under these cases, an otherwise dischargeable tax debt was not dischargeable if it was filed even one day late.

The Eleventh Circuit in In re Justice, 817 F.3d 738 (2019) expressly avoided deciding whether the “one-day-late rule” was a correct interpretation of the statute.   Which brings us to the In re Shek.  Mr. Shek filed his 2008 Massachusetts income tax return in November 2009, seven months late.  He owed Massachusetts over $11,000 in tax, which remained unpaid.   In 2015 he filed a chapter 7 bankruptcy in Florida and received a discharge.  When Massachusetts resumed its efforts to collect the unpaid tax, Shek reopened his bankruptcy case for a determination of whether his 2008 tax debt had been discharged.  Both the bankruptcy court and the district court held that the debt was discharged.  Rejecting the reasoning of its sister circuits, the Eleventh Circuit affirmed and held that a document that qualifies as a return under non-bankruptcy law remains a return even if filed late.

Massachusetts advanced two arguments why Mr. Shek’s return was not a return for purposes of sec. 523: a) it was not filed when due and thus did not satisfy the “applicable filing requirements” and b) under applicable non-bankruptcy law (i.e., Massachusetts tax law) a return must be timely.  Massachusetts’s first argument, that “applicable filing requirements” includes filing deadlines, was an interpretation that was implicitly adopted by the First, Fifth and Tenth Circuits.  In rejecting this interpretation, the Eleventh Circuit honed-in on the word “applicable,” which Congress chose to use rather than just “filing requirements” or “all filing requirements.”

The Shek court noted that in interpreting another provision of the Bankruptcy Code, the Supreme Court distinguished “applicable” from “all,” stating that “applicable” requires an analysis of context and normally means “appropriate, relevant, suitable or fit.” Applicable requirements are those having a material bearing on what constitutes a “return” rather than “more tangential considerations” such as whether it was filed on time.

The court looked at the statutory context of the paragraph to determine define “applicable.”  When it added the “hanging paragraph,” Congress did not modify the provision that a late-filed return can qualify for discharge if it is filed two years or more before the commencement of the bankruptcy case.  Reading the hanging paragraph as proposed by Massachusetts would render the second exception a near nullity, since it would only apply to the relatively rare case of returns prepared under IRC sec. 6020(a) and those resulting from a stipulated judgment.   If accepted, this would mean that a late-filed return almost never qualifies for discharge.  Such an interpretation would violate the statutory canon of surplusage, which applies when an interpretation would leave a “clause, sentence, or word … superfluous, void,  or insignificant.”  The court believed that Congress did not intend to narrow the scope of the second exception to only an insignificant number of cases when it made no change to the sec. 523(a)(1)(B) itself.  According to the Court, Congress could have achieved the result advocated by Massachusetts by the more direct method of changing the language of the exception to state that it only applied to returns prepared under IRC sec. 6020(a).  The court stated that “It would be a bizarre statute that set forth a broad exclusion for the discharge of tax return debts but limited the application of that exclusion via an opaque and narrow definition of the word ‘return.’”  Further, the court noted that its interpretation of the statute harmonized with the principle that “exceptions to discharge should be confined to those plainly expressed.”

The court rejected Massachusetts’ second argument, that Massachusetts tax law defined return with reference to timely filing by noting that the state’s tax code treats late filed returns as “returns.”  Thus, under applicable law, Mr. Shek’s late return was a return.

This will not be the last word on what constitutes a return for purposes of bankruptcy discharge.  Even if certiorari is not sought, or if sought is denied, this issue will ultimately be headed for the Supreme Court

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

 

In 2018, Robert Horwitz posted a blog on the Appeal of Mitchell (8/2/2018), a favorable Office of Tax Appeals Opinion (the “Opinion”) that approved a “drop and swap” transaction. The FTB filed a Petition for Rehearing, which has been pending until last week when a majority Opinion on Petition for Rehearing concluded that the FTB had not shown good cause for a new hearing.

In addressing the FTB’s contention that the Opinion was contrary to the law because the Opinion failed to apply the substance-over-form doctrine, the Opinion on Petition for Rehearing described how since 1984, when Section 1031 was amended to prohibit exchanges of partnership interests, there has not been a clear path to guide partners who desire to continue their investment in like-kind property. The majority ultimately reiterated that the appellant, who relied on a lawyer’s advice, did not engage in an improper tax avoidance scheme, the transaction was not a sham, and the “parties engaged in a series of reasonable, necessary, and integrated transactions to accomplish a 1031 exchange.”

While it is not yet clear whether the Decision will be precedential, Mitchell provides a clear guide post in response to the FTB’s substance over form and other challenges to “drop and swap” transactions, while also bringing California Section 1031 authorities closer in line to the more liberal 9th Circuit federal interpretations.

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com Mr. Stigile is a principal at Hochman Salkin Toscher Perez P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state tax controversy matters and litigation, including complex examinations for individuals, business enterprises, partnerships, limited liability companies, and corporations. Additional information is available at http://www.taxlitigator.com

Enforcement and compliance is a top priority of the Internal Revenue Service (“IRS”). The IRS has 150 penalties at its disposal to assist in its stated goals of enforcement and obtaining compliance with the tax laws of the United States. Many of these penalties can be assessed not only against taxpayers but also against tax professionals and related parties such as accountants preparing returns and consultants advising on tax issues.

A frequently utilized penalty is the delinquency penalty. This penalty can be imposed in addition to a tax deficiency assessed by the IRS. Moreover, this penalty can be stacked with accuracy penalties, fraud penalties, or listed transaction penalties against noncompliant taxpayers.

