TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

Most tax professionals are familiar with the Supreme Court’s Flora decision: a taxpayer has to pay in full a tax assessment plus penalties and interest before you can bring a refund suit.  California has had a similar rule, which has been part of the California Constitution since 1913.  Article XIII, sec. 32 of the California Constitution states:

No legal or equitable process shall issue in any proceeding in any court against this State or any officer thereof to prevent or enjoin the collection of any tax.  After payment of a tax claimed to be illegal, any action may be maintained to recover the tax paid, with interest, in such manner as may be provided by the Legislature.

Jeremy Daniel was an officer of a defunct California corporation that owed sales tax, penalties and interest.  The Board of Equalization assessed him for the unpaid sales tax, penalties and interest under its policy for assessing responsible persons and Reg. sec. 1702 (18 CCR sec. 1702).  Daniel filed a suit challenging the assessment against him without paying or filing a refund claim.  The case was dismissed.

Daniel subsequently filed an amended complaint after failing a portion of the assessment and filing a refund claim. The amended complaint against  the California Department of Tax and Fee Administration (CDTFA), successor to the Board of Equalization.  The amended complaint did not directly challenge the assessment.  Instead, it alleged that policy and regulation for assessing persons for unpaid sales tax was illegal and unconstitutional.  It prayed for a declaration that the policy and regulation were illegal and unconstitutional and any assessment based on the policy and regulation was not a tax under the California constitution.  The CDTFA filed a demurrer on the ground that the complaint was barred by sec. 32.  The superior court denied the demurrer, holding that the action was to determine the validity of a regulation, not to determine the validity of an assessment against an individual taxpayer or for a refund of tax.  Thus, according to the superior court the pay first, litigate later rule did not apply.  The CDTFA petitioned the Court of Appeal for a writ of mandate.  The Court granted the writ in California Department of Tax and Fee Administration v. Superior Court (May 7, 2020) Docket No. B294400

Finding that the writ petition presented a “significant issue” of “great public interest” the Court of Appeal denied a motion to dismiss the writ.  It then addressed the two questions raised by the petition: a) whether sec. 32 (which the Court termed the “pay first, litigate later” or “pay up or shut up” rule) bars the suit and b) whether Government Code sec. 11350, which authorizes declaratory judgment actions to determine the validity or governmental regulations carves out an exception to sec. 32.  The Court answered the first question “yes” and the second question “no.”

With respect to the first, the Court stated that sec. 32 bars a taxpayer from maintaining any action the net effect of which would be to resolve his liability for a disputed tax unless he pays the entire amount owed with penalties.  Because Daniel had not paid the tax in full and followed the procedures established for bringing a refund suit, sec. 32 barred his action for declaratory relief.   It rejected his argument that he could proceed as a member of the general public or as an officer of a new corporation to whom the regulation may apply in the future since allowing a taxpayer to proceed on that basis would make sec. 32 “a dead letter.”

The Court then turned to the second question.  Gov. Code sec. 11350 allows “any interested person” to obtain a declaration as to the validity of any regulation.  The Court held that this declaration does not exempt the action from sec. 32’s reach.  It gave three reasons for its conclusion:

First, under the rules of statutory construction, sec. 11350 does not on its face exempt claims from the reach of sec. 32’s pay first requirement.  Sec. 32 controls tax actions so that an action for declaratory relief that would result in invalidating an assessment cannot be maintained.

Second, the purpose of sec. 11350 is to provide an avenue for relief where none previously existed.  Taxpayers have always had an avenue for relief from a tax assessment: they can pay the tax and then pursue a claim for refund.

Third, the California Supreme Court has “strongly suggested” that sec. 11350 is not meant to be an exception to sec. 32.

The Court rejected two final claims of Daniel: a) that he is not seeking to determine the amount of tax he owes, but to determine whether the assessment is unconstitutional since by its very terms sec. 32 applies where a taxpayer claims a tax is “illegal;” b) that he is not seeking to enjoin collection, since that would be the effect of granting the relief requested.

The Court remanded to case to the superior court with instructions to dismiss the amended complaint without leave to amend.

Tax litigation in California reminds me of an old Chicago saying about politics:  if you wanna play you gotta pay.

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.

For decades, the Internal Revenue Service (“IRS”) has maintained a voluntary disclosure policy which provides an opportunity for taxpayers to come forward and disclose their noncompliance with the tax laws with the primary incentive being that, in almost all cases, the taxpayer will avoid criminal prosecution. The IRS made some significant announcements recently that could benefit those who wish to consider a voluntary disclosure to come into compliance with the tax laws.

IRS Announcement for Non-Filers

On March 25, 2020, the IRS announced the new IRS People First Initiative to provide immediate relief to help people facing uncertainty over taxes.[1] A highlight of the key actions in the IRS People First Initiative focused on Non-Filers with the IRS reminding people who have not filed their returns for tax years before 2019 that they should file their delinquent returns and consider taking the opportunity to resolve any outstanding liabilities with the IRS to obtain a “Fresh Start.”

IRS Memorandum Limiting New LB&I Examinations

On April 14, 2020, a Memorandum was issued to all IRS Employees assigned to the Large Business and International Division (“LB&I”) regarding compliance priorities during COVID-19 Pandemic.[2] The Memorandum directed that through July 15, 2020, with some limited exceptions[3], LB&I will not open new examinations unless it falls within a continuing activity as defined therein.

IRS’s Voluntary Disclosure Program

 The IRS’s Voluntary Disclosure Program is designed to give taxpayers with exposure to potential criminal liability or substantial civil penalties due to a willful failure to report legal source income and/or foreign assets an opportunity, with potential protection from criminal liability, to pay all tax due associated with respect to unreported income and foreign assets.  The current procedures, applicable for voluntary disclosures made after September 28, 2018, apply to both domestic and offshore voluntary disclosures. That said, the current policy bears many of the earmarks found under the prior offshore voluntary disclosure programs.

Current IRS Voluntary Disclosure Program

 On November 20, 2018, the IRS announced its newest voluntary disclosure procedures as set forth in a five-page guidance memorandum.[4] The guidance makes several points very clear: (1) taxpayers who did not commit any tax or tax related crimes and do not need the voluntary disclosure practice to seek protection from potential criminal prosecution can continue to correct past mistakes using the Streamlined Filing Compliance Procedures or by filing an amended or past due tax return; (2) for those taxpayers who do need protection, the filing of corrected tax returns for the most recent six-year period will be required, with IRS agents having the discretion to expand the disclosure period to cover additional years and cooperative taxpayers also being allowed to expand the disclosure period; (3) for taxpayers participating in a voluntary disclosure, cooperation with the IRS means more than just making full disclosure of unreported income and offshore assets, extending the time to assess, and arranging for payment: the IRS expects taxpayers to assent to all adjustments that result from the audit; and, (4) while the current voluntary program, unlike the preceding offshore voluntary programs, does permit the right to seek review by IRS Appeals, the IRS expects that taxpayers will not to exercise their legal rights to contest audit adjustments and seek review by IRS Appeals in return for the IRS’s agreement, in general, not to assess more stringent penalties.

Voluntary Disclosure Preclearance by IRS-Criminal Investigation

IRS-Criminal Investigation (“CI”) will continue to screen all voluntary disclosure requests to determine if a taxpayer is eligible to make a voluntary disclosure. For all cases where CI grants preclearance, taxpayers must then promptly submit all required voluntary disclosure documents using Form 14457.

