Tax Controversy Litigation

In Wendell Falls Development, LLC v. Commissioner, T.C. Memo. 2018-45, the Tax Court denied a charitable contribution deduction for a taxpayer’s contribution of a conservation easement because the taxpayer expected to receive a substantial benefit from the donation.

The taxpayer purchased 27 contiguous parcels of unimproved land, comprising 1,280 acres. The taxpayer planned to subdivide the 1,280 acres into a master-planned community with residential areas, commercial spaces, an elementary school, and a park. The taxpayer would then sell the lots to builders.

The taxpayer identified 125 acres of the 1,280 acres as land upon which a park would be placed. The taxpayer and the County discussed the County acquiring the 125 acres for use as a county park. The taxpayer sought to ensure that the 125 acres would be restricted to park use and proposed placing a conservation easement on the 125 acres. Ultimately, the taxpayer and the County entered into a purchase agreement for the 125 acres, and placing a conservation easement on the land was a precondition to the sale. The taxpayer granted a conservation easement on the 125 acres in favor of a land trust and transferred ownership of the 125 acres to the County. The taxpayer claimed a charitable deduction for its contribution of the conservation easement on its tax return.

The issue here is the “substantial benefits” test. No deduction for a charitable contribution is allowed if the taxpayer expects a substantial benefit from the contribution. The taxpayer owned and intended to sell the 1,280 acres of land adjoining the 125 acres that was designated as park land. The taxpayer’s master-planned community was designed so that all residential areas would have access to the 125-acre park.  According to the Court, the taxpayer expected a substantial benefit from the donation because it sought to ensure that the 125 acres was restricted to park use, and as the prospective seller of the lots the taxpayer “would benefit from the increased value to the lots from the park as an amenity.” Because the taxpayer expected a substantial benefit from the donation, the Court disallowed the charitable deduction. (Note: alternatively, the Court determined that the value of the easement was zero because the park land did not diminish the value of the 125 acres).

Recently, the written supervisory approval requirement of Section 6751(b) has been one of the primary issues in Tax Court litigation concerning penalties that the IRS has asserted against taxpayers. The focus of this litigation is the effect of Section 6751(b) and its interplay with the Commissioner’s burden of production as to penalties in court proceedings under Section 7491(c). In Dynamo Holdings v. Commissioner, 150 T.C. No. 10 (May 7, 2018), the Tax Court addressed these issues in a partnership-level proceeding.

Section 6751(b)(1) provides that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination…” (note that Section 6751(b)(2) provides certain exceptions to this general rule).

Section 7491(c) provides that the IRS “shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title.”

Until the Chai and Graev III opinions, there had been little litigation over the effect of Section 6751(b).

In Chai v. Commissioner, 851 F.3d 190 (2nd Cir. 2017), the taxpayer argued in his post-trial brief that compliance with the written-approval requirement in Section 6751(b)(1) is an element of the Commissioner’s claim for penalties and is therefore part of the Commissioner’s burden of production under Section 7491(c). The Second Circuit Court of Appeals agreed, holding that Section 6751(b)(1) requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty. Chai held that Section 6751(b) is part of the Commissioner’s burden or production in a deficiency case in which a penalty is asserted.

In Graev v. Commissioner (Graev III), 149 T.C. No. 23 (Dec. 20, 2017), the Tax Court held that the Commissioner’s burden of production under Section 7491(c) includes establishing compliance with the written supervisory approval requirement of Section 6751(b). Thus, in a deficiency case in which a penalty is asserted, it is the IRS’s burden to introduce sufficient evidence establishing compliance with the supervisor approval requirement.

In Dynamo Holdings, the Tax Court addressed the interplay between the supervisor approval requirement and the IRS’s burden of production in a partnership-level proceeding. The Court held that the IRS does not bear the burden of production with respect to penalties under Section 7491(c) in a partnership-level proceeding. The Court reasoned that Section 7491(c) provides that the IRS has the burden of production “with respect to the liability of any individual for any penalty…” Because partnership-level proceedings do not determine liabilities and are not with respect to individuals, the IRS does not bear the burden of production as to penalties. In a similar vein, the IRS does not bear the burden of production with respect to penalties asserted against corporations.