While challenging the IRS’s imposition of a deficiency penalty is more often than not an uphill battle, recently the court in  Estate of Agnes R. Skeba v. United States,[1] found that the taxpayer should not be held liable for the delinquency penalty based upon both a legal statutory grounds as well as a factual reasonable cause grounds.

Delinquency Penalty

The Internal Revenue Code (“IRC”) §6651(a) imposes a penalty assessed against a taxpayer for failing to either file their tax return by the due date or pay a tax due by the due date.  In case of a failure to timely file a tax return, the penalty is 5 percent (5%) of the amount of such tax required to be shown on the return if the failure is for not more than 1 month, with an additional 5 percent (5%) for each additional month or fraction thereof during which such failure continues, not exceeding 25% in the aggregate.[2]  Pursuant to IRC §6651(b)(1), such penalty is imposed on the “net amount due,” which is the amount of tax required to be shown reduced by any credit and any payment on or before the return due date.

If a taxpayer fails to pay the tax shown on the return by the due date, there is a penalty of .05% of the amount of such tax if the failure is for not more than 1 month, with an additional 0.5 percent for each additional month or fraction thereof during which such failure continues, not exceeding 25% in the aggregate. The failure to pay penalty is imposed on the unpaid balance of the tax shown due on the return.[3]  There is a similar penalty for failing to pay a tax deficiency assessment after notice and demand.[4]  The failure to file and failure to pay penalties do not apply if the failure is due to reasonable cause, and not due to willful neglect.  Reasonable cause exists when a taxpayer exercises ordinary business care and prudence but is unable to file a return.[5]

Estate of Agnes R. Skeva v. United States

In Estate of Agnes R. Skeba, the executor filed a suit for a refund of the failure to file penalty assessed by the IRS.  The Estate consisted mostly of farmland and equipment, was valued at $14,500,000, and owed federal estate taxes in excess of $2.5 million, as well as $575,000 to the State of New Jersey and $250,000 to the State of Pennsylvania, but only had liquid assets of $1,475,000.  The Estate could not obtain a loan to pay off all tax debts in full by the due date of the return as a result of valuation issues; was also involved in litigation contesting the will.   Nonetheless, the Estate timely satisfied its State tax debts and paid the remainder ($725,000) to the IRS towards its federal estate tax liability and timely submitted a Form 4768 requesting an extension for time to file the federal estate tax return.  The IRS granted the taxpayer’s request and the due date for filing the return was extended to September 10, 2014.  The Estate then, a week and a half after the original due date for filing the return, made a second estimated payment of $2,745,000, resulting in the timely “payment” of the tax due per the extension granted by the IRS.  However, it was not until June 30, 2015, which was 9 months past the extended due date of September 10, 2014, that the Estate filed the return.  The IRS then assessed the full 25% penalty failure to file penalty under §6651(a)(1) on the $2,745,000 paid just after the original due date.

Penalty Assessed and the Government’s Argument

The issue for the Court was on what amount did the 25% “late filing” penalty apply?  The government took the position that since the tax return was not filed timely then all payments ($2,745,000) made after the return’s original due date of March 10, 2014, were delinquent and the taxpayer was only entitled to a reduction under §6651(b) for the amount ($750,000) paid before the original due date, despite the fact that the IRS had granted the taxpayer an extension to file the return, factually rendering both payments timely under the “new” due date of the return.

Penalty Assessed and the Estate’s Argument

The Estate argued that  IRC §6651(b) should be read in conjunction with §6651(a).  In reading these sections together, the Estate argued that the late filing penalty is calculated by using the formula set forth in subsection (a)(1) incorporating the “net amount due” on the “date prescribed for payment” as set forth in (b)(1).

Since the extension ran until September 10, 2014 there was no net amount due on the extended due date; hence, the Estate asserted, no penalty may be imposed under the applicable statute.

The Court’s Decision

In determining which interpretation of  §6651 should be applied to calculate the delinquency penalty, the court relied on the Supreme Court’s decision in Gould[6], which held that it “is the established rule not to extend their [tax] provisions, by implication, beyond the clear import of the language used, or to enlarge their operations so as to embrace matters not specifically pointed out” and that, even in the event of ambiguity, the Court’s interpretation should be “construed most strongly against the government, and in favor of the citizen.”[7]

The court then found that there was no ambiguity; rather, the government’s position that the extension of the due date of the return should be read out of the statute was inconsistent with the clear language set forth in §§6651(a)(1) and (a)(2), both of which designate the specific day on which penalties will be assessed whether for the late filing of the estate tax return or the late payment of the estate tax debt to be “determined with regard to any extension of time for filing”.  As such, the court ruled that as a matter of statutory interpretation, the calculation of the delinquency penalty required the estate to be credited with the payments made before the new date extended for the filing of the return, resulting in the appropriate penalty calculation being zero.

Reasonable Cause

In addition to the statutory argument, the Estate also asserted that the failure to file timely was based upon “reasonable cause” and not due to willful neglect and thus, IRC §6651 (a)(1) protected the taxpayer from the imposition of the delinquency penalty.  Interestingly, perhaps anticipating a government appeal on the statutory issue above, the court addressed this alternative, factual issue in its ruling.

The court, cited the Supreme Court’s decision in United States v. Boyle, [8] which in ruling in the government’s favor, reasoned that there is an administrative need for strict filing requirements, and also cited to Treas. Reg. §301.6651-1(c)(1), which sets forth that to avoid the delinquency penalty, it must be shown that, given all facts and circumstances, the taxpayer exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time.

