Analysis of and reflections on recent cases and rulings.
Taxpayers Not Entitled to Question IRS Officials About Summonses
The Supreme Court held that a taxpayer is entitled to question IRS officials about the reasons the IRS issued a summons only if the taxpayer points to specific facts and circumstances that plausibly raise an inference of bad faith on the part of the IRS.
Suspicious about large interest expenses claimed in 2005 through 2007 by Dynamo Holdings Limited Partnership (Dynamo), the IRS initiated an examination of the partnership's returns for those years. As the investigation proceeded, Dynamo agreed to two yearlong extensions of the usual three-year limitation period for assessing tax liability. In 2010, with the second extension period drawing to a close, Dynamo refused to grant the IRS a third extension. Shortly afterward, the IRS issued summonses to four individuals associated with Dynamo (the taxpayers) who the IRS believed had information and records relevant to Dynamo's tax obligations. None of the taxpayers complied with the summonses. In December 2010 (still within the extended limitation period), the IRS issued a final partnership administrative adjustment proposing changes to Dynamo's returns that would result in greater tax liability. Dynamo filed a suit (which is currently pending) in February 2011 in Tax Court to challenge the adjustments. In April 2011, the IRS filed suit in district court to compel the taxpayers to comply with the summonses.
Those enforcement proceedings developed into a dispute about the IRS's reasons for issuing the summonses. The IRS submitted an affidavit from the Service's investigating agent stating that (1) the summonses met the factors from Powell, 379 U.S. 48 (1964), among other things; (2) the testimony and records sought were necessary to properly investigate the correctness of Dynamo's federal tax reporting; and (3) the summonses were not issued to harass or for any other improper purpose.
The taxpayers claimed the IRS had two ulterior motives for issuing the summonses: (1) to punish Dynamo for refusing to agree to a further extension of the applicable statute of limitation and (2) to evade the Tax Court's limitations on discovery and thus gain an unfair advantage in that litigation.
As evidence of the first motive, the taxpayers pointed out that although the IRS had not asked for information in its investigation for some time, it suddenly issued the summonses immediately after Dynamo refused to grant a third extension. As evidence of the second motive, the taxpayers introduced an affidavit of one of their attorneys, who reported that the attorneys handling the Tax Court case, and not the original investigating agents, were present at the interview of his client. In light of this evidence, the taxpayers asked for an opportunity to question the agents about their motives.
The district court denied that request and ordered the taxpayers to comply with the summonses, finding that they "ha[d] made no meaningful allegations of improper purpose" warranting examination of IRS agents and that their statute-of-limitation theory was mere conjecture. The district court further determined that the respondents' evasion-of-discovery-limits claim was incorrect as a matter of law because the validity of a summons is tested as of the date of issuance, not at the time of enforcement, and the Tax Court proceedings had not begun when the IRS issued the summonses.
The taxpayers appealed the district court's decision, and the Eleventh Circuit reversed, holding that the district court's refusal to allow the respondents to examine IRS agents constituted an abuse of discretion. The Eleventh Circuit found that its precedent dictated that simply making an allegation of improper purpose, even if the allegation lacked any factual support, entitled a taxpayer to question IRS officials concerning the IRS's reasons for issuing a summons.
However, every other appellate circuit that has addressed this issue has rejected the Eleventh Circuit's view.
Therefore, the Supreme Court agreed to hear the case to resolve the conflict between the circuits.
The Supreme Court's Decision
The Supreme Court vacated the Eleventh Circuit's decision and remanded the case with specific instructions to the Eleventh Circuit on how it should determine whether the individuals were entitled to examine the IRS investigators. The Court explained that while an individual is entitled to contest a summons in an enforcement proceeding, these proceedings should be summary in nature and courts may ask only whether the IRS issued a summons in good faith. The Court further stated that under its precedent, absent contrary evidence, the IRS could satisfy the good-faith standard by submitting an affidavit from the investigating agent.
According to the Court, in the adversarial process concerning a summons's validity, the applicable rule is that "the taxpayer is entitled to examine an IRS agent when he can point to specific facts or circumstances plausibly raising an inference of bad faith."