The Court further held that where the IRS does not bear the burden of production as to penalties, the lack of supervisory approval of penalties may be raised as a defense to those penalties. However, taxpayers should note that they must affirmatively argue that the IRS failed to comply with the supervisory approval requirements of Section 6751. Failure to make such an argument can be costly, as the taxpayer will be deemed to have waived the defense.

On May 30, the newly-formed Philadelphia Chapter of the Federal Bar Association’s Section on Taxation will host a meet-and-greet event with the Honorable Mark V. Holmes of the United States Tax Court. The event is free and open to all tax practitioners in the greater Philadelphia area. To RSVP for this event, please email events@foxrothschild.com.

Judge Holmes was appointed to the Tax Court by President George W. Bush in 2003, and was recently re-appointed for a second fifteen-year term. Judge Holmes is a prolific jurist known for delightfully colorful opinions that bring to life often dreary tax concepts. In recent years, he has authored numerous opinions addressing cutting edge tax issues, including his decision last year in Avrahami, the first judicial opinion to tackle the validity of micro-captive insurance arrangements. Judge Holmes also presided over the lengthy trial involving a dispute between the Internal Revenue Service and the estate of pop star Michael Jackson, and practitioners are eagerly awaiting his decision in this closely-watched case. In recent months, Judge Holmes has authored multiple opinions addressing the fallout from the Chai and Graev decisions, which held that IRS supervisory approval is required before penalties may be asserted, including decisions involving the aforementioned Jackson estate as well as pro football Hall of Famer Warren Sapp. In another case that is generating significant interest, Judge Holmes is set to rule on the application of Internal Revenue Code section 280E to a marijuana business in Patients Mutual Assistance Collective Corporation.

Established in February 2018, the Philadelphia Chapter is the newest chapter of the Federal Bar Association Section on Taxation. The Philadelphia Chapter is co-chaired by Matthew D. Lee of Fox Rothschild and Kevin M. Johnson of Baker Hostetler.

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United States v. Gerard, a recent case from the Northern District of Indiana, demonstrates how a tax lien, once attached, can stay with property even after the property is conveyed to someone other than the taxpayer.  In 1990, a husband and wife named Robert and Cynthia Gerard bought a residence as tenants by the entirety.  Although the Gerards bought the residence together, Robert paid at least 90% of the purchase price.  Between 2003 and 2008, Cynthia owned a business with outstanding employment and unemployment taxes.  The Gerards and the government generally agreed that the assessments for these tax liabilities attached to Cynthia’s interest in the property.  As time went on, Robert and Cynthia decided to convey the property solely to Robert.  The deed stated that the conveyance was “by way of gift and without any consideration other than for love and affection.”

The government, however, still wished to enforce the liens.  Litigation ensued, and the government moved for summary judgment.  The key issue was whether the liens that were attached to Cynthia’s interest in the property survived the severance of the tenancy by the entirety.  Section 6323 provides that a lien is not valid against a purchaser until the IRS files proper notice.  Thus, according to the court, Robert would not be liable for Cynthia’s outstanding tax balance if Robert was a “purchaser.”  A “purchaser” is “[a] person who, for adequate and full consideration in money or monies worth, acquires an interest (other than a lien or security interest) in property which is valid under local law against a subsequent purchaser without actual notice.”  IRC § 6323(h)(6).  “Adequate and full consideration in money or money’s worth” is “a consideration in money or money’s worth having a reasonable relationship to the true value of the interest in property acquired.”  Treas. Reg. § 301.6323(h)-1(f)(3).

The Gerards argued that Robert was a purchaser because Cynthia used marital assets to pay her business’s expenses and then transferred her interest in the property in repayment of those debts.  The government, however, pointed out that the deed specifically stated that the transfer was made “by way of gift and without any consideration other than for love and affection,” and that any consideration would have been past consideration, which was insufficient.

The court was not concerned that the deed stated that the property was a gift.  It noted that “[i]t is a well-known fact that often a conveyance recites a nominal consideration whereas the true consideration is not nominal.  It is therefore never certain that the recited consideration is the true consideration.”  Clark v. CSX Transp., Inc., 737 N.E.2d 752, 759 (Ind. Ct. App. 2000).  The court was, however, concerned with the fact that the parties agreed that the use of marital assets to pay Cynthia’s business expenses was “past consideration.”  Under the regulations, “adequate and full consideration” includes past consideration only if, “under local law, past consideration is sufficient to support an agreement giving rise to a security interest. . .”  Treas. Reg. § 301.6323(h)-1(a)(3); (f)(3).  Accordingly, the court turned to Indiana law to determine whether past consideration could create a security interest.