Form 14457 requires information related to taxpayer noncompliance, including a narrative providing the facts and circumstances, assets, entities, related parties, and equally important, identification of any professional advisors involved in the taxpayer’s noncompliance.

After CI has preliminarily accepted the taxpayer’s voluntary disclosure, it will notify the taxpayer of preliminary acceptance by letter and simultaneously forward the voluntary disclosure letter and attachments to the LB&I unit in Austin, Texas. This LB&I unit will select the most recent tax year covered by the voluntary disclosure for examination and forward cases to the appropriate Business Operating Division and Exam function for civil audit. All voluntary disclosures will follow standard audit procedures.

Voluntary Disclosure Penalty Framework

 The nature and extent of penalties assessed under the voluntary disclosure program will, in large part, be a function of the taxpayer’s cooperation during the process.  A taxpayer who provides prompt and full cooperation during the examination of a voluntary disclosure is entitled to civil penalty mitigation, whereas a taxpayer whose case is not resolved by agreement can expect to face maximum civil penalties under the law.

A summary of the penalties applied to taxpayers who fully cooperate with the IRS during the process are as follows:

Civil Fraud Penalty
The civil penalty under IRC § 6663 for fraud or the civil penalty under IRC §6651(f) for the fraudulent failure to file income tax returns will apply to the one tax year with the highest tax liability. In limited circumstances, the IRS may apply the civil fraud penalty to more than one year  – up to all six years – based on the facts and circumstances of the case. Typically, the IRS’s assertion of the civil fraud penalty beyond six years will only occur if the taxpayer fails to cooperate and resolve the examination by agreement. Note, while the taxpayer may request imposition of accuracy-related penalties under IRC §6662 instead of civil fraud penalties, the IRS expects that such requests will involve  exceptional circumstances.

 FBAR Penalty
If the voluntary disclosure also involves a non-disclosed foreign bank account, then willful FBAR penalties will be asserted in accordance with existing IRS penalty guidelines contained in the Internal Revenue Manual, which include mitigation guidelines that permit the IRS to reduce FBAR penalties if certain criteria are met.  A taxpayer must present convincing evidence to justify why such penalty should not be imposed.  Additionally, while a taxpayer may request that the IRS impose non-willful FBAR penalties, the granting of such request is again expected to only happen in exceptional circumstances.

Information Return Penalties
The penalties for failure to file information returns will not be automatically imposed. This is a positive development for taxpayers, as the penalties for not filing information returns such as Forms 5471 (requiring disclosure of ownership of foreign corporations), Forms 8938 (requiring disclosure of foreign financial assets), and Forms 3520 (requiring disclosure of information regarding foreign trusts), can be significant, especially if the taxpayer’s noncompliance spans multiple years. The procedures provide that agents will exercise discretion as to these types of penalties and will take into account the application of other penalties (such as the civil fraud penalty and the willful FBAR penalty) and the extent of the taxpayer’s cooperation.

Other Penalties
Other penalties, such as those relating to excise taxes, employment taxes, and estate and gift taxes, will be based upon the facts and circumstances of each case and taxpayers should anticipate that when such facts exist, the examining agent may seek assistance from the appropriate subject matter experts within the IRS.

 Options for Taxpayers with Unfiled Returns or Unreported Income Who Do Not Need Protection from Potential Criminal Prosecution

There are other programs for taxpayers with unfiled returns or unreported income who may not have exposure to criminal liability or substantial civil penalties due to willful noncompliance.  As noted above, those options include the Streamlined Filing Compliance Procedures, the delinquent FBAR submission procedures, or the delinquent international information return submission procedures.  Most taxpayers would prefer to settle things through these later programs, as the options call for significantly smaller penalties, if not penalty-free, resolutions with the IRS. So, while the adage no “one size fits all” may always be applicable when it comes to noncompliant taxpayers coming in from the cold, with the IRS currently standing down on the opening of new examination cases, the adage that “timing is everything” in the context of getting to the IRS before the IRS gets to you, is especially true right now.

Sandra R. Brown is a Principal at Hochman Salkin Toscher Perez P.C.  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).  Ms. Brown  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. 

[1] IR-2020-59, March 25, 2020.

[2] Revision to Internal Revenue Manual 4.46.3; LB&I-04-0420-009.

[3] Id.(e.g., LB&I managers have discretion with respect to examinations of prior, subsequent, and related returns associated with an existing examination.)

[4] https://www.irs.gov/pub/foia/ig/spder/lbi-09-1118-014.pdf

The Internal Revenue Service (“IRS”) has recently provided notice that it will, in large part, not follow the adverse decision issued by the Fifth Circuit Court of Appeals in Rothkamm v. United States[i] which found that seeking help from the Taxpayer Advocate Service (“TAS”) tolled the time limits under IRC § 6343(b) for the filing of an administrative claim to challenge a wrongful levy.[ii]

Rothkamm v. United States

Kathryn Rothkamm and her husband filed separate tax returns. Mr. Rothkamm incurred a tax liability. The IRS levied on funds in Mrs. Rothkamm’s bank account to help pay for Mr. Rothkamm’s tax debts despite Mrs. Rothkamm’s assertion that the funds were her separate property and thus, not subject to her husband’s tax debts.  The bank honored the levy and turned over the funds to the IRS.

Mrs. Rothmann sought assistance from the TAS by filing a taxpayer assistance order (“TAO”) application. Five months later the TAS case was closed and nine months thereafter, i.e., fourteen months after the date of the levy, Mrs. Rothmann filed her administrative claim directly with the IRS asserting that the levy was wrongful and the funds should be returned to her. The IRS denied her claim asserting that it was untimely under IRC § 6343(b) as the applicable statute of limitations for the filing of an administrative claim to challenge a wrongful levy is not tolled for the time in which her request was pending with TAS.

Mrs. Rothmann filed suit in District Court to challenge the IRS’s denial of her wrongful levy claim.  After the District Court dismissed her suit, finding that the statute of limitations had not been tolled by her pending TAO, Mrs. Rothmann filed an appeal with the Circuit Court. Thereafter, the Fifth Circuit overturned the decision of the lower court and found that Mrs. Rothmann’s TAO did toll the applicable statute of limitations and thus, her claim was timely.  The Fifth Circuit’s decision in Rothkamm is now final.

IRS’s Nonacquiescense in Rothkamm

On March 27, 2020, the IRS published its notice regarding its nonacquiescence in the court’s decision in Rothkamm. [iii]  Specifically, the IRS has stated that, for cases that would be filed in courts not within the Fifth Circuit, it will not follow the holding that filing a TAO with TAS automatically tolls the statute of limitations under IRC § 6343(b) to extend the time period for the filing of a wrongful levy lawsuit.

Reiterating its’ legal position on tolling, as advanced in the Rothkamm litigation, the IRS will continue to assert that “a plain reading of section 7811(d) shows that the time periods tolled [for pending TAOs] relate to actions available to the IRS, not actions available to taxpayers.”[iv] In simple terms, the IRS’s legal position, for matters outside of the jurisdiction of the Fifth Circuit, is that it is solely within the discretion of the IRS to determine whether or not a TAO applicant’s claim is tolled.

So, before summarizing “how” the IRS is legally able to “nonacquiesce” with an adverse decision, it is worth noting “what” the IRS’s Acquiescence Policy is and “why” it exists.

