Briefing Complete in NPR

As we mentioned in our last post, the only brief remaining to be filed in NPR was the taxpayer’s reply brief.  That brief has now been filed and with it a DOJ motion to strike part of that reply as an inappropriate sur-reply.  The motion concerns a section in the reply in which the taxpayer takes on DOJ for arguing (in its previously filed reply brief ) that the only relevant factor in determining the incidence of the valuation misstatement penalty (between partnership and partner) is whether there are partnership items involved and not where the specific misstatement results in a loss.

The taxpayer’s view is that DOJ is trying to have its cake and eat it too – arguing that the penalty applies at the partnership level because it is related to partnership items but refusing to allow section 6664 arguments to be heard on the grounds that those are specific to the partner.  DOJ’s position is that it would be barred from raising the penalty outside of the context of a partnership proceeding because the penalty relates to a partnership item (or items) and that it is not inconsistent to require section 6664 intent to be evaluated at the partner level (and, in any event, it is required by the regulations).  All of this, as we have extensively discussed, is intertwined in the silliness of trying to separate partner and partnership intent between TEFRA levels something the regulations perhaps should not have done but clearly do.  It will be interesting to see how the Fifth Circuit handles the case.

NPR Update

It has been a while since we published an update on NPR (please no comments on Supreme Court Justices, schoolchildren, and bloggers taking summers off).  Since our last post discussing the government’s opening brief, the taxpayer filed its brief responding to the government and opening the briefing on their cross-appeal.  The government also filed its response/reply.  All that remains now is the taxpayer’s reply brief on its cross-appeal, currently due on August 15.  There are a slew of technical TEFRA issues that are raised by the parties.  The taxpayer is appealing the district court’s rulings regarding whether a no change letter can ever be an FPAA and, if it can be, whether an erroneously checked box on the tax return (claiming that the partnership was not a TEFRA partnership) can constitute a misrepresentation of a material fact such that the no-second-FPAA rule of section 6223(f) is inapplicable.  As we discussed last post, the parties are jointly briefing — in the government’s appeal — the application of the Heasley/Weiner line of cases to the taxpayer’s concession strategically made to circumvent the gross valuation misstatement penalty.  Mayo is implicated by the application of Treasury Regulation section 1.6662-5(d) (DOJ relies on Brand X to argue that the regulation controls over the contrary rule previously announced in Heasley).

However, as we discussed in prior posts, the main issue here is good faith reliance on counsel — R.J. Ruble — by the taxpayer for purposes of the section 6664 reasonable cause defense and when, procedurally, that defense can be raised.  The government continues to hew to the line that reliance is inappropriate (because of a technical conflict and because reliance was just not reasonable under the circumstances).  DOJ also argues that the defense can be raised only in a partner-level proceeding pursuant to then Temporary Treasury Regulation section 301.6221-1T(d) (the judges may want to get a cholesterol test with all of this Mayo being spread around).  For its part, the taxpayer argues that the district court already determined — after seeing the witness testimony — that the reliance was in good faith.  Furthermore, since one of the partners is the TMP, the reasonable cause defense is being raised by the partnership as much as by the partners.  Setting aside whether you believe the testimony (which the district court judge did), if we could decide cases based on the fact that section 301.6221-1T(d) of the TEFRA penalty regulations is stupid, this would be easy.  As we have said before, separating partner and partnership intent in a transaction involving a partnership that was purposefully created by the partners to implement that very same transaction is like trying to dance on a headless pin.  With deference under Mayo, however, “stupid is as stupid does” is not the test for striking down regulations.  We will just have to wait and see how much patience the Fifth Circuit has for this Forrest Gump of a regulation.

Update on Bush-whacked

The en banc Federal Circuit heard oral argument in the Bush TEFRA case on Wednesday the 10th of May.  For those still interested after reading this, you can listen to the argument here.  As we indicated in our prior analysis, we think the resolution of this case is simple.  Unfortunately, although the parties and the court almost escaped the weeds several times, with one of the judges asking a question very close to the mark, it was a dissatisfying oral argument (from our perspective).  The point that needed to be made is that an agreement to “no change” a partnership item is “treatment” of a partnership item in and of itself — you have just treated it the same as it was originally treated.  Thus, a change in tax liability that “reflects” a partnership no change is a computational adjustment.  