The Gerards could not cite any Indiana authority indicating that past consideration gives rise to a security interest.  Also, other federal courts hold that past consideration does not make a party a “purchaser” under section 6323(a).  See, e.g., United States v. Register, 727 F. Supp. 2d 517, 526 (E.D. Va. 2010).  Thus, the court concluded that Robert was not a purchaser under section 6323(a) and that the liens attached to Cynthia’s interest in the property survived the conveyance.

The parties still disputed the extent to which the liens attached to the property.  The government argued that the liens remained attached to a one-half interest in the property.  The Gerards, however, argued that Cynthia’s actual interest was worth less than one-half of the property when it was conveyed, so the liens only attached to something less than a one-half interest.  Here again, the court found that Indiana law did not support the Gerards’ argument.  For example, in Radabaugh v. Radabaugh, the court held that the trial court erred by “conclud[ing] that appellee was the owner of less than an undivided one-half interest in the mortgage loan” for real estate owned by a husband and wife as tenant by the entirety.  35 N.E.2d 114, 115-16 (Ind. Ct. App. 1941).  Thus, the court concluded that the liens were still attached to one-half of Robert’s interest in the property, even after the conveyance.

 

Earlier this week the United States Tax Court announced that Judge Maurice B. Foley has been elected Chief Judge to serve a two-year term beginning on June 1, 2018.

Judge Foley was appointed President William J. Clinton on April 9, 1995. He was reappointed by President Barack Obama on November 25, 2011, for a second term ending November 24, 2026. He received a bachelor of arts degree from Swarthmore College, a juris doctor from Boalt Hall School of Law at the University of California, Berkeley, and a master of laws in taxation from Georgetown University Law Center. Before his appointment to the Tax Court, he was an attorney for the Legislation and Regulations Division of the Internal Revenue Service, Tax Counsel for the United States Senate Committee on Finance, and Deputy Tax Legislative Counsel in the United States Treasury’s Office of Tax Policy. Judge Foley is an adjunct professor at American University Washington College of Law, the University of Colorado Law School, and the University of Baltimore School of Law.

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In Rajagopalan v. Commissioner, Judge Holmes confronted what he called the Chai ghoul.  See Rajagopalan v. Commissioner, Docket No. 21394-11, Order, Dec. 20, 2017.  In Chai v. Commissioner, the Second Circuit held that the section 6751(b)(1) written approval requirement “requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty.”  Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017), aff’g in part, rev’g in part 109 T.C.M. 1206.  The Tax Court agreed with the Second Circuit’s holding in Chai soon after it was released.  See Graev v. Commissioner, 149 T.C. __ (Dec. 20, 2017).

These decisions prompted the Commissioner to ask the court to reopen the record in Rajagopalan (and in a number of other cases) so that he could introduce penalty-approval forms to show he complied with section 6751(b)(1) for the 20% accuracy-related penalties.  Trial and briefing in Rajagopalan took place long before Chai and Graev, and the Commissioner did not introduce evidence that he complied with section 6751 at trial.

In support of his motion, the Commissioner submitted an IRS supervisor’s declaration to authenticate the penalty-approval forms and to show how the supervisor approved the penalty determination.  The forms also listed the applicable IRS examiner.  In her declaration, the supervisor stated that she was the examiner’s immediate supervisor and that she signed the forms approving the examiner’s penalty determination.

As a general rule, the Tax Court has broad discretion to reopen the record.  But its discretion is not unlimited.  The court will not reopen the record to admit evidence that is merely cumulative or impeaching.  Instead, the evidence must be material and likely to change the outcome of the case.  Butler v. Commissioner, 114 T.C. 276, 287 (2000), abrogated on other grounds by Porter v. Commissioner, 132 T.C. 203 (2009).  The court must also weigh the Commissioner’s diligence against the possibility of prejudice to the petitioners.  Prejudice here turns on whether the submission of evidence after trial prevents the petitioners from questioning the evidence as they could have during trial.

