You could be forgiven for thinking that law enforcement officers have to identify the location to be searched accurately when asking a judge to sign a search warrant.  The Fifth Circuit decided on March 4, 2020, that missing the address by ½ and not even describing the actual premises to be searched, aren’t big enough problems to throw out evidence obtained during the search.

Robert Scully co-owned (with his nephew and a third man) and operated a frozen-meals business that imported shrimp from Thailand.  Scully and his nephew arranged for relatives to inspect shrimp in Thailand, paid the relatives, and then skimmed some of the inspection commissions and didn’t report the receipt of the skimmed commissions on his tax returns.  The third owner uncovered the skim and reported Scully to the authorities.

Seeking evidence of tax and wire fraud crimes, the IRS Special Agent prepared and submitted a search warrant for Scully’s house at 1015 East Cliff Drive in Santa Cruz, California.  The SA really wanted to search Scully’s home office, which wasn’t connected to the house but was instead a separate structure behind the house.  The search warrant was defective in two important (although apparently not that important) ways: (1) had the SA checked utility records or with the post office, he would have learned that the home office had a different address than the residence: 1015 ½ East Cliff Drive; and (2) although the SA knew that the home office was unconnected to the house and he had even checked satellite images of the property, the SA didn’t even include the home office within the “premises to be searched” in the search warrant.  It isn’t fair to put all of the blame on the SA for the second error, as the local U.S. Attorney’s Office reviewed the search warrant before submitting it to a Magistrate Judge, and the Magistrate Judge reviewed it before signing it.  The second problem was obvious from the face of the warrant, as the SA described the home office as well as its importance in his affidavit in support of the search warrant, yet neither the AUSAs nor the Magistrate Judge noticed that the warrant itself (frequently the only document that agents assisting in the search will read) failed to mention the home office.

Recognizing that including the wrong address on the search warrant and not even mentioning the home office were both problems, the government paid lip service to the argument that the warrant was accurate, but fell back on the “good faith” defense to search warrant errors.  This defense is designed to save searches that were done in good faith reliance on the warrant that a Magistrate Judge had signed.  Appellate law has a low bar for the government to clear: so long as the search didn’t involve a “deliberate, reckless, or grossly negligent violation,” any evidence seized in a later-invalidated warrant can still be admitted against a defendant.

Taking up the two errors in the warrant, the Court of Appeals brushed past the government’s argument that the warrant sufficiently described the premises – no surprise, given that the address was wrong and the warrant didn’t mention the home office that yielded the evidence at issue – and marshalled facts to show that the errors weren’t deliberate, reckless, or grossly negligent.  The saving grace appears to have been that the SA who signed the search warrant affidavit (and made the aforementioned mistakes) briefed his fellow agents and personally took part in the search, permitting him to guide his fellow agents to the home office, avoid another structure on the property that was rented to someone else, and ensure that agents searched the right premises.  Further, the affidavit described the home office, so there was little doubt that the Magistrate Judge actually found probable cause to search the home office; the defect was just in the warrant and not in the affidavit and the warrant, which presumably would have been more troubling for the Court.  Left unsaid is that the agents did, in fact, search the right premises.  If they had searched and seized evidence of a crime at the wrong premises, such as the additional structure on the property rented to a third party, then the result could have been different.  It’s hard to ignore the effect of hindsight in situations like this.

The decision also underscores that trimming, as opposed to expanding, an indictment in response to post-indictment knowledge, is generally acceptable.  Here, prosecutors learned through deposing witnesses in Thailand that an allegation in the Indictment was incorrect, and they superseded the Indictment to eliminate that allegation and charges against the nephew, who died while awaiting trial.  The Court focused on whether the defendant had been prejudiced, and found none. Additionally, and not surprisingly, the Court rejected the defendant’s Speedy Trial violation argument, noting that the vast majority of the years-long trial delay was due to the defendant’s requests for more time.

The overall takeaway from the case?  The Affiant for any search warrant should brief his or her fellow agents and participate in any search to blunt the effect of any errors in the warrant.  On the flip side, the absence of the Affiant should be highlighted by any defense counsel seeking suppression.

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 (including foreign-account and cryptocurrency) 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 campaign finance, FARA, money laundering, and health care fraud.

You could be forgiven for thinking that law enforcement officers have to identify the location to be searched accurately when asking a judge to sign a search warrant.  The Fifth Circuit decided on March 4, 2020, that missing the address by ½ and not even describing the actual premises to be searched, aren’t big enough problems to throw out evidence obtained during the search.

