Archive for the ‘Tax’ Category



Tax Litigation Update: Supreme Court Limits Taxpayers’ Ability to Fight IRS Summons

Tuesday, July 15th, 2014

BACKGROUND

As we previously reported, on April 23, 2014, the United States Supreme Court heard oral argument in United States v. Clarke, a case which involved the extent to which a taxpayer may investigate the underlying reasons or motivations for the IRS’s issuance of a summons.  Under IRC § 7602, the IRS may issue a summons to:

a person liable for the tax or required to perform the act, or any officer or employee of such person, or any person having possession, custody, or care of books of account containing entries relating to the business of the person liable for tax or required to perform the act, or any other person the Secretary may deem proper, to appear before the Secretary at a time and place named in the summons and to produce such books, papers, records, or other data, and to give such testimony, under oath, as may be relevant or material to such inquiry.

On June 19, 2014, in a unanimous opinion delivered by Justice Kagan, the Supreme Court held that “a bare allegation of improper purpose does not entitle a taxpayer to examine IRS officials. Rather, the taxpayer has a right to conduct that examination when he points to specific facts or circumstances plausibly raising an inference of bad faith.”

UNITED STATES V. CLARKE

As we previously reported, Clarke arose out of an IRS examination of a partnership called Dynamo Holdings for tax years 2005-2007.  During the course of the examination, Dynamo agreed to extend the statute of limitations for assessment two times. When the IRS requested a third extension of the statute of limitations, the partnership refused.  Soon thereafter, the IRS issued five summonses, including one to Michael Clarke, the CFO of two partners of Dynamo.  The focus of the IRS’s summonses was interest deductions of $34 million taken by Dynamo during two of the years subject to the IRS’s examination.

The IRS issued a Final Partnership Administrative Adjustment (FPAA) in December 2010, three days before the expiration of the statute of limitations.  In February 2011, Dynamo challenged the FPAA in the Tax Court.  Meanwhile, Clarke had refused to obey the summons, and the IRS began summons enforcement proceedings in April 2011, well after commencement of the Tax Court case.

Before the district court, Clarke argued that the IRS did not have a legitimate purpose in issuing the summonses because, among other reasons, they were (1) issued in retaliation for the partnership’s refusal to extend the statute of limitations period a third time and (2) designed to circumvent the U.S. Tax Court’s limitations on the scope of discovery. United States v. Clarke, 111 AFTR 2d 2013-1697 (S.D. Fla. Apr. 16, 2012).

Clarke presented some evidence supporting the contention that the summons was designed to circumvent the Tax Court’s discovery limitations, including (1) the fact that the IRS sought to continue the Tax Court proceeding on the ground that the summonses were still outstanding and (2) a declaration from the lawyer of the sixth summoned individual (who ultimately complied with the summons request) that her IRS interview was conducted exclusively by the two lawyers representing the IRS in the Tax Court proceeding and that the examining agent was not even in attendance. According to Clarke, this fact was significant because in United States v. Powell, 379 U. S. 48 (1964), the Supreme Court ruled that only examining agents, and not lawyers representing the IRS in Tax Court proceedings, were allowed to interview summoned individuals.

Clarke also requested an evidentiary hearing to inquire into the government’s purposes for issuing and enforcing the summonses (and also requested pre-hearing discovery).  The district court, however, ordered enforcement of the summonses.  It rejected Clarke’s first argument as a “naked assertion” unsupported by evidence. The Court then dismissed Clarke’s second contention because it determined that, even if the IRS had used the summons process to sidestep discovery limitations, such a finding was not a valid reason to quash a summons.   Cf. Mary Kay Ash v. Commissioner, 96 T.C. 459, 462, 472-73 (1991) (denying taxpayer’s motion for protective order barring IRS from using evidence obtained through a summons but emphasizing that it was not deciding the enforceability of the summons since that issue was in the district court’s jurisdiction). The district court also denied Clarke’s request for an evidentiary hearing.

On appeal, the Eleventh Circuit Court of Appeals reversed and held that the district court abused its discretion in refusing to hold an evidentiary hearing.  The Eleventh Circuit held that an allegation of improper purpose is sufficient to trigger a limited adversary hearing before enforcement is ordered, and that, at the hearing, the taxpayer may challenge the summons on any appropriate ground.  The Eleventh Circuit’s reasoning was based in part on a prior summons enforcement case, Nero Trading.  In that case, the Eleventh Circuit reasoned that requiring the taxpayer to provide support for an allegation of improper purpose without giving the taxpayer the opportunity to obtain such facts “saddles the taxpayer with an unreasonable circular burden.”

THE SUPREME COURT’S OPINION

In its opinion, the Supreme Court stated that a person receiving an IRS summons is entitled to contest it, but only in an enforcement proceeding. Further, the Court reasoned that because Congress recognized that the power vested in tax collectors may be abused, as all power may be abused, enforcement of an IRS summons must be contingent on a court’s approval. In addition, the Court held that that requisite judicial proceeding is adversarial, the summoned party must receive notice and may present argument and evidence on all matters bearing on a summons’s validity.

While the Court recognized a taxpayer’s right to challenge a summons, it emphasized that summons enforcement proceedings must be “summary in nature.” Further, the Court reasoned that as part of the adversarial process concerning a summons’s validity, the taxpayer is entitled to examine an IRS agent regarding facts or circumstances plausibly raising an inference of bath faith; that is, the taxpayer must offer some credible evidence supporting his charge. The Court recognized that although a 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.

In light of competing interests between the parties involved, the Supreme Court struck a balance between preventing abuse from IRS officials when issuing a summons, and preventing taxpayers from making naked allegations of improper purpose. Therefore, the Supreme Court held that “a bare allegation of improper purpose does not entitle a taxpayer to examine IRS officials. Rather, the taxpayer has a right to conduct that examination when he points to specific facts or circumstances plausibly raising an inference of bad faith.”

The Supreme Court also ruled that the standard it announced will allow for inquiry where the facts and circumstances make inquiry appropriate, without turning every summons dispute intro a fishing expedition for official wrongdoing. Nevertheless, the Court did not decide whether the evidence provided by those summoned in connection with Dynamo Holdings was insufficient to meet that standard. Rather, it sent the issue back to the district court to apply the “correct legal standard” to the facts.

UNRESOLVED ISSUES: IMPROPER PURPOSE AND BAD FAITH

This case presented two issues which the Supreme Court left unresolved: (1) whether the IRS can punish taxpayers for not extending the statute of limitations, and (2) whether the IRS was attempting to use its summons enforcement power in bad faith.

As we previously reported, the IRS is authorized to use a summons for the purposes described in IRC §7602, which are generally related to tax determination and collection. When the IRS uses its summons power for an unauthorized purpose or for any purpose reflecting on the good faith use of its power, the Supreme Court has said that the summons will not be enforced. Reisman v. Caplin, 375 US 440 (1964). Further, in Powell the Supreme Court ruled that an “improper purpose” includes harassing the taxpayer, pressuring the taxpayer to settle a collateral dispute, or any other purpose reflecting negatively on the good faith of the particular investigation. (See also IRM 5.17.6.2.2, which discusses summonses legal authority). In addition, case law and IRC §7602(c) make it clear that the IRS is not authorized to use this power to assist another agency by, for example, using a summons to investigate a matter already being investigated by a grand jury, or by gathering evidence for the Department of Justice in its prosecution of a criminal case. United States v. LaSalle Nat’l Bank, 437 US 298 (1978).

In general, since it is the court’s process that the IRS invokes in an enforcement proceeding to obtain compliance with a summons, a court will not order compliance unless it is satisfied that the IRS has served the summons in a good faith pursuit of its summons authority.

Before 1982, the IRS’s authority to issue summons did not expressly include power to use a summons to investigate a criminal violation of the tax laws. As a result, there was much litigation over the question whether the IRS was using a summons for an improper criminal purpose. In 1982, IRC §7602 was amended to provide that the statutorily authorized purposes for which a summons may be issued include “the purpose of inquiring into any offense connected with the administration or enforcement of the internal revenue laws.” Accordingly, the IRS is permitted to use a summons to gather evidence of a criminal violation of the tax laws. IRC §7602 was further amended to prohibit the use of a summons when a Department of Justice referral for criminal prosecution or grand jury investigation is in effect.