Judge Holmes found that the penalty-approval forms met the first requirement, and would have actually been admissible at trial under the business-records exception to the hearsay rule.  Judge Holmes was also unconvinced that the petitioners would be prejudiced by the court’s decision to reopen the record.  The petitioner’s main argument was that they should have been “entitled to question” the supervisor and examiner to confirm that the penalties “were properly asserted and whether [the Commissioner] complied with Code section 6751(b).”  But it was unclear how the petitioners would have benefited from cross-examination.  Judge Holmes pointed out that the penalty-approval forms either did or did not answer those questions, and would have been admitted under the business-records exception regardless.

As a result, Judge Holmes granted the Commissioner’s motion to reopen the record.  Despite the court’s decision to admit the penalty-approval forms, Chai continues to present the Commissioner with major challenges as he seeks to assert penalties in cases tried before Chai.

In United States v. Stein, the Eleventh Circuit recently decided a novel – but critical – issue for taxpayers.  It held that an affidavit that satisfies Rule 56 of the Federal Rules of Civil Procedure (the summary judgment rule) may create an issue of material fact precluding summary judgment, even if it is self-serving and uncorroborated.  The case centered around an IRS assessment.  IRS assessments are entitled to a presumption of correctness, which can be a difficult burden for taxpayers to overcome.

In 2015, the government sued Estelle Stein for outstanding tax assessments, late penalties, and interest for the 1996 and 1999-2002 tax years.  The government moved for summary judgment and tried to show that Ms. Stein had outstanding tax assessments by submitting her federal tax returns, account transcripts, and an affidavit from an IRS officer.  Ms. Stein responded with her own affidavit, stating that, “to the best of [her] recollection,” she had paid the taxes and penalties at issue.  Her affidavit also explained that she used an accounting firm to file the tax returns, that she remembered paying the taxes and penalties due, but that she did not have bank statements showing these payments.

The district court granted summary judgment for the government because, it explained, Ms. Stein did not produce any evidence documenting payments.  An Eleventh Circuit panel affirmed based on Mays v. United States, 763 F.2d 1295 (11th Cir. 1985).  In Mays, the court affirmed summary judgment for the government, holding that a taxpayer in a refund suit must not only show the government’s assessment is wrong, but also establish the “correct amount of the refund due.”  Mays further held that the taxpayer’s claim “must be substantiated by something other than tax returns, uncorroborated oral testimony, or self-serving statements.”

The Eleventh Circuit sitting en banc in Stein, however, disagreed and overruled Mays “to the extent it holds or suggests that self-serving and uncorroborated statements in a taxpayer’s affidavit cannot create an issue of material fact with respect to the correctness of the government’s assessment.”  Under Rule 56(a), summary judgment may be granted only when “there is no genuine dispute as to any material fact” and the moving party is “entitled to judgment as a matter of law.”  The Eleventh Circuit further held that nothing in the Federal Rules of Civil Procedure prohibit an affidavit from being self-serving.

Stein is a significant win for taxpayers, and it may make it easier for taxpayers to overcome the presumption of correctness that IRS assessments have enjoyed.

The Supreme Court recently granted certiorari in South Dakota v. Wayfair Inc., a case that could dramatically change how sales taxes apply to online retail activity. Under the Supreme Court’s current precedent in Quill Corp. v. North Dakota, online retailers need not collect sales taxes unless they have a physical presence in a state. But Quill was decided in 1992, when most remote sales were via phone or mail order. If the Supreme Court overturns Quill, online retailers may face significant new tax liabilities in numerous jurisdictions. States, on the other hand, see Wayfair as an opportunity to significantly increase their tax revenues. It is estimated that state and local governments could have collected around $13 billion more in 2017 had they been allowed to require online retailers to collect sales taxes, even with no physical presence. South Dakota made it clear that the law at issue in Wayfair is designed to test the Quill standard.

The Supreme Court will hear oral arguments this spring. Stay tuned for updates as the parties submit their briefs.

The Tax Court’s recent opinion in Roth v. Commissioner, T.C. Memo. 2017-248, raises interesting issues about the need for supervisor approval when the IRS asserts penalties.  In 2007, the petitioners in Roth donated a conservation easement encumbering 40 acres of land in Colorado to a charitable organization.  The petitioners claimed a charitable contribution deduction of $970,000, but the IRS disallowed the deduction.

On examination, the IRS determined that the petitioners improperly valued the conservation easement and that the easement was actually worthless.  The examiner also determined that the petitioners were liable for a 40% gross valuation misstatement penalty under section 6662, and his determination was approved in writing by his immediate supervisor.  The examiner determined that the petitioners were alternatively liable for a 20% accuracy-related penalty.