IRS’s Acquiescence Policy

What is the IRS’s Acquiescence Policy?

If the IRS wants taxpayers to know that it will follow an adverse decision in future cases involving similar facts and issues, it will announce its “acquiescence” in the decision. Conversely, if it wants taxpayers to know that it will not follow the decision in such future cases, it will announce its “nonacquiescence.” In cases involving multiple issues, the IRS may acquiesce in some issues but not others.[v] In decisions supported by extensive reasoning, it may acquiesce in the result but not the rationale.  This policy is known as the IRS acquiescence policy.

The IRS does not announce its acquiescence or nonacquiescence in every decision it loses. Furthermore, it may retroactively revoke an acquiescence or nonacquiescence.

When it does announce its acquiescence or nonacquiescense, the IRS publishes its notice  as “Actions on Decision” first in the Internal Revenue Bulletin (“IRB”), then in the Cumulative Bulletin (“CB”). The footnotes to the relevant announcement in the IRB and CB indicate the nature and extent of IRS acquiescences and nonacquiescences.

Why does the IRS have a Acquiescence Policy?

These acquiescences and nonacquiescences have important implications for taxpayers. If a taxpayer bases his or her position on a decision in which the IRS has nonacquiesced, he or she can expect an IRS challenge in the event of an audit. In such circumstances, the taxpayer’s only recourse may be litigation. On the other hand, if the taxpayer bases his or her position on a decision in which the IRS has acquiesced, he or she can expect little or no challenge. In either case, it is important to be aware that the IRS examining agent will be bound by the IRS position in the Actions on Decision published in the IRB and CB

Judicial Precedence

How is the IRS able to legally nonacquiesce in an adverse decision?

A quick summary of a legal concept known as “judicial precedence” explains why the IRS is not always bound by an adverse decision when it faces future litigation on similar facts and issues.

Judicial precedence means lower courts have to follow decisions of higher courts in deciding cases where the facts are sufficiently similar.  Absent an “Act of Congress” to change in the law, rulings of the U.S. Supreme Court are binding on all courts; whereas, rulings by a particular Court of Appeals, albeit given a level of deference by the other appellate courts, are only legally binding on the specific lower courts within that appellate court’s jurisdiction.[vi]

That means, for a litigant like the IRS, which can find itself litigating the same issues with multiple taxpayers who are located in different parts of the country, the IRS is not necessarily bound by an adverse decision – as long as the IRS’s loss was in a different appellate court’s jurisdiction than the appellate court in which it is litigating.

To be clear, judicial precedence is not limited to the IRS. For example, if the Fifth Circuit had ruled against Mrs. Rothkmann, another taxpayer could proceed to litigate similar facts and issues against the IRS in any court within the jurisdiction of the other twelve federal courts of appeals.[vii]

Sandra R. Brown is a Principal at Hochman Salkin Toscher Perez P.C.  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)  Ms. Brown  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. 

[i] Rothkamm v. USA, 802 F.3d 699 (5^th Cir. 2015); https://taxpayeradvocate.irs.gov/Media/Default/Documents/NTAblog/Rothkamm%20-%20Fifth%20Circuit%20Opinion%20(9-21-2015).pdf

[ii] In 2012, when the IRS issued it’s the levy in this case, the applicable period for filing an administrative claim to challenge an IRS levy was only nine-months under IRC § 6532(c).  That period was extended to two years with respect to levies issued after December 22, 2017, or for which the nine-month statute had not already expired. See, Public Law 115-97.

[iii] https://www.irs.gov/pub/irs-aod/aod-2020-03.pdf

[iv] Rothkamm at page 20.

[v] An example of the IRS agreeing in part is present in the Rothkamm case, where: (1) the IRS raised a second legal argument, i.e., that Mrs. Rothkamm lacked standing as a “taxpayer” to obtain tolling under a TAO; (2) lost both that argument and the tolling argument; and (3) decided to provide notice that it will acquiesce in one issue, i.e., the “taxpayer”, but not the tolling issue.

[vi] Jurisdiction of the U.S. Circuit Courts can be determined by region of the country or specific subject matter of the litigation.

[vii] https://www.uscourts.gov/about-federal-courts/court-role-and-structure

Eleven months ago I blogged on a district court decision in Taylor Lohmeyer Law Firm P.L.L.C. v. United States, 385 F.Supp. 3d 548 (W.D. TX 2019), enforcing a John Doe summons seeking documents for clients who between 1995 and 2017 used the firm to acquire, establish maintain or control any foreign account, asset or foreign entity, or any domestic or foreign account in such an entity’s name. https://www.taxlitigator.com/a-district-court-enforces-a-john-doe-summons-issued-to-a-law-firm-prefaced-by-a-brief-primer-on-john-doe-summonses-by-robert-s-horwitz/.  As expected, the law firm appealed the decision to the Fifth Circuit.  Although the firm raised several issues before the district court, its appeal raised only one issue: whether the attorney-client privilege protected the documents sought from disclosure.  The John Doe summons was issued  as the apparent result of an Offshore Voluntary Disclosure Program case involving a client (C-1) for whom the firm had established foreign accounts and entities and executed transactions involving those accounts and entities.

The firm argued that the summons was over broad and represented “an unprecedented intrusion into the attorney-client relationship.”  The firm further asserted that while the identity of a firm’s client is not generally privileged, it is if revealing the client’s identity would disclose confidential communications.  The Fifth Circuit rejected the firm’s argument and affirmed the enforcement order.

The Fifth Circuit began by noting that the federal law governing attorney-client privilege applies.  That privilege is interpreted narrowly to ensure that it is used strictly to achieve its purpose: to keep confidential communications made to secure a legal opinion, legal services or assistance in a legal proceeding.  This is especially true in cases involving IRS summonses given Congress’ “policy choice in favor of disclosure of all information relevant to a legitimate IRS inquiry.”  In the case of documents, the privilege must “be specifically asserted” as to “particular documents.”  The identity of a client is not shielded by the privilege unless revealing it would reveal a confidential communication.  An example given by the Fifth Circuit was “where revelation of such information would disclose other privileged communications such as the confidential motive for retention.”

The firm relied on two cases to support its position:  Reyes-Requena, 926 F.2d 1423 (5^th CIR. 1991), and United States v. Liebman, 742 F.2d 807 (3^rd CIR. 1984).  The Fifth Circuit distinguished both cases.  In Reyes-Requena, involving a grand jury subpoena, the court was presented with documents under seal and the identity sought was that of the person who was paying the target’s fees, which was being done for joint representation in a criminal case. In Liebman, the IRS issued a John Doe summons for the identities of all clients who were advised by the firm that certain legal fees were deductible, so that by its terms the summons was designed to disclose the substance of privileged communications.

According to the Fifth Circuit, the summons issued to the firm did not seek the substance of any confidential communication and an affidavit submitted by one of the firm’s partners undermined its position since the partner stated C-1, unlike other clients, did not follow the firm’s advice.  The Fifth Circuit noted that the IRS did not indicate it knew the substance of the firm’s legal advice and that it sought documents concerning “any client” on whose behalf the firm formed or acquired “any” foreign entity or opened or maintained “any” foreign account.

