Government Brief Filed in MassMutual

The government has filed its opening brief in MassMutual contesting the Court of Federal Claims’ conclusion that the taxpayer could accrue the amount of certain policyholder dividends in the year before they were paid.  See our prior post on this case and the New York Life case here.  The government’s brief raises three distinct objections to the decision.

The primary argument is that the liability to pay the dividends was not “fixed” under the all-events test.  The government contends that no individual obligation was fixed at the close of the year, even if all the premiums had been paid, because the dividend would not be paid unless the policy remained in force on the anniversary date.  This is the same argument that was accepted by the Second Circuit in New York Life, and the government’s brief here argues that the cases are indistinguishable (asserting that the Second Circuit’s effort to distinguish them was based on a misperception of the facts in MassMutual).

The brief argues that the case “clearly fits the General Dynamics fact pattern,” which it describes as one where the “potential obligee has taken some action that renders him preliminarily eligible to receive the payment, subject only to some other condition that is within his exclusive control” – here, “forgoing the right to surrender the policy for its cash value prior to the next anniversary date.”  It rejects the proposition argued by the taxpayer that this alleged final condition is not a genuine “event,” but rather just a continuation of the status quo.  The government points to a comment in the Restatement (Second) of Contracts stating that “a duty may be conditioned upon the failure of something to happen . . ., and in that case its failure to happen is the event” that constitutes a condition precedent.  And it rejects the contrary suggestion in Burnham Corp. v. Commissioner, 878 F.2d 86 (2d Cir. 1989), as misguided.  Finally, the brief argues that the taxpayer’s all-events-test interpretation proves too much because its logical implication is that the amount of the dividend could be accrued even if the company had not passed a board resolution in the taxable year guaranteeing an aggregate dividend – a position that the taxpayer has not argued.

Second, the government argues that the dividend guarantees did not even give rise to an obligation, fixed or otherwise, because they were not communicated to the persons who were to benefit from them.  Thus, the government argues, the taxpayer could have walked away from the guarantees at any time.  In addition, the government argues, the guarantees were not a meaningful “substantive undertaking” because, based on the historical data, the guaranteed payments were “already virtually certain to occur in the ordinary course of the companies’ business operations, independent of any ‘guarantee’ to that effect.”  There is some degree of irony in this argument; on its face, certainty that the amounts will be paid would appear to be an argument in favor of accrual, not against it.  But the certainty of which the government speaks refers to the aggregate amount of payment; it is not a concession with respect to an individual obligation being fixed.

Third, the government contests the Court of Federal Claims’ holding that the dividends fell within the “recurring item” exception.  The government’s primary point here is that this determination turns on the meaning of “rebate, refund, or similar payment” in Treas. Reg. § 1.461-4(g)(3), and therefore the court should have deferred to the IRS’s interpretation of that regulation – even if that interpretation did not conclusively emerge until this litigation and is at odds with some earlier internal guidance on the regulation’s meaning.  The general principle of so-called Auer or Seminole Rock deference to an agency’s interpretation of its own regulations has come under fire recently, with Justice Scalia stating that it should be abandoned and Chief Justice Roberts and Justice Alito indicating that they are at least open to reconsidering it.  See Decker v. Northwest Environmental Defense Center, No. 11-338 (Mar. 20, 2013).  So it will be interesting to see how the Federal Circuit responds to this argument, which presents a relatively weak case for deference because the claimed agency interpretation is just based on its litigation position.

The taxpayer’s brief is due April 4.

MassMutual – Gov’t Opening Brief

Briefing Underway in Barnes as Second Circuit Considers Application of Step-Transaction Doctrine to Impose Dividend Treatment on Movement of Foreign Cash

In Barnes Group v. Commissioner, the Tax Court (Goeke, J.) looked askance at the taxpayer’s strategy for minimizing the tax consequences of a movement of foreign cash to U.S. affiliates.  As the taxpayer explained it, its foreign subsidiary in Singapore had excess cash and borrowing capacity that Barnes wanted to use to finance international acquisitions.  For the time being, however, there was no suitable acquisition target, and the cash was earning only 3% in short-term deposit accounts while it could have been used more profitably in the U.S. to reduce Barnes’s expensive long-term debt.  Barnes hired PricewaterhouseCoopers to help it develop an approach to allow the foreign cash to be used in the U.S. without incurring the adverse U.S. tax consequences of a direct loan or distribution to the U.S. parent.