To put some more meat on that, section 6221 illustrates the purpose of TEFRA to require “the tax treatment of any partnership item [to be] determined at the partnership level.”  Section 6230(a) coordinates the Code’s deficiency proceedings with TEFRA and mandates that, aside from converted items, notices of deficiency are required only for “affected items which require partner level determinations.”  Claims arising out of erroneous “computational adjustments” can be litigated but the underlying treatment of partnership items resolved in a TEFRA proceeding cannot be re-litigated.  Section 6230(c).  Section 6231(a)(6) defines a “computational adjustment” as a “change in the tax liability of a partner which properly reflects the treatment … of a partnership item.”  

Where you have a change in tax liability of a partner that “reflects” the “treatment” (not the “change” in treatment, just the treatment) of a partnership item and no partner-level determinations are necessary, then no notice of deficiency is required.  In Bush, the partners settled the “treatment” of the partnership items as a no change and agreed to all of the necessary partner level determinations so there was no need for a partner-level determination to determine tax consequences.  Accordingly, no notice of deficiency was necessary.  Contrary to the taxpayers’ position at oral argument (and in the briefs), the fact that there could be other (non-partnership) items contested in a notice of deficiency is irrelevant.  Likewise, it is irrelevant that the partnership items or treatment of those items never changed.  You don’t need a change in a partnership item or a change in the treatment of that item to have a computational adjustment.  Instead, you need a change in tax liability that reflects the treatment of partnership items.  Any TEFRA-based adjustment does that even if the partnership items stay as they are on the original return because their treatment is reflected in that tax liability.  That is the whole point of TEFRA: partnership item treatment is relegated to TEFRA proceedings and everything flows out of that treatment.  So a change in tax liability driven by a change in allowed partnership losses based on a change in a partner’s at-risk amount reflects the treatment of a partnership item (the losses, which are no-changed, which is a form of “treatment”) and thus is a computational adjustment.  

Although the court asked several questions on the period of limitations and assessment issues and asked other questions to determine the scope of the problem, the rest of the taxpayers’ arguments are a sideshow.  It is always tough to tell how a case will be decided based on the arguments, but, even though it was less than satisfying, the court’s questioning indicates to us that the government will prevail and the court will find its way out of this part of the TEFRA forest.

NPR Still Dragging Itself Out of the Minefield

The Government has filed its brief in its Fifth Circuit appeal from the denial of penalties in the NPR Investments case (for prior discussion go here).  There are no surprises.  The Government takes the position that the district court’s reliance on Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990) (likely abrogated by Treas. Reg. § 1.6662-5(g) and certainly weakened on these facts by Weiner v. United States, 389 F.3d 152 (5th Cir. 2004)) is misplaced.  Thus, the government argues that the mere fact that the taxpayer’s entire transaction (and not just a valuation or basis item) was concededly devoid of substance is not a bar to valuation misstatement penalties.  The Government also takes issue with the alleged consideration by the district court of the partners’ (as opposed to the partnership’s) reasonable cause defenses in this TEFRA proceeding contrary to Temp. Treas. Reg. § 301.6662-1T(c)-(d).  At a big picture level, the Government is still none-too-pleased with the district court’s open reliance on an R.J. Ruble opinion as contributing to such defenses, an act of reliance that it argues is contrary to case law prohibiting a taxpayer from relying on conflicted advisers for reasonable cause and also contrary to, among other things, the restriction on relying on a legal opinion that is based on representations the taxpayer knows are untrue.  Treas. Reg. Sec. 1.6662-4(c)(1)(i).