Determining that the clients’ identities were not “inextricably” connected with a privileged communication, the Fifth Circuit held that the exception to the rule that a client’s identity is not privileged is inapplicable.  At this point, the firm will need to decide whether it will petition for rehearing en banc and, if it is unsuccessful, petition the Supreme Court for a writ of certiorari.  If it ultimately is required to comply with the summons, it can still assert the privilege as to specific documents in a privilege log.

Two points of the Fifth Circuit’s decision were troubling:  First, the Fifth Circuit at the beginning of its discussion stated that “where revelation of [the client’s identity] would disclose other privileged communications such as the confidential motive for retention” then the privilege would shield disclosure.  Here the summons didn’t ask for the identity of clients who were retained by the firm concerning foreign accounts or entities, but clients who “used the firm” to set up foreign accounts and foreign entities.  To my mind this is a situation where revealing the identity of the client would disclose the “confidential motive for retention.”  As such, the substance of the inquiry by the IRS, rather than the selection of words, would fall under the shield noted by the court at the outset of the opinion.

Second, the Fifth Circuit’s statement about the privilege being narrowly interpreted, especially given Congress’ policy choice in favor of disclosure to the IRS.  Is this an indication that where the IRS seeks information privilege claims will be more narrowly construed than in instances where some other entity or person seeks the same information?

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.

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act)[1] enacted many relief provisions for taxpayers.. In particular, the CARES act will allow taxpayers who have net operating losses (NOLs) for tax year 2018, 2019, and 2020 to carry the NOL back to each of the five preceding years unless the taxpayer elects to waive or reduce the carry back.[2]   The CARES Act also  modifies the credit for prior-year minimum tax liability for corporations, including to accelerate the recovery of remaining minimum tax credits of a corporation for it’s 2019 taxable year from it’s 2021 taxable year and to permit  a corporation to elect instead to recover 100% of any of its remaining minimum tax credits in its 2018 taxable year.[3] These changes are significant because the Tax Cuts and Jobs Act of 2017 disallowed carrybacks of NOL deductions and repealed the corporate alternative minimum tax.  The IRS has also now taken administrative action to assist taxpayers in expediting these refunds.

Temporary Procedures to Fax Tentative  Refund Claims for NOLs

On April 13, 2020, the IRS posted FAQs on faxing claims for credit or refund resulting from NOL carrybacks and corporate AMT credits under secs. 2303 and 2305 of the CARES Act.  Beginning April 17, 2020 the IRS will accept eligible tentative  refund claims Form 1139 and Form 1045 that are faxed.[4] The IRS has allowed these forms to be faxed due to the health emergency impacting the timeliness of these forms being mailed. Taxpayers can fax Form 1139 to 844-249-6236 and Form 1045 to 844-249-6237.  Previously, all claims for refund or credit had to be mailed to the IRS. This procedure only applies to CARES Act NOL carrybacks and corporate AMT credits.  All other claims for credit or refund must still be mailed to the IRS.

A maximum of 100 pages can initially be faxed to either of the fax numbers listed above.  If additional documentation is required to be attached or deemed to be necessary, taxpayers will be notified during the processing of Form 1139 or Form 1045.

The procedures to process refund claims will otherwise remain the same.  If the taxpayer has previously mailed in Form 1139 or Form 1045 the taxpayer is free to fax the forms starting April 17.  All claims will be processed in the order of receipt. If a document faxed is deemed an ineligible refund claim it will be processed after normal operations resume.  This will not become a permanent method of processing the applications after the COVID-19 pandemic is no longer in existence.

Refunds in Tax Years Related to IRC §965(a) Inclusions

The Tax Cuts and Job Acts imposed a one-time transition tax of 15.5% for cash positions and 8% for other amounts on U.S. shareholders’ share of a specified 10% owned foreign corporation’s deferred earnings and profits. There is a §965(n) election taxpayers can make to not have the NOL deduction apply to their transition tax liability and not affect foreign tax credits that the taxpayer can elect. If a taxpayer has §965(a) deemed repatriation income, Forms 1139 and 1045 can be used despite instructions on the forms saying they are not eligible to be used for “§965(a) years.”

The IRS will plan to issue additional instructions for taxpayers that have a §965(a) inclusion.

Form 4446 Corporation  Application for Quick Refund of Overpayment of Estimated Tax

The IRS will not extend these temporary procedures to Form 4466.  Form 4466 must be filed in accordance with existing Form instructions.  If this Form is faxed it will not be accepted for processing.

Robert S. 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. Mr. Horwitz can be reached at horwitz@taxlitigator.com or 310.281.3200.   Additional information is available at http://www.taxlitigator.com.

 Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C. Mr. Tunden is a 2019 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] P.L. 116-136.

[2] §2303 of the CARES Act.

[3] §2305 of the CARES Act.

[4] Only refund claims filed under sections 2303 and 2305 of the CARES Act.

On April 13, 2020, the Tax Court issued an opinion in Hakkak v. Comm’r, T.C. Memo 2020-46, holding that a taxpayer was not a real estate professional in the tax years at issue for purposes of being able to qualify for the exception to the rule that rental activities are per se passive under the Section 469 passive loss limitation rules.[i]  The issue before the Tax Court was whether the taxpayer, a California attorney practicing primarily in personal injury, was a real estate professional within the meaning of Section 469(c)(7) as a result of his activities with respect to his investments in certain flow-through entities owning rental property.[ii]

The taxpayer at trial took a contrary position to his tax return.  On his tax return for the years at issue (2011 and 2012), the taxpayer reported his losses from his real estate rental activities as passive losses.  He then used these losses to offset shareholder income from his personal injury law practice, which he reported as passive income.  In the Notice of Deficiency issued following an audit, the IRS asserted that his income from his law practice was nonpassive (active) income, and as a result, could not be netted against the taxpayer’s passive losses from his rental activities.

At trial, the taxpayer contended not that the income from his law practice was passive, as stated on his return, but rather that his losses from two of his rental activities were in fact nonpassive, which would then allow the taxpayer to offset the losses against the nonpassive income from his law practice.  The rental properties at issue were two commercial rental properties located in Texas.  In addition to these two properties, the taxpayer had an interest in two additional commercial rental properties in Texas, two residential rental properties in California, and a gas station in California.

A taxpayer is a real estate professional under Section 469(c)(7) if, during the taxable year, the taxpayer spent more than 750 hours and half of his personal service hours in a real estate trade or business.  If a taxpayer qualifies as a real estate professional, the per se passive rule will not apply to the taxpayer’s rental properties and the taxpayer may demonstrate that he materially participated in the rental activities, making them nonpassive activities.[iii]

At trial, the taxpayer submitted the following evidence in support of his contention that he was a real estate professional during the years at issue: his testimony at trial, handwritten calendars (together with a partial transcription of these calendars), and documents consisting of emails and other written correspondence, lease agreements, bank account and credit card statements, invoices, loan statements and documents, photos, insurance documents, financial reports, property tax records, and various commercial real estate news articles.[iv]  He contended that he “exerted comprehensive and extensive time, effort, labor, and consideration relating to his operation, control and oversight” over the two properties in Texas.[v]  The Tax Court was unpersuaded, finding that the taxpayer’s “vague testimony discussing (at best) generalities about what he might have done and how long he might have spent does not sufficiently supplement or explain the calendar entries.”  The Tax Court further found that the evidence showed that much of his time was spent on investor-type activities, which don’t count for purposes of the 750-hour requirement.[vi]  In fact, day-to-day management of the rental properties was handled by a property management company and a leasing agent was used to find new tenants.