Robert Scully co-owned (with his nephew and a third man) and operated a frozen-meals business that imported shrimp from Thailand.  Scully and his nephew arranged for relatives to inspect shrimp in Thailand, paid the relatives, and then skimmed some of the inspection commissions and didn’t report the receipt of the skimmed commissions on his tax returns.  The third owner uncovered the skim and reported Scully to the authorities.

Seeking evidence of tax and wire fraud crimes, the IRS Special Agent prepared and submitted a search warrant for Scully’s house at 1015 East Cliff Drive in Santa Cruz, California.  The SA really wanted to search Scully’s home office, which wasn’t connected to the house but was instead a separate structure behind the house.  The search warrant was defective in two important (although apparently not that important) ways: (1) had the SA checked utility records or with the post office, he would have learned that the home office had a different address than the residence: 1015 ½ East Cliff Drive; and (2) although the SA knew that the home office was unconnected to the house and he had even checked satellite images of the property, the SA didn’t even include the home office within the “premises to be searched” in the search warrant.  It isn’t fair to put all of the blame on the SA for the second error, as the local U.S. Attorney’s Office reviewed the search warrant before submitting it to a Magistrate Judge, and the Magistrate Judge reviewed it before signing it.  The second problem was obvious from the face of the warrant, as the SA described the home office as well as its importance in his affidavit in support of the search warrant, yet neither the AUSAs nor the Magistrate Judge noticed that the warrant itself (frequently the only document that agents assisting in the search will read) failed to mention the home office.

Recognizing that including the wrong address on the search warrant and not even mentioning the home office were both problems, the government paid lip service to the argument that the warrant was accurate, but fell back on the “good faith” defense to search warrant errors.  This defense is designed to save searches that were done in good faith reliance on the warrant that a Magistrate Judge had signed.  Appellate law has a low bar for the government to clear: so long as the search didn’t involve a “deliberate, reckless, or grossly negligent violation,” any evidence seized in a later-invalidated warrant can still be admitted against a defendant.

Taking up the two errors in the warrant, the Court of Appeals brushed past the government’s argument that the warrant sufficiently described the premises – no surprise, given that the address was wrong and the warrant didn’t mention the home office that yielded the evidence at issue – and marshalled facts to show that the errors weren’t deliberate, reckless, or grossly negligent.  The saving grace appears to have been that the SA who signed the search warrant affidavit (and made the aforementioned mistakes) briefed his fellow agents and personally took part in the search, permitting him to guide his fellow agents to the home office, avoid another structure on the property that was rented to someone else, and ensure that agents searched the right premises.  Further, the affidavit described the home office, so there was little doubt that the Magistrate Judge actually found probable cause to search the home office; the defect was just in the warrant and not in the affidavit and the warrant, which presumably would have been more troubling for the Court.  Left unsaid is that the agents did, in fact, search the right premises.  If they had searched and seized evidence of a crime at the wrong premises, such as the additional structure on the property rented to a third party, then the result could have been different.  It’s hard to ignore the effect of hindsight in situations like this.

The decision also underscores that trimming, as opposed to expanding, an indictment in response to post-indictment knowledge, is generally acceptable.  Here, prosecutors learned through deposing witnesses in Thailand that an allegation in the Indictment was incorrect, and they superseded the Indictment to eliminate that allegation and charges against the nephew, who died while awaiting trial.  The Court focused on whether the defendant had been prejudiced, and found none. Additionally, and not surprisingly, the Court rejected the defendant’s Speedy Trial violation argument, noting that the vast majority of the years-long trial delay was due to the defendant’s requests for more time.

The overall takeaway from the case?  The Affiant for any search warrant should brief his or her fellow agents and participate in any search to blunt the effect of any errors in the warrant.  On the flip side, the absence of the Affiant should be highlighted by any defense counsel seeking suppression.

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 (including foreign-account and cryptocurrency) 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 campaign finance, FARA, money laundering, and health care fraud. 

 

Section 1501 of the Internal Revenue Code allows a parent corporation and its subsidiaries to file a consolidated return that effectively treats the consolidated group as one entity for tax purposes.  The IRS has issued detailed regulations concerning consolidated groups.  It has not issued any regulations on how refunds to a consolidated group are to be distributed among members of the group.  In 1973 the Ninth Circuit decided In re Bob Richards Chrysler-Plymouth, Inc., 473 F.2d 262, holding that absent a tax allocation agreement under federal common law the tax refund belongs to the group member responsible for generating the loss that resulted in the refund.