Significantly, persons affected by a summons have made objections that the summons has been issued for improper purposes other than for gathering evidence for use in a criminal prosecution. In United States v. LaSalle Nat’l Bank, 437 US 298 (1978), the Supreme Court recognized that a summons might be unenforceable for reasons other than an improper criminal purpose. Further, in Pickel v. United States, 746 F2d 176 (3d Cir. 1984), the third circuit stated that it did not doubt that portions of the Powell and LaSalle discussions of bad faith retain vitality even after the 1982 amendment to IRC §7602  and that where the taxpayer can prove that the summons is issued solely to harass him, or to force him to settle a collateral dispute, or that the IRS is acting solely as an information-gathering agency for other departments, such as the Department of Justice, the summons will be unenforceable because of the IRS’s bad faith. Further, where a substantial preliminary showing of abuse of the court’s process has been made, a summoned party is entitled to substantiate his allegations by way of an evidentiary hearing. United States v. Millman, 765 F2d 27 (2d Cir. 1985) (at the hearing, the agents responsible for the investigation and other witnesses may be called). See also United States v. Church of Scientology, 520 F2d 818, 824 (9th Cir. 1975)(limited evidentiary hearing approved).

When the challenge to a summons is based on an improper purpose, discovery and an evidentiary hearing are critical to prove the challenge, and it is by no means certain that the moving party will have either one or both opportunities. The district court’s decision to deny discovery and an evidentiary hearing is reviewed by a court of appeals under an abuse of discretion standard—that is, only if the taxpayer demonstrates in the summons enforcement hearing that the district court abused its substantial discretion in denying discovery and an evidentiary hearing.

The Internal Revenue Manual (“IRM”) and IRS standard operating procedures require IRS employees to review taxpayer documents with enough time to make a tax assessment before the statute of limitations period ends. See IRM 25.6.22.2. Further, the IRM requires that statute of limitations extensions be requested with enough time and based on a genuine need for more time to investigate a matter before making a tax assessment. Id. A taxpayer has a right to refuse to extend the normal statute of limitations period and the IRS should not retaliate for a taxpayer’s refusal to do so. See IRM 25.6.22.3.

In Clarke, the taxpayer alleged that the IRS had an improper purpose in issuing the summons, and thus was not entitled to enforce its subpoena. Specifically, Clarke asserted that the IRS was retaliating against the Dynamo’s refusal to extend the statute of limitations for a third time and that the IRS was seeking to circumvent the limited discovery rules available to litigants in Tax Court proceedings.

While there seemed to be enough evidence to support the contention that the IRS was in fact punishing the taxpayers for not agreeing to extend the statute of limitations and that the summons were issued for an improper motive, the Supreme Court did not rule on those issues. Instead, the Supreme Court sent the issues back to the district court to decide.

CONCLUSION

As a matter of law, the Supreme Court’s reasoning in this case is understandable. If any naked allegation of impropriety triggered a full blown evidentiary hearing, the resulting litigation would create a log jam in courts which would bring the justice system to a standstill. Nevertheless, the Supreme Court’s reasoning does not reflect the practical realities of most people who receive IRS summons. While Justice Kagan’s opinion rightly sets forth that a summons represents an inquiry rather than an accusation, the person receiving the summons has no choice but to act as though it is an accusation.

Because the Supreme Court left certain issues unanswered – sending them back to the court below to apply what it called the “correct legal standard” to the facts – it is difficult to predict what the lower courts will consider “credible evidence supporting [the taxpayer’s] charge” or what facts will the taxpayer need to show which “give rise to a plausible inference of improper motive.” In light of this new legal standard, it is hard to predict whether the court below will find that the IRS was punishing taxpayers for not extending the statute of limitations, and whether the taxpayers pointed to specific facts or circumstances plausibly raising an inference of improper motive in enforcing the summons.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax litigation.  They will continue to monitor developments in this and similar cases. If you have any questions, an attorney can be reached by emailing us at contact@fuerstlaw.com or by calling 305.350.5690.

Tax Litigation Update: Eleventh Circuit Holds Clear and Convincing Evidence Standard Applies to Penalties Imposed under IRC § 6701

Wednesday, June 25th, 2014

The Eleventh Circuit Court of Appeals, which hears appeals from the federal district courts in Florida, Georgia, and Alabama, ruled earlier this month that in order to impose penalties under IRC § 6701, the government bears the burden of proving each element of the statute by clear and convincing evidence.  In so doing, the Eleventh Circuit reversed the holding of the Middle District of Florida that a lower standard, preponderance of the evidence, applies to § 6701.  Moreover, the Eleventh Circuit’s decision was contrary to the Second and Eighth Circuits, which have held that proof by a preponderance of the evidence is the proper standard.  The Eleventh Circuit’s decision also created precedential case law that tax practitioners can potentially use to defend their clients from civil penalties beyond just § 6701.

Background

The case before the Eleventh Circuit, Carlson v. United States, involved a tax return preparer, Frances Carlson, working for two companies doing business as Jackson Hewitt.  Prior to starting this job, Carlson did not have any professional tax return experience.  In this position, Carlson prepared both individual and corporate returns.  In total, Carlson worked for Jackson Hewitt for five years and prepared between 1200 and 1500 tax returns.

In 2006, the owner of the two Jackson Hewitt franchises that employed Carlson was arrested for, among other crimes, money laundering.  The arrest prompted an investigation of the businesses by the IRS.  In its investigation, the IRS determined that approximately 40 of the returns prepared by Carlson during the course of her employment contained unsubstantiated deductions.  The IRS thereafter assessed penalties against Carlson under IRC § 6701(a), which imposes a penalty against any person who:

(1) aids or assists in, procures, or advises with respect to, the preparation or presentation of any portion of a return, affidavit, claim, or other document,

 

(2) knows (or has reason to believe) that such portion will be used in connection with any material matter arising under the internal revenue laws, and

 

(3) knows that such portion (if so used) would result in an understatement of the liability for tax of another person.

Carlson paid 15 percent of the assessed penalty, filed a claim for refund, which was rejected, and then sued in the district court for a refund.  Prior to trial, the IRS conceded 13 of the 40 penalties (one for each return bearing unsubstantiated deductions), leaving 27 penalties to determine.  At trial, Carlson moved for judgment as a matter of law as to 5 of those penalties because the Government had failed to introduce any evidence that Carlson knew the returns she prepared were incorrect.  The district court denied the motion and all 27 penalties went to the jury.  Carlson then objected to the district court’s jury instruction that the Government’s burden of proof under IRC § 6701 was proof by a preponderance of the evidence rather than by clear and convincing evidence.  The Court overruled the objection and the jury returned a verdict in favor of the government on all of the 27 penalties at issue, resulting in a judgment of $119,173.12 against Carlson.

The Eleventh Circuit’s Reasoning

On appeal, the Eleventh Circuit determined that the district court was incorrect in its jury instruction and in denying Carlson’s motion for judgment as a matter of law.  In reversing the district court on the jury instruction issue, the Eleventh Circuit began by stating that under its longstanding precedent, the Government’s burden for proving fraud in a civil tax case was “clear and convincing evidence.”  Based on this principle, the Eleventh Circuit stated that the pertinent question before it was whether § 6701 requires the Government to prove fraud.  If so, then the proper burden of proof is “clear and convincing evidence.”

In holding that § 6701 does require the Government to prove fraud, the Eleventh Circuit analyzed the text of § 6701(a), particularly subsection (a)(3) which requires the defendant to “know[s] that such portion [of a return or other document] (if so used) would result in an understatement of the liability for tax of another person…”

Section 6701(a)(3) contains the statute’s scienter requirement–the state of mind the defendant must have had to be liable under the statute.  The Eleventh Circuit read § 6701(a)(3) to require actual knowledge by the return preparer that the return the prepare had assisted in the preparation of would deprive the government of tax that is owed to it.  To the Eleventh Circuit, § 6701’s requirement of actual knowledge of the understated tax is akin to “the preparer deceitfully prepar[ing] a return knowing it misrepresented or concealed something that understates the correct tax,” which amounts to “a classic case of fraudulent conduct.”