Moreover, the Tax Court found no evidence that the taxpayer spent over half of his personal service hours on real estate trade or business activities during the taxable year, other than the taxpayer’s self-serving testimony it found to be unreliable.[vii]  This is a particularly difficult obstacle to overcome for taxpayers who have a full time job in a non-real estate trade or business.  It is important for taxpayers seeking to take advantage of the real estate professional exception to document the time the taxpayer spent on all personal services during the relevant tax years, both real estate-related activities and non-real estate activities, such as the practice of law.

Because the Tax Court held that the taxpayer was not a real estate professional, the court did not have to decide the question of whether the taxpayer materially participated in the rental activities at issue.

Lacey Strachan is a Principal at Hochman Salkin Toscher Perez P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury).  Ms. Strachan has experience in a wide range of civil and criminal tax cases, including cases involving technical valuation issues, issues of first impression, and sensitive examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise. 

[i] Hakkak v. Comm’r, T.C. Memo 2020-46.  The Petitioners were a husband and wife who filed a joint return.  In this blog post, the “taxpayer” refers to the husband.

[ii] For a background discussion on the Section 469 passive loss limitation rules as they pertain to rental real estate, see Lacey Strachan, “A Primer on Material Participation Rules for Real Estate Businesses, Part 1: General Overview,” Taxlitigator – Tax Controversy (Civil & Criminal) Report, August 29, 2017, https://taxlitigator.me/2017/08/29/a-primer-on-material-participation-rules-for-real-estate-businesses-part-1-general-overview-by-lacey-strachan/.

[iii] For additional discussion about the real estate professional exception to the passive loss rules, see Lacey Strachan, “A Primer on Material Participation Rules for Real Estate Businesses, Part 2: Who is a Real Estate Professional?” Taxlitigator – Tax Controversy (Civil & Criminal) Report, September 12, 2017, https://taxlitigator.me/2017/09/12/a-primer-on-material-participation-rules-for-real-estate-businesses-part-2-who-is-a-real-estate-professional-by-lacey-strachan/ and Lacey Strachan, “A Primer on Material Participation Rules for Real Estate Businesses, Part 4: Special Considerations for Real Estate professionals with Rental Activities,” Taxlitigator – Tax Controversy (Civil & Criminal) Report, October 14, 2017, https://taxlitigator.me/2017/10/14/a-primer-on-material-particiation-rules-for-real-estate-businesses-part-4-special-considerations-for-real-estate-professionals-with-rental-activities-by-lacey-strachan/.

[iv] Hakkak at *16-*17.

[v] Id. at *17.

[vi] Id.

[vii] Id. at *18-*19.

IRC Section 7508A gives the Treasury Secretary the power to postpone certain deadlines in the case of a Presidentially-declared disaster.  Previously, the Secretary had postponed until July 15, 2020, the time for filing income tax returns and paying federal income tax due April 15, 2020.  On April 9, the IRS issued Notice 2020-23, which postpones until July 15, 2020, the filing of returns and the payment of tax due on or after April 1, 2020, and by July 14, 2020.  Notice 2020-23 also postpones the time for filing refund claims, Tax Court petitions and refund suits and for the IRS to assess and collect tax and to bring lawsuits regarding taxes.

Postponement of the Time to File Returns and Pay Taxes

The affected returns and payments are individual income tax returns, corporate income tax returns, partnership returns, estate and trust income tax returns, estate and generation skipping transfer tax returns, gift and generation transfer tax returns, exempt organization business income tax returns, certain excise tax payments on investment income, quarterly estimated tax payments, and any forms, schedules or returns required to be filed with such returns.  Any election required to be made on an affected return (or accompanying form or schedule) is timely if filed on or before July 15, 2020.  The period between April 1 and July 15, 2020, will be disregarded in calculating interest, penalties and additions to tax for failure to file or pay.  These will begin to accrue on July 16, 2020.

A taxpayer who wants an extension beyond July 15, 2020, must file a request for extension beyond that date, but no extensions will be allowed “beyond the original statutory or regulatory extension date.”  Thus, if an estate is on extension to file an estate tax return by May 1, 2020, will have until July 15, 2020, to file and may not get a further extension.  An estate whose return was originally due on May 1, 2020, however, can file for an extension if it does so by July 15, 2020. The affected tax returns and forms are listed at the end of this blog, for those who are interested.

Relief is given to Opportunity Zone investors.  Where the 180 day period for making an investment at the election of the taxpayer under sec. 1400Z-2(a)(1)(A) falls between April 1 and July 14, 2020,  the taxpayer will have until July 15, 2020, to make the investment.

Postponement of Time to File Refund Claims, Tax Court Petitions and Refund Suits

The IRS also postponed until July 15, 2020, the time to perform any of the following “time-sensitive acts” that were due to be performed between April 1 and July 14, 2020: filing claims for refund or credit of any tax, filing a petition with the Tax Court, filing for review of a decision of the Tax Court, and filing a suit based upon a claim for credit or refund.  The Notice does not list other suits that a taxpayer can file, such as a wrongful levy suit, a suit for illegal collection action, or a suit to quash an Internal Revenue Service summons.  How does the Secretary have the power to extend the time for filing a refund suit in district court or the Court of Federal Claims or a petition with the Tax Court?  Sec. 7508A grants the Secretary the power to postpone any act that can be postponed under sec. 7508 (postponements for military personnel on service in a combat zone).  Sec. 7508(a)(1)(C) and (F) authorize the Secretary to postpone the date for filing petitions with the Tax Court or for review of a Tax Court decision and to file a suit on any claim for credit or refund.

Postponement of Certain “Time-Sensitive” Acts by the IRS

Finally, the Notice postpones the time within which the IRS is to perform certain time sensitive acts described in Treas. Reg. sec. 301.7508A-1(c)(2) with regard to the following persons: a) those under examination; b) those whose cases are with the Independent Office of Appeals; and c) those who between April 6, 2020 and July 15, 2020, file amended returns or make payments for a tax for which the time for assessment would otherwise expire.  The time-sensitive acts are: (i) assessing any tax; (ii) giving or making any notice or demand for the payment of any tax, or with respect to any liability to the United States in respect of any tax; (iii) collecting by levy or otherwise, of the amount of any tax liability; (iv) filing by the United States, or any officer on its behalf, of any suit in respect of any tax liability; (v) allowing a credit or refund of any tax; and (vi) any other act specified in a revenue ruling, revenue procedure, notice, or other guidance published in the Internal Revenue Bulletin).  If any of these acts were required to be performed between April 6 and July 15, 2020, the IRS has 30 days following the last date for performance (i.e., 30 days from July 15, 2020).