Western Bancorp, Inc., was the parent corporation of Western Bank Corporation.  When the bank faced financial difficulties, it was placed in receivership and the FDIC was appointed receiver.  Western Bancorp. filed a chapter 7 bankruptcy petition and Mr. Rodriquez was appointed chapter 7 trustee.  As a result of net operating losses generated by the bank, the IRS issued a $4 million refund.  This initiated a fight between the chapter 7 receiver and the FDIC over who was entitled to the refund.  The Tenth Circuit in In re United Western Bancorp, Inc.914 F. 3d 1262, 1269–1270 (2019), adopted the Ninth Circuit’s rule and held that the FDIC, as receiver for the bank, was entitled to a refund.

Because the Sixth Circuit had rejected the Bob Richards rule, the U.S. Supreme Court decided to hear the case in order “to decide Bob Richards fate.”  In Rodriquez v FDIC, ___ U.S. ____ (Feb. 25, 2020), Justice Gorsuch, writing for a unanimous court, buried Bob Richards, holding that in the absence of a tax allocation agreement you look to state law, not federal common law.

According to the Court, “judicial lawmaking in the form of federal common law plays a necessarily modest role under a Constitution that rests the federal government’s ‘Legislative Powers’ in Congress and reserves most other regulatory authority to the States.”  Citing Erie R. Co. v. Tompkins, 304 US 692 (a938) for the proposition that there is “no federal general common law,” the Court stated that absent express Congressional authorization, federal common lawmaking must be used only when “necessary to protect uniquely federal interests.”  Since there was no unique federal interest in how a refund is allocated among members of a consolidated group once it is issued, the Court held that the issue must be decided under state law.

So who got the refund?  The Supreme Court didn’t make that decision.  Instead it remanded the case to the courts below “for further proceedings consistent with this opinion.”

There are a couple of points of interest.  First, the Solicitor General, arguing on behalf of the FDIC, conceded that federal common law should not have been applied but that under state law the FDIC should get the refund.

Second, in tax cases federal courts normally look to state law to determine property rights, so in that sense the decision was not a major departure.  The case itself may however be a preview of the Court’s retreat from expansive reading of the powers of the federal courts and, potentially, federal agencies.

Third:  The federal courts have developed a body of rules concerning tax cases, including the sham transaction doctrine, the economic substance doctrine, the substance-over-form doctrine, and the tax benefit rule. The application of these rules may sometimes reach results different than those that would be reached if state law was applied, such as disregarding a transaction as a sham that a state court would respect.  It is doubtful that the federal courts will revisit these rules in light of the Rodriquez case, but you may find taxpayers trying to argue that state law, and not “federal common law” should apply if it would result in more favorable treatment.

Query: Would the Court have reached a different decision if the IRS had issued a regulation on how a refund is allocated among members of a consolidated group, absent express authorization from Congress to make that determination?

 

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.

The Internal Revenue Service (“IRS”)  took a major step in enhancing its criminal fraud referral program by announcing a national coordinator who will oversee fraud referrals from all of the operating divisions.  Damon Rowe, formally the Executive Director of International Operations for IRS Criminal Investigations and former Special Agent in Charge of the Los Angeles and Dallas Field offices, has been appointed the Director of the newly created Fraud Enforcement Office. Mr. Rowe will serve as the principal adviser and consultant to IRS Division Commissioners and Deputy Commissioner on all issues involving Fraud Enforcement strategic plans, programs and policy.  His  responsibilities will include overseeing the IRS’s entire fraud referral program and will coordinate among all of the operating divisions (Small Business Self-Employed, Large Business International and Tax Exempt Government Organizations) in order to make sure they are all focused on the potential  for fraud referrals and the importance of fraud referrals to overall tax compliance. Importantly for practitioners, IRS charged a seasoned and experienced former executive of Criminal Investigations to ensure that only the best cases and those with real criminal potential get referred over to Criminal Investigations for further investigation.

The appointment of  Mr. Rowe comes on the heels of last year’s appointment of Eric Hylton formerly Deputy Director of Criminal Investigations, to be the Commissioner of the Small Business Self-Employed Division. It reflects a continuing trend in the IRS tapping its best and brightest in order to make sure that all operation divisions are operating with common purpose – fair enforcement of the tax laws.

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 a former Trial Attorney with the Tax Division of the U.S. Department of Justice. 

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 civil and criminal tax matters.  Prior to joining the firm, she was Acting U.S. Attorney for the Central District of California and Chief of the Tax Division in the U.S. Attorney’s Office.

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.

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