The resulting “reinvestment plan” involved the creation of two new subsidiaries, one in Bermuda and one in Delaware, and two successive contributions of cash in section 351 exchanges – first from Singapore to Bermuda and second from Bermuda to Delaware.  The Delaware subsidiary then loaned the cash to Barnes.  Feel free to examine the opinion linked below for the details of the transaction, but suffice it to say here that a linchpin of the tax planning was reliance on Rev. Rul. 74-503, which concluded that when two corporations exchange their own stock under circumstances similar to the section 351 exchange between the Bermuda and Delaware subsidiaries, they take a zero basis in the stock received.  (Rev. Rul. 74-503 was revoked by Rev. Rul. 2006-2, but the earlier ruling is still relevant in this case because Rev. Rul. 2006-2 is prospective and provides that the IRS will not challenge positions already taken by a taxpayer that reasonably relied on Rev. Rul. 74-503.)  Although Bermuda’s ownership of stock in its Delaware affiliate was an investment in U.S. property under section 956 and therefore would typically result in adverse U.S. tax consequences similar to a distribution, Barnes argued that Bermuda’s basis was zero and therefore that its section 956 inclusion should be zero.

The Tax Court disagreed, holding that the U.S. tax consequences of the transaction were different from those anticipated by Barnes.  The court first determined that Rev. Rul. 74-503 did not preclude the IRS from challenging the taxpayer’s position, giving two reasons.  First, the court briefly stated that, because it believed that “the substance of the reinvestment plan was a dividend from [Singapore] to Barnes” (as it would explain later in the opinion), the court did not “respect the form of the reinvestment plan” and therefore the ruling was irrelevant.  Second, the court said that the ruling was irrelevant in any event because of the “substantial factual differences” between the ruling and this case.  The court acknowledged that the section 351 exchanges, “considered alone, do have factual similarities to the revenue ruling,” but noted that they also were different in that they involved new subsidiaries, including a controlled foreign corporation.  In addition, the Tax Court emphasized that the Barnes transaction was more complex than the one described in the ruling and listed seven “vast factual disparities” between the two situations.  The court, however, devoted  little attention to explaining why these factual differences were material to whether the principle of the ruling should apply here.  Instead, the court simply recited the factual differences and then concluded that, “because the reinvestment plan far exceeded the scope of the stock-for-stock exchange addressed in Rev. Rul. 74-503,” the IRS was not precluded from challenging the taxpayer’s position.

The court then applied a step-transaction analysis to support its holding that “the substance of the reinvestment plan was a dividend” from Singapore to Barnes and should be taxed as such.  According to the court, the step-transaction doctrine provides that “a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly but instead included the step for no other purpose than to avoid tax liability.”  The court stated that the doctrine applies if any of three tests are satisfied:  (1) the binding commitment test; (2) the end result test; and (3) the interdependence test.  Finding the third test to be the most appropriate, the Tax Court concluded that the various steps were “so interdependent that the legal relations created by one step would have been fruitless without completion of the later steps.”  The key premise underlying that ultimate conclusion was the court’s determination that there was no “valid and independent economic or business purpose . . . served by the inclusion of Bermuda and Delaware in the reinvestment plan.”  This analysis is an aggressive application of the step-transaction doctrine, taking it beyond its usual sphere, given that the steps ignored by the court were not transitory and that the characterization of the transaction as a dividend did not leave the parties in an economic position consistent with their legal rights and obligations following the actual transaction.

The court further found that Barnes did not “respect the form of the reinvestment plan” as Barnes made no interest payments to Delaware on the loan (even though interest had been accrued) and did not provide sufficient evidence that Delaware made any preferred dividend payments to Bermuda.

Finally, the court rejected the taxpayer’s contention that the reinvestment plan was intended to be a temporary structure under which the Singapore funds would ultimately be invested overseas when the right target appeared, noting that Barnes did not return any funds to Singapore.