List of Affected Tax Returns and Forms

For tax nerds and others who may be interested, here are the specific returns and forms affected by the notice:

1. Individual federal income tax returns: Forms 1040, 1040SR, 1040NR, 1040NR-EZ, 1040PR, 1040SS
2. Corporate income tax returns: Forms 1120, 1120C, 1120F, 1120FSC, 1120H, 1120L, 1120PC, 1120POL, 1120REIT, 1120RK, 1120S, 1120SF
3. Partnership returns: Forms 1065, 1066
4. Estate and trust income tax returns: Forms 1041, 1041-N, 1041QFT
5. Estate and generation skipping transfer tax returns: Forms 706, 706-NA, 706-A, 706-QGT, 706-GS(T), 706-GS(D), 706-GS(D-1)
6. Gift and generation skipping transfer tax returns: Form 709
7. Form 8971
8. Estate tax payments of principal or interest due as a result of an election under secs. 6166, 6161, or 6163 and annual recertification requirements under sec. 6166
9. Exempt organization business income tax form: Form 990-T
10. Excise tax payments on investment income and return filings: Forms 990-PF, 4720
11. Quarterly estimated income tax payments: Forms 990-W, 1040-ES, 1040-ES(NR), 1040-ES(PR), 1041-ES, 1120-W
12. All schedules, returns and other forms that are filed as an attachment to the forms listed above or required to be filed by the due date of any of those forms, including Schedules H and SE and Forms 3520, 5471, 5472, 8621, 8858, 8865, 8938
13. Any installment payment due under sec. 965(h) on or after April 1 and before July 15, 2020

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”) has several tools to utilize in obtaining information about a taxpayer’s financial records.  One of these tools involves contacting third parties.  Those third parties may be a taxpayer’s business associates or even friends and relatives.  Third parties may, however, also be governmental agencies.  While there are rules in place as to when the IRS must provide a taxpayer with advance notice that the agency intends to contact third parties, there are also exceptions to such rules.  One such example for which the IRS has recently provided notice of such an exception involves contacts with governmental agencies.  As discussed below, pursuant to IRS Office of Chief Counsel Memorandum 202013015, the IRS is now taking the position that contact with government agencies is not considered prohibited third-party contact for which notice, which would otherwise be required by law, must be provided to the taxpayer in advance of such contact.

What are Third-Party Notices

An IRS third-party notice is used to verify or collect information about the taxpayer when the taxpayer is unable or, perhaps, unwilling, to provide the information directly to the IRS. This type of notice is a common tool used by the IRS and is codified in the Internal Revenue Code (“IRC”) in § 7602. There are interpretive regulations published in Treas. Reg. § 301.7602-2 as well.  In 2019, the law surrounding third-party notices was amended to provide taxpayers with additional protections.

Taxpayer First Act, the 9^th Circuit, and Third-Party Notices

On July 1, 2019, the Taxpayer First Act (“TFA”) was signed into law.[i]  The TFA, a pro-taxpayer legislation[ii], modified numerous policies at the IRS concerning organizational structure, customer service, enforcement procedures, IRS free file program, and cybersecurity.  It also provided additional procedural protections to taxpayers with regards to the IRS’s issuance of third-party notices.

Provision 1206 of the TFA amended IRC § 7602 and the regulations thereunder with respect to the  requirement for IRS third-party notices.[iii]  Previously, the IRS would issue a relatively generic notice of an intent to contact third parties by simply providing the taxpayer with Publication 1 entitled “Your Rights as a Taxpayer” and sending Letter 3164 to the taxpayer at some point prior to contacting third parties.[iv]  It was this specific practice that in 2018, prior to the enactment of the TFA, was the subject of litigation in the 9th Circuit Court of Appeals.  Ultimately, just months prior to the enactment of the TFA, the 9^th Circuit ruled in favor of the taxpayer and held that Publication 1 did not provide taxpayers with reasonable advance notice as was then required under the prior § 7206(c).[v] Recognizing that the third parties whom the IRS may contact could include the taxpayer’s neighbors, employer, employees, or the bank that the taxpayer has accounts with, the court recognized major privacy and reputational concerns for taxpayers came into play when the IRS utilized a third party notice. [vi] As such, the 9^th Circuit concluded that a reasonable notice must provide the taxpayer with a meaningful opportunity to volunteer records on his own, so that third-party contacts can be avoided if the taxpayer complies with the IRS’s demand.[vii]

Consistent with the 9^th Circuit’s decision, published in February 2019, the TFA amended IRC §7602(c)(1), effective August 15, 2019, providing that:

• The auditor must notify the taxpayer that he or she intends to contact third parties
• When the auditor notifies the taxpayer, he or she must actually intend to contact the third parties
• The auditor must notify the taxpayer at least forty five (45) days before he or she contacts the third party and
• The auditor must tell the taxpayer the time period in which he or she intends to make the contact and the period must not exceed more than a year.

Taxpayer First Act and Post-Contact Reports of Third-Party Notices

The TFA did not impact IRC § 7602(c)(2) which requires the IRS to provide taxpayers with post-contact reports, both periodically and upon request.[viii] As such, in addition to advance notice requirements under the new law, the taxpayer can  also request post-contact reports from the IRS for information as to who the agency  contacted with third party notices.[ix] The availability of both provisions is important. But it should be noted that there are actually three types of notice that a taxpayer should be aware of: (1) the advance notice provision which only covers every third-party contact that the IRS “may” make; (2) the post-contact notice provision which covers only “persons contacted” while excluding third-party contacts authorized by the taxpayer, where notice would jeopardize collection or could lead to reprisals against the person contacted, and in criminal cases; and (3) a copy of any third-party summons sent by the IRS to the taxpayer.[x] In the 9^th Circuit case discussed above, for example, the advance notice provision would have required the IRS to notify the taxpayers before contacting the third-party, which in that case was the California Supreme Court, a governmental agency.  However, because those taxpayers received a copy of the summons which the IRS ultimately sent to the California Supreme Court, under § 7206(c)(2), the IRS would not need to include the California Supreme Court on a list of “persons contacted”.[xi]

IRS Chief Counsel Says Contacts with Other Governmental Agencies Are Not Subject to TFA’s Advance Notice Requirements

Pursuant to a recently published Chief Counsel Memorandum, the IRS has stated that IRS contacts with foreign, federal, state and local government agencies are generally not considered prohibited third-party contacts under Treas. Reg. §301.7602-2(f)(5).[xii] In issuing this memorandum, the IRS is taking this position, not simply in matters where cases are being referred to the Department of Justice for enforcement, but in matters where the IRS is seeking information from a third-party governmental agency involved in a nontax-related settlement with a taxpayer.

The Chief Counsel Memorandum dealt with a taxpayer and the tax treatment of a settlement under IRC §162(f).  In a situation where the underlying settlement was between the taxpayer and the Department of Justice, the IRS sought information from the DOJ attorney with knowledge of the case as well as a request for a DOJ-generated Financial Management Information System (FMIS) audit report and/or other information about the manner in which DOJ handled and/or settled the lawsuit with the taxpayer, similar to information the IRS might seek from a private party who had entered into a monetary settlement with the taxpayer.  The primary issue in the above instance was whether the IRS request for information from the DOJ regarding the government’s settlement with a taxpayer (in a non-tax case) should be considered third-party contacts for which IRC §7602(c) advance notice and post-contact reporting rules apply.

The new amendments to IRC § 7602(c)(1), which generally apply to IRS contacts with any “person other than the taxpayer” contain no explicit exception for contacts with governmental entities.[xiii] Treasury Regulation § 301.7602-2(f)(5), however, specifically excepts governmental entities from the § 7602(c) notice rules[xiv] Citing Congressional concerns about a taxpayer’s reputation, third parties privacy, and the IRS’s enforcement of the law underlying the change in the law governing such notice provisions, Chief Counsel concluded that the exception for governmental entities is consistent with the Congressional intent in amending § 7602(c) of the TFA.  Whether this position will stand is open for debate, particularly in the 9^th Circuit, where the Court found the IRS’s use of Publication 1 as insufficient for a contact with a governmental entity, specifically the California Supreme Court, under a less taxpayer-friendly version of § 7206(c).

