We welcome Professor Caleb Smith from the University of Minnesota writing today about designated orders that might also have been Tax Court opinions. Each of the three case he discusses has a meaty order deciding the case at the summary judgment stage. These opinions cause me to wonder what distinguishes a case when it comes to writing an opinion which will get published and one that will not. Parties researching the issues presented here will need a significant amount of diligence to find the Court’s orders in these case. Having gone to significant effort to reach the conclusions in these cases, it would be nice for the Court to find a way to make its thinking more transparent. Keith
There was something of a deluge of designated orders after the shutdown, so in order to give adequate time to each (and to group them somewhat coherently) I decided to break the orders into two posts. Today is post one, which will focus on some of the interesting summary judgement orders.
At the end of January there were three orders involving summary judgment that are worth going into detail on as they bring up both interesting procedural and substantive issues. However, in keeping with the theme (and title) of this blog, focus will mostly be kept on the procedural aspects. Those interested in the underlying substantive law at issue would also do well to give the orders a close read.
Big Value, BIG Tax? H R B-Delaware, Inc. & Subsidiaries v. C.I.R., Dkt. # 28129-12
We begin with how to get summary judgment in the rarest of places: a valuation question. Judge Holmes begins the order with a note almost of incredulity on the petitioner’s motion for partial summary judgment: “The motion calls for the application of old case law to a half-century old contract, and seeks a ruling that there is no genuine dispute about a material fact — valuation of intangible assets — that is only rarely capable of decision through summary judgment.”
So, how do you get to summary judgment on a valuation issue -which by default tends to be a “material fact” at issue between the parties? Argue that the real material facts are already agreed upon such that a particular value results as a matter of law. How that works in this case is (briefly) as follows:
The “H R B” in petitioner’s caption is referring to the well-known tax preparation service H&R Block -and more specifically, the franchisees of national H&R Block. (Also for your daily dose of tax trivia, H&R Block apparently stands for/is named after Henry and Richard Bloch.) That the petitioners are franchisees of H&R Block is important because the case pretty much entirely deals with the valuation of franchise rights. At its core, the IRS is contending that the franchise rights of petitioner were worth about $28.5 million as of January 1, 2000, and the petitioner is arguing their franchise rights were worth… $0.
The valuation of the franchise rights on January 1, 2000 matters (a lot) because the petitioner converted from a C-Corp to an S-Corp effective of that date. I don’t deal with these conversions in practice (ever), but one of the lessons imprinted upon me from Corporate Tax lectures was that you can’t just jump back-and-forth without tax consequences. In particular, when you convert from subchapter C to subchapter S, you may contend with “unrecognized built-in gain (BIG)” consequences under IRC 1374(d)(1) later down the line. Essentially, you may have “BIG” tax if (1) at the time you convert from C to S you have assets with FMV in excess of your adjusted basis and then (2) you sell those assets within 10 years of conversion. Here, petitioner converted from C to S in 2000, and then sold all its assets back to H&R Block (national) in 2008 (i.e. within 10 years of conversion).
Petitioner reported BIG tax of roughly $4 million on the 2008 return, which apparently included tax on the franchise rights self-report to be worth at about $12 million. But the IRS did the favor of auditing the H&R Block franchisee, which led to a novel realization during litigation: the tax return was wrong in valuing the franchise rights at almost $12 million. It should have been $0. In other words, petitioner may have vastly over paid their taxes.
Back to the procedural aspects. How do we get to summary judgment on this valuation issue? The IRS argues you can’t because what we are dealing with (valuation) is a contested factual determination. Essentially, this implies that wherever valuation is at issue summary judgment is de facto inappropriate.
Petitioner, on the other hand, argues that the valuation at issue here (of the franchise rights) flows as a matter of law from the undisputed facts as well as some rather old case law. Specifically, petitioner points to Akers v. C.I.R., 6 T.C. 693 (1946) and the slightly more modern Zoringer v. C.I.R., 62 T.C. 435 (1974). Petitioner argues that under these cases (1) where an intangible asset is nontransferable, and (2) terminable under circumstances beyond their control, and (3) the existing business is not being transferred to a third party, the value of the intangible asset is $0 as a matter of law. Because the undisputed facts (namely, the contract in effect at the time of the conversion) show elements one and two, and because this case does not involve the transfer of the business to another party, the value of the franchise rights must be $0.
And Judge Holmes agrees. There can be no genuine dispute about the value of the franchise rights based on the undisputed facts and controlling law. Summary judgment is therefore appropriate. A BIG win for the petitioner in what appeared to be an uphill battle.