The court then found that in this case, the Estate had presented sufficient evidence, including factors outside of the taxpayer’s control both due to the nature of the estate’s assets, third-party litigation and serious health issues of the estate’s attorney, as well as evidence of due diligence, to satisfy its burden of establishing the taxpayer’s exercise of ordinary business care and prudence in the face of its inability to file the return on time and therefore the Estate was entitled to a finding of “reasonable cause” as an alternative basis for granting a full refund of the delinquency penalty.

Sandra R. Brown is a Principal at Hochman Salkin Toscher & Perez P.C., and specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court.  Prior to joining the firm, Ms. Brown served as the Acting United States Attorney, the First Assistant United States Attorney and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal). 

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C. Mr. Tunden recently graduated from the Graduate Tax Program at NYU School of Law and the J.D. Program at UC Davis School of Law. During law school, Mr. Tunden served as an intern at the Franchise Tax Board Legal Division and at the Tax Division of the U.S. Attorney’s Office (N.D. Cal).

 

[1] Estate of Agnes R. Skeba v. United States, No. 3:17-cv-10231 (D. N.J. 2020).

[2] IRC §6651(a)(1).

[3] IRC §6651(a)(2), (b)(2).

[4] IRC §6651(a)(3).

[5] Treasury Regulation § 301.6651-1(c).

[6] Gould v. Gould, 245 U.S. 151, 153 (1917).

[7] Id.

[8] United States v. Boyle, 469 U.S. 241, 246 (1985).

On December 2, 2019, the Internal Revenue Service released Rev. Proc. 2019-42, which applies to any income tax return filed on 2019 tax forms for the 2019 tax year, including 2019 tax forms for short taxable years beginning in 2020 if filed before the forms for 2020 are available.  This updated revenue procedure, which updates Rev. Proc. 2019-09, 2019-02 I.R.B. 292, identifies circumstances under which disclosures on a taxpayer’s income tax return, with respect to an item or position, is adequate for the purpose of reducing the understatement of income tax under I.R.C. § 6662(d), and for the purpose of avoiding the tax return preparer penalty under I.R.C. § 6694(a).

I.R.C. § 6662(a) allows the I.R.S. to impose a 20% penalty for any portion of an underpayment of tax required to be shown on a return.  I.R.C. § 6662(d) defines a substantial understatement of income tax as an understatement that exceeds the greater of 10 percent of the tax required to be shown on the return for the taxable year or $5,000.00.  Section 6662(d) provides for special rules in classifying a substantial understatement for corporations and taxpayers claiming a Section 199A deduction.

I.R.C. § 6662(d)(2)(B)(ii) states that the amount of the understatement shall be reduced by the portion of the understatement attributable to any item if the relevant facts affecting the item’s tax treatment are adequately disclosed in the return and requires there be a reasonable basis for the tax treatment of the item.

I.R.C. § 6694(a) focuses on tax preparers that prepare returns or refund claims which have an understatement of liability due to an unreasonable position where the tax preparer knew or reasonably should have known of the position.  In such cases, the tax preparer shall pay a penalty for each return or claim, amounting to the greater of $1,000 or 50% of the income received for preparing the return which included the unreasonable position.  I.R.C. § 6694(a)(2) defines an unreasonable position as one that does not have substantial authority for the position or was not properly disclosed and did not have a reasonable basis.  A position with respect to a tax shelter is unreasonable unless it is reasonable to believe that the position would more likely than not be sustained on the merits.

This updated revenue procedure provides guidance for determining when disclosure on the return is adequate for the purposes of I.R.C. § 6662(d)(2)(B)(ii) and I.R.C. § 6694(a)(2)(B) without the need to provide the I.R.S. with additional, separate disclosures.  Section 4.02 of the revenue procedure lists those items which are acceptable for disclosure on the return without the need for a separate disclosure, including:  (1) Form 1040, Schedule, Itemized Deductions; (2) Certain Trade or Business Expenses; (3) Differences in book and income tax reporting; and (4) Foreign Tax Items.  For a disclosure to be adequate, the taxpayer must: (1) include all required information; (2) file all applicable forms; and, (3) be able to verify the amounts entered on the forms.  Additional disclosures of facts related to, or positions taken with respect to, issues involving any of the listed items is unnecessary.  However, the updated revenue procedure does caution that the disclosure of such items on a return may still provide no relief from I.R.C. § 6662 accuracy-related penalties if the item is not properly substantiated or the taxpayer fails to keep adequate books and records with respect to the item or position in issue.

The items and positions which are not included in the updated revenue procedure will require a separate and more robust disclosure to be considered adequate.  Specifically, non-listed items require that the disclosure be made on a properly completed Form 8275 or 8275-R, and as appropriate, attached to the return for the 2019 tax year.  For corporate returns, a complete and accurate disclosure of a tax position on the appropriate year’s Schedule UTP, Uncertain Tax Position Statement, will be treated as if the corporation filed a Form 8275 or Form 8275-R regarding the tax position, but filing a Form 8275 or Form 8275-R will not be treated as if the corporation filed a Schedule UTP.

Sandra R. Brown is a principal at Hochman Salkin, Toscher Perez P.C., and specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court.  Prior to joining the firm, Ms. Brown served as the Acting United States Attorney, the First Assistant United States Attorney and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal).

Gary Markarian is an associate at Hochman Salkin Toscher Perez P.C., and a recent graduate of the joint JD/LL.M. Taxation program at Loyola Law School, Los Angeles. Mr. Markarian’s prior tax experience includes externships with the Tax Division of the U.S. Attorney’s Office (CDCA), the Office of Chief Counsel, IRS (LB&I), Los Angeles, and Loyola Law School’s Sales and Use Tax Clinic.

