In Interior Glass Systems, Inc. v. United States, No. 17-15713 (9th Cir. 2019) the court held that a taxpayer against whom the IRS had assessed an IRC 6707A listed transaction penalty could not have the penalty abated on the basis that the pre-litigation assessment and collection of the penalty violated due process. The decision does not break new ground and in some respects the appeal of this issue surprised me because I thought the law well settled here. In part, I write about this case because the first factor of the three factors the court uses to analyze whether a violation of due process exists, intrigues me when applied to cases such as the case of Larson v. United States, 888 F.3d 578 (2nd Cir. 2017) blogged here.
The company joined a Group Life Insurance Term Plan to fund a cash-value life insurance policy owned by its sole shareholder and only employee. The IRS applied the tests in Notice 2007-83 in determining that participating in the cash-value life insurance policy involved a listed transaction. Because the taxpayer did not alert the IRS of its participation in a listed transaction, the IRS imposed three $10,000 penalties, one for each year of participation, pursuant to IRC 6707A(a). The taxpayer paid the $30,000 and sued for a refund of the money paid on the penalties. The taxpayer’s first and perhaps primary argument addressed the application of the listed transaction provisions to the facts of its case. Taxpayer argued unsuccessfully that it was not a listed transaction.
The taxpayer’s second argument concerned due process. The 6707A penalty is one of many assessable penalties added by Congress in the last few decades. Once the IRS determines that the taxpayer has engaged in the activity controlled by the penalty, Congress authorized the IRS to assess the penalty prior to giving the taxpayer the opportunity to litigate the correctness of the penalty in a pre-assessment setting. Assessable penalties allow the IRS to move quickly to impose a liability on what it perceives as wrongdoing but the process also causes the taxpayer to lose the opportunity to judicially contest the matter without first paying the penalty (or for some divisible penalties a portion of the penalty.
The 9th Circuit cites to Flora v. United States, 362, U.S. 145, 177 (1960) for the proposition that the taxpayer first had to pay the penalty in order to get into court. It then provides the general rule that the “government may require a taxpayer who disputes his tax liability to pay upfront before seeking judicial review. Standard stuff. In support of its statement that the government can require a taxpayer to pay first before litigating, the court cites Phillips v. Commissioner, 283 U.S. 589, 595 (1931) as well as one of its own cases Franceschi v. Yee, 887 F.3d 927, 936 (9th Cir. 2018). It points to Jolly v. United States, 764 F.2d 642 (9th Cir. 1985) as establishing a three-factor test based on Mathews v. Eldridge, 424 U.S. 319 (1976) for deciding whether a taxpayer is “entitled to pre-collection judicial review of a tax penalty.
Factor one concerns “the private interest that will be affected by the official action.” With respect to this factor, the 9th Circuit finds that the taxpayer’s private interest will not significantly suffer since the post-deprivation proceedings will provide full retroactive relief if the taxpayer prevails in its refund suit. The court says this is not a case in which an individual faces abject poverty in the interim citing Goldberg v. Kelly, 397 U.S. 254, 264 (1970). That seems true in the case of Interior Glass but how does this test work in assessable penalty cases such as Larson in which the taxpayer must pay $60 or $160 million in order to bring the refund suit. Maybe the court would say that the requirement to make such a payment would not send the taxpayer into abject poverty because the taxpayer has no possibility of making such a payment. The Second Circuit did not apply this three factor test when asked to allow a taxpayer into court in Larson faced with the ridiculously high liability. It seems that this test could aid a taxpayer owing a huge amount even though it did not aid Interior Glass where the amount owed was only $10,000 for each of three years.
Factor two concerns the “risk of an erroneous deprivation of the private interest.” Here the court found that deciding if a penalty should apply did not involve a difficult task. Instead it simply involved comparing the language of the transaction with the language of the notice regarding listed transactions in a setting in which “the IRS is therefore unlikely to err in the generality of cases.” Further mitigating the possibility of a problem here is the opportunity the taxpayer has for an administrative appeal as the taxpayer had in Larson. The court does not mention, and did not need to mention, that in Larson the taxpayer raised some issues that would require testimony to resolve and may not lend themselves to an easy determination. In this same paragraph of the opinion the court extolled the benefits of this administrative opportunity to appeal and cited the Collection Due Process (CDP) cases of Lewis v. Commissioner, 128 T.C. 48, 59-60 (2007) and Our Country Home Enterprises, Inc. v. Commissioner, 855 F.3d 773, 781 (7th Cir. 2017) in which the courts turned away taxpayers seeking to use CDP as a means of litigating the merits of the liability prior to paying the tax because of their opportunity to talk with the Appeals Office.
Factor three measures the “government’s interest in retaining the full-payment prerequisite to this refund action.” The court cited the difficulty of learning about listed transactions that taxpayers do not self-identify and how IRC 6707A encouraged voluntary disclosure of such transactions. It went on to say this objective would be jeopardized if taxpayers had a pre-payment forum in which to litigate the proposed penalty. I wonder why assessable penalties are more important than tax itself. Congress gives taxpayers the right to a pre-payment forum prior to assessment of income tax. Penalties do not seem more important to the government or its operation than income tax.
The outcome here is not surprising. On factor one I would like to see an analysis of this factor in a case like Larson where the payment of the tax is a monetary impossibility. Does the impossibility of making a payment cause it to slip outside something that would impact the party’s interest and therefore not impact the person from a due process perspective?