Sandra R. Brown is a Principal at Hochman Salkin Toscher & Perez P.C.  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)  Ms. Brown  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. 

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C. Mr. Tunden is a 2019 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).

[i] Taxpayer First Act of 2019, H.R. 3151; Pub.L. 116-25.

[ii] According to the House Ways & Means Committee, the TFA’s passage was the result of the committee’s effort to implement pro-taxpayer reforms at the IRS for the first time in more than 20 years.

[iii] See https://www.congress.gov/bill/116th-congress/house-bill/3151/text. Also see https://www.finance.senate.gov/imo/media/doc/Taxpayer%20First%20Act_Section%20by%20Section-converted.pdf at 3.

[iv] Publication 1 Your Rights as a Taxpayer. Letter 3164 Notification of Third Party Contact.

[v] J.B. v. United States, 916 F.3d 1161, 1173 (9^th Cir. 2019); http://cdn.ca9.uscourts.gov/datastore/opinions/2019/02/26/16-15999.pdf.

[vi] Id. at 1165. Also see Publication 1.

[vii] Id.

[viii] IRC § 7602(c)(2). Also See Treas. Reg. § 301.7602-2(e)(1).

[ix] Id.

[x] Cf. I.R.C. § 7602(c)(1) with I.R.C. § 7602(c)(2); see also Treas. Reg. § 301.7602- 2(e)(4), Ex. 4 (“providing a copy of the third party summons to the taxpayer pursuant to section 7609 satisfies the post-contact recording and reporting requirement”).

[xi] Id.

[xii] See IRS Office of Chief Counsel Memorandum 202013015, The Application of I.R.C. §7602(c) to Government Contacts in the Context of DOJ Settlements with a Taxpayer, at 2.

[xiii] IRC §7602(c).

[xiv] See Treas. Reg. §301.7602-2(f)(5) (“Section 7602(c) does not apply to any contact with any office of any local, state, Federal or foreign governmental entities” and that “the term office includes any agent or contractor of the office acting in such capacity.”)

Do-overs are rare in criminal law, unlike a weekend golf game.  Finality is an important factor in what appellate courts do, which is why they establish hard-to-meet standards for reversal such as “plain error.”  Another tip: judges don’t like defendants to use the time between pleading guilty and being sentenced to commit the same crimes that they have pled to, and the sentence imposed may underscore this point.

Rule 11 of the Federal Rules of Criminal Procedure establishes what a district court must do when taking a guilty plea. When a defendant changes her plea to guilty and doesn’t object to any Rule 11 violations, she can only throw out her guilty plea on appeal if she shows the district court committed “plain error.”  Plain error in this context means that there’s an obvious error in the Rule 11 process, it affected substantial rights, and there’s a reasonable chance the defendant wouldn’t have pled guilty if the district court had done the Rule 11 colloquy correctly.  Each of these is difficult to show, and showing all three is rare.

Enter David Adams, a man with a 14-year history of

obstruct[ing] the IRS’s efforts to collect his delinquent tax payments and to secure overdue tax returns.  He lied to and manipulated his accountant, filed extension requests containing false information, claimed to have made payments that he had not made, missed deadlines, lied that checks were in the  mail, unjustifiably blamed his accountant for errors and delays, bounced checks, and fraudulently claimed financial distress at times when he had the funds necessary to pay his tax liability, all the while spending lavishly on a lifestyle that included purchasing and leasing multiple luxury vehicles, spending millions to construct a mansion in East Lyme, Connecticut, and staying at upscale hotels.

Given this history, it’s not surprising that he was indicted for a variety of tax crimes, including filing false returns, tax evasion, and obstructing the IRS.  When he decided he didn’t want to go to trial the government apparently made him “eat the sheet,” meaning, Adams had to plead guilty to all six counts in his indictment instead of just picking one or two (as the government often agrees to when a defendant agrees to plead guilty early rather than late in the game).  Each count carried a three-year or five-year statutory maximum sentence.

Can’t Withdraw Guilty Plea

When a defendant is convicted of multiple offenses, district judges have discretion to run sentences consecutively (stacking) instead of concurrently, to achieve what the court believes is an appropriate sentence.  Adams’ presentence report showed the recommended sentence under the Federal Sentencing Guidelines was 78-97 months – well above the 60-month maximum for any of his individual counts of conviction.  The district court sentenced Adams to 90 months, and he sought to withdraw his guilty plea by claiming that he didn’t understand that sentences could run consecutively.  Relying on well-established precedent, the Second Circuit rejected Adams’ attempt to “manufacture plain error,” and noted that Adams had plenty of chances to object or ask questions and he didn’t.

Penalties and Interest Included in Guideline Tax Loss Despite No Tax Evasion Conviction

Additionally, and as an issue of first impression, Adams complained that only tax, and not penalties and interest, should be used to compute his tax loss for Sentencing Guidelines purposes, because he hadn’t been convicted of “evasion of payment” or “willful failure to pay” taxes.  There is an important distinction in computing criminal tax loss between evasion of assessment and evasion of payment: in assessment cases, only the tax and not interest or penalties is included, primarily because when you take evasive action generally no interest or penalties are due; whereas in collection cases, the IRS is trying to collect assessed penalties and accrued or assessed interest, so it’s logical to include both in the criminal tax computation.  The Guidelines state the distinction at U.S.S.G. § 2T1.1 cmt. n.1, noting penalties and interest don’t count “except in willful evasion of payment cases under 26 U.S.C. § 7201 and willful failure to pay cases under 26 U.S.C. § 7203.”

Adams raised the issue whether one must be convicted of evasion of payment or failure to pay for a district judge to be allowed to include penalties and interest in tax loss, as the district judge did to Adams.  This, a legal issue reviewed de novo (meaning the district court’s decision isn’t given any weight), is a closer question than whether Adams could show plain error in the district court’s refusal to allow him to withdraw his plea.

Noting it was an issue of first impression in the Second Circuit, the appellate court stated the First and Seventh Circuits had already decided that a district court could include penalties and interest in the tax computation even if the defendant hadn’t been convicted of evasion of payment or failure to pay, where the defendant’s conduct included evading payment.  The Guidelines permit judges to include conduct related to the offense(s) of conviction when computing the accurate Guideline.  Relying on the Guidelines and the First and Seventh Circuit decisions, the Second Circuit determined that the Guideline comment regarding penalties and interest did not trump the Guidelines’ general rule that relevant conduct is included regardless of the counts of conviction.

Post-Plea Obstruction Merits 2-Point Enhancement

Adams had the temerity to object to an “obstruction of justice” enhancement as well, which arguably could have been based on his pre-indictment conduct (described in great detail above) but the Second Circuit didn’t need to decide that harder question.  Instead, the district court and Second Circuit zeroed-in on Adams’ conduct after pleading guilty that included “concealing, transferring and failing to disclose his assets” tantamount to a “game of ‘cat and mouse’” with both the IRS and the district court.  This is primarily a reminder not to stick a thumb in the eye of the person who will be sentencing you.