The IRS recently has become more aggressive in assessing foreign information reporting penalties against taxpayers who fail to file required forms for foreign trusts or who file them late.  For years, we have been writing about the IRS’ enforcement efforts with respect to offshore accounts and assets.   With what has generally been perceived as successfully run programs, tens of thousands of taxpayers have participated in various announced Offshore Voluntary Disclosure Programs (“OVDP”) over the past decade.  With the closure of OVDP in September 2018, taxpayers’ compliance options have now focused on the remaining filing options available for the non-compliant taxpayer.  While rougher treatment by the IRS may lie ahead for the delinquent Form 3520-A and Form 3520 filers, at least one court has just provided relief.

Delinquent Filing Options.

Taxpayers who are not in compliance with their reporting and filing options regarding undeclared interests in foreign financial accounts, foreign trusts and other assets should consider various options to come into compliance, including:

(a)    Formal Voluntary Disclosure:   On November 28, 2018, the IRS released a memorandum addressing the process for all Voluntary Disclosure (domestic and foreign) following the closing of the 2014 OVDP.  For all Voluntary Disclosures received after that date, the Service will examine a six-year disclosure period.  Examiners will determine applicable taxes, interest and penalties, including a fraud penalty (75%) for the highest year and a willful FBAR penalty (up to 50%) will be asserted.  Penalties for failure to file information returns, including Forms 3520-A and 3520 could also be imposed.  Under the voluntary disclosure practice, taxpayers are required to promptly and fully cooperate during civil examinations.  Formal Voluntary Disclosures are designed for taxpayers with exposure to potential criminal liability or substantial civil penalties due to a willful failure to report foreign financial assets and pay all tax due in respect of those assets. They provide taxpayers with such exposure potential protection from criminal liability and terms for resolving their civil tax and penalty obligations.

(b)   Streamlined Procedures for Non-Willful Violations.  In addition to the Formal Voluntary Disclosure, the IRS maintains other more streamlined procedures designed to encourage non-willful taxpayers to come into compliance. Taxpayers using either the Streamlined Foreign Offshore Procedures (for those who satisfy the applicable non-residency requirement) or the Streamlined Domestic Offshore Procedures are required to certify that their failure to report all income, pay all tax, and submit all required information returns, including FBARs, was due to “non-willful” conduct.  For these Streamlined Procedures, “non-willful conduct” has been specifically defined as “conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.”

(c)   Delinquent Submission Procedures. Taxpayers who do not need to use either the formal disclosure program or the Streamlined Filing Compliance Procedures to file delinquent or amended tax returns to report and pay additional tax, but who have reasonable cause for not filing a required FBAR or other international disclosure forms including Forms 3520-A and 3520, should considering filing the delinquent FBARs or other delinquent forms according to the instructions, along with a statement of all facts establishing reasonable cause for the failure to file. FBARs or delinquent information returns will not be automatically subject to audit but may be selected for audit through the existing IRS audit selection processes that are in place for any tax or information returns.

The Delinquent Form 3520-A and Form 3520 Quagmire.

Stiff penalties are being automatically applied to those who failed to timely file required Forms 3520-A and 3520, and the delinquent submission procedures, even for the appropriate taxpayer with reasonable cause, are not providing relief.

A Form 3520-A is the annual information return of a foreign trust with at least one U.S. owner. The form provides information about the foreign trust, its U.S. beneficiaries, and any U.S. person who is treated as an owner of any portion of the foreign trust under the grantor trust rules (IRC sections 671 through 679.   A Form 3520 is used to report certain transactions with foreign trusts, ownership of foreign trusts, or the receipt of certain large gifts or bequests from certain foreign persons.  A separate Form 3520 must be filed for transactions with each foreign trust.

For the taxpayer with reasonable cause and who do not need to use the other filing procedures, the Delinquent International Information Return Filing Procedures (DIF) should allow the taxpayer to get compliant without the automatic assessment of very severe penalties  However, our experience has been is that there is a systemic problem with this procedure when it comes to Forms 3520-A and 3520 penalties.  The issue seems to be that the reasonable cause statements being submitted as part of the DFP are not being considered (by agents) and the penalties are being automatically assessed.   Most practitioners’ perception and expectation of the DFP is that the reasonable cause statement would be reviewed and considered by qualified IRS personnel and if it was not accepted, there would be some communication and dialogue between the Service and the taxpayer before assessment. That is simply not happening by and large.

The automatic assessment of penalties without an opportunity to have the matter previously reviewed and addressed by IRS personnel appears to go against the spirit of the DFP.  The IRS website on DFP states:

“Information returns filed with amended returns will not be automatically subject to audit but may be selected for audit through the existing audit selection processes that are in place for any tax or information returns”.

The posted FAQ #1 on DFP states in part:

“Taxpayers who have unreported income or unpaid tax are not precluded from filing delinquent international information returns. Unlike the procedures described in OVDP FAQ 18, penalties may be imposed under the Delinquent International Information Return Submission Procedures if the Service does not accept the explanation of reasonable cause. The longstanding authorities regarding what constitutes reasonable cause continue to apply, and existing procedures concerning establishing reasonable cause, including requirements to provide a statement of facts made under the penalties of perjury, continue to apply. See, for example, Treas. Reg. § 1.6038-2(k)(3), Treas. Reg. § 1.6038A-4(b), and Treas. Reg. § 301.6679-1(a)(3).”

The effect is that taxpayers who file delinquent Forms 3520-A and 3520 face assessed penalties without any benefits offered by the DFP and are required to endure protracted administrative review for something the procedure was intended to avoid   Moreover, counsel are being left in the odd position of explaining what if any benefits are gained from filing delinquent returns at all and becoming compliant for past periods.  That is certainly against the compliance the IRS would want to encourage.  We are hopeful that the IRS is working on a fix to this quagmire.