The Tax Court also upheld the government’s imposition of a 20% accuracy-related penalty.  The taxpayer raised two defenses to the penalty, arguing that its position was based on “substantial authority” and that it reasonably and in good faith relied on the PwC opinion letter.  The court gave the “substantial authority” argument short shrift, simply repeating that Rev. Rul. 74-503 was “materially distinguishable” and hence should be afforded little weight.  In response to the taxpayer’s additional citation of a 1972 General Counsel Memorandum, the court stated that GCMs “over 10 years old are afforded very little weight.”  Given that taxpayers are generally invited to rely on the legal principles set forth in revenue rulings as precedent (see Treas. Reg. § 601.601(d)(2)(v)(d)), the court’s perfunctory dismissal of the taxpayer’s reliance on Rev. Rul. 74-503 as substantial authority – and consequent imposition of a penalty – appears fairly harsh.

With respect to reliance on the PwC opinion, the court rested its decision on its finding that Barnes and its subsidiaries did not respect the structure of the reinvestment plan by failing to pay loan interest or preferred stock dividends.  In the court’s view, “by failing to respect the details of the reinvestment plan set up by PwC, . . . [the taxpayer] forfeited any defense of reliance on the opinion letter.”

The taxpayer’s opening brief contends that all of these determinations by the Tax Court are erroneous.  The first and longest section of the brief criticizes the court’s step-transaction analysis and ultimate conclusion that the transactions simply amounted to a dividend from Singapore to Barnes.  In the taxpayer’s view, the court’s analysis “invent[s] a new step” of a constructive dividend that “fails to account for all of the commercial realities that continue to this day for the four legally separate corporate entities.”  For example, the taxpayer argues that the evidence showed that Barnes intended to repay the loans and therefore it could not be a constructive dividend.  Much of this portion of the taxpayer’s brief argues that the Tax Court’s key factual findings were clearly erroneous – namely, that the two new subsidiaries lacked a non-tax business purpose; that Barnes paid no interest to Delaware; that no preferred dividends were paid; and that the reinvestment plan was not intended to be temporary.

Second, the brief argues that the government impermissibly disavowed Rev. Rul. 74-503.  The taxpayer points to Rauenhorst v. Commissioner, 119 T.C. 157 (2002), for the proposition that the IRS cannot challenge the legal principles set forth in its own revenue rulings.  It then argues that the factual differences identified by the Tax Court are irrelevant to the rationale for Rev. Rul. 74-503 and thus provide no basis for the government’s failure to abide by that rationale.

It will be interesting, and instructive for other cases, to see how the government deals with this point.  If it is true that revenue rulings are supposed to provide guidance on legal principles on which taxpayers can rely, and if the IRS is constrained to some extent by its own rulings, it would seem apparent that merely identifying factual differences is not enough of a justification for disregarding the legal principles articulated in a revenue ruling.  There are always going to be factual differences, especially when the ruling at issue contains only a brief and generic description of the facts, like Rev. Rul. 74-503.  Will the government question the premise of the taxpayer’s argument in any way?  Or will it accept the taxpayer’s statements about Rauenhorst and limit itself to defending the Tax Court’s position that the facts at issue are so materially different that the rationale of  Rev. Rul. 74-503 cannot reasonably be applied here?  Will it try to buttress the Tax Court’s reliance on the “vast factual disparities” between the two situations or will it simply focus on the argument that the tax effect of any individual step viewed in isolation is irrelevant (and therefore so is the ruling) because the transactions in substance amounted to a dividend?

Third, the taxpayer contests the court’s penalty determination.  With respect to “substantial authority” the taxpayer relies primarily on the earlier discussion in the brief and maintains that it was reasonable to rely on the revenue ruling.  With respect to the good faith argument, the taxpayer repeats its earlier discussion disputing the Tax Court’s finding that it did not respect the form of the transaction.  It also argues that the PwC opinion, in any event, did not even address the loan and preferred dividend details on which the Tax Court rested its findings, and therefore the taxpayer’s alleged failures regarding those details do not undermine its claim of reasonable reliance on the PwC opinion.  Finally, the taxpayer argues broadly that the Tax Court could not rest its good cause determination “on events that occurred after the returns were filed.”

The government’s brief is due May 15.

Barnes – Tax Court opinion

Barnes – Taxpayer Opening Brief

 

Federal Circuit to Consider Accrual of Policyholder Dividends

The Federal Circuit is preparing to consider a government appeal in Massachusetts Mutual Life Ins. Co. v. United States, on an issue involving accrual of annual dividends paid by a mutual insurance company to its policyholders.  This issue was also recently addressed by the Second Circuit, and it turns on an application of the “all events test.”

