In the recent decision Davis v. United States, No. 13-16458 (9th Cir. 1/25/2016), the Ninth Circuit reversed a district court decision that had invalidated certain IRS assessments against Al Davis and his wife, relating to a TEFRA partnership proceeding involving the Oakland Raiders, a California limited partnership of which Al Davis had the largest interest.
The Davises had brought a refund suit for the amounts paid pursuant to the partner-level assessments the IRS made stemming from the terms of a settlement reached between the IRS and the partnership in the TEFRA case, which was documented in a closing agreement and a corresponding decision entered by the Tax Court. The closing agreement, which was signed by Al Davis as president of the Tax Matters Partner, contained a provision that provided that prior to assessing any amounts against the partners of the partnership pursuant to the settlement, the IRS must provide each partner of the partnership 90 days to review its proposed computational adjustments that implement the terms of the settlement, and 60 days to review any revised computational adjustments. However, because the statute of limitations for assessment was about to expire, the IRS ultimately made an assessment against the partners without giving the partners the required 60-day period to review its revised computations, in breach of the terms of the settlement agreement.
The Davises brought the refund suit on the grounds that the assessments were invalid, making two arguments in support: (1) the assessments were invalid because they were not made in accordance with the terms of the closing agreement; and (2) the assessments were made after the statute of limitations had run. The district court granted summary judgment in the Davises’ favor, finding that the IRS’ breach of the closing agreement caused the assessments to be invalid. On appeal, the Ninth Circuit reversed, holding that the district court erred in invalidating the assessments.
Closing Agreements. Section 7121 of the Internal Revenue Code allows the IRS to enter into closing agreements with taxpayers, which are final and conclusive agreements relating to the tax liability of a taxpayer, binding both the IRS and the taxpayer to the terms of the agreement. Section 7121(b) provides that when a closing agreement is properly entered into, (1) the matters agreed upon cannot be later reopened or modified by the Government, and (2) any determination, assessment, payment, refund, etc. made in accordance with the closing agreement cannot be modified or set aside.
In Davis, the Ninth Circuit explained that closing agreements are contracts governed by federal common law that for “most purposes…are just like other contracts.” [i] The Ninth Circuit cites two cases that involved the interpretation of terms in a closing agreement, which held that contract law principles should be applied in resolving the dispute.[ii]
Other cases, though, have acknowledged differences between closing agreements and contracts governed by state law, with one difference being that closing agreements do not require any consideration to be binding on both parties. In Perry v. Page, 67 F.2d 635 (1st Cir. 1933), the First Circuit held that consideration is not a requirement for a valid closing agreement unlike under contract law, explaining: “If entered into between the taxpayer and the Commissioner voluntarily, and approved by the Secretary of the Treasury or Undersecretary, [a closing agreement’s] effect is regulated by statute and takes on legal consequences by virtue of the statute, and not under the law of contracts….”[iii]
Remedy for Breach of a Closing Agreement. The Ninth Circuit was presented in Davis with the question of whether the remedy for the IRS’ admitted breach of the closing agreement should be the invalidation of the assessments that were made notwithstanding the fact that the IRS had not complied with its agreement to provide the taxpayers with a second opportunity to review the computations prior to assessment.
