The Court of Federal Claims decision in Diversified Group, Inc. v. United States continues the recent focus on what it takes to get into the door with a refund suit. (See recent posts on Flora rule here and here) The Court bars the door to a tax shelter promoter seeking to pay only a fraction of the penalty imposed under IRC 6707 for failing to register a tax shelter scheme. While feeling sorry for someone who promotes an egregious tax shelter scheme requires a great deal of effort, I think parties should have the opportunity to litigate the imposition of a tax or penalty without full payment. The Court of Federal Claims decision rests on firm ground, yet barring someone against whom the IRS assesses a penalty, any penalty, from disputing that penalty in court without paying over $24 million seems inappropriate. Maybe tax shelter promoters have access to that kind of money but most parties do not.
In this post I will explain the opinion but also connect the result with CDP and how the result in the trial court opinion possibly opens the door to litigating the merits of the penalty in a CDP proceeding.
Imposition of the Penalty
Diversified Group, Inc. (DGI), a boutique merchant banking firm, and its president created a Son of Boss type shelter which they marketed between 1999 and 2002 to 193 clients seeking to evade or avoid their income tax liabilities. Around the Ides of March in 2002 the IRS notified DGI it was opening a 6707 penalty audit which later expanded to include the corporate president. A short eleven years later in May, 2013, the IRS sent a notice of proposed adjustment to each promoter informing them that it had determined they each owed $42 million as a penalty for failure to register the tax shelter. The promoters were given a chance to request a pre-assessment meeting with Appeals which they did not request. They later received notice that the penalty was reduced to $24 million because of payments by others. The penalty imposed resulted from “1 percent of the aggregate amount invested in [the] tax shelter” by their clients. The IRS provided them with charts showing the investment by each of the 193 clients.
Attempt to Use Flora to Get into Court
The IRS assessed the penalty and sent notice and demand on February 21, 2014. Shortly thereafter each promoter made a payment to the IRS reflecting 1% of the aggregate investment by one client. (Note that the law on the computation of this penalty has changed since the year at issue though it would still produce a big number.) DGI paid $15,450 and the president paid $18,310 plus interest. With the payments, the promoters filed refund claims. The IRS denied these claims on April 10, 2014, less than 45 days after the claims were filed, advising the promoters that the “penalty is not assessed on each individual transaction, but instead assessed based on the aggregate amount invested in the tax shelter, or the aggregate amount of fees paid to promoters of the tax shelter…. Thus, [the] penalties are non-divisible and must be paid in full before commencing a refund suit.” The promoters filed suit three months later and the IRS immediately moved to dismiss the case. The opinion addresses that motion and sustains it.
The fight here centers on the concept of divisibility. The section 6707 penalty does not require the IRS to issue a notice of deficiency prior to assessment. For liabilities the IRS can assess without issuing a notice of deficiency, litigation concerning the correctness of the penalties normally occurs in the district courts or in the Court of Federal Claims though I will discuss some other options below that become available in the collection process or in bankruptcy. Under the Flora rule, the doors to the district courts or the Court of Federal Claims only open after a taxpayer fully pays the tax. To mitigate the difficulty created by this jurisdictional barrier, many of the types of taxes not subject to the deficiency procedures allow the taxpayer to pay a divisible portion of the overall assessment and then sue. The promoters sought to create a similar exception for the 6707 allowing them to pay only a portion of the penalty and get into court.
The Court of Federal Claims describes the promoter’s argument as “one that raises an issue of first impression, and that, if accepted, would carve out a new judicially created exception to the rule requiring full payment of the tax owed prior to filing suit in this court.” In arguing for divisibility of the penalty as a path to refund jurisdiction, the promoters relied heavily on two cases, Noske v. United States and Humphrey v. United States. Both of these cases dealt with the 6700 penalty for promoting abusive tax shelters and found that the penalty imposed by that section is divisible into each activity underlying the imposition of the penalty. Because of the location in the Code of the 6700 and 6707 penalties as neighbors and the goals of the two penalties to stop tax shelters, the promoters here argued for the adoption of a similar rule of divisibility with respect to 6707.
