Frequent contributor Carlton Smith discusses last month’s Larson v United States out of the Second Circuit. The Larson opinion situates civil penalties in the context of the Flora full payment rule, the APA, the 5th Amendment’s procedural due process protections and the 8th Amendment’s prohibition on excessive fines. Today’s post looks at the Flora full payment issue. Future posts will address the other issues. Les
In Flora v. United States, 357 U.S. 63 (1958) (“Flora I”), and, again, in an expanded opinion at 362 U.S. 145 (1960) (“Flora II”), the Supreme Court held that a jurisdictional predicate to a district court or Court of Federal Claims suit under 28 U.S.C. § 1346(a)(1) for refund of an income tax deficiency is full payment of the tax deficiency. In oral argument in a later Supreme Court case, Laing v. United States, 423 U.S. 161 (1976), the Solicitor General’s office made clear its position that Flora’s full payment requirement only applies where the taxpayer could have, instead, petitioned the Tax Court to contest the deficiency prepayment, but chose not to. A recent opinion, Larson v. United States, 2018 U.S. App. LEXIS 10418 (2d Cir., Apr. 25, 2018), involved a tax shelter promoter penalty assessed under section 6707 – one of the many “assessable” penalties that Congress has enacted since Flora that may be assessed without first allowing prepayment review in Tax Court through a notice of deficiency. In Larson, the DOJ argued contrary to what the SG’s office did in Laing, and the Second Circuit accepted this changed position – holding that the Florafull payment requirement also applies to assessable penalties for which there is no possibility of Tax Court prepayment review through deficiency procedures.
The facts of Larson were as follows: Larson was criminally convicted in connection with promoting several tax shelters. The IRS later decided to impose assessable penalties under section 6707 for the promoters’ failure to file the necessary form under section 6111 (Form 8918) with the Office of Tax Shelter Analysis in Ogden, Utah alerting the IRS to the shelters. Under section 6707 at the time (though not currently), the penalty under section 6707 was calculated as 1% of “the aggregate amount [that taxpayers] invested in such tax shelter”.
The IRS proposed to assess penalties of $160 million on a collection of promoters (including Larson), jointly and severally. This means that the “aggregate amount invested”, according to the IRS, was $16 billion.
Other promoters paid the IRS about $100 million toward the penalty. Larson contested the $160 million penalty at Appeals, arguing that the amount actually invested in the shelters in cash was only about $700 million, meaning the total penalty should be $7 million. The rest “invested” was through notes that the courts had now held to be bogus for income tax purposes, so he argued that they were bogus, as well, for purposes of calculating the penalty. (Of course, the taxpayers must have used those bogus notes to inflate their bases for purposes of claiming deductions far beyond the cash they invested.)
Appeals did not agree with Larson’s argument for lowering the penalties to $7 million, though it did give him credit for the penalties already paid by other promoters, reducing what Larson owed to about $60 million.
Larson District Court Suit
Larson paid $1.4 million toward the penalties, filed a refund claim, and then sued for a refund in the district court of the Southern District of New York. It is not clear why he paid $1.4 million, but it appears that he thought the section 6707 penalty was “divisible”, and that $1.4 million was enough payment of a divisible tax to give the court jurisdiction. In a footnote in Flora II, the Supreme Court said that full payment would not be required if a divisible tax was involved — a footnote that many people take advantage of with respect to section 6672 responsible person penalties (which have been held to be divisible).
In his suit, Larson argued that he had made a sufficient jurisdictional payment to commence suit, but that, even if he did not, the court had alternative jurisdiction under the Administrative Procedure Act, mandamus, Due Process, and because the size of the penalty violated the Eight Amendment’s excessive fines clause.
Unfortunately for Larson, shortly after he commenced his suit, the Federal Circuit held in Diversified Group Inc. v. United States, 841 F.3d 975 (Fed. Cir. 2016), that the section 6707 penalty was not divisible, so Flora IIrequired full payment in order to commence a refund suit. The district court in Larson cited and followed Diversified Group, also rejecting all the other bases for jurisdiction that Larson alleged. Larson v. United States, 2016 U.S. Dist. LEXIS 179314 (SDNY 2016). Stephen did a prior post on both Diversified and the Larson district court opinion.
This post will not address the other grounds alleged for jurisdiction, but Les will be doing a later post on at least one of those other grounds.