This case has the potential to be another Mayo/Brand X battle-royale (what tax case doesn’t these days?) given that there are at least three regulations explicitly relied on by the Government some of which post-date contrary court opinions.  But at bottom the case is just about a district court judge who looked into the eyes of the taxpayers and found not malice but, rather, an objectively good faith belief in the adviser who was hired to bring them safely past the landmines and snipers that fill the no-man’s land also known as the tax code.  Although they didn’t make it across (the taxpayers abandoned defense of the claimed tax benefits and R.J. – metaphorically shot – is serving time), the district court apparently couldn’t fault them for trying.  The government’s view is much harsher.  In essence, it thinks that in trying to find a way to make it to the tax-free promised land, the taxpayers should have tried a little harder to explore the obstacles in their way before taking their guide’s word for it.  At least their place shall never be with those cold and timid souls who know neither victory nor defeat.

The taxpayer’s brief is due May 17th.  We will keep you posted.

Update 2 on Bush(whacked)

We have added the taxpayer’s reply brief to the original post.  We will update you as soon as we hear what the en banc court does.

Update on Bush(whacked)

We have added DOJ’s brief to the original post.  Nothing much surprising in it; the arguments adopted reflect the same approach taken in our initial post (and in the Court of Federal Claims).  A point of interest is that there are 30 related cases holding at the Court of Federal Claims that depend on its resolution.  We will update you as soon as we hear what the en banc court does.

Bush-whacked

As can be seen by the sheer number of our posts that deal with it, the unified partnership audit procedures of the Tax Equity and Fiscal Responsibility Act (“TEFRA”) can cause confusion.  In fact, they can be downright bewildering.  It is particularly easy to get lost if one walks into the TEFRA wilderness without keeping one eye fixed at all times on the overarching purpose of TEFRA.  The case of Bush v. United States, et. al., Fed Cir. Nos. 2009-5008 and 5009, is a textbook example of what happens when you lose sight of that landmark.  An apparently innocuous TEFRA proceeding resulted in a startling panel opinion authored by Judge Dyk and joined by Judge Linn that has baffled TEFRA practitioners.  (Judge Prost concurred in the result on a theory that comports with the common understanding of TEFRA.)  Bush v. United States, et. al., 599 F.3d 1352 (Fed. Cir. 2010).  Instead of ending the case, that opinion has triggered a flurry of activity that should eventually lead to an en banc decision by the full court.  Thus far, the panel decision has generated two sets of petitions for rehearing and responses, a vacated panel opinion, an order from the en banc court identifying four sets of questions to be addressed in new briefs, and at least one new amicus brief.  And the en banc briefing process is just getting started.  In order to keep from drawing the reader too far into the wilds ourselves, we describe the issue and the law first and then explain what happened to get us to where we are.

The facts in Bush are relatively simple.  The taxpayers had TEFRA partnerships.  Those TEFRA partnerships were audited, and a TEFRA partnership proceeding was brought.  That proceeding was settled by the taxpayers.  The Internal Revenue Service sent notices of computational adjustment to the taxpayers to reflect the adjustments agreed in the settlement; no notices of deficiency were sent.  The taxpayers paid the amounts reflected in the notices of computational adjustment.  Later, the taxpayers filed claims for refund with respect to the amounts they paid pursuant to the settlement and eventually sued in the Court of Federal Claims seeking to recover those amounts.

Now for the law.  The purpose of TEFRA is to determine the tax treatment of “any partnership item” at “the partnership level.”  Section 6221.  This ensures “consistent . . . treatment” among partners and between the partners and the partnership.  Section 6222.  Consistency and unity is so important that the Service is empowered to issue “computational adjustments” to make the partners’ individual returns consistent with the partnership return.  Section 6222(c)(2).  Section 6226 provides the sole mechanism to judicially challenge the Service’s proposed adjustment of a “partnership item” – namely, filing a petition in court in response to the notice of final partnership adjustment issued by the Service.  The notice of deficiency process, found in subchapter B of Chapter 63 of the Code, is specifically integrated with the TEFRA process outlined above (which is found in subchapter C of Chapter 63 of the Code), by section 6230.  As relevant here, section 6230(a) contains the rules for when the IRS is required to issue a notice of deficiency under subchapter B with respect to various items, and section 6230(c) contains rules that allow a taxpayer to challenge a computational adjustment.