Tax Restitution Only Permissible as Supervised Release Condition

Finally, the district court erred in treating taxes like normal losses for restitution purposes.  Absent a plea agreement where a defendant agrees to it, taxes can only be ordered as a condition of supervised release or probation, and not during custody or after supervision has terminated (unlike fraud losses, for example).  However, the district court ordered that Adams’ restitution obligation began immediately after sentencing, when it should have ordered it solely as a condition of supervised release.  The Court of Appeals fixed this problem without sending it back down to the district court.

Takeaways

In addition to the obvious takeaway that constructing a mansion and leasing luxury vehicles while claiming poverty with the IRS might result in the Revenue Officer referring you to Criminal Investigation, the other takeaway is that, even once you’ve been charged, your conduct matters.  Had Mr. Adams accepted responsibility early, he might have negotiated fewer charges of conviction and, therefore, a lower statutory maximum.  Halting the cat-and-mouse game after pleading guilty would have saved a two-point enhancement and avoided the ire of the district judge.  Tax sentences tend to be lower, and sometimes much lower, than the low end of the Guideline range, but here it was above the mid-range.  Why?  Only the district judge knows, but post-indictment obstructive conduct and the late guilty plea is the likely answer.

The case is United States v. David M. Adams, No. 18-3650 (2d Cir. April 7, 2020), and the decision is available at http://www.ca2.uscourts.gov/decisions/isysquery/fc3a03ee-eb58-44b1-8480-325829418c50/2/doc/18-3650_opn.pdf#xml=http://www.ca2.uscourts.gov/decisions/isysquery/fc3a03ee-eb58-44b1-8480-325829418c50/2/hilite/

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. 

Transfer pricing tax disputes are the highest dollar for dollar cases that are before the U.S Tax Court currently, with cases that involve cross-border transactions of large multinational corporations. These are particularly important tax matters for states where multinational corporations are headquartered and/or conduct business.  But transfer pricing controversies are not limited to large multinationals—the transfer pricing rules apply to every company engaged in cross-border transactions with related parties.  Transfer pricing issues will sometimes even be raised in domestic transactions involving related parties, where the related parties have different tax situations.

Transfer pricing has now gotten the attention of states.  States have been hiring outside experts and consultants, many of whom are former senior government officials, for transfer pricing expertise to assist the tax agencies in transfer pricing examinations of intercompany transactions.

What is Transfer Pricing

Transfer pricing refers generally to the setting of prices for property and service sold between controlled entities, such as a parent corporation selling goods to a subsidiary. These intercompany transactions often occur between “high tax” jurisdictions and “low tax” jurisdictions, such as Ireland and Luxembourg.[i]

IRC §482 and the regulations thereunder[ii] govern the pricing between these entities. IRC §482 is designed to prevent income shifting through controlled transactions, by allowing the IRS to adjust the amount charged in related-party transactions for purpose of determining a related party’s taxable income, if the amount charged is determined to not be “arm’s length.” Under §482’s transfer pricing rules, the IRS has the power to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among related parties if it determined that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or to clearly reflect their income.

If the IRS makes an adjustment, the adjustment may be subject to a substantial or gross valuation misstatement penalty.^[iii] Areas covered by IRC §482 and the Treasury Regulations include: loans, use of tangible property, sale of tangible property, transfer and use of intangible property, services, and cost-sharing arrangements. Under IRC §482, controlled entities should price transactions in the same way that uncontrolled entities would under similar circumstances.  Obtaining a transfer pricing study when setting prices will help taxpayers be prepared for an audit and potentially avoid penalties.[iv]

State Tax Implications

Numerous states have a statutory provision that either conforms or substantially conforms to IRC §482.  While some states still retain a separate reporting regime for taxpayers, a majority of states have combined reporting (such as a water’s edge combined reporting). This filing method requires affiliated domestic companies that are engaged in a unitary business to report their total income—regardless of where earned—as though the group were a single unified business.

Some states, such as Connecticut and Washington D.C., also require taxpayers to include in their water’s edge reporting affiliates that are doing business in overseas “tax havens,” regardless of the amount of U.S. activity they have conducted.[v] If there are transactions between entities that are within and without the water’s edge group, then there exists the potential for intercompany transfer pricing issues. While the IRS’s focus is mostly on cross-border transactions, states are also focused on ensuring that income is clearly reflected for domestic related companies, where a company may want to take advantage of another state’s more favorable regime.

Cooperation Amongst State Tax Agencies

The Multistate Tax Commission (MTC) is an intergovernmental state tax agency with the mission of promoting uniform and consistent tax policy and administration among the states.[vi] The MTC developed a plan in 2015 to help states jointly address intercompany transactions.[vii]  This led to the creation of the MTC’s “Arm’s Length Adjustment Service Committee” the following year.  The MTC’s goal was to create a program of services for participating states, including the ability to combine their resources to make more efficient use of top transfer-pricing experts.  Although the program did not come to fruition since few states participated in the program, this kickstarted an effort by numerous states to cooperate together in transfer pricing audit issues.

The MTC’s most recent two-day training on transfer pricing took place in March 2019 and was attended by revenue staff from 16 states, including staff from the following eight new participating jurisdictions: Arkansas, Delaware, Kansas, Missouri, Oregon, Utah, West Virginia and Wisconsin.

In the past five years, consulting firms have most frequently been retained by state tax departments to train their staff. The contracts have been for services ranging from training on transfer pricing methods to assistance in selecting taxpayers for audit, preparation of economic reports that support a state’s adjustments, and serving as expert witnesses during litigation.

We expect to see increased audit activity by states into intercompany transacting pricing matters, as state agencies become better trained on transfer pricing matters and have greater resources through cooperation of other states to hire transfer pricing experts.

Steven Toscher is a Principal at Hochman Salkin Toscher & Perez P.C., and specializes in civil and criminal tax litigation. Mr. Toscher is a Certified Tax Specialist in Taxation, the State Bar of California Board of Legal Specialization and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation.

Lacey Strachan is a Principal at Hochman Salkin Toscher Perez P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury).  Ms. Strachan has experience in a wide range of civil and criminal tax cases, including cases involving technical valuation issues, issues of first impression, and sensitive examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise. 

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).

[i] See Veritas Software Corp. et al. v. Comm’r, 133 T.C. 297 (2009) and Amazon v. Comm’r, 148 T.C. No. 8 (2017).

[ii] Treas. Reg. §1.482-0 through §1.482-9.

[iii] IRC §6662(e)(1)(B)(i) 40% gross valuation misstatement if the price is 400% or more or 25% or less. Also see IRC §6662(h)(2)(A)(ii)(1).

[iv] See ”IRS Increases Focus on Transactions Between Commonly Controlled Entities in the Mid-Market Segment,” by Lacey Strachan, TAXLITIGATOR – Tax Controversy (Civil & Criminal Report) (June 8, 2017), https://taxlitigator.me/2017/06/08/irs-increases-focus-on-transactions-between-commonly-controlled-entities-in-the-mid-market-segment-by-lacey-strachan-2/.

[v] See D.C. Code Sections 47-1805.02a(a)-(b);-1810.07(a)-(c). Also see Conn. Gen. Stat. sections 12-213(a)(29) and 222(g)(1).

[vi] Multistate Tax Commission, http://www.mtc.gov.

[vii] MTC History, http://www.mtc.gov/The-Commission/MTC-History.