The petitioners submitted a protest letter to IRS Appeals.  The parties did not reach an agreement, however, and Appeals ultimately issued a notice of deficiency.  In a closing memorandum, the Appeals officer informed the petitioners that “[t]he proposed penalties are fully sustained for the government.”  The closing memorandum was signed by the Appeals officer’s immediate supervisor.

The notice of deficiency omitted the 40% penalty and included only the 20% accuracy-related penalty.  The petitioners then filed a petition in Tax Court.  In its answer – which was signed by an IRS senior counsel and her immediate supervisor – the IRS asserted the 40% penalty.

The parties eventually settled the case.  They agreed that the petitioners were entitled to a charitable contribution deduction of $30,000 and that the petitioners had reasonable cause for the value of the conservation easement.  As a result, the IRS conceded that the petitioners were not liable for a 20% accuracy-related penalty.

The difference between the settlement value of $30,000 and the claimed value of $970,000, however, met the gross valuation misstatement test under section 6662(h).  Unlike for the 20% accuracy-related penalty, taxpayers cannot claim reasonable cause to avoid liability for the 40% penalty.  So the petitioners tried another escape route – they argued that the 40% penalty was inappropriate because the IRS failed to comply with the procedural requirements of section 6751(b).

Section 6751(b)(1) states that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”  Complying with this requirement is part of the IRS’ burden of production under section 7491(c).  See Graev v. Commissioner, 149 T.C. __ (Dec. 20, 2017), supplementing 147 T.C. __ (Nov. 30, 2016).

The petitioners argued that “initial determination” means the issuance of the notice of deficiency.  Although written approval for the 40% penalty was obtained before the notice of deficiency was issued, the petitioners argued that the Appeals officer made the “initial determination,” not the examiner.  As a result, the petitioners argued that, because the Appeals officer did not receive approval from his immediate supervisor before issuing the notice of deficiency, the IRS did not comply with section 6751(b) and could not assess the penalty.

The court observed that this issue was controlled by its decision in Graev and Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017), vacating and remanding in part, aff’g in part, and rev’g in part T.C. Memo. 2015-42.  The court held that each time the IRS sought to assert penalties, the individual proposing the penalties received approval from his or her immediate supervisor.  The examiner who proposed the 40% penalty received written approval from his group manager.  The Appeals officer received written approval from his team manager.  The senior counsel who filed the IRS’ answer received written approval from her associate area counsel, which was demonstrated by the associate area counsel’s signature on the answer.

The Tax Court held that regardless of which of these instances was the initial determination of the 40% penalty, section 6751(b) was satisfied because each instance was approved in writing by an immediate supervisor.  Thus, the court concluded that the IRS complied with section 6751(b) and found the petitioners liable for the 40% penalty.

The recent Tax Court decision in Woodley v. Commissioner, T.C. Memo. 2017-242, demonstrates the hazards of trust fund recovery penalties (TFRPs) for taxpayers.  A TFRP is a penalty imposed by section 6672(a) on anyone who is responsible for paying payroll taxes but who willfully fails to do so.  Generally, the TFRP is the amount the employer withheld from its employees’ wages that was not paid to the IRS.

The petitioner in Woodley was an officer, employee, and part owner of LAJE, a corporation that operated a sandwich shop in the U.S. Virgin Islands.  LAJE became delinquent on its employment taxes, and the IRS assessed employment taxes against it for seven quarters in 2007 and 2008.  The IRS sent the petitioner a trust fund recovery penalty letter, informing her that it had determined that she was one of the people required to collect and pay over LAJE’s employment taxes.  The IRS also assessed TFRPs against another owner of LAJE for the same trust fund tax liabilities.

The petitioner argued that the IRS could not collect the TFRPs from her because it was receiving payments from another party for the same underlying tax liabilities.  The Tax Court disagreed.  It noted that section 6672 imposes liability on “[a]ny person required to collect . . . and pay over any tax imposed by this title” but who willfully did not.  The Tax Court observed that employers are liable for trust fund taxes that should have been withheld.  Importantly, when TFRPs are assessed, multiple individuals and entities may be liable for the same penalties from the same unpaid tax.  The IRS can try to collect simultaneously from an employer, as well as other responsible persons.

This case serves as a reminder of the extensive liability taxpayers face if they fail to pay trust fund taxes.