Section 6230 leaves a relatively narrow gap within which the standard notice of deficiency process is to operate in TEFRA partner-level proceedings.  Setting aside a very specific (and irrelevant for our purposes) innocent spouse rule, section 6230(a)(2) provides that a notice of deficiency must be issued with respect to “affected items which require partner level determinations” and “items which [although they had been partnership items] have become nonpartnership items.”  For all other “computational adjustments” related to: (i) partnership items; or (ii) affected items that do not require partner level determinations “subchapter B of this chapter shall not apply.”  Section 6230(a)(1).  This limitation on the notice of deficiency requirement, however, does not leave the partner facing a computational adjustment without recourse.  Section 6230(c) allows the partner to file a claim for refund in several cases including, among others: (i) to apply a partnership settlement; or (ii) to seek a credit or refund of an overpayment attributable to the application of such a settlement.  Section 6230(c)(1)(A)(ii) and (B).  Critically, under either of these refund claim provisions, substantive review of the “treatment of partnership items” resolved in the settlement is verboten.  Section 6230(c)(4).  This is necessarily the case because the whole unifying purpose of TEFRA would be undermined if a later proceeding could affect the treatment of items properly agreed in a settlement by the parties at the partnership level.

Readers that are still awake will see that there are really only two nuts to crack in order to resolve Bush.  First, were the items subject to the settlement either partnership items or affected items that do not require partner level determinations (which would mean that there was no notice of deficiency requirement)?  Second, assuming they were, did the questions raised in the claim attempt to substantively re-review the determination of those items (which, again, is a statutory no-no)?  As to the first question, the item at issue in Bush was the section 465 “at-risk” amount (basically, the amount that the taxpayer has placed at risk in the venture and thus as to which deductions are allowed).  At-risk amounts are affected items to the extent they are not partnership items.  Treas. Reg. §301-6231(a)(5)-1(c).  The settlement agreement set out that the taxpayers’ at-risk amounts were equal to their capital contributions to the partnership and actually specified the dollar amount.  Thus, it is arguable that the affected item in Bush is actually a partnership item.  See Treas. Reg. §301-6231(a)(3)-1(a)(4)(i) (considering capital contributions generally as partnership items).  Regardless, it is certainly not an “affected item[] which require[s] partner level determinations” because it was finally resolved in the settlement agreement and the partner’s specific situation doesn’t affect it at all.  Therefore, no notice of deficiency was required under section 6230.  Having made it this far, even a blind squirrel in the dark TEFRA forest can find and crack the second nut; if the settlement agreement resolved the item, and if that item doesn’t require a partner-level determination, then a claim challenging the substantive application of that item is barred by section 6230(c)(4).

The foregoing analysis is consistent with Federal Circuit precedent.  Olson v. United States, 172 F.3d 1311, 1318 (Fed. Cir. 1999) (no notice of deficiency required where the computational notices involved “nothing more than reviewing the taxpayers’ returns for the years in question, striking out the [items] that had been improperly claimed, and re-summing the remaining figures”).  It is also essentially the analytical methodology applied by the Court of Federal Claims in denying the taxpayers’ refund claim.  See Bush v. United States, 78 Fed. Cl. 76 (Fed. Cl. 2007).  But someplace between here and there, the Federal Circuit majority got turned around over the definition of a computational adjustment vis-à-vis section 6230(a)(1).  It affirmed the trial court, but only after a convoluted analysis that began with the conclusion that the Service had erred in failing to issue a notice of deficiency to the taxpayers as a prerequisite to assessing the amounts agreed to in the settlement.

