Tax Notes logo

DOJ in 9th Cir. Seeks to Keep Penalty Improperly Computed Under Rand Because of Taxpayers’ Failure to Timely Plead the Computation Error

Posted on July 14, 2014

We welcome back guest blogger Carl Smith who updates us on continuing litigation and fallout from last year’s Rand decision. Les

In a post last month, Keith Fogg announced that the DOJ had terminated, with prejudice, its protective Seventh Circuit appeal of the Tax Court’s opinion in Rand v. Commissioner, 141 T.C. No. 12 (Nov. 18, 2013).  In Rand, an en banc Tax Court held that disallowed refundable tax credits do not form part of the “underpayment” that is the base of the accuracy-related penalty, except to the limited extent that the credits were used to reduce tax down to zero.  In a post of mine Seven Tax Court Judges Depart From the Court’s Pleading Precedents from March 24, I had noted that, since Rand, Tax Court Judges in about ten cases involving pro se taxpayers had removed (or, in orders to show cause, threatened to remove) penalties not computed in accordance with Rand — even though the taxpayers in those cases did not raise the underpayment issue in their pleadings.  Some of those cases were regular cases that could have been appealed either on the issues of (1) the proper amount of the penalty (i.e., whether Rand was correctly decided) or (2) the judges’ not following their pleading precedents that hold that the failure to plead penalties in a petition — even after the enactment of section 7491(c) imposing the burden of production on penalties on the IRS — results in a concession of the penalties, not requiring the IRS to met any burden of production.  This post is an update on the appeal situation in the cases other than Rand — a situation which is not as uniform as one might hope.

Before giving the update, though, I wanted to point out that the Tax Court has, since my last Rand post in late March, continued to remove penalties computed inconsistently with Rand, despite the pro se taxpayers’ failure to mention penalties in their petitions.  In three of those cases, on April 15, 2014, Judge Gale issued orders and decisions in regular cases subject to appeal.  Faecher, Docket No. 16049-12; Mendelsohn, Docket No. 10497-11; and Tauber, Docket No. 15816-12.  In one of those cases, Faecher, on November 21, 2013, the judge had issued an order to show cause why the penalties should not be recomputed in accordance with Rand.  In a filing on January 2, 2014, the IRS argued that the penalties shouldn’t be recomputed — both because Rand was wrongly decided and because the Tax Court’s pleading precedents should have resulted in the penalties having been conceded, since the errors in the penalties were not pleaded in the petition. In each of the three orders and decision issued in those cases on April 15, 2014, Judge Gale addressed the question of whether the Tax Court’s pleading precedents allowed him to remove the penalties in the absence of the taxpayers having mentioned the penalties in their petitions.  Here is what he wrote in the Faecher order and decision (which is similar to his language in the other two orders and decisions):

The Commissioner generally bears the burden of production with respect to the liability of any individual for any penalty or addition to tax. Sec. 7491(c).  However, we have held that where the taxpayer fails to state a claim with respect to a penalty or addition to tax, the Commissioner incurs no obligation to produce evidence in support of the individual’s liability pursuant to section 7491(c), see Funk v. Commissioner, 123 T.C. 213, 216-218 (2004); Swain v. Commissioner, 118 T.C. 358, 364-365 (2002), at least where nothing in the record suggests the addition or penalty has been incorrectly computed.  Where, as here, the record demonstrates that the penalty sought by respondent is erroneously calculated, we conclude that it should not be sustained, without regard to whether petitioner has stated a claim in the petition concerning the penalty.

In effect, Judge Gale made a new exception to the Swain and Funk pleading holdings for situations where the record shows an erroneous calculation.  Under this exception, the court should fix computational errors, even if they are not pleaded by taxpayers.

The time to appeal the April 15, 2014 orders and decisions in Faecher, Mendelsohn, and Tauber expires today (July 14), and I suspect the IRS will let that time run.  Why?

Because the IRS has already let the time run to appeal orders in all three other regular cases where the Tax Court had removed the penalties (in accordance with Rand) from pro se taxpayers who had not mentioned penalties in their petitions.  See Bey, Docket No. 3469-13 (order of dismissal and decision, dated March 11, 2014); Aumann, Docket No. 23021-10 (order and decision, dated March 12, 2014, entering modified proposed stipulated decision); and Bukshpan, Docket No. 24533-10 (order and decision, dated March 13, 2014, entering modified proposed stipulated decision).  These cases could have been appealed to either the Fourth Circuit (Bey) or the D.C. Circuit (Aumann and Bukshpan).  But, it is now too late to do so.  The 90-day periods have run.