Section 7121 does not directly address what happens when an assessment is made contrary to the terms of the closing agreement. In Davis, the Ninth Circuit held that the taxpayers would be limited to the contractual remedy of damages for the IRS’ breach, reasoning that “damages are always the default remedy for breach of contract.”[iv]
The taxpayers cited in support of their position a Third Circuit case, Philadelphia & Reading Corp. v. United States, 944 F.2d 1063 (3d Cir. 1991), which held certain assessments to be invalid where they were made prematurely under the terms of a settlement agreement. The settlement in that case provided that the taxpayers would waive their statutory right to a notice of deficiency, conditioned on the IRS delaying the assessments until after the IRS had approved a schedule of offsetting overpayments. The Ninth Circuit distinguished Philadelphia & Reading Corp. on the basis that the reason the assessments were invalid in that case was because the statutory notice of deficiency requirement had not been complied with as a result of the breached settlement agreement, whereas in Davis, the Ninth Circuit held that the IRS had complied with all statutory requirements to be able to make the assessments.[v]
The court’s holding turned on its conclusion that the IRS “violated no law in making the assessments.”[vi] The Ninth Circuit explained that “the problem with Davis’s argument is that his obligation to pay taxes validly and accurately assessed comes from the Internal Revenue Code, not the Closing Agreement, which only specified the treatment of certain Partnership income as inputs to the calculation of his taxes.”[vii] Because this was a TEFRA case, the taxpayers were not parties to the Closing Agreement—the closing agreement was between the IRS and the partnership and was signed by the attorney for the partnership’s Tax Matters Partner. The Ninth Circuit further explained: “The IRS’s failure to perform its contract with the Partnership cannot relieve Davis of his statutory obligation to pay taxes; nothing in the Closing Agreement provided that any taxes assessed on the partners pursuant to statute would be rendered invalid if the government failed to perform.”[viii]
Rejecting the notion that a small breach should entitle the taxpayer to total relief from his “pre-existing obligation to pay taxes,”[ix] the Ninth Circuit suggested that the Davises’ remedy would be to file a refund claim to dispute the assessments if they believed the computations to be incorrect, and to seek damages for the additional costs involved in correcting the amount of the assessments.[x]
Statute of Limitations in TEFRA Cases. The taxpayers alternatively argued that regardless of the IRS’ breach of the closing agreement, the assessments were invalid because they were made after the statute of limitations had run.
While the TEFRA provisions provide that partnership tax disputes are to be resolved at the partnership level, the IRS may enter into settlement agreements with individual partners, which causes the individual’s partnership items to convert to nonpartnership items and the partner is dismissed from the partnership-level proceeding.[xi] Generally, the statute of limitations for assessing the flow-through adjustments in a TEFRA case at the partner level is one year from when the Tax Court decision becomes final.[xii] However, if the IRS enters into a settlement agreement with an individual partner, because the partner is then no longer a party to the TEFRA proceeding, the one-year statute of limitations begins to run from the date the settlement agreement is made final, instead of running from the date the Tax Court decision becomes final.
Davis argued that the closing agreement was “a settlement agreement with the partner,” causing the statute of limitations to begin running from the date the closing agreement was finalized and approved by the court instead of from when the Tax Court decision became final, which would cause the assessments to be untimely. The Ninth Circuit rejected this argument, holding that although individual partners are parties to and bound by the Tax Court TEFRA proceeding, it was the partnership, not Davis, who entered into the settlement agreement with the IRS and, therefore, the one-year statute of limitations ran from the date the Tax Court decision became final.
LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, 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. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue domestic civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. She has considerable expertise in handling matters arising from the U.S. government’s ongoing civil and criminal tax enforcement efforts, including various methods of participating in a timely voluntary disclosure to minimize potential exposure to civil tax penalties and avoiding a criminal tax prosecution referral. Additional information is available at http://www.taxlitigator.com.
[i] Davis v. United States, No. 13-16458 at *8 (9th Cir. 1/25/2016) (9th Cir. 1/25/2016) (citing States S.S. Co. v. Comm’r, 683 F.2d 1282, 1284 (9th Cir. 1982) and United States v. Nat’l Steel Corp., 75 F.3d 1146, 1150 (7th Cir. 1996)).
[ii] States S.S. Co. v. Comm’r, 683 F.2d 1282, 1284 (9th Cir. 1982); United States v. Nat’l Steel Corp., 75 F.3d 1146, 1150 (7th Cir. 1996)).
[iii] Perry v. Page, 67 F.2d 635, 636 (1st Cir. 1933).
[iv] Id. (citing the Supreme Court case United States v. Winstar Corp., 518 U.S. 839, 885 (1996) (plurality opinion), which cited the Restatement (Second) of Contracts § 346, cmt. a (Am. Law. Inst. 1981)).
[v] Id. at *9-*10.
[ix] Id. at *9.
[x] Id. at *10-*11.
[xi] IRC § 6231(b)(1).
[xii] IRC § 6229(d).