Section 6231(a)(6) defines a computational adjustment as “the change in the tax liability of a partner which properly reflects the treatment under this subchapter of a partnership item.”  Perhaps this language, like much in TEFRA, could be clearer, but it is hard to imagine that Congress intended to give it the construction adopted by the Federal Circuit majority.  The majority read the statute as associating the term “change,” at the beginning of the subsection, with the term “partnership item,” at the end of the subsection; meaning that there always has to be a “change” in a “partnership item” in order for any adjustment to be “computational.”  However, based on the language itself, the statute is better read as including all situations involving a change in tax liability driven by any “treatment of a partnership item,” and not just those involving a “change” in that treatment.  The word “change” directly modifies only tax liability and the use of the word “treatment” (as opposed to “change”) to define the connection to a partnership item appears to be an intentional distinction.  Furthermore, any computational adjustment “affect[] items,” and “affected item” is defined as an item “to the extent such item is affected [not necessarily “changed”] by a partnership item.”  If the partner’s tax liability changed (which it did), and that change “properly reflect[ed] the treatment” of a partnership item (and didn’t require any partner-level determinations), it is a computational adjustment.  This reading also harmonizes sections 6230 and 6231 and is consistent with the broader purpose of TEFRA in unifying partnership proceedings and making partners’ returns consistent with partnership returns.  See generally section 6222 (which contemplates changes to partner returns by “computational adjustment” to make them consistent with partnership returns); see also Judge Prost’s concurrence, 599 F.3d at 1366.

But the majority disagreed.  And having made it this far into the woods, it turned around only to find that all of its breadcrumbs had been eaten.  Worse, it could see the right answer (the taxpayer loses), but couldn’t easily get there from its entanglement in the thicket of TEFRA.  Creatively, the majority got to the desired destination by stepping out of the TEFRA forest to stand on the federal harmless error statute, 28 U.S.C. §2111 (a provision, it is fair to say, that is not regularly seen in tax cases).  The Federal Circuit applied section 2111 to find that the Service’s failure to issue a notice of deficiency was harmless because the taxpayer had other methods to challenge the underlying issue including both their original proceeding and a hypothetical collection due process hearing.  See section 6330.  If you are not badly in need of a GPS at this point, you are doing very well.

The parties filed dueling petitions for rehearing.  The taxpayers did their best to take advantage of the panel opinion’s vulnerabilities (vulnerabilities that were created by the majority getting so tangled up in TEFRA it had to reach out of the tax code to solve the problem).  Positing that a valid assessment was a prerequisite for the Government to retain timely made payments, the taxpayer argued that section 6213 must be mechanically followed in order to legitimately assess taxes, and therefore the alternative methods suggested by the Federal Circuit would be ineffective and could not render the error harmless.  For its part, the Government tried to reorient the court to the correct reading of “computational adjustment” and pointed to Lewis v. Reynolds, 284 U.S. 281 (1932), which might allow the taxpayers a refund (due to some of the payments apparently being made after the assessment statute had closed) in spite of the court’s harmless error analysis.  (As an aside, on the valid assessment point, Judge Allegra’s recent opinion in Principal Life Ins. Co. v. United States, 2010 U.S. Claims LEXIS 856 (Fed. Cl. 2010), drawing from Lewis, nicely slays the chimera that is the “requirement” of “valid assessment” for non-time-barred years)

Thankfully, the Court vacated the panel opinion and granted rehearing en banc limited to the following four issues:

a) Under I.R.C. § 6213, were taxpayers in this case entitled to a pre-assessment deficiency notice? Were the assessments the results of a “computational adjustment” under § 6230 as the term “computational adjustment” is defined in § 6231(a)(6)?

b) If the IRS were required to issue a deficiency notice, does § 6213 require that a refund be made to the taxpayers for amounts not collected “by levy or through a proceeding in court”?

c) Are taxpayers entitled to a refund under any other section of the Internal Revenue Code? For example, what effect, if any, does an assessment without notice under § 6213 have on stopping the running of the statute of limitations?

d) Does the harmless error statute, 28 U.S.C. § 2111, apply to the government’s failure to issue a deficiency notice under I.R.C. § 6213? If so, should it apply to the taxpayers in this case?