The Government attempted to argue that the statute could not require a finding of fraud, and therefore could not necessarily require clear proof of a violation by clear and convincing evidence, because the statute does not contain the word “fraud.”  The Court summarily rejected that argument as elevating form over substance—“the lack of the word ‘fraud’ is immaterial if the conduct the government must prove meets the definition of fraud.”

Moreover, the Government itself had previously argued that because § 6701 is an anti-fraud provision, no statute of limitation applied to deficiencies resulting from actions prohibited under § 6701.  Thus, the government was seeking to cabin the characteristics of fraud contained in § 6701 to situations in which only it benefitted.

Creation of a Circuit Split

In holding that § 6701 requires proof by “clear and convincing evidence,” the Eleventh Circuit contradicted the Second Circuit and the Eighth Circuit Courts of Appeal.  In Mattingly v. United States, 924 F.3d 785 (8th Cir. 1991), the Eighth Circuit determined that § 6701 requires proof by a preponderance of the evidence for two reasons (which the Second Circuit followed without much elaboration in Barr v. United States, 67 F.3d 469 (2d Cir. 1995)): first, the Eighth Circuit reasoned that § 6701 does not require proof of fraud (and thus does not require a heightened standard of proof) because it does not refer to the “evasion of tax.” The Eleventh Circuit in Carlson rejected this notion because it could not discern a reason why a reference to evasion of tax in § 6701 was relevant to its analysis of the burden of proof imposed by § 6701.  Moreover, the Eleventh Circuit reasoned, even if it were necessary for the statute to reference tax evasion to implicate a higher standard of proof, § 6701 does reference tax evasion (without explicitly using that phrase) due to its requirement that the return preparer’s knowing violation “result in an understatement of the liability for tax of another person.”

Second, in Mattingly, the Eighth Circuit reasoned that the structure of sections 6700, 6701, 6702, and 6703 suggests the application of a uniform standard of proof.  The Eleventh Circuit dismissed this reasoning on the basis that applying standards of proof based on a statute’s relationship to other statutes could lead to perverse results.  Additionally, even if sections 6700-6703 suggest the need to apply a uniform standard of proof, there is no specified standard of proof for those sections.  Thus, there is nothing specifically requiring a court to impose a preponderance of the evidence standard over a clear and convincing evidence standard in any of those statutes.

Finally, the Eighth Circuit, in justifying the application of a lower standard of proof to § 6701, reasoned that § 6701 was enacted as “another piece in the expansive non-fraud penalty scheme” applicable to taxpayers and tax preparers.  In refusing to follow this rationale, the Eleventh Circuit, drawing on the case of Sansom v. United States, 703 F.Supp. 1505 (N.D. Fla. 1988), identified three penalties applicable to tax preparers, IRC §§ 6694(a), 6694(b), and 6701.  Of those, only § 6701 requires the return preparer to actually know that that the return understates the proper amount of tax, thus suggesting that § 6701 was unique among those three statutes and worthy of a higher standard of proof.

The Fallout

After rejecting the approach taken by the Second and Eighth Circuits and holding that the imposition of penalties under § 6701 required proof by clear and convincing evidence, the Eleventh Circuit further determined that the district court’s application of the incorrect standard of proof was not harmless and required a new trial.

Additionally, the Eleventh Circuit reversed the district court’s decision to deny Carlson’s motion for judgment as a matter of law as to the penalties imposed on five specific returns.  With regard to each of these five penalties, the Government only presented evidence that the taxpayer assisted by Carlson did not substantiate the claimed deductions.  The Government did not present evidence that Carlson actually knew the returns understated the correct tax.

A verdict based on evidence that merely demonstrates that the taxpayers could not substantiate their deductions would have the effect of improperly transferring the burden to Carlson to prove that she did not actually know of the error, as opposed to the Government proving she did know of the error.  Additionally, it would be an impermissible inference by a jury to conclude that Carlson actually knew of the error based solely on the fact that the taxpayer could not substantiate his deduction—the presence of an incorrect deduction does not prove that the return prepare knew the return was inaccurate.

Because the government failed to present any evidence as to Carlson’s knowledge of the inaccurate returns on these five penalties, the Eleventh Circuit held that Carlson’s motion for judgment as a matter of law should have been granted.  The Eleventh Circuit went out of its way to state that it was not deciding what standard of proof should be used to review a district court’s denial of a motion for judgment as a matter of law on § 6701 penalties (as opposed to the context of jury instructions, which it did decide).  Under either the preponderance of the evidence or clear and convincing evidence standards, the government’s failure to introduce any evidence of Carlson’s knowledge required judgment as a matter of law in Carlson’s favor.

The Carlson decision is an important victory for tax return preparers operating in the Eleventh Circuit.  Under a fair reading of the decision, tax return preparers are entitled to rely upon the information supplied to them by the taxpayer, without the fear of being accused they were “willfully blind” to the errors contained in the taxpayer’s claimed deductions.  Additionally, by deciding the question in contravention of the Eighth and Second Circuits, the Eleventh Circuit has created a circuit split, heightening the chances the Supreme Court may ultimately decide the question.

Potential Relevance in Other Contexts

        i.            Willful FBAR Violations

It remains to be seen if the Eleventh Circuit’s articulation of the burden of proof under IRC § 6701 will translate to or be adopted in other areas where the correct burden of proof is less than clear.  A very active area where the burden of proof is less than clear is the imposition of willfulness penalties for failing to file a Report of Foreign Bank Account (“FBAR”).  A non-willful failure to file an FBAR may lead to a penalty of $10,000 per violation, but a willful failure to file an FBAR can lead to a penalty of the greater of $100,000 or 50 percent of the highest balance in the undisclosed account during the given year, so the determination of willfulness or non-willfulness is an important one.

There is a dearth of judicial precedent regarding the proper burden of proof in determining willfulness in the FBAR context.  In a recent high profile case, United States v. Zwerner, the Southern District of Florida submitted the willfulness question to the jury with the instruction to apply the preponderance of the evidence standard, and the jury found that the taxpayer had willfully failed to meet his FBAR obligations.

While the amount of the penalty to be imposed in the Zwerner case settled before the jury’s verdict could be appealed, some have speculated that had the Eleventh Circuit’s decision in Carlson been released earlier, the taxpayer in Zwerner would have had leverage to seek a more favorable settlement.  This is because under Carlson, the imposition of civil penalties based on fraudulent conduct requires the Government to prove its case by clear and convincing evidence, even where the subject statute does not explicitly reference fraud.  Rather, under Carlson, the key determination was whether the return preparer knew that her actions would result in the understatement of liability for the taxpayer, which the Eleventh Circuit held to be synonymous with fraud.

Willfulness is generally defined as an intentional violation of a known legal duty.  It can be effectively argued that knowingly taking action that would result in an understatement of liability (which the Eleventh Circuit held in Carlson to require proof by clear and convincing evidence) is analogous to an intentional (i.e. knowing) violation of the FBAR requirement.  Hence, establishing willfulness for purposes of applying the higher civil FBAR penalty should require proof by clear and convincing evidence just as proving the elements of a § 6701 violation now (in the Eleventh Circuit at least) requires proof by clear and convincing evidence.

While there are certainly counterarguments as to why the Carlson should not extend to the context of FBARs, the Carlson decision certainly provides a weapon for clever and resourceful tax attorneys to use in defense against civil penalties imposed beyond the scope of IRC § 6701.

     ii.            The Offshore Voluntary Disclosure Program

In a related issue, the IRS recently modified the rules applicable to its Offshore Voluntary Disclosure Program (OVDP).  As we wrote about more extensively here, a key determination regarding what type of voluntary disclosure a taxpayer may make is whether that taxpayer’s past non-compliance (such as failure to file FBARs) was willful or non-willful.  In general, far more lenient treatment is provided to those OVDP filers who successfully establish that their past non-compliance was not willful.