Larson Appellate Arguments
In his Second Circuit Appeal, Larson repeated all of his arguments for why the district court had jurisdiction, but abandoned his argument that section 6707 penalties are divisible. Rather, Larson’s main argument was now that Flora II did not require full payment in a case like section 6707 penalties where no prepayment review was available in the Tax Court through a notice of deficiency. Larson also argued that he couldn’t afford to pay the roughly $60 million left to make full payment, so requiring him to make full payment would leave him without a practical remedy for judicial review.
Flora II expanded upon the opinion in Flora Iand corrected a significant misstatement in the earlier opinion. Hereafter, I will discuss only Flora II. In Flora II, the IRS had sent the taxpayer a notice of deficiency for income tax. He did not file a Tax Court petition, but rather paid part of the deficiency, filed a refund claim, and brought suit for refund in district court. The Supreme Court held that a jurisdictional predicate to a refund suit under 28 U.S.C. § 1346(a)(1) is full payment of the tax. But, the way it got to this holding was curious.
The statute being interpreted first appeared in the Revenue Act of 1921. But, the court found that, even though there were statutory antecedents, with regard to whether full payment is required for a refund suit, the actual “statutory language . . . is inconclusive and legislative history . . . is irrelevant”. Flora II, 362 U.S. at 152.
So, the Court then turned to three subsequent enactments of Congress to conclude that section 1346(a)(1) required full payment:
- The establishment of the Board of Tax Appeals in 1924, which allowed taxpayers to contest deficiencies without prepayment, seemed to be done with the assumption that the Board was needed because refund suits concerning deficiencies otherwise required full payment.
- In 1935, Congress amended the Declaratory Judgment Act (28 U.S.C. § 2201) to prohibit declaratory judgments “with respect to taxes”. The Court noted that if full payment were not required, then nothing would stop a taxpayer from paying $1, filing a refund claim, and suing for a refund. The latter would effectively be a suit for a declaratory judgment.
- The adoption of section 7422(e), which provides that, if a refund lawsuit is underway when the taxpayer receives a notice of deficiency for the same taxable year, the taxpayer may either continue the suit in district court or move it to the Tax Court, but not litigate simultaneously in both courts.The Court concluded that the logic of not requiring full payment for a refund suit would be that a taxpayer could simultaneously conduct a deficiency suit in the Tax Court and a refund suit in the district court – a situation that section 7422(e) does not contemplate.
The Flora II court concluded with the following observation:
A word should also be said about the argument that requiring taxpayers to pay the full assessments before bringing suits will subject some of them to great hardship. This contention seems to ignore entirely the right of the taxpayer to appeal the deficiency to the Tax Court without paying a cent. If he permits his time for filing such an appeal to expire, he can hardly complain that he has been unjustly treated, for he is in precisely the same position as any other person who is barred by a statute of limitations.
362 U.S. at 175 (footnote omitted).
Laing v. United States, 423 U.S. 161(1976), involved income tax termination and jeopardy assessments under section 6851 and 6861 at a time when those sections did not state that the IRS must issue a notice of deficiency in connection with making such assessments. The IRS had made such an assessment and argued that it was not required to issue a notice of deficiency before or after the assessment.
At the oral argument, the Solicitor General’s Office assured the Court that there would be no problem with the FloraII full payment rule, since Flora II did not require full payment if no deficiency notice could be sent to the taxpayer. Here is a portion of the SG’s office oral argument that was quoted to the Second Circuit on page 6 of the Larson reply brief:
What this Court held in Flora was that under general circumstances a taxpayer cannot bring a refund suit until he has paid the full amount of the assessment. In reaching that decision, the Court painstakingly went through the legislative history in connection with the creation of the Board of Tax Appeals, and there were indications going both ways as to what Congress really intended. But I think that the really operative portion of the Chief Justice’[s] opinion in Flora was the fact that there the taxpayer had another remedy. He could have gone to the Tax Court, and that made all the difference in Flora . . . .
For those interested, attached are all the briefs filed in Larson: the appellant’s brief, the appellee’s brief, the reply brief(which contains the entire Laing oral argument transcript as an addendum), and an amicus brieffiled by the tax clinics at Harvard and Georgia State. I believe that Keith will be doing a further post about what the amicus brief discussed.