The District Court in Wilson to the Rescue 

In Wilson v. United States, (E.D.N.Y. 11/17/19), however, the IRS’s aggressiveness met with rejection when the district court held that the IRS went too far in imposing a 35% penalty for filing a Form 3520 late.  Sec. 6048 requires a U.S. person who is the owner of a foreign trust to report the activities and operations of the trust for the taxable year and a U.S. beneficiary of a foreign trust who received a distribution during the taxable year to report the distribution.  Form 3520 is filed by both owners and beneficiaries.  Under sec. 6677, a U.S. beneficiary who fails to timely file Form 3520 can be assessed a penalty equal to 35% of the amount distributed during the year and a U.S. owner of a foreign trust who fails to timely file can be assessed a penalty equal to 5% of the total assets in the trust at the end of the taxable year.

Joseph Wilson set up a foreign trust in 2003 and funded it with $9 million in U.S. Treasury bills.  Each year he would report the trust assets and income on his income tax return.  In 2007 he terminated the trust and transferred all the assets to his accounts in the United States.  The total transferred was $9.203 million.  The IRS assessed a penalty equal to 35% of the amount transferred, or $3,221,183, against him for late filing.  He paid the amount with interest and filed a refund claim.  When the IRS failed to act on the claim within 6 months, he filed a refund suit with the Court of Federal Claims (CFC).  The CFC dismissed without prejudice because the refund claim was not properly executed.

Before the CFC dismissed the case, Wilson filed an amended refund claim asserting that there was reasonable cause for the late filing and as sole owner of the trust he only liable for a 5% penalty.  When the IRS failed to act on his refund claim, he sued in district court.  The IRS moved to dismiss Wilson’s cause of action that he was liable only for a 5% penalty on the ground that the refund claim lacked sufficient information to apprise the IRS of the exact basis for the claim.  Wilson moved for partial summary judgment on the ground that as the trust’s owner he was only liable for the 5% penalty for late filing and for judgment on the pleadings.

The Court denied the Government’s motion, holding that the refund claim, which stated that as owner Wilson was only liable for a 5% penalty not a 35% penalty, had sufficient information to alert the IRS to Wilson’s claim and to compute the correct penalty.

The Court granted Wilson’s motion for partial summary judgment.  According to the Court, the only material facts were undisputed:  that Wilson was the sole owner and sole beneficiary of the trust; that during 2007 he transferred all the trust’s assets, $9.203 million, to his U.S. bank accounts; and that he filed Form 3520 late.  Partial summary judgment was thus appropriate.

The Court turned to the language of sec. 6677.  Where a person is both the owner and beneficiary of a foreign trust, he is only required to file one Form 3520.  Subsection (a) imposes a penalty of up to 35% of the amount distributed on a beneficiary who fails to timely report the distribution.  Subsection (b) provides that in the case of the owner of a foreign trust, 5% is substituted for 35%.  The Court reasoned that the statutory language mandated that where a person is a trust owner, only a 5% penalty can be imposed.  The Court rejected the Government’s argument that both a 5% and a 35% penalty can be applied to a person who is both an owner and a beneficiary.

The Court further noted that under sec. 6677(a)(1), the penalties assessed may not exceed “the gross reportable amount.”  For a trust owner, the gross reportable amount is the trust assets at the end of the year, which in Wilson’s case was zero.  Since the penalty assessed by the IRS, $3.221 million, it exceeded the amount that could be assessed.

The Court also granted Wilson’s motion to find that as owner of the trust he is liable for a 5% penalty on the amount of the trust’s assets at the close of 2007.  It denied, however, Wilson’s motion for judgment on the pleadings, since the Government had not filed an answer.   What remains to be done, since the Court found that the maximum penalty that can be imposed is zero?  Wilson will have to move for summary judgment or, after the Government files its answer, judgment on the pleadings.

The Wilson decision is a reminder that sometimes the IRS goes too far in asserting penalties.

MICHEL R. STEIN – For more information please contact Michel Stein – Stein@taxlitigator.com  Mr. Stein is a principal at Hochman Salkin Toscher Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation.  Mr. Stein has significant experience in matters involving previously undeclared interests in foreign financial accounts and assets, the IRS Offshore Voluntary Compliance Program (OVDP) and the IRS Streamlined Filing Compliance Procedures. Additional information is available at www.taxlitigator.com

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz at horwitz@taxlitigator.com.  Mr. Horwitz is a principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

Last August, I blogged on the Court of Federal Claims (CFC) decision in the Mindy Norman FBAR willful penalty case.  Rejecting the decisions in Colliot and Waldham, the CFC held that 31 CFR § 1010.820 (which limited the willful FBAR penalty to $100,000) was invalid due to the 2004 amendment to 31 U.S.C. §5321(a)(5).  Disagreeing with the CFC’s decision, Ms. Norman appealed to the Court of Appeal for the Federal Circuit.  The Federal Circuit issued its decision on November 8, 2019, in which it determined that the CFC’s analysis was spot on.

Ms. Norman raised three issues in her appeal:  first, that the CFC erred in finding her FBAR violation was willful; second, that the regulation limited the maximum penalty to $100,000; and third that the penalty imposed against her violated the Eight Amendment prohibition on excessive fines.

Initially, the Federal Circuit addressed Ms. Norman’s argument that willfulness requires evidence of “actual knowledge of the obligation to file an FBAR.”  Noting that the Supreme Court in Safeco Ins. Co. v. Burr, 551 U.S. 47 (2007), held that “where willfulness is a statutory condition of civil liability, we have generally taken it to cover not only knowing violations of a standard, but reckless ones as well,” the Federal Circuit held that for purposes of the willful FBAR penalty, recklessness suffices to show willfulness.