The problem, as more thoroughly explained in our previous blog entry, is that defining “non-willfulness” in the context of the OVDP is extremely difficult.  Under the new OVDP rules, the ultimate arbiter of whether an OVDP filer’s past non-compliance was or was not willful is the IRS—its determinations are final and the methodology it will employ in evaluating willfulness is unknown to both taxpayers and to IRS personnel.

To compound the uncertainty, as the Carlson case demonstrates, not even the Circuit Courts of Appeal are in agreement as to what proof is required to establish certain penalties, such as those imposed under § 6701, that are based on the violator’s knowledge and willfulness, and there appears to be no circuit-level authority regarding the standard of proof for imposing civil, willful FBAR penalties.  The disagreement and lack of guidance from the courts on these points simply exacerbates the uncertainty surrounding how the IRS will evaluate willfulness in the OVDP and leaves potential OVDP filers searching for answers.

The attorneys at Fuerst, Ittleman, David & Joseph have extensive experience litigating tax cases in the Tax Court, Federal District Courts, and the Court of Claims. We will continue to monitor the development of the Carlson case and other issues relating to IRC § 6701, FBAR penalties, and the non-willfulness in the OVDP and we will update this blog with relevant information as often as possible. You can reach an attorney by calling us at 305-350-5690 or emailing us at contact@fuerstlaw.com.

International Tax Compliance Update: Offshore Voluntary Disclosure Program Modifications: A Trap for the Unwary

Monday, June 23rd, 2014

Several weeks ago, we reported that changes to the IRS’s Offshore Voluntary Disclosure Program (“OVDP”) were imminent and would focus on distinguishing between taxpayers who willfully violated their reporting requirements, and those whose past reporting failures were non-willful.

On Wednesday, the IRS officially announced the anticipated changes to the OVDP.  The IRS’s announcement of the modifications and additional guidance regarding the modifications can be found here.  As predicted, the changes create a clear distinction in treatment between OVDP filers who can successfully certify their reporting failures were non-willful and those who cannot.

Fundamentally, OVDP filers whose past reporting failures were non-willful are, from July 1, 2014 forward, eligible for admission into the OVDP under “streamlined” procedures that previously only applied to a narrow category of filers (generally non-US residents with less than $1,500 of unpaid tax in tax years covered by the OVDP).  Moreover, taxpayers whose past non-compliance was non-willful will be subject to dramatically lowered penalties (5 percent of the penalty base as opposed to 27.5 percent for US residents or no penalties for non-US residents). A more detailed description of the new, streamlined procedure is set forth below.  However, before an OVDP filer can take advantage of the streamlined procedure and reduced or eliminated penalties, he must establish that his violations were non-willful.

Non-willfulness: A Crucial, Yet Uncertain, Determination

The streamlined procedures and reduced or eliminated penalties only apply under the modified OVDP if the filer can successfully certify that his or her past non-compliance was non-willful.  For this purpose, the IRS has defined non-willful conduct as “conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.”  By adopting this definition, the IRS has more closely aligned the concept of willfulness within the OVDP with the standard definition of willfulness applied by the federal courts in civil cases, i.e. an intentional violation of a known legal duty.

It is essential to recognize that filing a streamlined disclosure and certifying that past reporting failures were non-willful does not immunize the OVDP filer from examination and does not guarantee that the non-willfulness certification will be accepted.  The information and supporting documents submitted by the filer may still be examined and the IRS is permitted to overrule the filer’s non-willfulness certification.  Thus, the IRS’s ability to reject a non-willfulness certification upon its independent examination may justifiably create a great deal of uncertainty for an OVDP filer whose non-willfulness is difficult to prove.

Although the IRS has articulated a standard of non-willfulness that appears to be in line with the standard generally applied by courts across the country, the true test lies in whether the IRS will be faithful to that standard.  Willfulness is a potentially malleable concept, and though court decisions regarding willfulness under civil and criminal tax statutes abound, because the OVDP is subject to the IRS’s plenary authority, it is doubtful whether judicial precedent regarding willfulness can be meaningfully relied upon.  Also, there are no appeal rights in the OVDP; once the IRS makes a determination regarding the willfulness or non-willfulness of an OVDP filer’s past non-compliance, that determination is fixed.

Moreover, due to privacy laws applicable to the IRS and the generally secretive nature with which the IRS treats its resolution of cases under the OVDP, it will be extremely difficult for potential OVDP filers to discern any sort of uniform applicability of the non-willfulness requirement with the IRS.  The standard applied could vary from case to case and examining agent to examining agent without OVDP filers ever being aware of the disparate standards being applied.

The uncertainty surrounding the standard by which the IRS will analyze non-willfulness in the context of the streamlined OVDP was exemplified by reports of comments made by IRS officials at a recent conference held by New York University Law School.  Specifically, division counsel for the Small Business and Self-Employed Division, John McDougal, was reported as saying that an OVDP filer is non-willful if he “isn’t really worried about being prosecuted.”  Additionally, McDougal was quoted as saying “the concept of willfulness is well-documented in the case law,” and “we’re depending on practitioners to help clients work their way through what the risk is of criminal prosecution and significant penalties.”  In other words, it appears not even IRS officials are exactly sure what “non-willfulness” means for the streamlined OVDP, which begs the question: if the IRS can only vaguely define what non-willfulness means, what hope does an uncertain OVDP filer have?

The Effect of Rejection

The fact that the IRS’s initial determination regarding whether an OVDP filer’s past reporting failures were willful or non-willful are binding and final leads to perhaps the most pressing underlying issue created by the OVDP modifications.  If a taxpayer certifies that his past non-compliance was not willful and thereby attempts to take advantage of the streamlined disclosure program, and the IRS examines the disclosure and rejects the non-willfulness assertion, that taxpayer is precluded from entering the traditional OVDP, as confirmed by this statement in the IRS announcement of the streamlined program: “Once a taxpayer makes a submission under either the Streamlined Foreign Offshore Procedures or the Streamlined Domestic Offshore Procedures, the taxpayer may not participate in OVDP.”

As a result, if an OVDP filer attempts to certify non-willfulness and the certification is overruled, the filer will have disclosed his offshore assets and past non-compliance, and exposed himself to the maximum potential penalties, without any benefit.  In essence, taxpayers that are not completely confident about their ability to prove that their past non-compliance was not willful–as that term is defined by the IRS–are taking a significant risk in attempting to avail themselves of the streamlined procedure.

Unfortunately for potential OVDP filers, how strict the IRS will be in evaluating a filer’s past non-compliance can only remain to be seen.  Further, unless the IRS alters its generally secretive approach to the OVDP, OVDP filers will be forced to rely on anecdotal evidence gleaned from others who have attempted to participate in the streamlined disclosure.  Sadly, while the OVDP program is meant to provide certainty for taxpayers seeking to resolve past non-compliance, the IRS, in attempting to draw the line between willful and non-willful filers, appears to have created a brand-new source of uncertainty.

The Specifics of Disparate Treatment for Willful and Non-Willful Past Noncompliance

Under the modified OVDP, taxpayers successfully certifying that their non-compliance was non-willful are treated much more leniently than they previously were, when almost all OVDP filers were subject to a 27.5 percent penalty regardless of the circumstances surrounding their past non-compliance.  Moreover, the disclosure obligations of non-willful OVDP filers are less onerous than those of willful filers.

Under the modified program, non-willful filers (again, those who successfully establish that their reporting failures were due to negligence, inadvertence, or a good faith misunderstanding of the law) are broken into two groups: those who are U.S. residents and those that are not.  For each group, the procedure for taking advantage of the new, streamlined OVDP is largely the same, with a key difference noted below.  OVDP filers in either non-willful group are required to:

  1. File three years of amended or delinquent returns.  Note that US residents cannot file delinquent returns, so for US residents to be eligible for the streamlined procedures, they must have filed a return for the previous three tax years.  If a US resident has not filed returns for the previous three tax years, that person should not attempt to enter the OVDP under the streamlined procedures, as it is likely their submission will be rejected and they may end up being precluded from using the traditional OVDP;
  2. Pay all previously unpaid tax and interest reflected on the newly filed returns;
  3. File any FBARs that were required to be filed, but were not, for any of the six most recent tax years for which the filing due date has passed;
  4. Sign and file a certification regarding the taxpayer’s residency status (either a U.S. resident or non-resident), and further certifying that all required FBARs have been filed and that all past reporting failures were due to non-willful conduct.