The Court, accepting the argument of the IRS, explained that 6707 is a different type of penalty than 6700 because 6707 is based on one event – failing to list a tax shelter and not individual transactions of shelter promotion. While the 6707 penalty gets calculated based on the amount of money going through the promotion, the penalty itself does not spring from individual transactions with investors but rather with the promotion as a whole. Since the transaction sprang from the overall promotion and not from actions with respect to individual investors, the Court found that 6707 did not allow divisible payments. In defining what makes a tax or penalty divisible the Court stated divisibility applies “when ‘it represents the aggregate of taxes due on multiple transactions.’ Stated otherwise, divisible ‘taxes or penalties….are seen as merely the sum of several independent assessments triggered by separate transactions.’” The Court listed the specific taxes and penalties deemed divisible by judicially-created exceptions or by statute and found that 6707 is “not on the same footing as any of the taxpayers described in the exceptions set forth above.”
Other Routes to a Merit Determination – CDP
So, is there anything the promoters can do, short of full payment, to obtain judicial review of the IRS determination that they owe over $24 million in penalties? What if they requested a CDP hearing following the filing of the inevitable notice of federal tax lien or a notice of intent to levy? Does CDP provide a path to consideration of the merits unavailable through the divisible payment refund process? It appears that they can litigate the merits of this penalty using the CDP process though the path to that answer may not be as clear as one might like and the answer appears to turn on whether the taxpayer has administratively requested penalty abatement after the assessment.
In Lewis v. Commissioner the Court held that the post-assessment opportunity to appeal the penalty determination administratively provides the taxpayer with all of the relief needed to prevent them from litigating the merits of the liability in a subsequent CDP hearing stating “Respondent argues that pursuant to section 6330(c)(2)(B) and section 301.6330-1(e)(3), QA-E2, Proceed. Admin. Regs., where a taxpayer has an opportunity for a conference with respondent’s Appeals Office before a collection action has begun, then the amount and existence of the underlying tax liability can neither be raised properly in a collection review hearing nor on appeal to this Court.” The decision is based on an interpretation of Treas. Reg. §301-6330-1(e)(3), Q&A-E2. Guest blogger Lavar Taylor wrote passionately on the incorrectness of the Court’s interpretation of the regulation.
Nonetheless, a question exists concerning the interpretation of the regulation as it relates to the timing of the trip to Appeals. Lavar wrote about this and the trap for the unwary in his submission on behalf of the California State Bar entitled “Clarification of the Jurisdiction of the Tax Court to Decide the Merits of Tax Liabilities in Collection Due Process Cases and to Remand These Cases to the Office of Appeals.” The regulation the Tax Court interpreted in Lewis provides: “An opportunity to dispute the underlying liability includes a prior opportunity for a conference with Appeals that was offered either before or after the assessment of the liability. An opportunity for a conference with Appeals prior to the assessment of a tax subject to deficiency procedures is not a prior opportunity for this purpose.”
The taxpayer in Lewis sought abatement of the penalty after assessment. The denial of the abatement request would have afforded him an opportunity to go to Appeals to discuss the denial. That opportunity was a post-assessment opportunity of the type described in the first sentence of Q&A-E2. When you make this type of appeal, no judicial remedy exists.
Lavar concludes that
the regulation is a trap for the unwary. Taxpayers and unsophisticated representatives will generally be unaware that, by seeking an administrative review with the Office of Appeals of a penalty or other liability that can otherwise be challenged in a CDP appeal prior to submitting a CDP appeal, they are forfeiting their right to seek judicial review of the liability in the context of a CDP case.
Sophisticated taxpayers who wish to preserve their right to contest the liability in Tax Court in the context of a CDP case will simply refuse to submit a request for abatement of penalties prior to initiating a CDP appeal in response to the filing of a lien notice or the issuance of a notice of intent to levy.
The decision in Diversified Group states that the taxpayer chose not to go to Appeals to contest the penalty but that statement refers to a pre-assessment opportunity to go to Appeals. The decision is silent on whether the taxpayer has sought penalty abatement post-assessment. If not, it would appear that CDP would offer an opportunity to litigate this liability without first paying $24 million.
After Lewis a series of cases allow or discuss the ability to litigate the merits of a penalty in the CDP context. Because these cases do not discuss Lewis, they do not parse the Q&A in the regulation. It appears that either the IRS conceded jurisdiction because no post assessment request for abatement exits (although that is not clear from the cases) or the Lewis issue was simply overlooked. The first case in this alternative line is Williams v. Commissioner where a taxpayer sought to litigate his liability for an FBAR penalty. The Tax Court in dismissing the case for lack of jurisdiction because of the absence of a notice of deficiency or notice of determination also explored the CDP context. The discussion of the taxpayer’s ability to get in the Tax Court’s door in the CDP context is dicta and does not appear to address an issue raised by the taxpayer. The government did not raise the CDP issue. Because the collection options available to the government with respect to the FBAR penalty do not include filing a notice of federal tax lien or making a levy, CDP would never be an option for contesting this type of penalty and the Court went through the analysis to show that its doors were barred in the case before it and would always be shut to a determination on the merits of this type of penalty.