Based on the evidence that Ms. Norman signed a return that checked the box “no” to the question whether she had an offshore financial account, that her account was a numbered account, that she signed a document directing UBS not to invest in U.S. securities, that when funds were withdrawn from the account UBS had it delivered to her in cash and that she lied to IRS agents when initially interviewed, the court had no problem holding that the CFC’s willful determination was supported by the evidence.  Troubling, however, is the penultimate paragraph of the Federal Circuit’s analysis of the evidence on willfulness:

Ms. Norman also argues that she could not have will-fully violated the FBAR requirement because she did not read her 2007 tax return. But whether Ms. Norman ever read her 2007 tax return is of no import because “[a] tax-payer who signs a tax return will not be heard to claim innocence for not having actually read the return, as he or she is charged with constructive knowledge of its contents.” Greer v. Comm’r of Internal Revenue, 595 F.3d 338, 347 n.4 (6th Cir. 2010); see also United States v. Doherty, 233 F.3d 1275, 1282 n.10 (11th Cir. 2000) (finding that taxpayer “signed the fraudulent tax form and may be charged with knowledge of its contents”). The fact that Ms. Norman did not read her 2007 tax return supports that she acted recklessly toward the existence of reporting requirements.

Slip op. at 8-9.  The court noted that there was more evidence than just the return to support the finding.  Pending on appeal to the Federal Circuit is the Kimble case, where the CFC granted summary judgment holding the plaintiff was willful based on two stipulations: that she did not read her return before signing it and that the return checked “no” to whether she had an offshore account.  If the Federal Circuit affirms Kimble, it will lessen considerably the government’s burden of proving willfulness.

Addressing the regulation limiting the penalty to $100,000, the Federal Circuit noted that the statutory language reads that for willful violations “the maximum penalty … shall be increased to the greater of” $100,000 or 50%.  Because the regulation predated the statute, the statute rendered it invalid.  The Court rejected Ms. Norman’s argument that the statute gives the Secretary discretion to determine the amount of the willful penalty and the regulation was an exercise of that discretion.  According to the Court, while the Secretary can exercise his discretion to impose a penalty below the maximum, it is done on a case by case basis.  The Secretary was not authorized to set a cap on all cases that was inconsistent with the statute.  It also rejected Ms. Norman’s arguments that regardless of whether the regulation is inconsistent with the statute, it is binding on the IRS until repealed and that the regulation is entitled to Chevron deference.

As to the Eighth Amendment claim, the Federal Circuit did not address it because it was not properly preserved in the CFC.  Finding Ms. Norman’s arguments lacking, the Federal Circuit affirmed the CFC’s decision.

Whether this is the end of the line for the argument that the regulation validly limits the maximum willful penalty to $100,000 is unclear.  All the trial level courts that have considered the matter, other than Colliot and Waldham, have sided with the Government.  The Government settled both cases after losing on the issue of the regulation’s validity and I assume it will do so in any future cases where the taxpayer prevails on this argument at trial.

 

I personally believe that the Federal Circuit’s analysis is incorrect.  The language governing the amount of the penalty is contained in §5321(a)(5)(B) and (C), as amended in 2004:

 

(B) Amount of penalty. —

(i)In general. —

Except as provided in subparagraph (C), the amount of any civil penalty imposed under subparagraph (A) shall not exceed $10,000.

*****

(C)Willful violations. — In the case of any person willfully violating, or willfully causing any violation of, any provision of section 5314—

(i) the maximum penalty under subparagraph (B)(i) shall be increased to the greater of—

(I) $100,000, or

(II) 50 percent of the amount determined under subparagraph (D)….

 

The verb phrase “shall be increased” refers to being increased from the maximum amount of the non-willful penalty under (B)(i).  Unlike the Federal Circuit, in my view it does not prohibit the Secretary from exercising his discretion by capping the maximum amount that can be assessed cases to an amount that is less than 50% of the account balance at the time of the violation.  But I am probably in the minority on this issue.

 

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.

White-collar prosecutors and defense counsel have noticed a downward trend in the number of fraud cases, including tax cases, since the 9/11 attacks. The FBI and other agencies since then have reallocated their resources to counterterrorism investigations.  However, this re-orientation only accounts for part of the drop; one of the other critical factors has been the increased resources needed to review the ever-growing volume of digital evidence.  The quicksand of federal investigations turns out not to be recalcitrant witnesses or destruction of evidence, but a volume of digital evidence that outstrips the agents’ and prosecutors’ capacity to review.  This is particularly true where the review must be done twice – first by a “filter team” for privileged matters and then, by a separate “investigative team,” for evidence to be used in the investigation.

When prosecutors think lawyers possess evidence of a crime, either as co-conspirators or as unwitting dupes who helped clients commit fraud, then prosecutors can circumvent the attorney-client privilege and work product protection of their records through a “crime-fraud” motion with the district court.  The question is, once a court is satisfied that prosecutors have demonstrated that they should gain access to some legal files, what process should be used to sort through a lawyer’s files to determine what is privileged and what is not (either because the crime-fraud exception applies or because the files aren’t privileged for another reason)?

Diligent prosecutors anticipate this problem, and most diligent prosecutors will propose a filter team procedure for the federal magistrate judge to approve at the time the prosecutors seek a search warrant for the lawyer’s files.  Filter teams are made up of prosecutors and agents who aren’t working on the investigation, and generally there should be a logical separation between the filter team and the investigative team, such as working in a different office or different section, to make accidental or sloppy sharing of privileged information less likely.