The primary difference in the IRS’s treatment of U.S. residents and non-residents is that non-residents are not subject to any penalties (and therefore are required only to pay back taxes and interest to resolve their past non-compliance), whereas U.S. residents will be required to pay a miscellaneous 5 percent penalty.  The determination of whether a taxpayer is a US resident depends on that taxpayer’s legal status.  If the taxpayer is a US citizen or green card holder, he will be considered a non-resident if, in any one or more of the three most recent years for which the tax return due date has passed, the individual did not have a US abode (which generally means the location of the taxpayer’s primary residence) and was physically outside the US for at least 330 full days.

For taxpayers who are not US citizens or green card holders, they will be considered non-residents for OVDP purposes if they do not meet the substantial presence test of IRC § 7701(b)(3), which generally requires a taxpayer to be present in the US for at least 31 days in the current year and at least 183 days over the previous three years (with days in the years 2 being counted as 1/3 of a day and days in year 3 being counted as 1/6 of a day).

Additional Modifications to the OVDP

While generally beneficial to OVDP filers whose past non-compliance was not willful, the IRS’s modifications increase the burden on filers who cannot certify that their non-compliance was not willful.  Before the IRS’s modifications, a 27.5 percent penalty was applied to OVDP filers almost uniformly.  Now, beginning August 4, 2014, if an OVDP filer fails to disclose an offshore account and it has become public that the host financial institution is under investigation by or is cooperating with the IRS or Department of Justice or the host financial institution has been identified by in a “John Doe summons,” then a 50 percent penalty will apply to all of the taxpayer’s undisclosed assets (not just those hosted by the subject financial institution).  The IRS has published a list of those financial institutions that currently meet these criteria:

1. UBS AG

2. Credit Suisse AG, Credit Suisse Fides, and Clariden Leu Ltd.

3. Wegelin & Co.

4. Liechtensteinische Landesbank AG

5. Zurcher Kantonalbank

6. swisspartners Investment Network AG, swisspartners Wealth Management AG, swisspartners Insurance Company SPC Ltd., and swisspartners Versicherung AG

7. CIBC FirstCaribbean International Bank Limited, its predecessors, subsidiaries, and affiliates

8. Stanford International Bank, Ltd., Stanford Group Company, and Stanford Trust Company, Ltd.

9. The Hong Kong and Shanghai Banking Corporation Limited in India (HSBC India)

10. The Bank of N.T. Butterfield & Son Limited (also known as Butterfield Bank and Bank of Butterfield), its predecessors, subsidiaries, and affiliates

Taxpayers who have or had accounts in those institutions and failed to report the accounts or pay tax on the interest or dividends generated by the account should act promptly if they plan to enter the OVDP.  Additionally, this list will likely expand in the future.

Furthermore, under the modified program all OVDP filers must provide the account statements generated during the OVDP period (previously that requirement applied only to account holders that had a balance in excess of $500,000 at any point during the OVDP period), and, more importantly, the OVDP filer must pay the OVDP penalty at the time the voluntary disclosure is made.  Under the old rules, the taxpayer waited until negotiations with the examining agent assigned to the disclosure were complete before paying the OVDP penalty.

Has the IRS Truly Eased the Burden on OVDP Filers?

In his statement previewing the OVDP modifications earlier this month, IRS Commissioner John Koskinen repeatedly emphasized the need to treat OVDP filers who did not willfully violate their reporting obligations consistently with the non-willful manner of their violations.  In some ways, the IRS’s modifications to the OVDP have met that goal.  The modifications more appropriately take into account the willfulness of the OVDP filer’s non-compliance in setting the applicable punishment and are especially helpful in the case of obvious non-willfulness, such as US citizens who have lived abroad for nearly their entire lives and were never aware they had any US tax obligations.

Yet at the same time, IRS’s modifications create a significant conundrum for potential filers whose non-willfulness is not clear cut.  In many factual circumstances, the IRS can plausibly assert that a taxpayer’s reporting failures were the result of willful blindness.  This is especially so given the questions regarding foreign accounts taxpayers are required to answer on Schedule B of the 1040.

Specifically, in order to determine whether the taxpayer has an FBAR filing obligation, schedule B asks taxpayers whether they have a financial interest in or signatory authority over a financial account located in a different country, and then directs the taxpayer to read the applicable instructions.  Any taxpayer who files schedule B with their tax return has arguably been placed on notice that they have an FBAR or other reporting obligation regarding their foreign account, which the IRS can use to overrule an OVDP filer’s non-willfulness certification.

One can imagine a multitude of other scenarios in which an OVDP filer’s honest misunderstanding of the facts or law can be painted as willful blindness.  Until the IRS more clearly articulates how it will judge non-willfulness in the context of the OVDP, based on real, practical circumstances rather than an abstract legal standard, the looming threat of the IRS making a willful blindness determination and rejecting a filer’s entry into the streamlined procedure will undoubtedly affect the decisions of many OVDP filers.

Additionally, while it is clear the IRS has reduced the burden on filers who successfully establish non-willfulness, a strong argument can be made that taxpayers whose non-willfulness was readily apparent should have never faced the possibility of significant penalties or criminal prosecution for their non-compliance in the first place, and that by including those taxpayers at all within the scope of the previous iterations of the OVDP the IRS was overreaching.

Now, by either eliminating or lowering the applicable penalty for non-willful filers, the IRS can be seen as justified in nearly doubling the penalty applicable to certain willful filers (i.e. taxpayers with undisclosed accounts in banks that are cooperating with the US government, such as those listed above).  Overall, while the fallout remains to be seen, the IRS’s OVDP modifications should not be viewed as being as forgiving to taxpayers disclosing their offshore assets and past non-compliance as the IRS might argue or publicize.

The attorneys at Fuerst, Ittleman, David & Joseph have extensive experience working with taxpayers who have undisclosed foreign bank accounts and who are seeking to avail themselves of the OVDP. We will continue to monitor the development of these issues, and we will update this blog with relevant information as often as possible. You can reach an attorney by calling us at 305-350-5690 or emailing us at contact@fuerstlaw.com.

International Tax Compliance Update: IRS Hints at Coming Changes for Certain OVDP Filers

Friday, June 6th, 2014

Remarks on Monday by John Koskinen, the Commissioner of Internal Revenue, indicate that the IRS is close to conceding to outside pressure to more clearly distinguish between Offshore Voluntary Disclosure Program (OVDP) filers whose past reporting failures were willful and those whose reporting failures do not rise to the traditional level of willfulness.

Specifically, speaking at the U.S. Council for International Business-OECD International Tax Conference in Washington, Koskinen noted with regard to the currently effective 2012 OVDP that “we [the IRS] are currently considering making further program modifications to accomplish even more. We are focusing on whether our voluntary programs have been too focused on those willfully evading their tax obligations and are not accommodating enough to others who don’t necessarily need protection because their compliance failures have been of the non-willful variety.”

As an example, Koskinen stated

We are well aware that there are many U.S. citizens who have resided abroad for many years, perhaps even the majority of their lives. We have been considering whether these individuals should have an opportunity to come into compliance that doesn’t involve the type of penalties that are appropriate for U.S.-resident taxpayers who were willfully hiding their investments overseas. We are also aware that there may be U.S.-resident taxpayers with unreported offshore accounts whose prior non-compliance clearly did not constitute willful tax evasion but who, to date, have not had a clear way of coming into compliance that doesn’t involve the threat of substantial penalties.