Next, a district court decision, harking back to the days when CDP cases could be heard in district court or Tax Court depending on the type of tax at issue, also addressed the issue in dicta. In D&M Painting, Corp. v. United States, the court indicated that taxpayers seeking an injunction to stop the IRS from collecting on an IRC 6707A penalty could not enjoin the IRS from collecting, in part, because they had the right to dispute the liability without paying first in a CDP hearing. The district court in D&M did not cite to Treas. Reg. §301-6330-1(e)(3), Q&A-E2.
Later that same year D&M is decided, the Tax Court looks at the possibility of CDP jurisdiction in another 6707A case. (There is a difference in the penalty between 6707 and 6707A; however, I cannot see how that difference would matter in the analysis here.) In Smith v. Commissioner, another regular T.C. opinion, the Tax Court says it does not have jurisdiction over 6707A cases in a deficiency proceeding similar to its finding in Williams regarding the FBAR penalty but, in dicta, states “we would presumably have jurisdiction to redetermine a liability challenge asserted by petitioners in a collection due process hearing.” The Court cites to Williams and to D&M. Again, no mention is made of the Lewis opinion or of the regulation and there is no indication, without going back and reading the documents filed by Chief Counsel’s office, that it agreed with or conceded this issue.
Yari v. Commissioner is another regular T.C. opinion in which the taxpayer seeks to contest the penalty in a CDP case. Taxpayer seeks to litigate the underlying 6707A penalty. The case was submitted fully stipulated and on the merits presented the issue of how to calculate the 6707A penalty. The Court states “the parties assume we have jurisdiction over the penalty issue in this case. But the Court has an independent obligation to determine whether it has jurisdiction.” So, Chief Counsel’s office did not raise the Lewis issue leading to the conclusion that no post-assessment abatement request occurred. The Court goes through an analysis concerning its jurisdiction citing to the Williams case and concluding that “Petitioner has not had an opportunity to dispute the amount of the penalty, and, consequently, we have jurisdiction to redetermine the amount of the penalty.” The Court cited to IRC 6330(c)(2)(B) but not to the underlying regulation. The use of the word opportunity raises the question of whether the taxpayer would always have the opportunity to make a post-assessment penalty abatement request and to appeal a denial and how that opportunity would color any decision.
Finally, in Gardner v. Commissioner decided in August, 2015, the Court in a 6700 penalty case brought under the CDP provisions accepts the concession of Chief Counsel’s office that petitioner did not have a prior opportunity to contest the liability. What makes this case different from the other post Lewis cases is that the Appeals Officer during the CDP hearing “declined to discuss the underlying liability, stating that Mr. Gardner had had a prior opportunity to dispute it but he had not done so and therefore was not permitted to raise the issue at the section 6330 hearing.” One presumes from the concession by Counsel that the Appeals Officer may have misread the regulation and its application in Lewis to the facts of this case.
The IRS has not abandoned Lewis despite Lavar’s plea to them. Lewis and the regulation make it unclear without more information whether the promoters here may be able to get into court to contest the penalties through the CDP process since their post-assessment activity regarding penalty abatement is unknown.
Another Route to Merits Determination – Bankruptcy
Assuming the promoters cannot get into Tax Court through the CDP process, one final chance at a judicial hearing on the merits of the penalty exists. I do not know the financial circumstances of the promoters. Bankruptcy offers a possible avenue to litigate the liability without paying; however, it comes with potentially high costs in other respects. Section 505(a) of the Bankruptcy Code permits debtors to litigate the merits of their tax liability either in pre or post-assessment status. If one or both of the promoters files bankruptcy, the possibility of a judicial review of the penalty prior to paying it exists.
As I mentioned at the outset, the requirement that a taxpayer pay $24 million in order to obtain judicial review of an IRS penalty determination without going into bankruptcy seems wrong. Yet, I agree with the reasoning of the Federal Circuit concerning the divisibility of the 6707 penalty under the Flora analysis. I agree with Lavar that the CDP regulation should change and the result in Lewis should change to allow for determinations on the merits of the penalty whenever the person upon whom the penalty is imposed has no opportunity for judicial review without full payment. Another fix is to rethink Flora. Maybe it’s time to retool the way taxpayers get into court.