Until Halloween 2019, most prosecutors would have assumed that the use of a filter team, approved in advance by a magistrate judge, was a “best practice” that would gold-plate admissibility of any documents that ran the gauntlet and ended up in the prosecutor’s hands.  In a Halloween decision by the Fourth Circuit, the use of filter teams and advanced approval moved from gold standard to lead.  The biggest losers in the process are federal district and magistrate judges, who will be required to take a much-more-hands-on role in the privilege-determination process.

In re: Search Warrant Issued June 13, 2019 No: 19-1730

In a unanimous decision, the Fourth Circuit struck down a magistrate judge’s pre-search approval of a filter team that appeared to check most (or all, depending on the federal district) of the “best practice” boxes for prosecutors.  In re: Search Warrant Issued June 13, 2019 (No. 19-1730, October 31, 2019).  The filter team of lawyers from a separate office would separate privileged from non-privileged materials; once materials were determined as non-privileged, they were sent to the investigative team; and for privileged materials, the filter team would try to redact items and would allow the investigation’s target (a lawyer in a 20-lawyer firm) to contest redactions and argue about a third category of potentially privileged documents.

The search revealed a pittance of responsive documents – only 116 of the 52,000 seized emails were from the client who was also under investigation. The vast majority of documents reviewed were related to the law firm’s clients who weren’t under investigation.

The law firm sought return of items so it could conduct a privilege review on its own, but the government refused.  Alternatively, the firm asked that all seized materials be submitted to the magistrate judge for in camera review – an unenviable task given the press of other business for a magistrate judge – but the government refused that request as well (in fact, the government simply ignored the law firm’s requests, which likely didn’t help the government’s litigating position).

The Fourth Circuit zeroed-in on the filter team’s unfettered discretion to decide what was not privileged and struck down the filter protocol that the magistrate judge had confirmed was appropriate. The law firm and government then tussled over a preliminary injunction.  Notably, after the district court initially agreed with the magistrate judge’s rejection of the preliminary injunction, the parties agreed that the filter team must allow the law firm to object to any “non-privileged” determination before a document was disclosed to the investigative team.

Even this modification to the filter protocol couldn’t save it on appeal.  In an unusual order, the Fourth Circuit quickly entered an interim order that benched the filter team and reassigned all its functions to the magistrate judge.  Six weeks later, it explained its decision in a lengthy opinion.  After noting that it’s hard to win a preliminary injunction under a four-factor test, the Fourth Circuit stated that the law firm did precisely that by showing it would suffer irreparable harm through the use of a filter team, the law firm was likely to win on the merits, the balance of equities tilted in the law firm’s favor, and that the public interest favored a preliminary injunction.  What’s particularly notable is that a target of the investigation could show that the public interest favored the target, over the public’s interest in conducting a quick criminal investigation.

The Fourth Circuit noted that the magistrate judge erred by not considering the result of the search – that fewer than 1% of the law firm’s records were responsive to the search warrant, and that the filter team was reviewing emails concerning other, ongoing federal criminal investigations of unrelated clients.  Delegating the privilege review to federal prosecutors and non-lawyer agents considering these factors was improper because it gave almost no weight to the attorney-client privilege and work product protections that are critical to the Sixth Amendment’s right to counsel.  The Fourth Circuit cited a recent decision, United States v. Elbaz (D. Md. June 20, 2019), as an example where a government filter team improperly disclosed thousands of potentially privileged documents, which further bolstered its conclusion that the magistrate judge can’t delegate its judicial responsibility to make privilege determinations.  The circuit also determined that the magistrate judge should have conducted adversarial proceedings on the use of a filter team.  Finally, the circuit was deeply troubled by the filter protocol’s authorization of the filter team’s contacting the law firm’s clients to seek waivers that endorsed prosecutors and their agents directly contacting represented parties.  The entire process smacked of unfairness, so the public’s interest weighed in favor of nixing the filter team and tasking the magistrate judge with the privilege-review process.

The Use of Filter Teams Going Forward

What are the takeaways from this decision?  Filter teams as we know them may be a thing of the past, at least filter teams that make decisions without allowing defense counsel to second-guess the decisions (and greatly slow down the process, as I learned as a prosecutor).  Judges, perhaps aided by special masters, will have to make privilege decisions and cannot delegate this role to filter prosecutors.  This inability to delegate will, in turn, further slow down the review process and exponentially increase costs over using agents and lawyers already on the government’s payroll.  Prosecutors will be leery of searching lawyers’ offices and computers, which will incentivize fraudsters to use lawyers even more to cover their tracks.  Particularly given that the courts aren’t set up to use sophisticated search technology, any case with a large volume of data will likely be shuttled to the bottom of the pile for already-busy magistrate judges.  They didn’t become magistrate judges to act as a filter team.  This could, in turn, make magistrate judges think long and hard before approving search warrants of law firms, as they may be buying a weeks- or months-long privilege review at the same time.  None of this bodes well for an increase in white-collar prosecutions.

EVAN J. DAVIS – For more information please contact Evan Davis – davis@taxlitigator.com or 310.281.3288. Mr. Davis is a principal at Hochman Salkin Toscher Perez PC.  He spent 11 years as an AUSA in the Office of the U.S. Attorney (C.D. Cal), spending three years in the Tax Division of the where he handed civil and criminal tax cases and 11 years in the Major Frauds Section of the Criminal Division where he handled white-collar, tax, and other fraud cases through jury trial and appeal.  As an AUSA, he served as the Bankruptcy Fraud coordinator, Financial Institution Fraud coordinator, and Securities Fraud coordinator.  Among other awards as a prosecutor, the U.S. Attorney General awarded him the Distinguished Service Award for his work on the $16 Billion RMBS settlement with Bank of America.  Before becoming an AUSA, Mr. Davis was a civil trial attorney in the Department of Justice’s Tax Division in Washington, D.C. for nearly 8 years, the last three of which he was recognized with Outstanding Attorney awards. 