The Willfulness Standard

The most common federal tax crimes require the government to prove that the taxpayer acted “willfully” in violating the specific statute. For example, IRC § 7201 makes it a felony to “willfully attempt in any manner to evade or defeat any tax imposed by this title or the payment thereof…” Similarly, IRC § 7203 prohibits “willfully” failing to pay estimated tax, pay tax, make a return, keep required records, or supply required information.

In the criminal context willfulness is usually defined as the intentional violation of a known legal duty. Implied in this definition is a level of bad faith on the taxpayer’s part—the taxpayer knew the law but intentionally chose to violate it. The willfulness requirement is designed to prevent individuals who sincerely believe they are not violating the law from being convicted for actions that meet every other element of the subject criminal statute. Willfulness is based on the subjective state of mind of the defendant. One’s honest belief that he or she was acting lawfully, or one’s honest failure to be aware that he or she was acting unlawfully, is a defense to willfulness tax crimes. Cheek v. United States, 498 U.S. 192 (1991).

Willfulness in the civil context is defined by a lower standard. Generally actions that rise to the level of reckless disregard of, or willful blindness to, legal obligations are sufficient to establish civil willfulness. See United States v. Williams, 489 Fed. Appx. 655, 658-59 (4th Cir. 2012). The distinction between criminal and civil willfulness lies in the fact that a civil defendant does not have to be specifically aware of his legal obligation to willfully violate it. However, in both the civil and criminal context, willfulness requires a heightened level of misconduct by the defendant. Honest mistakes, or honest failures to become apprised of a legal obligation, should not give rise to a willful violation of the law, and the attendant penalties, in either the criminal or civil contexts.

The Problem: “Willfulness” Disregarded in the OVDP

To date, the willfulness requirement for most tax crimes and civil penalties has proven to be too nuanced for the OVDP. As a result, taxpayers who willfully violated tax laws, particularly the requirement to disclose the existence of foreign financial accounts when their aggregate balance exceeds $10,000 (generally known as the FBAR requirement), are given the same protections, and penalized in the same manner, as those who did not willfully violate the tax laws. In order to understand the practical effect of generally treating all OVDP filers the same way, it is helpful to understand how the OVDP works.

Generally speaking, the OVDP offers the chance for amnesty from criminal prosecution in exchange for making a full disclosure about past, offshore tax non-compliance. We have written about the OVDP here, here, and here. The OVDP is designed for taxpayers holding assets offshore who have failed to report the existence of those assets and the income generated by them. In return for the reduced risk of criminal prosecution, OVDP filers are generally required to pay all back taxes, interest, accuracy related penalties under IRC § 6662(a), and a single penalty of 27.5 percent of the highest average annual balance in their offshore accounts over an eight year look-back period (unreported offshore assets, such as real property or artwork, that are related to tax non-compliance must also be included in the base amount from which the 27.5 percent penalty is calculated).

In many circumstances, while the 27.5 percent penalty is significant, it is less than the total penalties the taxpayer would otherwise have to pay, which can include penalties for failure to file FBARs, fraud penalties, and penalties for failure to disclose ownership in foreign corporations or trusts. For instance, if a taxpayer’s failure to file an FBAR is determined to be willful, the penalty for each year can be up to 50 percent of the maximum account balance. If a taxpayer has an offshore account with a million dollars in it, the penalties imposed for willful FBAR violations over several years would dwarf the penalty imposed by the OVDP.

However, for many taxpayers, the failure to file FBARs or meet other disclosure or reporting requirements was not willful. Many U.S. citizens living abroad are honestly and justifiably unaware of their obligation to report their foreign accounts, or even pay U.S. tax. Many U.S. citizens are titled on, or have a beneficial interest in, foreign, interest bearing accounts without being aware of their status as to the account. For these taxpayers, their FBAR violations do not rise to the level of an “intentional violation of a known legal duty” or “reckless disregard” of a legal obligation and should therefore not be considered willful, either criminally or civilly. However, many taxpayers, when faced with any risk of criminal prosecution or a finding that their FBAR violations could be considered civilly willful and therefore give rise to massive penalties, choose to take the safe route and enter the OVDP.

Once admitted to the OVDP, taxpayers are subject to a penalty regime that offers very little flexibility. That is, regardless of the level of willfulness involved in their tax non-compliance, the same 27.5 penalty is generally imposed and taxpayers are granted the same general reduction in the likelihood of criminal prosecution. For that reason, the OVDP in its current form unfairly favors individuals who willfully engaged in tax-noncompliance, i.e. those that knowingly violated or recklessly disregarded the tax and asset reporting laws. In other words, a taxpayer who willfully fails to file FBARs is subject to the same penalty rate as an individual who did not realize he had signatory authority over offshore bank accounts and thus had an FBAR filing obligation. Further, although the willfully acting taxpayer is much more likely to be subject to criminal prosecution absent the OVDP, both taxpayers will likely receive identical protection against criminal prosecution.

Right to Opt-Out Insufficient

The OVDP in its current form provides taxpayers with the option of “opting out” of the OVDP, and thereby remaining in the OVDP structure but choosing to bear the traditional penalties associated with their non-compliance, as opposed to the 27.5 percent penalty imposed by the OVDP. However, this is often little comfort to taxpayers. Once the opt-out election is made, it is irrevocable and the taxpayer faces the substantial risk that the IRS will undertake a full examination of the years included in the OVDP (as part of the OVDP submission, the taxpayer must agree to extend the statute of limitations to assess tax and FBAR penalties for all years covered by the taxpayer’s disclosure). If anything is uncovered in the examination that was not disclosed in the OVDP submission, the possibility of criminal prosecution reemerges.

Furthermore, the taxpayer again runs the risk of a determination that their FBAR violations were civilly willful, thus risking exposure to significantly higher penalties. This is a particularly strong concern because “willful blindness,” an extremely malleable and difficult to predict standard, is generally sufficient to give rise to a willful, civil FBAR violation which, as described above, can lead to a penalty of 50 percent of the highest balance in the subject account(s) each year for which there was a reporting failure. By opting out, taxpayers expose themselves to the risks they joined the OVDP to avoid in the first place.

Calls for Reform

These disparities have led to calls for the IRS to take a more exact approach in the application of penalties under the OVDP. Currently, there are only three possible penalty rates, 27.5 percent, 12.5 percent, and 5 percent. The 27.5 percent rate applies to the large majority of cases. The 12.5 percent applies only if the taxpayer’s undisclosed accounts and assets did not exceed $75,000 in any of the OVDP years, and the 5 percent rate applies only in narrow circumstances, such as for foreign residents who were unaware they were U.S. citizens, or where the taxpayer did not open the offshore account, had infrequent contact with the account, withdrew less than $1,000 per year from the account, and can prove that all income taxable by the U.S. in relation to the account has been paid. In short, the reduced penalties apply in very narrow circumstances and one misstep can cause a filer to lose the limited opportunity to take advantage of the reduced penalty.

This past January, the National Taxpayer Advocate issued scathing criticism of the current OVDP structure. In part, the Taxpayer Advocate stated:

The FBAR penalties are generally designed to apply to taxpayers who are intentionally evading U.S. tax by hiding significant untaxed assets in offshore accounts. But they are also affecting taxpayers with modest account balances and/or who did not intentionally evade tax, including those with assets in higher tax jurisdictions where no tax evader would reasonably plan to ide assets. In administering this law, the IRS needs to do a better job of recognizing this distinction, and a key part of what is needed is to remove the fear of opting out of the OVD programs.

The fundamental problem, as identified by the National Taxpayer Advocate and others, is that the willfulness requirement has been removed from the analysis of how to penalize non-compliant taxpayers. Whereas generally proving willfulness, either under the criminal or civil standard, is a burden the government must carry in order to convict taxpayers of serious tax crimes or impose significant penalties, once a taxpayer joins the OVDP willfulness is removed from the equation and all non-compliant taxpayers are treated equally.

