Deficiency notices must be specific.
Shifting the burden of proof to the IRS for new matters may have little practical significance if a new matter embodies a purely legal issue. On the other hand, shifting the burden of proof may prove decisive when a new factual dispute is presented and evidence must be produced. The tactical objective in Tax Court litigation is to shift to the Service the burden of proof on any issue that later arises. The Tax Court can bar the IRS from raising a new matter if it is advanced so late as to prejudice the taxpayer's defense; see Achiro, 77 TC 881 (1981), or Stewart, TC Memo 1982-202 (holding that fair notice is required, and that the test is whether the party is surprised and disadvantaged).
Neither Rule 142(a) nor its underlying commentary defines the term "new matter." Instead, case law provides for a clearer understanding. A new adjustment qualifies; see Carter, TC Memo 1957-65, aff'd in part and rev'd in part on another issue, 257 F2d 595 (5th Cir. 1958) (to the extent that the new adjustment has the effect of increasing the deficiency asserted in the deficiency notice, Rule 142(a) specifically provides that the IRS bears the burden of proving that increase). Similarly, a new legal theory to support an existing adjustment may constitute a new matter; see Weaver, 32 TC 411 (1959). However, a long line of cases, has held that a new legal theory is not a new matter if it is not inconsistent with the language of the deficiency notice (the inconsistency test); see Sorin, 29 TC 959 (1958), aff'd per curiam, 271 F2d 741 (2d Cir. 1959); Abatti, 634 F2d 1385 (9th Cir. 1985); Reese, 615 F2d 226 (5th Cir. 1980); Spangler, 278 F2d 665 (4th Cir. 1960); Bailey, 90 TC 558 (1988), aff'd in part and rev'd and rem'd in part on other issues, 912 F2d 44 (2d Cir. 1990); Barbourville Bank Co., 37 TC 7 (1961); and Barton, TC Memo 1992-481.
The inconsistency test has encouraged the Service to write broadly worded notices (e.g., "You have not established your right to the claimed deduction under any provision of the Internal Revenue, Code"); but see IRM 4464.23 (7/23/90), which states that explanatory paragraphs of a deficiency notice should inform the taxpayer in clear and concise language of the adjustment and state the IRS's position on the adjustment.
In a recent, fully reviewed opinion with no dissents, the Tax Court signaled that expansive deficiency notice language may no longer rescue the Service from a shift in the burden of proof when it raises a new matter before the court.
The Shea Case
In Shea, 112 TC No. 14 (1999), the IRS determined that the taxpayer (a sole proprietor and California resident) had substantially underreported his business gross income for 1990 through 1992. The taxpayer was married during these years, and the deficiency notice that he received did not explicitly deny him the benefit of state community property laws. (Sec. 66(b) disallows the benefits of community property laws to a spouse for purposes of splitting income if that spouse treats the income solely as his own and fails to notify his spouse of its nature and amount.) Nonetheless, the deficiency was computed as though all the omitted income was the taxpayer's alone.
Before trial, the Service notified the taxpayer that it intended to rely on Sec. 66(b) to support the deficiency determination. In turn, the taxpayer argued that, because the deficiency notice did not cite Sec. 66(b), the IRS had raised a new matter for which it must bear the burden of proof. The Service responded that the application of Sec. 66(b) was implicit in the deficiency computation and that an appeal would lie to the Ninth Circuit, which had previously recognized the inconsistency test. (In Abatti, the IRS's invocation of Sec. 482 at trial was not a new matter; although the section was not mentioned in the deficiency notice, it was cited and relied on in the revenue agent's report.)
The Tax Court sided with the taxpayer, disagreeing that the application of Sec. 66(b) was implicit in the deficiency notice. The court noted that the IRS had introduced no evidence that it had ever considered the application of community property laws in determining the deficiency. Moreover, Sec. 7522 had effectively eclipsed the inconsistency test, because it mandates that a deficiency notice must, among other things, "describe the basis for the deficiency." According to the court, the presence or absence of inconsistency is irrelevant for Sec. 7522 purposes. The IRS has the burden of proof under Rule 142(a) as to any basis for the deficiency if that basis is (1) not described in the deficiency notice and (2) requires the presentation of evidence different than that necessary to resolve the determinations that were so described.
Applying this standard, the court concluded that the Sec. 66(b) issue constituted a new matter on which the Service bore the burden of proof, because the statute was not mentioned in the deficiency notice and the issue required the presentation of new evidence. The court went on to find that the IRS had produced insufficient evidence at trial to meet that burden.
Given Shea, it is difficult to quarrel with the fairness of the Tax Court's results. To assert that an issue that the parties never even contemplated is not a new matter merely because it happens not to conflict with the broad language of the deficiency notice would be to elevate semantics over substance and reality. The Tax Court's broader, philosophical message is a salutary one: a deficiency notice must, as the name implies, provide notice in the fairest sense. A taxpayer should not have to speculate about the Service's reasons for asserting that he owes more tax,just as the IRS should not have to guess at the taxpayer's reasons for asserting that he does not. In other words, Shea calls for greater specificity in deficiency notice drafting, and, in the Tax Court, the inconsistency test may no longer immunize the Service from incurring a shift in the burden of proof on a factual matter when it issues a vague or indefinite notice. (Presumably, given its Sec. 7522 rationale in Shea, the Tax Court will not feel compelled to follow the inconsistency test in any circuit in which it has been adopted.)
Beyond this, Shea leaves open questions that hopefully will be resolved in the future:
1. Is there a difference between a basis for a deficiency determination and a theory (i.e., is a basis broader than a theory)? The majority does not seem to use the terms interchangeably, and the legislative history of Sec. 7522 does not provide guidance.
2. How much specificity will suffice in describing a basis for a deficiency in a deficiency notice? Is there an objective standard (e.g., "sufficient to apprise a person of reasonable intelligence of the Commissioner's position")? Must the IRS cite some form of authority (statutory or otherwise) in support of an adjustment?
3. Would the Tax Court reach the same result if the evidence showed that a taxpayer already knew what the Service's positions were, despite a deficient deficiency notice? If the purpose is to provide fair notice, the IRS might argue that shifting the burden of proof in such circumstances unduly penalizes it. A concurring opinion in Shea suggested that it would always be inappropriate to look beyond the notice to decide whether the Service had raised a new issue. The majority, however, does not appear to rule out such an approach, despite its seeming rejection of Abatti.
RONALD A. STEIN, LL.M., CPA, ARTHUR ANDERSEN LLP, CHICAGO, IL
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|Title Annotation:||tax deficiency|
|Author:||Stein, Ronald A.|
|Publication:||The Tax Adviser|
|Date:||Jul 1, 1999|
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