Mr. Davis represents individuals and closely held entities in criminal tax investigations and prosecutions, civil tax controversy and litigation, sensitive issue or complex civil tax examinations and administrative tax appeals, and federal and state white-collar criminal investigations including money laundering and health care fraud.  He is significantly involved in the representation of taxpayers throughout the world in matters involving the ongoing, extensive efforts of the U.S. government to identify undeclared interests in foreign financial accounts and assets and the coordination of effective and efficient voluntary disclosures (Streamlined Procedures and otherwise).

 

 

In a court reviewed opinion[1], a divided Tax Court held that IRC section 280E is not a penalty and therefore does not violate the Eighth Amendment prohibition on excessive fines.  This case provided a different spin on the usual 280E challenges and although the Court ruled that 280E was constitutional, there were three judges who dissented and would require additional arguments on whether 280E violated the Eighth Amendment.[2]

Petitioner operates a medical marijuana dispensary in Northern California, and the parties agreed that Petitioner was legal under California laws.  Petitioner made several arguments attacking the validity of 280E.  For those not familiar with IRC section 280E, it disallows ALL deductions or credits in carrying on a trade or business that consists of trafficking in a Schedule I or II controlled substance (which includes marijuana).

The primary argument was that 280E violated the excessive fines clause of the Eighth Amendment.  The majority rejected this argument using the age-old language that deductions are a matter of legislative grace and that disallowing a deduction is not a punishment or penalty.  Congress has the power to tax income under the Sixteenth Amendment, and any deduction is up to Congress.  Congress passed 280E to limit and deter trafficking in controlled substances and therefore prohibiting deductions is within its power.  The Court notes that in the 37 years since 280E was passed, there has been no case holding that a prohibition on a deduction was a penalty.  At the end of the opinion the majority notes that it is up to Congress to change 280E.

Judge Gustafson, joined by Judges Gale and Copeland, disagreed with the majority and wrote that 280E was a fine and penalty and subject to an Eighth Amendment challenge.[3]  His opinion gives strong support for an appeal and suggests that its argument might find some success in different courts.  He criticizes the majority holding, which relies on Congress’ power to tax incomes.  Section 280E he argues, by disallowed ALL deductions, is a tax on something other than income.  It should be noted, however, that marijuana businesses otherwise subject to 280E can still deduct cost of goods sold.

Professor Bryan Camp Texas Tech in an excellent analysis of the opinion writes that the main difference between Judge Goeke’s majority opinion and Judge Gustafson’s dissent is the baseline.  The majority looks at deductions as all a matter of legislative grace, whereas the dissent starts at deductions that are allowed and sees the disallowance as punishment.  In Professor Camp’s view, adopting Judge Gustafson’s approach would open up all sorts of tax protestor type arguments to Eighth Amendment challenges.  Instead of an Eighth Amendment argument, he believes Petitioner is really making an equal protection argument that would lose.

Another point of contention for Judge Gustafson is that even if Congress has the power to disallow all deductions, it cannot do so in ways that violate other constitutional limits like the Eighth Amendment or First Amendment.  Here he persuasively argues that laws favoring deductions for one religion over another would be unconstitutional as a First Amendment violation.  He reasons that the limit on deductions cannot violate the Eighth Amendment as well.

This case further illustrates that even state legal cannabis businesses are playing on different field with a different set of rules than just about any other business.   The disfavored status of cannabis businesses may be a generational issue and as attitudes towards cannabis change, we will see marijuana either became Federally legal, or 280E amended to allow deductions for marijuana businesses.

In California, Governor Gavin Newsom recently signed legislation (AB 37) which allows state legal cannabis businesses to deduct expenses and explicitly disavows IRC section 280E.  The tide is turning, and it is likely only a matter of time before legal marijuana businesses can deduct expenses, just like everyone else.  If other courts accept Judge Gustafson’s reasoning, it might happen sooner than many think.

Jonathan Kalinski is a principal at Hochman Salkin Toscher Perez, P.C. and specializes in both civil and criminal tax controversies as well as sensitive tax matters including disclosures of previously undeclared interests in foreign financial accounts and assets and provides tax advice to taxpayers and their advisors throughout the world.  He handles both Federal and state tax matters involving individuals, corporations, partnerships, limited liability companies, and trusts and estates.

Mr. Kalinski has considerable experience handling complex civil tax examinations, administrative appeals, and tax collection matters.  Prior to joining the firm, he served as a trial attorney with the IRS Office of Chief Counsel litigating Tax Court cases and advising Revenue Agents and Revenue Officers on a variety of complex tax matters.  Jonathan Kalinski also previously served as an Attorney-Adviser to the Honorable Juan F. Vasquez of the United States Tax Court.

 

Tags: Tax Court, Cannabis, 280E, Marijuana, Deductions, Eighth Amendment

 

[1] Northern California Small Business Assistants, Inc. v. Commissioner, 153 T.C. No. 4 (2019).

[2] The Court was unanimous in denying Petitioner’s motion for summary judgement.  Three judges concurred in the result, but disagreed with the central holding that IRC section 280E was not a fine or penalty and therefore not subject to an Eighth Amendment analysis.  The three judges concurred in the result because they believed a factual argument existed as to whether the fines were excessive.

[3] Judge Copland wrote a separate opinion concurring in part, dissenting in part agreeing with Judge Gustafson that IRC section 280E was a penalty.

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