The parties are in the process of briefing these issues.  We are hopeful that the Court has found its compass and is diligently working its way out of the trees.  Harmless error has nothing to do with the resolution of this case and neither do the technicalities of assessment.  The taxpayers agreed to the treatment of various items in a partnership proceeding.  There was no need for a partner-level determination in order to compute an adjustment with respect to those items.  Therefore, no notice of deficiency was required.  If the taxpayers had a complaint about how those calculations were performed that did not involve a substantive challenge to the agreed at-risk amount, they would have a claim.  They don’t, so they lose.

Briefing Underway in Intermountain

We recently surveyed the nationwide litigation addressing the government’s efforts to apply a six-year statute of limitations to Son-of-BOSS cases, including its efforts to have the courts defer to a late-issued temporary regulation.  The government has now filed its opening brief in the D.C. Circuit in Intermountain, the case in which the Tax Court addressed the issue.  Of note, the brief contains an extensive argument for applying Chevron deference to the temporary regulation, rather than “the differing standards of pre-Chevron jurisprudence” (an apparent reference to National Muffler Dealers, though the brief declines to acknowledge that case by name), and notwithstanding the lack of opportunity for notice and comment.  As we have discussed before here and here, the Supreme Court may shed some light in the next few months on the extent to which Chevron deference applies to Treasury regulations.

The taxpayer’s response brief is due January 5, 2011.

Intermountain – US opening brief

Schizophrenic Application of Tax Penalties (Part III)

We have been promising a post on the application of the section 6664 reasonable cause and good faith defense to tax penalties as it relates to reliance on tax advisers.  Here it is.

There has been much activity in this area in the district courts and the Tax Court and not much winnowing or rule setting in the circuits.  This is understandable; the application of the standards is highly factual and is well-placed in the hands of trial judges.  We will analyze here some potential inconsistencies in two recent high-profile section 6664 decisions, Canal Corp. v. Commissioner, (Slip Op. attached) (August 5, 2010) (which found reasonable cause and good faith lacking) and NPR Invs., LLC v. United States, (E.D. Tex. Aug. 10, 2010) (which found reasonable cause and good faith met).

Canal Corp.

In Canal Corp., the Tax Court considered the application of section 6664 to a should-level PricewaterhouseCoopers opinion.  (In the parlance, a “should-level” opinion means that the transaction “should” be upheld; it is a higher standard than more-likely-than-not, which means only that the transaction is more, perhaps only 51% more, likely to be upheld than not.)  The Canal Corp. transaction emerged from the decision of a predecessor of Canal Corp., Chesapeake Corporation, to dispose of its tissue business, WISCO.  After seeking advice from PwC and others, Chesapeake decided to dispose of the business by forming a partnership with Georgia Pacific to which WISCO would contribute its assets and liabilities and from which WISCO would receive a distribution of cash.  The cash was funded by the new partnership borrowing money, and that debt was indemnified by WISCO.  In essence, the substantive question presented to the court was whether the contribution/distribution amounted to the formation of a partnership (which would not trigger the built-in gain on the WISCO assets) or, rather, a sale of those assets to GP (which would).

In addition to helping structure and advise on the transaction, PwC was asked to prepare the aforementioned opinion.  The partner writing the opinion was not the historic PwC engagement partner but rather an expert from the Washington National Tax group of PwC.  PwC charged a flat fee of $800,000 for the opinion.  Because the area of the law was relatively unclear, the opinion relied on analogy and analytics to reach its conclusions (including a withdrawn revenue procedure that set out tests to apply for advance rulings in a different area); there was apparently little direct authority available to cite.  The parties effectuated the transaction on the day that PwC issued the opinion.

The Tax Court determined that the transaction was a disguised sale.  This was based largely on the court’s conclusion that the indemnity by WISCO was illusory and thus that WISCO should not be allocated any amount of the partnership’s liabilities.  If WISCO had been allocated these partnership liabilities then the transaction would be viewed as a financing transaction and not a sale.  After all, you can’t call something a sale if the seller gets left holding the bag for the purchase price.  But the court found WISCO’s bag empty and proceeded to penalties.