Under this rule, a taxpayer must offer some credible evidence of the IRS's improper purpose, not merely a naked allegation that the IRS had one. However, circumstantial evidence could be used to meet this burden because direct evidence of bad faith at that stage of the proceedings will rarely, if ever, be available. In addition, it is not necessary for the taxpayer to present a "fleshed out" case, and the taxpayer only needs to show facts that support a plausible inference of improper motive. The Court noted that following this standard would ensure that an inquiry was allowed where appropriate "without turning every summons dispute into a fishing expedition for official wrongdoing."
Because the Eleventh Circuit had not even assessed what evidence it had before it regarding the taxpayers' allegations, it did not apply the standard.
On remand, the Court instructed the Eleventh Circuit in making its determination to consider the evidence submitted by the individuals in light of this standard. Observing that the correct standard of review in the case was abuse of discretion, the Court told the Eleventh Circuit that it must take into account the district court's broad discretion to determine whether the taxpayers had shown enough that they should be allowed to examine the IRS investigators. However, it gave two caveats to its general instruction. First, it stated that the district court's decision was entitled to deference only if was based on the correct legal standard. Second, the Court stated that the district court's latitude in making its decision did not extend to legal issues about what counts as an illicit motive. As an example, the Court pointed out that the question of when a summons's validity should be judged is a pure question of law, so if the question was raised again on remand, the Eleventh Circuit was not required to defer to the district court.
While the standard for evaluating a summons requires some evidence of improper purpose to trigger a hearing, the Court gives lower courts considerable leeway to decide whether a taxpayer has met the standard and what evidence they can consider. If a taxpayer has a legitimate allegation of improper purpose, seemingly the taxpayer should be able to meet the standard if a court applies it properly.
Clarke, No. 13-301 (U.S. 6/19/14)
Six-Year Statute of Limitation Applies to Assessment
The Tax Court held that the six-year statute of limitation of Sec. 6501(e)(1) (A) applied to an assessment of tax based on a distribution from an employee stock option plan (ESOP) because the taxpayer had not adequately disclosed the distribution on his tax return.
Thomas Heckman. owned an S corporation, KC Investment Management Inc. (KCIMI). On Jan. 1, 2001, KCIMI established an ESOP, and the ESOP acquired 100% of KCIMI's stock, which was its only asset. Heckman participated in the ESOP beginning in 2001, along with one other participant. In December 2002, KCIMI liquidated and transferred all of its assets and liabilities to the ESOP.
In February 2003, Prairie Capital LLC (Prairie Capital) and SMR Holdings LLC (SMR) were formed, and each received a 50% undivided interest in each of the ESOP's assets (other than a note receivable that was contributed solely to Prairie Capital), and the ESOP held 100% of the interests in Prairie Capital and SMR. On April 8, 2003, the ESOP distributed assets in kind to Heckman's and the other participant's traditional individual retirement accounts (IRAs). Heckrnan's partial interest in Prairie Capital was distributed to his IRA and was worth $137,726, so he received a distribution from the ESOP in that amount in 2003.
Heckman, however, did not include this distribution in gross income on his 2003 return. He also did not explicitly refer to either the ESOP distribution to his IRA or his IRAs membership interest in Prairie Capital on his 2003 return or in any statement attached to it. On July 30, 2010, more than three years but less than six years after the petitioner filed his 2003 return, the IRS mailed Heckman a notice of deficiency for 2003, 2004, 2006, and 2007.
The notice of deficiency determined that Heckman had received a taxable distribution from the ESOP due to the distribution of the interest in Prairie Capital. It stated that the distribution was taxable because the ESOP did not meet the Sec. 401(a) requirements for qualified status and therefore the distribution was not a distribution from a qualified plan that could be rolled over into an IRA. The IRS further claimed that the six-year statute of limitation in Sec. 6501(e)(1)(A) applied to the distribution, so the assessment was timely.
Heckman challenged the IRS's determination in Tax Court. He did not dispute that the distribution was taxable; rather, he asserted that the three-year statute of limitation in Sec. 6501(a) applied to the distribution instead of the six-year statute of limitation, barring the assessment of his 2003 tax liability.
Sec. 6501 and Adequate Disclosure
Pursuant to Sec. 6501(a), the IRS must assess the amount of any tax imposed within three years after the return was filed. Sec. 6501(e)(1)(A) extends the three-year period of limitation to six years where the taxpayer "omits from gross income an amount properly includible therein which is in excess of 25 percent of the amount of gross income stated in the return."