First, a quick refresher course.  The “all events test” is described as the “touchstone” for determining when a liability has been incurred and a deduction can be accrued.  Dating back to United States v. Anderson, 269 U.S. 422, 441 (1926), and now codified at I.R.C. § 461(h)(4), it originally provided for accrual when “all events have occurred which determine the fact of liability and the amount of such liability can be determined with reasonable accuracy.”  In the mid-1980s, litigation over the application of this two-pronged test yielded two Supreme Court decisions in rapid succession, with the taxpayer prevailing in the first one and the government prevailing in the second.

In United States v. Hughes Properties, Inc., 476 U.S. 593 (1986), the Court held that a casino could treat as a fixed liability the amounts shown on the jackpot meters of its progressive slot machines at the close of the taxable year.  In United States v. General Dynamics Corp., 481 U.S. 239 (1987), the Court held that a self-insuring employer could not accrue amounts that it had reserved for payment of employee medical claims not yet filed for services already performed, even assuming that the amount of the liability had been determined with reasonable accuracy.  The Court held that the fact of liability was not established until the employee filed a claim for reimbursement, which it termed a “condition precedent” to the establishment of liability that was not “a mere technicality” or a mere “ministerial” act.  Id. at 242-45 & nn.4-5.  Three dissenters argued that the case was essentially indistinguishable from Hughes Properties, where the Court had rejected the government’s argument that the fact of liability did not arise until the winning patron pulled the handle because until then it was possible that the jackpot would never be paid – for example, if the casino went out of business or declared bankruptcy.  Id. at 248-49.  The majority, by contrast, held that failing to file a claim was not “the type of ‘extremely remote and speculative possibility’” that was found in Hughes Properties not to “render an otherwise fixed liability contingent.”  Id. at 244-45.

In 1984, Congress codified the traditional all events test in Code section 461(h)(4) and added a third prong for future years by enacting section 461(h)(1), which provides that generally “the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.”  The Code, however, contains an exception from the economic performance requirement for “certain recurring items” if economic performance occurs within a reasonable period after the close of the taxable year and certain other conditions are met.  I.R.C. § 461(h)(3).  In the case of policyholder dividends issued by mutual insurance companies, the taxpayers have contended that the section 461(h)(3) exception is satisfied and therefore that their right to accrue those dividend payments turns on whether the original two-pronged all events test has been satisfied.

The insurer in MassMutual adopted Board Resolutions before the close of the taxable year guaranteeing an aggregate amount of policyholder dividends that would be paid in the upcoming year on each individual policyholder’s anniversary date.  The government argued that the all events test was not satisfied until the year in which the dividends were paid because the Board Resolution could be revoked (though government counsel apparently characterized this as a “weak argument” at oral argument) and also because no precise dividend amounts could be allocated at the time of the resolution to an identifiable policyholder, since any individual policy might not still be in force on the anniversary date.

After a trial, the Court of Federal Claims rejected these arguments and allowed the taxpayer to accrue the amount of the dividends in the year before they were paid.  Citing to Hughes Properties, the court said that it was not necessary that the identity of the individual recipients be known at the time of accrual.  The court also stated that, “[a]lthough a condition precedent can prevent a liability from being fixed, if the only event(s) still to occur are the passage of time and/or the payment, the liability is considered fixed.”  The court added that “the group of policyholders with paid-up policies were not at risk for their policies lapsing,” so the company “had an unconditional obligation” to those policyholders “to pay the guaranteed amounts of policyholder dividends.”  The court then ruled that the dividends were “rebates” or “refunds” falling within the “recurring item” exception of section 461(h)(3), and therefore “economic performance” was not required before the expenses could be accrued.

After the Court of Federal Claims decision issued, but before it was ripe for appeal, the Second Circuit came to the opposite conclusion in a case involving policyholder dividends accrued by New York Life.  That mutual insurance company also paid annual dividends on the anniversary date, but only if the policy was still in force and fully paid up (payment was required a month in advance).  The taxpayer sought to accrue dividend payments due in January of the following year, since those policies had been fully paid up in December.  The Second Circuit, however, ruled that the all events test was not satisfied for the January anniversary date policies, because of the possibility that the policyholder might choose to cash in the policy in January before the anniversary date and thus the policy would no longer be in force when the dividend came due.