The Canal Corp. court began its analysis of section 6664 by recognizing that “[r]easonable cause has been found when a taxpayer selects a competent tax adviser, supplies the adviser with all relevant information and, in a manner consistent with ordinary business care and prudence, relies on the adviser’s professional judgment as to the taxpayer’s tax obligations.” Slip Op. at 31.  However, the court noted that such advice “must not be based on unreasonable factual or legal assumptions” and cannot be relied upon when given by an advisor “tainted by an inherent conflict of interest.”  Id. at 32.  Citing Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993), a case involving promoters of master recording leasing programs, the Court concluded that a “professional tax adviser with a stake in the outcome has such a conflict of interest.”  Id.

Applying these conceptual standards to the PwC opinion, the Tax Court found it lacking.  At the outset, the court thought it incredible that significant time had been spent on an opinion so “littered with typographical errors, disorganized and incomplete.”  Id. at 33.  The Court’s confidence in the opinion was further undermined by the fact that only a draft could be found and the author (even after presumably being prepared for trial) did not recognize parts of the opinion when asked about them in court.  On the question of assumptions generally, the lack of specific citation in support of the opinion’s premises and the frequent use of terms such as “it appears” in the place of hard analysis was also troubling for the court, which found it unreasonable that anyone would issue a should-level opinion on analogy and analytics with no direct support for the position.  The Court found the author’s testimonial responses to challenges on these points unsettling and bluntly concluded that the only reason the opinion was issued at the should level was that “no lesser level of comfort would have commanded the $800,000 fixed fee that Chesapeake paid for the opinion.”  Id. at 35.

On the question of a conflict of interest, the Court found a large one.  Commenting that it “would be hard pressed to identify which of his hats” the author was wearing when he rendered the opinion, the Court concluded that the author’s work in developing, planning, structuring, and implementing the transaction took away too much of his independence (which the Court found to be “sacrosanct to good faith reliance”) to allow him to objectively analyze the merits of the transaction.  Slip Op. at 36-38.  Given that the only hurdle to closing the transaction was, in the end, the $800,000 flat fee opinion, the Court found that Chesapeake was attempting to buy “an insurance policy as to the taxability of the transaction.”  Id. at 37.  The Court voided the policy.

NPR 

NPR involved a transaction the IRS characterized as a “Son of BOSS” transaction involving offsetting foreign currency options.  As explained by the Court, the IRS’s view of a Son of BOSS transaction is “a series of contrived steps in a partnership interest to generate artificial tax losses designed to offset income from other transactions.”  Slip Op. at 2 n.3.  It is fair to say that Son of BOSS transactions are considered by the IRS to be one of the “worst of the worst,” so much so that they are the only transaction that is specifically barred from being considered by IRS Appeals.  See Announcement 2004-46, Sec. 5 (May 24, 2004).  Indeed, NPR conceded the merits of the transactions at issue prior to the decision.  Accordingly, the only items considered by the district court were a period of limitations issue (which we will not discuss here) and the penalties.

After working through the background elements of section 6662, the district court in NPR began its analysis in a similar way to the Tax Court in Canal Corp., setting out both the restrictions on relying upon unreasonable assumptions and on a conflicted adviser.  Slip Op. at 24-26.  The conclusion, however, was quite different.  Finding that the taxpayers were “not tax lawyers” and were not “learned in tax law” the court held that their reliance on the more-likely-than-not opinion of R.J. Ruble (who, at the time of the court’s ruling, had already been convicted of tax evasion associated with the rendering of tax opinions) was reasonable based on its findings that the opinion reached “objectively reasonable conclusions” and detailed a “reasonable interpretation of the law” (albeit one that the taxpayers conceded before trial).  Id. at 27-28.  Critically, the Court found persuasive the taxpayer’s plea that they, as unsophisticated men, sought out the advice of professionals who they did not know were conflicted and followed that advice; “what else could we have done except follow their advice?” Id. at *28.