There is, frankly, a lot more going on in this case that could be of interest to practitioners that deal with valuation issues, BIG tax, and the like. But, as someone that focuses on procedure, I want to make one parting observation on that point. Although petitioner’s counsel did a wonderful job of researching the applicable tax law, note how the pre-litigation work also plays a large role in this outcome.
As a sophisticated party with a high-dollar and complicated tax issue, there is no doubt in my mind that this case resulted only after lengthy audit (the tax at issue, after all, is from 2008 and the petition was filed at the end of 2012). One of the things that (likely) resulted from the audit was a narrowing of the issues: it wasn’t simply a disagreement about petitioner’s intangible assets broadly, it was a disagreement about the franchise rights specifically. This is critically important to the success of the summary judgment motion.
One argument the IRS raises is that the motion should fail because it isn’t clear which intangible assets are even at issue (the petition just assigns error to the valuation of the intangible assets broadly). But petitioner is able to point to the notice of deficiency and Form 886-A that resulted from the audit, and which clearly states that the dispute is about the value of the “FMV of the Franchise Rights.” In other words, the IRS only put the franchise rights as the intangible asset at issue in the notice of deficiency, so it is necessarily the only intangible asset at issue in the case (barring amended pleadings from the IRS). And, for all the reasons detailed above, the franchise rights have a value that can be determined to be $0 as a matter of law, thus allowing for summary judgment.
Consistency in Law, or Consistency in Fact?: Deluca v. C.I.R., Dkt. # 584-18
In Deluca the Court is faced with another motion for summary judgment by the petitioner, again involving fairly convoluted and fact-intensive law: tax on prohibited transactions under IRC 4975. In the end, however it isn’t IRC 4975 that plays a starring role in the order, but the statute of limitations on assessment and an ill-fated IRS argument about the “duty of consistency.”
The agreed upon facts are fairly straightforward. Petitioners established a regular IRA, and then converted it to a Roth in 2010. The Roth IRA maintained an account with “National Iron Bank” presumably in Braavos (just kidding). The Roth IRA repeatedly made loans to petitioner from 2011 – 2016. Unfortunately, loans between a Roth IRA and a “disqualified person” are a big “no-no.” See IRC 4975(c)(1)(B) and IRC 4975(e)(2). When the creator and beneficiary of an IRA engages in a prohibited transaction the IRA essentially ceases to be. See IRC 408(e)(2)(A). Since petitioner definitely engaged in prohibited transactions in 2014, the IRS issued a notice of deficiency for that tax year finding a deemed distribution from the Roth IRA of almost $200,000.
Those of you paying close attention can probably see where the issue is. The first prohibited transaction took place in 2011. An IRA is not Schroedinger’s Cat: it either is or isn’t. In this case, it ceased to be in 2011, which is when the distribution should have been taxed. Presuming there was no fraud on the part of the petitioners (and that they mailed a return by April 15, 2012), the absolute latest the IRS could hope to issue a Notice of Deficiency for that tax year would be April 15, 2018 (i.e. six years after the return was deemed filed, if it was a substantial omission of income: see IRC 6501(e). We are currently in 2019, so this spells trouble for the IRS.
But perhaps the IRS can avoid catastrophe here, in what appears (to some) to be an unfair result. The petitioners were never taxed on the prohibited transaction that took place in 2011 (they did not report it on their return), and now they are taking the position that the transaction took place then? What about consistency? Maybe the IRA is like Schrodinger’s cat after all: not really dead, but not really alive, but somewhere in-between because no one thought to look into it until 2014?
Fairness and the duty of consistency certainly seem to go hand-in-hand. The Tax Court has described the “duty of consistency” as “based on the theory that the taxpayer owes the Commissioner the duty to be consistent in the tax treatment of items and will not be permitted to benefit from the taxpayer’s own prior error or omission.” Cluck v. C.I.R., 105 T.C. 324 (1995). Generally, the elements of a taxpayer’s duty of consistency are that they (1) made a representation or reported an item for tax purposes in one year, (2) the IRS relied on that representation (or just let it be), and (3) after that statute of limitations on that year has passed, the taxpayer wants to change their earlier representation. Id. In Deluca, the IRS may argue the taxpayer (1) represented that the IRA still existed/that there was no prohibited distribution in 2011 (or any year after), (2) the IRS acquiesced in that position by leaving the earlier returns unaudited, and (3) only now that the ASED has passed does the taxpayer say there was a prohibited transaction. Seems like a reasonable argument to me.
Alas, it is not to be. Under the Golsen rule, because the case is appealable to the 2nd Circuit, that court’s law controls. The Second Circuit has held (way back in 1943, in an opinion by Judge Hand I find somewhat difficult to parse) that in deficiency cases the duty of consistency only applies to inconsistencies of fact, not inconsistent positions on questions of law. Bennet v. Helvering, 137 F.2d 537 (2nd Cir. 1943). Why does that matter? Because summary judgment is all about framing the issue as a matter of law, not fact.
