Schizophrenic Application of Tax Penalties (Part I)

Based our recent post on the Sala decision here, we have had several comments inquiring about the varied application of penalties in the “tax shelter” cases.   This is the first in a planned series of responses to those comments that will try to explain, iron out, or at least flag, some of the irregularities.

When looking at the application of penalties to “shelter” cases generally, procedural posture matters.  A good example of this is Sala.  Why did the 10th Circuit discussion in Sala omit penalties?  Because it was a refund case in which the taxpayer appears to have filed a qualified amended return (“QAR”) prior to being “caught” by the IRS.  See generally 26 C.F.R. § 1.6664-2(c)(2).  There is a discussion of whether Sala’s amended return was qualified in the district court opinion and that ruling apparently was not a subject of the appeal.  Sala v. United States, 552 F. Supp. 2d 1167, 1204 (D. Colo. 2008).  Thus, in a refund suit posture, there may be procedural reasons why penalties are inapplicable.

The refund claim situation is contrasted for penalty purposes with either deficiency proceedings or TEFRA proceedings.  In either of the latter, penalties cannot be abated by a QAR (at least as to the matter at issue) because the taxpayer must have a deficiency or adjustment (to income) in order to bring either action.  See generally sections 6212 and 6225-6.  Thus, in cases such as Gouveia v. Commissioner, T.C. Memo 2004-25 (2004), the Tax Court addressed (and imposed) penalties in a deficiency context.  And, in Castle Harbor, the courts addressed (but did not impose) penalties in the context of a TEFRA proceeding.  TIFD III-E Inc. v. United States, 2009 U.S. Dist. LEXIS 93853 (D. Conn 2009).  (We previously discussed the pending appeal in Castle Harbour here.)

While there is nothing mysterious about the foregoing, the different routes tax cases take can often cause an illusion that there is inconsistency in the application of penalties when, in fact, the cases are just procedurally different.  One other area in which this confusion is particularly common (and an area in which there is a bit of a dispute as to the correct application of the law) concerns whose behavior “counts” for purposes of the sections 6662 (reasonable basis) and 6664 (reasonable cause and good faith) defenses in the context of a TEFRA proceeding.  We will address that issue in our next post on penalties.

Appellees’ Response Filed in Virginia Historic

The Appellees filed their response brief yesterday in Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, No. 10-1333 (4th Cir.) (linked below).  Our previous discussion of the case is here.

The government has advanced two basic arguments.  First, it argues that the partners of the state tax credit partnerships were not bona fide partners that made capital contributions; rather, the government contends, the alleged partners were, in substance, purchasers of state tax credits.  As such, the proceeds of these sales transactions are gross income to the partnerships, not non-taxable contributions to capital.  In making this argument, the government focuses on the fact that the alleged partners had no possibility of realizing any economic benefit from their purported investments other than the acquisition of state tax credits at a discount from their face value.  Second, the government argues that even if the partners were bona fide partners, the disguised sale rules under I.R.C. § 707 apply to recharacterize the transactions as taxable sales of property by the partnership to the partners acting in non-partner capacities.

The Appellees (comprised of two of the tax credit funds at issue and their tax matters partner) contend that the investors in the tax credit funds were bona fide partners for federal income tax purposes because they pooled their capital with the intent of sharing in a pool of non-federal-tax economic benefits pursuant to partnership allocation provisions under state law.  Relying on Frank Lyon Co. v. United States, 435 U.S. 561 (1978), Appellees further contend that the partnership form of the transactions at issue was compelled by state-law regulatory realities (Virginia law prohibits the direct transfer of historic preservation tax credits), and thus the form should be respected.  With respect to the government’s I.R.C. § 707 argument, Appellees argue that the disguised sale rules do not apply where, as here, the partners were acting in their capacities as partners, the alleged consideration constitutes a contribution to capital, the partnership allocates tax attributes as opposed to transferring property (i.e., the state tax credits are not property), and there is a meaningful sharing of risk among partners.

Stay tuned—the Fourth Circuit’s decision could have a substantial impact on the question of the nature of a partner for federal income tax purposes and the scope of the disguised sale rules, as well as substance-over-form principles generally.

Virginia Historic Appellee Brief

Tenth Circuit Reverses District Court in Sala

In a brief (and some might say terse) opinion, the Tenth Circuit has reversed the District Court in Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008)  (decision linked below).  As many readers will recall, Sala was considered an outlier among the tax shelter cases litigated over the past few years, with the taxpayer winning at trial in a Son-of-BOSS case.  See our prior discussion of the case here.

Citing to Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356 (Fed. Cir. 2006), and Black & Decker Corp. v. United States, 436 F.3d 431, 441 (4th Cir. 2006), the Tenth Circuit focused narrowly on the specific transaction that gave rise to the claimed tax benefits, thus adding to the emerging trend of using a narrow definition of the transaction to defeat the efforts of tax planners. It remains to be seen whether the Tenth Circuit and other courts will embrace Coltec as closely when confronted with more traditional tax planning, rather than a Son-of-BOSS tax shelter.