Comparison

As shown above, the differences between Canal Corp. and NPR are not differences in legal standards but differences in fact-finding.  Both courts invoked and applied the same standards and prior interpretations of those standards; they just applied them to different facts as each judge found those facts.  That is exactly what trial courts are supposed to do; take legal standards and do the hard work of applying them to the myriad fact patterns that arise.  Viewed from that perspective, there is nothing in conflict between the two rulings; different facts support different results.

In a sense, the “inconsistencies” give a certain comfort in the decisions of both courts.  Judges say what the law is, that is true.  But more relevant to a trial lawyer, in a bench trial, they say what the facts are.  In both Canal Corp. and NPR, the judges reached a conclusion based on their common-sense perceptions of what happened in the courtroom.  While they can (and likely will) be second-guessed, that is their job.  The NPR court was not swayed by all of the IRS’s anti-Son-of-BOSS rhetoric.  Rather, the court evaluated the honesty and integrity of the specific taxpayers before it, their options (not the foreign currency kind) and their knowledge, and decided that no more could reasonably be asked of them.  Similarly, the Canal Corp. court wasn’t swayed by the involvement of a major accounting firm in a business transaction between two large, sophisticated companies.  Instead, the court looked at the analytics and thoroughness of the opinion, the involvement of the author in the transaction (including what he was paid), and his credibility on the stand, and concluded that it was unreasonable for a sophisticated consumer of tax advice to rely on his opinion.  Whether you agree with the fact-finding (which is tough to do if you didn’t sit through both trials), the fact-finding has to be separated from the analytics; the analytics were sound (and consistent).

Viewed from the perspective of the tax planner, however, justifying the different outcomes on the basis of different fact-finding does not provide much comfort.  Most tax planners would turn up their nose at a Son of BOSS opinion given to a group of individual investors to generate relatively large foreign currency options losses on a relatively minor investment.  Yet a significant number have criticized the Tax Court’s opinion in Canal.  Perhaps the distinction is just based on an “I know [a good transaction] when I see it” analysis, but many view what Canal Corp. did as “legitimate” tax planning and believe that a PwC advisor from the esteemed Washington National Tax group should have been viewed as more credible than a convicted felon.  However, when a judge looks into the eyes of the adviser and doesn’t like what she sees, the taxpayer is at grave risk on penalties.  Similarly, when the written product is capable of being analytically questioned, even undermined, based on sloppiness and lack of support or detail, a judge can be expected to have a negative reaction to that work product.  That negative reaction will carry over to the credibility of its author, particularly where a substantial fee was received.  On the flip side of the coin, if the judge finds the taxpayer honest and forthcoming about what he believed and what he tried to do to confirm that belief, the judge is likely to find reasonable cause and good faith.  In short, the way the judge perceives the facts determines the outcome; that is why they call it a facts and circumstances based test.

Asking for “consistency” in such matters amounts to nothing less than the neutering of the trial court.  “The ordinary lawsuit, civil or criminal, normally depends for its resolution on which version of the facts in dispute is accepted by the trier of fact.”  NLRB v. Pittsburgh S.S. Co., 337 U.S. 656, 659 (1949).  Indeed, rather than chasing the siren song of legal consistency, it is better to accept that fact-based tests like section 6664 belong to the trial lawyers to prove and to the trial judges to find.  While that may appear to create a lack of consistency, it doesn’t.  As we have shown, the inconsistency some see in Canal Corp. and NPR does not flow from an inconsistency in the law.  Rather, there is always unpredictability as to how the facts will be perceived by different decision-makers.  That is merely the uncertainty of litigation: the risk that a given judge on a given day may or may not believe your witnesses or your theory of the case.  This is necessarily so; “[f]indings as to the design, motive and intent with which men act depend peculiarly upon the credit given to witnesses by those who see and hear them.”  United States v. Yellow Cab Co., 338 U.S. 338, 341 (1949).  Said differently, what a lawyer (or a client) thinks the facts are doesn’t matter if they can’t convince the judge they draw to perceive the facts as they see them.  Making choices between “two permissible views of the weight of evidence” (id.) is precisely what trial judges are supposed to do and precisely what both of the judges in these cases did.  Appeals in both cases, if they are filed, will have to take this into account.

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