Focus On Tax Controversy And Litigation - July 2014

In addition to a discussion of the Supreme Court's recent decision in Clarke, this month's issue features articles regarding the Southern District of New York's decision in Schaeffler, which denied attorney-client privilege and work product protection to a tax memorandum circulated to a bank consortium, the IRS's recent announcement to expand the OVDP streamlined program to include resident US taxpayers, developments in connection with OECD's BEPS Action Plan, welcomed changes to Circular 230 covered opinion rules, and criminal sentencing of a former partner at Jenkens & Gilchrist in connection with tax shelter activities.

Supreme Court Limits A Taxpayer's Ability To Examine The IRS At A Summons Enforcement Hearing

By Richard A Nessler

On June 19, 2014, the United States Supreme Court held that a taxpayer has a right to examine IRS officials regarding their purpose of issuing a summons.1 However, in reversing and vacating an Eleventh Circuit's decision, the Supreme Court did not recognize a taxpayer's right to a formal hearing based on unsupported allegations that the summons was issued in bad faith. The Supreme Court found that the Eleventh Circuit erred in ruling that a bare allegation of improper purpose was sufficient to question IRS officials and remanded the case to the circuit court for further consideration in light of the Supreme Court's decision.

The summons dispute arose from an IRS examination of the tax returns of Dynamo Holdings Limited Partnership (Dynamo) for the 2005–2007 tax years. The IRS questioned interest expenses that those returns had reported. As its investigation proceeded, Dynamo agreed to two year-long extensions of the usual 3-year limitations period for assessing tax liability. In 2010, with that period again drawing to a close, Dynamo refused to grant the IRS a third extension. Shortly thereafter, in September and October 2010, the IRS issued summonses to the respondents, four individuals associated with Dynamo whom the Service believed had information and records relevant to Dynamo's tax obligations. None of the respondents complied with those summonses.

In December 2010 (within the limitations period), the IRS issued a Final Partnership Administrative Adjustment proposing changes to Dynamo's returns that would result in greater tax liability. Dynamo responded by filing suit in the United States Tax Court to challenge the adjustments. While that litigation was pending, a few months later, the IRS instituted proceedings in District Court to compel the respondents to comply with the summonses. In the enforcement proceeding respondents disputed the IRS's reasons for issuing the summonses. The IRS submitted the usual investigating agent's affidavit attesting to the Powell factors; among other things, the declaration maintained that the testimony and records sought were necessary to "properly investigate the correctness of [Dynamo's] federal tax reporting" and that the summonses were "not issued to harass or for any other improper purpose."2 In reply, the respondents pointed to circumstantial evidence that, in their view, suggested "ulterior motive[s]" of two different kinds.3

In response, the respondents asserted that the IRS issued the summonses to punish the taxpayer for refusing to agree to a further extension of the applicable statute of limitations. In particular, respondents alleged in sworn declarations that after Dynamo refused to grant a third extension of time, the IRS, "despite having not asked for additional information for some time, . . . suddenly issued" the summonses.4 In addition, the respondents asserted that the IRS sought to enforce the summonses, subsequent to Dynamo's filing suit in Tax Court, to "evad[e] the Tax Court['s] limitations on discovery" and thus gain an unfair advantage in that litigation.5 In support of the allegations, the respondents submitted an affidavit from the attorney of another Dynamo associate, who had chosen to comply with a summons issued at the same time. In light of those submissions, the respondents asked for an opportunity to question the IRS agents about their motives.

The District Court denied the respondents' request and ordered compliance with the summonses. The court found that the respondents' theory was "mere conjecture" and "ha[d] made no meaningful allegations of improper purpose" warranting examination of the IRS agents.6

On appeal, the Eleventh Circuit reversed, holding that the District Court's refusal to allow the respondents to examine IRS agents constituted an abuse of discretion. In support of that ruling, the circuit court cited binding Circuit Court precedent holding that a simple "allegation of improper purpose," even if lacking any "factual support," entitles a taxpayer to "question IRS officials concerning the Service's reasons for issuing the summons."7

In reversing the Eleventh Circuit, the Supreme Court first noted that a taxpayer who receives a summons is entitled to contest it in an enforcement proceeding.8 But summons enforcement proceedings are to be "summary in nature." According to the Court, the purpose of a summons is "not to accuse," much less to adjudicate, but only "to inquire." Accordingly, it is well established that courts may ask only whether the IRS issued a summons in good faith, and must eschew any broader role of "oversee[ing] the [IRS's] determinations to investigate."9 A simple affidavit from the investigating agent can satisfy the IRS's burden.

Notwithstanding this low threshold of proof required by the IRS, as part of the adversarial process concerning a summons's validity, the taxpayer is entitled to examine an IRS agent when he can point to specific facts or circumstances plausibly raising an inference of bad faith. The court provided guidance to the Eleventh Circuit and for future disputes over the availability of such hearings. According to the Supreme Court, the standard to be applied by a court in considering the summoned party's right to a hearing must focus on whether the summoned party has pointed "to specific facts or circumstances plausibly raising an inference of improper motive."10 It elaborated on that standard and stated:

[T]he taxpayer is entitled to examine an IRS agent when he can point to specific facts or circumstances plausibly raising an inference of bad faith. Naked allegations of improper purpose are not enough: the taxpayer must offer some credible evidence supporting his charge. But circumstantial evidence can suffice to meet that burden; after all, direct evidence of another person's bad faith, at this threshold stage, will rarely if ever be available. And although bare assertion or conjecture is not enough, neither is a fleshed out case demanded: the taxpayer need only make a showing of facts that give rise to a plausible inference of improper motive. That standard will ensure inquiry where the facts and circumstances make inquiry appropriate, without turning every summons dispute into a fishing expedition for official wrongdoing.11

Court Determines Tax Memo not Protected by Attorney-Client Privilege and Work Product Doctrine

By Judy Fisher

The Southern District of New York, in Schaeffler v. United States12, recently denied a petition to quash an IRS summons for a tax memorandum prepared by the petitioner's accounting firm in connection with a complex refinancing and corporate restructuring on the part of the Schaeffler Group, determining that (i) the tax memorandum was not protected by the work product doctrine, and (ii) attorney-client and tax practitioner privilege was...