The Second Circuit reasoned that the case was analogous to General Dynamics, stating that “‘the last link in the chain of events creating liability’—the policyholder’s decision to keep his or her policy in force through the policy’s anniversary date—did not occur until January of the following year.”  The taxpayer argued that an “event” that would defeat accrual must be something that marks a change in the status quo, rather than a non-event like the policyholder’s failure to cash in a policy.  The court, however, rejected this position, stating that the fact of liability “depend[ed] upon an actual choice by the third-party policyholder:  her decision not to redeem her policy for cash, for example, and invest her money elsewhere.”

The court suggested that the MassMutual decision was distinguishable on its facts because there “the policy was considered ‘in force’ simply ‘if the premiums for the policy [had been] paid through its anniversary date,’” whereas in New York Life the company defined eligibility as “requiring both that the policyholder have paid all premiums and that she not have surrendered her policy for cash prior to the policy’s anniversary date.”  Recognizing that this distinction might be viewed as less than compelling, the Second Circuit added that, “to the extent the reasoning of the MassMutual court is at odds with ours . . ., we respectfully disagree with that court’s approach.”

New York Life has filed a petition for certiorari seeking review of the Second Circuit’s decision.  The petition focuses on the court of appeals’ reliance on the possibility that the policyholder might not receive a dividend because she chose to cash in her policy before the January anniversary date.  The question presented in the petition is whether the court erred in holding that “the continuation of the status quo is a required event, and thus a ‘condition precedent,’ needed to establish the fact of liability under the all-events test.”

The petition’s main contention is that the Second Circuit’s decision cannot be squared with Hughes Properties.  Because MassMutual is just a trial court decision, the cert petition rests its claim of a circuit conflict primarily on older cases that predate General Dynamics, arguing that the Second Circuit’s decision “recreates a multi-circuit conflict resolved by this Court in Hughes Properties.”  The timing of the respective decisions is such that MassMutual is not likely to provide much help in this regard; the Supreme Court can be expected to act on the cert petition by the end of May at the latest, well before a Federal Circuit decision is likely in MassMutual.

The government’s opening brief in MassMutual is due February 20.  Its opposition to the petition for certiorari in New York Life is due, after one extension, on March 20.

MassMutual – Court of Federal Claims opinion

New York Life – Second Circuit opinion

New York Life – Petition for Certiorari

D.C. Circuit Holds in Loving that IRS Lacks Authority to Regulate Tax-Return Preparers

Yesterday, the D.C. Circuit unanimously held in Loving v. IRS, that the IRS lacks statutory authority to regulate tax-return preparers.  See our previous coverage here.  In its February 11 decision, the court characterized the IRS’s interpretation as “atextual and ahistorical,” and, more humorously, as a large elephant trying to emerge from a small mousehole.

In 2011, the IRS for the first time attempted to regulate tax-return preparers, issuing regulations requiring that paid tax-return preparers pass an initial certification, pay annual fees, and complete at least 15 hours of continuing education courses each year.  The IRS estimated that the regulations would apply to between 600,000 and 700,000 tax-return preparers.  Before 2011, the IRS had never taken the position that it had the authority to regulate tax-return preparers.  According to the D.C. Circuit panel (Kavanaugh, Sentelle, and Williams): “In light of the text, history, structure, and context of the statute, it becomes apparent that the IRS never before adopted its current interpretation for a reason:  It is incorrect.”

The IRS claimed that 31 U.S.C. § 330 provided statutory authority for the regulations.  That statute authorizes the IRS to “regulate the practice of representatives of persons before the Department of Treasury.”  31 U.S.C. § 330(a)(1).  The D.C. Circuit cited the familiar two-step Chevron standard of review:  (1) is the statute ambiguous, and (2) if so, is the agency’s interpretation reasonable.   The court of appeals concluded that the “IRS’s interpretation fails at Chevron step 1 because it is foreclosed by the statute,” and, in any event, “would also fail at Chevron step 2 because it is unreasonable in light of the statute’s text, history, structure, and context.”  The court of appeals cited six reasons foreclosing the IRS’s interpretation of the statute:

