Pattern evidence in tax shelter litigation.

The IRS has been challenging tax shelters for more than 35 years. One weapon it relies on is Sec. 6103(h), which permits the Service to disclose third-party information in judicial proceedings without violating the confidentiality rule for returns and return information.

IRS's Approach

To deal with the increasing volume of tax shelter cases and to underscore the government's contention of many cases involving mass-marketed transactions, the IRS recently redefined how it intends to apply the item and transaction tests of Sec. 6103, to use certain third-party returns and return information in tax proceedings; see Chief Counsel Notice 2006-003. It also released questions and answers to illustrate how it proposes to employ "pattern evidence" in tax shelter proceedings; see Chief Counsel Notice 2006-006.

Authority for disclosing information about other taxpayers' transactions, the Service argues, can be found in Sec. 6103(h)(4)(B) (the so-called "item" exception to the general privacy rules) and Sec. 6103(h)(4)(C) (the so-called "transaction" exception).

As interpreted by the Service and endorsed by some courts (see Northern Trust, 210 FSupp 955 (ND IL 2001) and Shell Petroleum, 47 Fed. Cl. 812 (2000)), the item exception permits disclosing tax information about taxpayers who participated in substantially similar transactions promoted by the same promoter, provided the nonparty taxpayer information relates to the resolution of an issue in the taxpayer's proceeding.

As interpreted by the Service and endorsed by the court in Balanced Financial Management, 662 FSupp 100 (D UT 1987), the transaction exception permits disclosure of third-party tax information if such information directly relates to a transactional relationship between the third party and a person who is a party to the proceeding, provided the information relates to the resolution of an issue in the proceeding.

The IRS first used transaction pattern evidence successfully to challenge individual tax shelters in which different individuals invested in the same shelter. Now it is focusing primarily on corporate tax shelters in which taxpayers have participated in distinct but arguably similar transactions. Thus, the item exception set forth in Sec. 6103(h)(4) is more likely to be relevant.

Effect on Taxpayers

The use of pattern evidence may not only affect taxpayers that choose to contest transactions, but also taxpayers that have elected to settle their tax shelter transactions. A taxpayer that contests the IRS's treatment of a promoted reportable transaction (in administrative or judicial proceedings) may find resolution turning not merely on the facts of its implementation, but also on the promoter's pattern of conduct, as well as that of some or all of the promoter's other clients. Evidence of similar transactions, "cookie-cutter" documents, etc., may be cited by the IRS in an effort to rebut the taxpayer's arguments about why its specific situation, business purpose or profit motivation was unique. If this effort is successful, the taxpayer could find individual facts or efforts that distinguish its particular case are diminished by the stream of pattern evidence. Moreover, in light of information sources such as settlement initiatives, promoter and taxpayer audits, the Office of Tax Shelter Analysis database of required disclosures and other sources, it may not be difficult for the Service to gather information that it considers pattern evidence.

Equally troubling for taxpayers that chose to resolve a controversy through an audit or a comprehensive settlement (in part to avoid adverse publicity) is the later introduction of information, provided pursuant to settlement discussions, as pattern evidence in proceedings involving a totally unrelated taxpayer. It is unclear what level of protection, if any, these third-party taxpayers will receive.

The Service views pattern evidence as a highly effective litigation tool. It used it in ACM Partnership, TC Memo 1997-115, against "lease strips," and recently in Jade Trading, 65 Fed. Cl. 188 (2005), against "son-of-boss" transactions. Since it has redefined how pattern evidence applies and provided guidance in Chief Counsel Notices 2006-003 and 2006-006, the IRS is expected to use it in other tax shelter litigation.

Conclusion

Taxpayers against whom the Service uses pattern evidence should be prepared to contest this approach by:

1. Arguing against the introduction of pattern evidence;

2. Arguing that pattern evidence is not reliable (especially if provided in a summary format);

3. Demanding access to information underlying any summary evidence;

4. Arguing such evidence is neither relevant nor proves the Service's assertions;

5. Arguing that multiple implementations of any given transaction are not per se evidence of impropriety; and

6. Focusing the court's attention on the individual facts of the current proceeding.

This approach may be time consuming and costly, and it is unclear how the courts will ultimately rule on pattern evidence.

The renewed use by the IRS of pattern evidence may significantly alter a corporate taxpayer's decision whether to litigate IRS treatment of a reportable transaction.

FROM CORINA TRAINER, J.D., WASHINGTON, DC