To remedy this, the National Taxpayer Advocate proposed classifying OVDP filers in three categories:

  • The first category, applicable to taxpayers whose underpayment of tax is below a reasonable threshold, would be permitted to come forward and pay their back tax, interest, and penalty without the imposition of any information-reporting related penalties, such as the FBAR penalty.
  • The second category would cover OVDP filers that cannot meet the threshold of category one, but can provide an explanation as to why their actions were non-willful. They would be required to pay back tax, interest, penalties, and Title 26 information reporting penalties (i.e. failure to file Form 5471 disclosing an interest in a foreign corporation) but not FBAR penalties.
  • The third category would cover all others, and they would be subjected to the currently applicable OVDP penalties (i.e. payment of back tax, penalties, interest, and a single 27.5 percent penalty).

While the structure proposed by the National Taxpayer Advocate is not perfect, it does at least attempt to address the disparity between willful and non-willful non-compliance.

As Commissioner Koskinen’s comments seem to make clear, the IRS finally appears to be headed in that direction. As we have written before, past criticism of the OVDP by the National Taxpayer Advocate has been ignored by the IRS, so the Commissioner’s comments represent a significant step forward. While the Commissioner’s comments were vague, he stated that the IRS’s “goal is to ensure we have struck the right balance between emphasis on aggressive enforcement and focus on the law-abiding instincts of most U.S. citizens who, given the proper chance, will voluntarily come into compliance and remedy past mistakes.” This seems to be an indication that some modification of the current, one-size-fits-all treatment of OVDP filers will be forthcoming.

Moreover, the modification will likely be coming soon as the Commissioner noted “We believe that re-striking this balance between enforcement and voluntary compliance is particularly important at this point in time, given that we are nearing July 1, the effective date of FATCA.” FATCA is a law that generally requires foreign banks and financial institution to disclose their U.S. account holders or face a withholding tax on payments coming from U.S. sources. Its implementation, along with other efforts by the United States to acquire information about offshore accounts held by U.S. taxpayers has placed pressure on foreign banks to disclose their account holders’ identities which, in turn, has placed pressure on non-compliant account holders to address their past non-compliance. The IRS’s proposed modification of the OVDP could not come at a better time, and those contemplating making an offshore voluntary disclosure should give serious consideration to the current circumstances in deciding whether to proceed with a disclosure.

The attorneys at Fuerst, Ittleman, David & Joseph have extensive experience working with taxpayers who have undisclosed foreign bank accounts and who are seeking to avail themselves of the OVDP. We will continue to monitor the development of these issues, and we will update this blog with relevant information as often as possible. You can reach an attorney by calling us at 305-350-5690 or emailing us at contact@fuerstlaw.com.

FATCA Update: As Additional Countries Agree to Share International Tax Information, Hiding Assets Abroad becomes Increasingly Difficult

Tuesday, May 20th, 2014

In recent years the United States has increasingly amplified the pressure on United States persons to disclose assets they hold and income they earn abroad, especially relating to offshore financial accounts.  Two prominent examples of these efforts are the United States’ increased focus on imposing penalties and prosecuting entities and individuals for failing to file Foreign Bank Account Reports (FBARs), and the passage and forthcoming implementation of the Foreign Account Tax Compliance Act (FATCA), Internal Revenue Code §§ 1471-1474.  Many of our previous blog entries have focused on FBAR and FATCA enforcement and compliance, such as those entries found here, here, and here.

Now, the United States’ focus on reining in offshore tax evasion has spurred other countries to cooperate and agree to share financial information on a global scale, greatly reducing the effectiveness of well-established bank secrecy laws in the process.

Recent Efforts to Compel Account Information: FATCA

Generally, FATCA imposes a regime under which Foreign Financial Institutions (FFIs), such as foreign banks, foreign mutual funds, and foreign private equity funds, as well other foreign, non-financial entities are subject to a 30 percent withholding tax on income that would not otherwise be taxable by the United States, unless they enter into agreements with the IRS to identify and provide information regarding their US account holders or, in the case of a foreign entity, their US owners.  For instance, if a Foreign Financial Institution is due to be paid an interest payment from a US obligor that would otherwise qualify as tax-exempt portfolio interest, and that FFI has not entered into an agreement under FATCA with the IRS, the US business making the interest payment is obligated to withhold 30 percent of the otherwise non-taxable interest payment.

After passing FATCA, the United States found that in some cases conflicts existed between the mandates of FATCA and the domestic law of the FFIs that were subjected to FATCA.  In particular, certain nations’ domestic bank secrecy laws prevented the disclosure of much of the information required by FATCA.  In order to overcome these conflicts, the United States has entered Inter Governmental Agreements (IGAs) specifically intended to facilitate the implementation of FATCA.  There are two models of IGAs, Model 1 and Model 2.  Model 1 requires foreign financial institutions to report information regarding US account holder to their domestic government, with the domestic government to then provide the information to the United States.  Under Model 2, the foreign financial institution provides the US account holder information directly to the United States.  Most nations have entered into a Model 1 agreement.  A complete list of countries that have entered into IGAs with the United States is here.

The United States has entered into IGAs with a number of prominent banking nations, including Switzerland and the Cayman Islands.  Additionally, the United States has just agreed to an IGA with Israel and Singapore in substance (i.e. it has been agreed to but not yet signed) at the end of April and the beginning of May respectively.  On account of the IGAs, banks in the corresponding countries will generally not be able to rely on domestic bank secrecy laws to avoid meeting their obligations under FATCA.

As described above, a key part of FATCA is the withholding obligation imposed on payors with obligations to FFIs.  If the FFI does not comply with FATCA and reach an agreement with the IRS to disclose information regarding its account holders, income that is otherwise not taxable will be taxed at a flat 30 percent and is collected by requiring payors to withhold the tax.  This regime creates an extremely strong incentive for foreign banks to comply with FATCA.  In the end, most banks will protect their own bottom line rather than the keeping secret the identity of their account holders.  As a result, US persons holding offshore accounts should expect disclosure of their identity and account information as FATCA begins to be implemented.

Withholding under FATCA was initially set to begin January 1, 2014.  That date was moved back to July 1, 2014.  While the July 1, 2014 date is still effective, the IRS recently announced that 2014 and 2015 would be viewed as transitional years, and that foreign banks and withholding agents subject to FATCA that make good faith efforts to comply with FATCA may be relieved from its withholding regime.  Absent good faith compliance efforts, however, the IRS will not provide relief.

Exchange of Information among OECD Nations: Applying the Principles of FATCA on a Global Scale

FATCA requires FFIs and other foreign entities to disclose information regarding their account holders or owners only to the United States.  However, international cooperation in the sharing of tax information on a much wider scale took a big step forward earlier this month when two of the world’s most prominent hosts of offshore bank accounts, Switzerland and Singapore (along with a number of other countries) agreed to participate in the Organization of Economic Cooperation and Development’s (OCED) Automatic Exchange of Information in Tax MattersSome have speculated that the pending implementation of FATCA accelerated the sharing of tax information across a wider international scale.

Under the OECD Agreement, taxpayers’ financial information, including bank balances, dividend income, interest income, and information regarding asset sales, will be automatically shared among the member countries on an annual basis.  In addition, financial companies will be required to identify and disclose the ultimate beneficiaries of shell corporations, foreign trusts, and other foreign entities that can potentially be used to disguise beneficial recipients of taxable income.  With this information, signatories to the OECD Agreement will be able to largely determine their citizens’ offshore income without reliance on the citizens fulfilling their reporting obligations.

Particularly relevant is the inclusion of Switzerland and Singapore in the agreement.  Switzerland has long been a destination for those seeking to hide assets abroad, primarily due to the country’s strict bank secrecy laws.  Singapore has recently grown in prominence as a host of offshore bank accounts.  Switzerland’s and Singapore’s decision to agree to the automatic sharing of financial information is a clear indication that the United States’ efforts to combat offshore tax evasion are working.

The United States has made tremendous efforts to compel Swiss banks in particular to identify their US account holders notwithstanding Swiss bank secrecy laws.  For example, in the second half of 2013 the United States Department of Justice partnered with the Swiss Federal Department of Finance and established a program allowing Swiss banks not currently under criminal investigation by the Department of Justice to come forward and disclose potential past violations, pay penalties, close accounts of recalcitrant account holders, and establish programs to comply with FATCA going forward in exchange for an agreement by the Department of Justice to not prosecute the bank. We have previously written about these cooperative efforts between the United States and Switzerland here.