First, the D.C. Circuit concluded that the term “representative” generally is understood to refer to an agent with authority to bind others.  “Put simply, tax-return preparers are not agents.  They do not possess legal authority to act on the taxpayer’s behalf.”  Second, the preparation of a tax return does not constitute “practice . . . before the Department of the Treasury.”  “Practice before” an agency generally implies an investigation, adversarial hearing, or other adjudicative proceeding.  Moreover, a related section of the statute allows the Secretary of the Treasury to require that a representative admitted to practice before the agency demonstrate four qualities, one of which is “competency to advise and assist persons in presenting their cases.”  31 U.S.C. § 330(a)(2).   Filing a tax return is not understood in ordinary usage to be “presenting a case.”  Third, the original version of the statute, enacted in 1884, referred to “agents, attorneys, or other persons representing claimants before [the] Department.”  The court of appeals concluded that this original language clearly would not encompass tax return preparers.  When the statute was recodified in 1982, the phrase, “agents, attorneys, or other persons representing claimants” was simplified to “representatives of persons,” but the language change expressly was not intended to effect a substantive change.  Fourth, the IRS’s interpretation is inconsistent with the “broader statutory framework,” in which Congress has enacted a number of statutes specifically directed at tax-return preparers and imposing civil penalties.  Those statutes would not have been necessary, the court reasoned, if the IRS had authority to regulate tax-return prepares.  Fifth, if Congress had intended to confer such broad regulatory authority upon the IRS, allowing it to regulate “hundreds of thousands of individuals in the multi-billion dollar tax-preparation industry,” the statute would have been clearer.  Referring to the statutory language, the court of appeals concluded:  “we are confident that the enacting Congress did not intend to grow such a large elephant in such a small mousehole.”  Sixth, the court noted that the IRS in the past had made statements and issued guidance indicating that it did not believe it had authority to regulate tax-return preparers.  The court found it “rather telling that the IRS had never before maintained that it possessed this authority.”

The decision ends with the court of appeals noting that new legislation would be needed to allow the IRS to regulate tax-return preparers.

Given that the membership of the D.C. Circuit has recently expanded to include three additional judges, the government might believe that it is worthwhile to seek rehearing en banc before the full court.  A petition for rehearing would be due on March 28.  If the government does not seek rehearing, a petition for certiorari would be due on May 12.  Whether it pursues the litigation further or not, the government can be expected to seek new legislation that would give the IRS the regulatory authority that the court of appeals refused to find.

Loving – Court of Appeals Opinion

Supreme Court to Address the Right to an Evidentiary Hearing in Summons Enforcement Proceedings

The Supreme Court has granted certiorari in United States v. Clarke, No. 13-301, to explore the circumstances under which an entity is entitled to an evidentiary hearing before an IRS summons is enforced, so that it can question IRS officials about their motives for issuing the summons.  The parties’ different views of the case are aptly captured by the dueling questions presented.  The government says the case presents the question “whether an unsupported allegation” that the IRS issued a summons for an improper purpose entitles an opponent to examine IRS officials at an evidentiary hearing.  The entities contesting the summons say the case presents the question whether the court erred in ordering such an evidentiary hearing “in light of [their] substantial allegations that the IRS had issued summonses to them for an improper purpose.”

The basic summons enforcement rules are long established, but the devil can be in the details.  Under United States v. Powell, 379 U.S. 48 (1964), a summons is to be enforced if the IRS demonstrates that:  (1) “the investigation will be conducted pursuant to a legitimate purpose”; (2) “the inquiry may be relevant to the purpose”; (3) the IRS does not already have the information; and (4) the IRS followed the proper administrative steps.  The IRS generally carries its initial burden simply by producing an affidavit from the investigating agent, which then shifts the burden to the party contesting the summons.  At that point, it gets a little murkier.  If the party contesting the summons raises a “substantial question” as to whether the summons is an abuse of process, then it is entitled to an “adversary hearing” at which it “may challenge the summons on any appropriate ground.”  Id. at 58.