Was Petitioner inconsistent on a matter of fact or a matter of law? On all of the returns (and in repaying the loans to the IRA) petitioner has appeared to have treated the IRA consistently as being in existence. Petitioner, in other words, has consistently behaved as if the “fact” was that the IRA was in existence. Because of the intricacies of IRC 408 and 4975, however, that fact was mistaken (even if treated consistently). As a matter of law the IRA ceased existing in 2011. And (apparently) petitioner is free to presently take the legal position that the IRA ceased existing in 2011 while also implicitly taking the (inconsistent) position that it did exist on that tax return.
If your head is spinning you are not alone.
However, if this appears to be an unfair result and sympathize with the IRS’s position, there is at least some concern to be aware of. Judge Thornton succinctly addresses one issue lurking behind the IRS’s position: “To adopt respondent’s position would essentially mean rewriting the statute [IRC 408(e)(2)] to postpone the consequences of prohibited transactions indefinitely into the future, depending on when the IRS might happen to discover them.” In other words, the cat would be neither alive or dead until and unless the IRS decided to take a look. The duty of consistency would almost write the assessment statute of limitations out of existence under such a reading.
Uncharted Waters of International Law: Emilio Express, Inc. Et. Al, v. C.I.R., Dkt. 14949-10
Two wins on two taxpayer motions for summary judgment: might the government go 0 for 3? As a matter of substantive law, Emilio Express, Inc. is probably the most compelling order of the three. It is also the only one where the IRS makes a cross-motion for summary judgment -and wins.
The substantive law at issue is well-beyond my expertise (I’m not in the “international-tax cloister” that Judge Holmes refers to while helpfully describing what “competent authority” means). I highly recommend that those who so cloistered, and particularly those that regularly work with Mexican tax issues, give this order a closer look. It appears to be an issue of first impression.
But, again in keeping with the procedural focus of this blog, we will focus on the cross motions for summary judgment. Again, we will look at the framing of the motions, and the facts established to understand why the petitioner’s motion for summary judgment was doomed, and the IRS’s was ultimately successful.
The consolidated cases in this order involve a C-Corporation (later converted to S-Corp.) “Emilio Express” as well as individual tax return of the sole shareholder, Emilo Torres Luque. Mr. Torres was a Mexican national and permanent resident of the United States. Mr. Torres did essentially all of his business moving cargo between Tijuana and southern California -the latter being where he appeared to live.
The gist of the issue is that the petitioner is arguing he owes no US Tax because he was (1) a resident of Mexico under the terms of the relevant US-Mexico treaty, (2) Mexico accepted his tax returns as filed for the years at issue, and (3) on their understanding of the treaty, their income should only be taxed by Mexico (in whatever amount Mexico determines) and not “double-taxed” by the US. Apart from needing to be correct on their understanding of the substantive law, for petitioner to prevail this motion for summary judgment they would have to show that there was no genuine issue of material fact.
The factual questions surrounding Petitioner’s residency matters because it is critical to how they frame the legal argument: as their argument goes if their residency is in Mexico, then the fact that Mexico accepted their tax returns means they are not subject to US income tax. The immediate problem is that determining their residency is a highly factual inquiry, with a lot of contested aspects. Everyone is in agreement that under the terms of the treaty petitioner is a “resident” of both the US and Mexico. There are additional rules under the treaty for determining “residency” where the taxpayer is, essentially, a dual-resident. Here, the petitioner needed to show that he had a “permanent home” in Mexico. Unfortunately, there was a legitimate question about exactly that matter raised by the IRS. And since that was a material fact that would need further development, petitioner’s summary judgment motion can be disposed of without even getting to whether the law would be favorable.
So how does the IRS prevail on a summary judgment motion if, as just stated above, there was a genuine issue on material fact? Because the IRS’s (winning) argument makes that fact (residency) immaterial.
As the IRS frames the issue, the residency of the petitioner (Mexico or US) is irrelevant: the law at issue really just concerns whether the individual is subject to double-taxation. In this case, the petitioner had no Mexican tax liability (the accepted returns had a $0 liability) so regardless of residency under the treaty, petitioner could be subject to US tax. The thrust of the treaty is all about double-taxation, which is the key issue here and can be resolved (based on the other agreed-upon facts) without delving into whether or not the petitioner owned a home in Tijuana. He didn’t owe Mexican tax under Mexican law. He does owe US tax under US law. Case closed.
All very interesting stuff. Again, if you work with international tax (and particularly Mexican-American tax) I recommend giving the order a closer look for the substantive issues at play.