Following its own precedent and a well-established approach to analyzing economic substance, the court concluded that the loss-generating transaction lacked economic substance.  In making this determination, the court considered both the taxpayer’s subjective business motivation in entering into the transaction, as well as whether the transaction had “objective economic substance.”  After engaging in a “common-sense examination of the evidence as a whole,” the court found it “clear that the transaction was designed primarily to create a reportable tax loss that would almost entirely offset Sala’s [tax year] 2000 income with little actual economic risk.”  The court also held that the “existence of some potential profit” is insufficient to imbue a transaction with economic substance where the purported tax benefits substantially outweigh the potential economic gains.  Holding for the government on the dispositive economic substance issue, the court declined to reach any of the other issues raised.

With this decision, Sala moves from being an interesting outlier to just another case in the mainstream of tax shelter decisions.  It is very unlikely that the taxpayer will be able to interest the en banc court or the Supreme Court in further review.  If he wants to try, a rehearing petition would be due on September 7 and a cert petition would be due on October 21.

Sala Tenth Circuit Opinion

Welcome to the Tax Appellate Blog!

The Tax Appellate Blog is a new blog dedicated to covering important tax cases pending before the various federal  courts of appeals that are of interest to practitioners and others who follow the development of federal tax law. We will try to post regularly as developments warrant, and we welcome commentary from the broader tax law community. We also plan to provide links to the pleadings and other pertinent documents in those cases.  So, welcome aboard.

Tenth Circuit Engaged in Lengthy Deliberation in Sala

In what is considered by many an anomaly among the so-called “Son-of-BOSS” cases, the IRS lost the trial of a refund claim before the United States District Court for the District of Colorado in 2008.  See Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008).  As many readers are no doubt aware, “Son-of-BOSS” is the nickname given to a type of loss-generating transaction described in IRS Notice 2000-44 (“BOSS” stands for “Bond and Option Sales Strategy”).  In one variation of such transactions, a taxpayer both buys and sells options on a given position and then contributes these options to an investment partnership.  Relying on Helmer v. Commissioner, T.C. Memo 1975-160, which held that liabilities created by short option positions are too contingent to affect a partner’s basis in a partnership, the taxpayer takes a basis in its partnership interest equal to the value of the long options position (i.e., not offset by the short options position).  Later, the investment partnership is liquidated and the assets sold, or the taxpayer’s interest is sold, with the taxpayer claiming substantial losses on what, economically speaking, was a pretty safe bet.

In Sala, the taxpayer invested in foreign currency options and contributed them to a partnership managed by renowned foreign currency trader, Andrew Krieger.  The amount of losses generated by the transactions at issue coincidentally offset a huge slug of income the taxpayer had in 2000 (approximately $60 million).  Despite the government’s best efforts, the court found for the taxpayer, holding that the transactions possessed economic substance.  The court also rejected the government’s attempt to retroactively apply regulations that reject the Helmer decision mentioned above.

The government appealed the case to the Tenth Circuit (briefing is linked below).  The government argues that the trial court erred in a number of respects, including: (1) determining that the transactions to be analyzed for economic substance are the entire array of transactions associated with a “legitimate” investment program, as opposed to the discrete options transactions giving rise to the claimed losses; (2) implicitly determining that the loss was a bona fide loss within the meaning of I.R.C. § 165; (3) invalidating or refusing to apply Treas. Reg. § 1.752-6 (which contains a basis-reduction rule designed to nullify “Son-of-BOSS” transactions); and (4) denying the government’s motion for a new trial after one of the taxpayer’s key witnesses (Krieger) recanted his testimony after accepting a plea agreement on criminal charges of promoting illegal tax shelters.

The taxpayer responded by arguing that: (1) the rule of Helmer was applicable law at the time of the contested transactions and should be followed; (2) the court blessed each phase of the contested transactions as having substance, not just the entirety; (3) the government did not adequately raise the § 165 argument at trial, and the provision nonetheless does not disallow the taxpayer’s loss; (4) Treas. Reg. § 1.752-6, as applied, is beyond the authority granted by the statute; and (5) the government did not meet its burden for obtaining a new trial.

Oral argument was held on November 16, 2009, and subsequently the government has directed the court’s attention pursuant to FRAP 28(j) to three of its recent wins in similar cases (supplemental submissions linked below).  Given that the case has been fully submitted for several months now, a decision could be imminent. The length of deliberation also may indicate that the court will engage in a detailed analysis that could depart from the opinions of other courts.  Should the taxpayer prevail, the case could be viewed as giving rise to a circuit split on the appropriate framework for analyzing alleged tax shelters, which could also have far-reaching implications for the recently codified economic substance doctrine.