So, is that the end of all litigation in these Rand-type cases?  Unfortunately, no.

There are companion cases (of a former husband and wife) in which I am pro bono counsel of record, Morales v. Commissioner, T.C. Memo. 2012-341, supplemented by T.C. Memo. 2013-192.  The Moraleses had filed pro se petitions in the Tax Court.  Judge Kroupa found that they had improperly claimed first-time homebuyer credits and were liable for accuracy-related penalties on the deficiencies because of negligence.  After her 2012 opinion was issued, in early 2013, I entered appearances for the Moraleses and timely moved to reconsider the opinion.  I argued that section 7491(c) imposed on the IRS the burden of production on penalties and that burden included showing there was an “underpayment.”  Making the same arguments being made in Rand, I argued there were no underpayments from the disallowed credits because the improper credits did not reduce the Moraleses’ tax liabilities; the credits only generated refunds.  In her second opinion in the case, Judge Kroupa denied the motion for reconsideration — even though she was aware that the Rand case was then pending and might result in a taxpayer-favorable ruling.  Citing the Swain and Funk cases that Judge Gale recently distinguished above, she ruled both that the Moraleses had conceded the Rand issue because they had not raised it in their pleadings (they only complained generally of penalties) and because a motion for reconsideration was not the proper place for raising what she held to be a new issue.

Prof. Elizabeth Goldman of Cardozo School of Law and I filed appeals to the Ninth Circuit of Judge Kroupa’s Morales II ruling refusing to take off the penalties on the ground of lack of any underpayment.  On April 2, 2014, we submitted our opening brief in the appeal.  In it, we argued both that there were no underpayments (i.e., Rand was right) and that Judge Kroupa abused her discretion in not removing the penalties.  After June 10, 2014, when the DOJ conceded its appeal in Rand, we assumed that the DOJ would stop trying to assess the similarly-miscomputed penalties in Morales.  But, we were wrong.

The DOJ has continued to defend the Morales appeal.  In a brief filed on June 19, 2014, in the cases, the DOJ does not argue that Rand was incorrectly decided.  Rather, it relies on Judge Kroupa’s ruling that, procedurally, the Moraleses raised the underpayment issue too late.  The DOJ also takes great exception to the Moraleses, in their briefs, asking the Ninth Circuit to take judicial notice of all the other cases in which the IRS is no longer trying to seek miscomputed penalties — cases in which the taxpayers also never raised the Rand issue in their pleadings.

Frankly, I am both astonished and offended by the DOJ position in Morales.  I think it borders on a violation of the Moraleses’ right to Equal Protection in administration of the laws.  Why should the Moraleses have to pay a penalty that the IRS is now conceding was incorrectly computed and where the IRS is no longer trying to collect similarly-miscomputed penalties from other Tax Court petitioners who likewise never raised the penalty computation issue in their pleadings?

In any event, this means that there is now a case where an appellate court will, for the first time, address the interaction of (a) section 7491(c)’s rule imposing the burden of production on penalties on the IRS with (b) the Tax Court’s Rule 34(b)(4) providing that issues not raised in pleadings are conceded.  Prof. Goldman and I will be arguing that the Tax Court got that interaction wrong in Swain and Funk and that 7491(c)’s rule trumps Rule 34(b)(4)’s rules where penalties are involved.  After all, Rule 34 is simply one of the Tax Court rules authorized by section 7453, and 7491(c) says it applies “[n]otwithstanding any other provision of this title”.  We contend that, after 7491(c)’s enactment, if an individual attaches a notice of deficiency including penalties to her petition, the IRS should bear the burden of production on all penalty sub-issues (save for those defenses like reasonable cause and substantial authority mentioned in the legislative history), whether or not the taxpayer mentions penalties in her petition.  Knowing that the vast majority of Tax Court petitions are filed pro se, we don’t think Congress intended a provision shifting the burden of production on penalties to benefit only rich taxpayers who can afford to retain counsel who know how to plead penalty subissues in their petitions.

The Tax Court opinions in Swain and Funk were decided only with briefing from the IRS on the penalty pleading issue.  Perhaps for the lack of anyone arguing for the taxpayers in those cases, we think the Tax Court got its precedent on this issue wrong.

Of course, if the Ninth Circuit just wants to hold that Judge Gale’s new exception to Swain and Funk — i.e., where evidence in the record reflects a miscalculation, the court should intervene — applies to the Moraleses, the Moraleses would be happy enough with that.

Subject Areas / Tax Topics
Copy RID