The majority in Laing held that the IRS was required to send a notice of deficiency, so it did not reach the issue of whether Flora II required full payment for a refund suit in the absence of the possibility of receiving a notice of deficiency.
But, Justice Blackmun (joined by Chief Justice Berger and Justice Rehnquist) wrote a lengthy dissent in which he argued that no notice of deficiency was required in connection with a termination or jeopardy assessment. However, he concluded that the taxpayer could bring suit in district court without full payment of the assessment. After quoting part of the quote that I have quoted above from Flora II, Justice Blackmun wrote:
This passage demonstrates that the full-payment rule applies only where a deficiency has been noticed, that is, only where the taxpayer has access to the Tax Court for redetermination prior to payment. This is the thrust of the ruling in Flora, which was concerned with the possibility, otherwise, of splitting actions between, and overlapping jurisdiction of, the Tax Court and the district court. Where, as here, in these terminated period situations, there is no deficiency and no consequent right of access to the Tax Court, there is and can be no requirement of full payment in order to institute a refund suit.
423 U.S. at 208-209 (citation omitted).
Larson Second Circuit Ruling
In its opinion in Larson, the Second Circuit held that Flora II required the full payment of the section 6707 penalty before a refund suit could be brought. It quoted the passage from Flora IIthat I have quoted above, yet argued that the availability of Tax Court deficiency review was not critical to the holding of Flora II. The Second Circuit wrote:
While it is true that Flora I and Flora II acknowledge the existence and availability of Tax Court review, see Flora I, 357 U.S. at 75–76; Flora II, 362 U.S. at 175, Tax Court availability was not essential to the Supreme Court’s conclusion in either opinion. The basis of the Flora decisions is that when Congress enacted § 1346(a)(1) it understood the statute to require full‐payment to maintain “the harmony of our carefully structured twentieth century system of tax litigation,” not that the full‐payment rule only applies when Tax Court review is available. Flora II, 362 U.S. at 176–77.
Slip op. at 10.
The Larson court did not acknowledge that the government had changed position as to the applicability of the full payment rule between Laingto Larson. The Larson court did quote Justice Blackmun’s statements from his dissent in Laing, but noted: “Justice Blackmun’s view did not garner majority support. No subsequent majority of the Supreme Court has adopted that understanding of the statute.” Slip op. at 12 n.8.
As more evidence that full payment was required to commence the section 6707 refund suit, the Second Circuit noted that other assessable penalties have been enacted by Congress since Flora II with specific provisions that allow for payment of 15% before a refund suit can be commenced. (“[O]ur reading is supported by Congress’s decision to provide partial payment review for other assessable penalties, but not for § 6707. See 26 U.S.C. §§ 6694(c), 6703(c).” Slip op. at 8.)
After rejecting the other bases alleged by Larson for jurisdiction (which I won’t discuss here), the court concluded that this is a problem for Congress, writing:
We close with a final thought. The notion that a taxpayer can be assessed a penalty of $61 million or more without any judicial review unless he first pays the penalty in full seems troubling, particularly where, as Larson alleges here, the taxpayer is unable to do so. But, “[w]hile the Flora rule may result in economic hardship in some cases, it is Congress’ responsibility to amend the law.” Rocovich v. United States, 933 F.2d 991, 995 (Fed. Cir. 1991).
Slip op. at 22.
The most surprising thing about the Larson opinion, to me, is that this issue of Flora’s application to assessable penalties has not been litigated before – i.e., until about 60 years later. But, then most assessable penalties are either severable, require only 15% payment to commence suit, or are rather nominal in amount, so there were few in a position to argue that a full payment requirement to commence an assessable penalty refund suit was neither required by Flora II nor economically practicable.
The second most surprising thing is that both Flora II and Larson defend their statutory interpretation exclusively by reference to understandings of later Congresses when legislating. I have always read that one is not to pay much attention to what later Congresses think a statute means.
But, ultimately, I was not surprised at the Larson ruling, and I don’t think Keith was either. I refer people to my statutory proposal made some years ago: “Let the Poor Sue for a Refund Without Full Payment”, Tax Notes Today, 2009 TNT 191-4 (Oct. 6, 2009). Although my proposal was designed primarily for the poor, it would help Larson (assuming that he gets himself on an installment agreement or in currently not collectible status first). The opinion in Larson just underscores the need for a legislative fix.