Sala District Court Opinion

Sala Appellant Brief

Sala Appellee Brief

Sala Reply Brief

Supplemental 1

Supplemental Response 1

Supplemental 2

Supplemental Response 2

Supplemental 3

Supplemental Response 3

U.S. Opening Brief Filed in Quality Stores

On July 13, 2010, the government filed its opening brief in the Sixth Circuit in In re Quality Stores, Inc:  United States v. Quality Stores, Inc., No. 10-1563.  In that case, the government is appealing the district court’s surprising decision holding that severance payments made to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes if they qualify for exclusion from income tax withholding as “supplemental unemployment compensation benefits” (“SUB pay”) under Code section 3402(o)(2).  As the district court acknowledged, its decision directly conflicts with the Federal Circuit’s ruling in CSX Corporation v. United States, 518 F.3d 1328 (2008), which had appeared to resolve this issue definitively in favor of the IRS.  (This Miller and Chevalier Tax and Employee Benefits Alert contains a fuller discussion of the district court’s opinion and the steps that companies can take to protect their rights pending the outcome of the appeal.)

Although the government’s opening brief  relies extensively on CSX, it also addresses the issues comprehensively as if the Sixth Circuit were the first circuit court to consider the issue.  Primarily, the government argues that the case is controlled by Code section 3121, which broadly defines wages as “all remuneration for employment” — a definition that encompasses severance pay.  The government criticizes the district court’s reliance on Code section 3402(o) both because that section relates to income tax withholding, rather than FICA taxes, and because its terms in any event do not dictate that SUB pay is not “wages.”  With respect to the district court’s reliance on Rowan Cos. v. United States, 452 U.S. 247 (1981), the government argues that Rowan does not support exempting SUB pay from FICA taxation and, in any event, Congress’s enactment of the “decoupling provision” in the wake of Rowan eliminates any possible support that the case could lend to the companies’ position.

The answering brief for Quality Stores is currently due September 8, 2010.   Links to the government’s brief and the district court opinion are attached.

US opening brief in Quality Stores

District Court opinion in Quality Stores

D.C. Circuit Declines to Follow Textron

The D.C. Circuit has now decided the Deloitte case that was previously discussed on this blog.  (See D.C. Circuit Considers Work Product Issues in Deloitte for that discussion and links to the briefs in the case.)  The decision addresses two basic issues, and on both scores it gives comfort to taxpayers who do not want to furnish the IRS with their counsel’s candid assessment of litigation prospects on potential tax disputes.

With respect to the mental impressions of taxpayer’s counsel embodied in documents that are acknowledged to be work product, the court held that a taxpayer does not waive the privilege by sharing the analysis with its auditors.   The court explained that a company’s auditor is not its adversary, and that the company has a reasonable expectation that the auditor will preserve the confidentiality of that information.  Deloitte now becomes the leading appellate decision on the waiver issue, reaching the same outcome as the since-vacated decision of the First Circuit panel in Textron.

With respect to the issue that the Supreme Court recently declined to review, the court held that the “Deloitte memo” did contain work product in the form of orally transmitted opinions of Dow’s counsel, even though the memo was prepared by accountants.  The court distinguished the two decisions from other circuits that have taken a much dimmer view of work product protection for tax accrual workpapers or similar documents.  The court distinguished the Fifth Circuit’s old decision in United States v. El Paso Co., 682 F.2d 530 (1982), because that circuit uses a more restrictive standard for the work product inquiry into whether the document was prepared “in anticipation of litigation” — the “primary purpose” test — rather than the “because of” test applied by most circuits.  With respect to the Textron decision, which comes from a circuit that has nominally adopted the “because of” test,  the court noted that Judge Torruella’s dissent from the en banc decision in Textron had questioned whether the majority had truly adhered to the First Circuit’s stated standard.  And the court suggested that there could be some difference in the content of the documents that warranted the different results.  (This Miller and Chevalier Tax Alert contains a fuller discussion of the D.C. Circuit’s opinion as well as some observations on how it might affect the IRS’s initiative in Announcement 2010-9 to require disclosure of uncertain tax positions.)

Despite the court’s efforts to avoid a direct rebuff to the First Circuit, the reasoning of Deloitte is difficult to square with the Textron decision.  And there is now a clear conflict with the Fifth Circuit’s El Paso decision, both with respect to the result in the case of tax accrual workpapers and with respect to the more general issue of the proper standard for assessing whether a document is work product.  Therefore, if presented with a petition for certiorari in Deloitte, the Supreme Court may be more inclined to step into the fray than it was in Textron.

Before considering Supreme Court review, the government is almost certain to seek rehearing en banc from the full D.C. Circuit.  That approach proved successful in Textron after the First Circuit panel had initially ruled in favor of the taxpayer.  In the likely event that the D.C. Circuit does not rehear the case, the government will have to decide whether to seek certiorari after telling the Supreme Court a few months ago in Textron that this issue did not warrant Supreme Court review.  That decision may depend in part on tactical considerations, such as whether the government believes that the Deloitte case presents a favorable factual setting in which to determine the correct test for work product, as well as the relative importance that the Solicitor General attaches to the workpapers issue.

The D.C. Circuit’s opinion is linked below.  A petition for rehearing is due Aug. 13.

Deloitte court of appeals opinion