What happened here is that the IRS wanted to look more carefully into a partnership’s tax returns, particularly its claim of $34 million in interest expenses over two years.  Although the partnership agreed to two extensions of the statute of limitations, it declined to extend the period a third time.  Shortly thereafter, the IRS issued six summonses to third parties connected to the partnership, but those parties did not comply with the summonses.  Just before the limitations period closed, the IRS issued a notice of Final Partnership Administrative Adjustment (FPAA) to the partnership, and the partnership challenged the FPAA by filing a petition in the Tax Court.  A couple of months later, the IRS filed summons enforcement actions.

The summoned parties, who are the respondents in the Supreme Court, responded by contending that the summonses were not issued for a legitimate purpose and requesting an evidentiary hearing and discovery.  They basically made two arguments.  First, they contended that the summons was issued in retaliation for the partnership’s refusal to extend the statute of limitations, pointing to the fact that the summonses were issued very soon after that refusal was communicated.  Second, they contended that the summonses were designed to circumvent the Tax Court’s restrictions on discovery.  They advanced some evidence to support this contention, including the IRS’s request for a continuance in the Tax Court on the ground that the summonses were outstanding.

The district court (for the Southern District of Florida) ordered the summonses enforced, stating that a hearing is not required based on a “mere allegation of improper purpose” to retaliate.  With respect to respondents’ second contention, the district court said that a finding that the IRS was using the summons process to avoid discovery limitations in the Tax Court would not be a valid ground for quashing a summons.

The Eleventh Circuit reversed in an unpublished opinion.  It ordered the district court to hold an evidentiary hearing at which respondents could question the IRS examining agent about his motives for issuing the summonses (though the court declined to authorize discovery).  The court explained that the district court had abused its discretion because the respondents were entitled to a hearing “to explore their allegation” that the summonses were issued “solely in retribution for [the partnership’s] refusal to extend a statute of limitations deadline.”

The difference in the way the two parties have phrased the question presented reflects the two different grounds on which the respondents challenged the summonses.  The allegation that the summonses were a form of retaliation or punishment, instead of for a legitimate investigative purpose, is pretty close to an “unsupported allegation.”  That the summons followed closely on the heels of the decision not to extend the statute of limitations is weak evidence of an improper retaliatory purpose, though, as the respondents point out, it is hard to have strong evidence of a retaliatory purpose without having discovery or a hearing.  Thus, the respondents may have a hard time defending the court of appeals decision on its own terms.

On the other hand, the respondents will be able to advance their second basis for challenging the summonses as an alternate ground for affirmance, even though the court of appeals did not rely upon it.  On that ground, the respondents have more than an “unsupported allegation” – they are more like “substantial allegations” – that the summonses were designed to obtain evidence for use in the Tax Court proceedings that could not have been obtained through discovery.  The government’s response on this point is the same as that of the district court – namely, that these allegations, if true, would not demonstrate an illegitimate purpose and would not be grounds for quashing the summons.  Two courts of appeals have reached this issue and have agreed with the government.  On the other hand, respondents have a logical argument that a summons is an investigative tool and the investigation phase is over by the time the FPAA has issued and the case has been docketed in the Tax Court.  Respondents note in this connection that the IRS’s own Summons Handbook states that, “[i]n all but extraordinarily rare cases, the Service must not issue a summons” after a notice of deficiency is mailed because at that point “the Service should no longer be in the process of gathering the data to support a determination because the [notice of deficiency] represents the Service’s presumptively correct determination and indicates the examination has been concluded.”  This second ground not reached by the court of appeals thus may prove to be the more interesting and closely contested aspect of this case.

To add a little more spice to this case, the Court’s determination to revisit summons enforcement comes at a time when the IRS may significantly increase its use of its summons power.  On January 2, 2014, a new policy went into effect for audits of the largest taxpayers that threatens the issuance of a summons when a taxpayer fails to timely respond to requests for documents and/or information.  The new policy sets out a mandatory timeline for warning letters and a drop-dead due date, after which the examining agent will initiate procedures for the issuance of a summons.  This policy could well lead to many more summons enforcement proceedings.  For more information on the IRS’s new IDR enforcement policy, please contact George A. Hani (ghani@milchev.com) or Mary W. Prosser (mprosser@milchev.com).

The government’s opening brief is due February 24.  The case will be argued in late April and a decision is expected by the end of June.

Clarke – petition for certiorari

Clarke – brief in opposition

Clarke – reply brief in support of certiorari petition

Clarke – court of appeals opinion