In computing the amount of gross income omitted, any amounts "disclosed in the return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature and amount of such item" are not taken into account. In determining whether a taxpayer has adequately disclosed omitted income on a return, the Tax Court has held that it will examine the return in question to see if it offered a "clue" regarding the existence, nature, and amount of omitted income (Quick Trust, 54 TC. 1336 (1970), aff'd, 444 F.2d 90 (8th Cir. 1971)).
The Tax Court's Decision
The Tax Court held that the six-year statute of limitation applied to the assessment and, consequently, the assessment was timely. The court found that Heckman had not adequately disclosed the 2003 distribution from the ESOP directly on his return and it could not consider information other than that on his return as evidence of adequate disclosure of the omitted income.
Because his 2003 return was totally devoid of any reference to the ESOP distribution, Heckman argued that the statements made on Prairie Capital's 2003 partnership return and other filings should be considered to be an adjunct to his Form 1040, U.S. Individual Income Tax Return, and thus, the IRS had been provided the necessary clue to the existence of his omission of the distribution from gross income. In particular, Heckman pointed to (1) the Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., attached to Prairie Capital's 2003 partnership return that identified the partner as "First Trust Company of Onaga FBO Thomas J. Heckman IRA," (2) the Form SS-4, Application for Employer Identification Number, which he filed in 2003 to obtain a taxpayer identification number for Prairie Capital, identifying him as "general managing member of Prairie"; and (3) the Form 5498, IR/1 Contribution Information, which listed him as the owner of the IRA. However, the Tax Court disagreed with Heckman's claims of the evidentiary value of these documents, stating: "To the contrary, no statement on any of those documents offers any 'clue' as to the existence, nature, or amount of the omitted income. At best, they reveal only that petitioner and/or his IRA are members of Prairie Capital."
In support of the general proposition that the Tax Court could consider information beyond that in his individual return to establish adequate disclosure, Heckman cited Benderoff, 398 F.2d 132 (8th Cir. 1968). The Tax Court found that this case was distinguishable on the facts. Unlike Heckman, the Benderoff taxpayers specifically referred to the amount of their share of =distributed income from an S corporation and the name of the S corporation on their return. Thus, the Eighth Circuit looked beyond the taxpayers' return to the S corporation's return in determining 1 whether the income had been disclosed.
Heckman also claimed that when communicating with the IRS about the audit in 2007, he had adequately disclosed the omitted income. The Tax Court concluded that oral communications three years after the filing of the return did not meet the requirement of being in the return or in a statement attached to the return.
Finally, Heckman cited Rev. Rul. 55415 to support his argument that disclosure on a partnership return is sufficient to meet the adequate disclosure exception under Sec. 6501(e)(1)(A)(ii). That revenue ruling held, with respect to the predecessor statute to Sec. 6501(e)(1)(A), a proportionate share of gross partnership income is imputed to an individual partner in determining his reportable gross income for purposes of determining whether there was an omission of 25% of gross income. But in Heckman's case, no return filed by the ESOP or any other entity indicated the existence of the distribution other than the 2003 Form 5500, Annual Return/Report of Employee Benefit Plan, for the ESOP that was filed in 2007, which reported that all the assets of the ESOP had been paid out as benefits during the year. Since that return was not filed until 2007, the Tax Court found that it could not be deemed a disclosure on Heckman's 2003 return, which he filed in 2004.
As this case makes clear, a taxpayer will likely get the benefit of information beyond the taxpayer's return only in cases where significant information about the existence of omitted income is actually included on the taxpayer's return. Thus, practitioners should make sure that clients understand the very real potential downside of failing to disclose income.
Heckman, T.C. Memo. 201 4-1 31
Challenge of IRS summons requires taxpayer to cite facts raising inference of bad faith; and returns must offer "clue" of omitted income to avoid six-year collection statute.
A taxpayer must offer some credible evidence of the IRS's improper purpose, not merely a naked allegation that the IRS had one.
The Tax Court found that it could not consider information other than that on the taxpayer's return as evidence of adequate disclosure of omitted income.
Author: James A. Beavers, J.D., LL.M., CPA, CGMA
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|Title Annotation:||tax trends|
|Author:||Beavers, James A.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 2014|
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