In addition, the United States has been investigating 14 prominent Swiss banks, including UBS and Credit Suisse, for potential criminal violations.  Through these criminal investigations, the United States has prosecuted banks, taxpayers, and individual bankers that evaded tax or aided or abetted US taxpayers in the evasion of income tax through undisclosed Swiss accounts.  Switzerland’s decision to sign onto the OECD Agreement represents a major shift in Switzerland’s historical approach to bank secrecy and appears to be, at least in part, a consequence of the United States’ efforts to compel information from Swiss banks.

The Fallout for US Taxpayers

The signatories to the OECD Agreement did not set a specific deadline to begin automatic sharing of information, but reports indicate that sharing will begin in 2017 and will involve tax information collected through 2015.  While the United States has entered into IGAs with a number of the countries that are parties to the OECD Agreement, there are a number of countries included in the OECD Agreement that do not yet have executed IGAs with the United States.  Therefore, to the extent local law still prohibits compliance with aspects of FATCA, the OECD Agreement should have the effect of breaking down those impediments and permitting the US to acquire information it would not otherwise be able to acquire relying on FATCA and IGAs alone.

More fundamentally, the wide range of countries that signed on to the OECD Agreement marks a significant indication that hiding assets in foreign jurisdictions for the purpose of avoiding tax on the income produced by those assets is becoming increasingly difficult.  Moreover, there is no indication that the United States’ interest in rooting out offshore tax evasion will wane anytime soon.  Taxpayers with offshore assets related to tax non-compliance need to seriously contemplate disclosing their assets and past non-compliance under the 2012 Offshore Voluntary Disclosure Program (OVDP).  As described in previous blog entries, the OVDP permits taxpayers with offshore assets and a history of non-compliance to come clean with the IRS for generally reduced penalties and a commitment from the IRS to not recommend criminal prosecution.  It is important to keep in mind that entry into the OVDP is generally unavailable to taxpayers whose identity and history of non-compliance has already been made known to the IRS or other federal authorities.

The attorneys at Fuerst, Ittleman, David & Joseph have extensive experience working with taxpayers who have undisclosed foreign bank accounts and who have availed themselves of the IRSs voluntary disclosure program. We will continue to monitor the development of these issues, and we will update this blog with relevant information as often as possible. You can reach an attorney by calling us at 305-350-5690 or emailing us at  contact@fuerstlaw.com.

Tax Litigation Update: United States v. Clarke Tests Limits of IRS Summons Enforcement Power

Monday, May 19th, 2014

On April 23, 2014, the United States Supreme Court heard oral argument in United States v. Clarke, a case which may affect every taxpayer subject to a future IRS examination.

At issue in the case is the extent to which a taxpayer may investigate the underlying reasons or motivations for the IRS’s issuance of a summons, a subpoena-like document that allows the IRS to demand documents, interview witnesses, and seek other information during the course of an examination.  Under IRC § 7602, the IRS may issue a summons to:

a person liable for the tax or required to perform the act, or any officer or employee of such person, or any person having possession, custody, or care of books of account containing entries relating to the business of the person liable for tax or required to perform the act, or any other person the Secretary may deem proper, to appear before the Secretary at a time and place named in the summons and to produce such books, papers, records, or other data, and to give such testimony, under oath, as may be relevant or material to such inquiry.

IRS SUMMONS POWER

The IRS’s summons power is immense, and the limitations placed on it, either by statute or by the courts, are limited.  The basic limitations placed on the IRS summons power were set forth in a seminal case, United States v. Powell, 379 U.S. 48 (1964), in which the Supreme Court held that in order to enforce a summons against an uncooperative recipient, the IRS must establish that (1) the examination is being conducted for a legitimate purpose; (2) the information sought may be relevant to that purpose; (3) the IRS does not already possess the information sought; and (4) the IRS has followed all necessary administrative steps, particularly regarding notice and service of the summons.

The Service’s burden to prove these matters is “slight.” An affidavit from the examiner attesting to these facts is sufficient. United States v. Samuels, Kramer and Co., 712 F.2d 1342, 1345 (9th Cir. 1983).

Once the IRS makes it prima facie showing, the burden shifts to the party opposing the summons to either disprove one of the four Powell elements or convince the court that enforcement of the summons would constitute an abuse of the court’s discretion.

Appropriate defenses to summons enforcement include asserting that (1) the summons was issued after the IRS had recommended criminal prosecution to the Department of Justice; (2) the summons was issued in bad faith; (3) the materials sought are already in the possession of the IRS; and, (4) the materials sought by the IRS are protected by either the attorney-client privilege, the work-product doctrine, or other traditional privileges and limitations. United States v. Riewe 676 F.2d 418, 420 n.1 (10th Cir. 1982).

IMPROPER PURPOSE AND BAD FAITH

The IRS is authorized to use a summons for the purposes described in IRC §7602, which are generally related to tax determination and collection. When the IRS uses its summons power for an unauthorized purpose or for any purpose reflecting on the good faith use of its power, the Supreme Court has said that the summons will not be enforced. Reisman v. Caplin, 375 US 440 (1964). Further, in Powell the Supreme Court stated that an “improper purpose” includes harassing the taxpayer, pressuring the taxpayer to settle a collateral dispute, or any other purpose reflecting negatively on the good faith of the particular investigation. (See also IRM 5.17.6.2.2, which discusses summonses legal authority). In addition, case law and IRC §7602(c) make it clear that the IRS is not authorized to use this power to assist another agency by, for example, using a summons to investigate a matter already being investigated by a grand jury, or by gathering evidence for the Department of Justice in its prosecution of a criminal case. United States v. LaSalle Nat’l Bank, 437 US 298 (1978)..

In general, since it is the court’s process that the IRS invokes in an enforcement proceeding to obtain compliance with a summons, a court will not order compliance unless it is satisfied that the IRS has served the summons in a good faith pursuit of its summons authority.

Before 1982, the IRS’s authority to issue summons did not expressly include power to use a summons to investigate a criminal violation of the tax laws. As a result, there was much litigation over the question whether the IRS was using a summons for an improper criminal purpose. In 1982, IRC §7602 was amended to provide that the statutorily authorized purposes for which a summons may be issued include “the purpose of inquiring into any offense connected with the administration or enforcement of the internal revenue laws.” Accordingly, the IRS is permitted to use a summons to gather evidence of a criminal violation of the tax laws. IRC §7602 was further amended to prohibit the use of a summons when a Department of Justice referral for criminal prosecution or grand jury investigation is in effect.

Significantly, persons affected by a summons have made objections that the summons has been issued for improper purposes other than for gathering evidence for use in a criminal prosecution. In United States v. LaSalle Nat’l Bank, 437 US 298 (1978), the Supreme Court recognized that a summons might be unenforceable for reasons other than an improper criminal purpose. Further, in Pickel v. United States, 746 F2d 176 (3d Cir. 1984), the third circuit stated that it did not doubt that portions of the Powell and LaSalle discussions of bad faith retain vitality even after the 1982 amendment to IRC §7602  and that where the taxpayer can prove that the summons is issued solely to harass him, or to force him to settle a collateral dispute, or that the IRS is acting solely as an information-gathering agency for other departments, such as the Department of Justice, the summons will be unenforceable because of the IRS’s bad faith. Further, where a substantial preliminary showing of abuse of the court’s process has been made, a summoned party is entitled to substantiate his allegations by way of an evidentiary hearing. United States v. Millman, 765 F2d 27 (2d Cir. 1985) (at the hearing, the agents responsible for the investigation and other witnesses may be called). See also United States v. Church of Scientology, 520 F2d 818, 824 (9th Cir. 1975)(limited evidentiary hearing approved).

When the challenge to a summons is based on an improper purpose, discovery and an evidentiary hearing are critical to prove the challenge, and it is by no means certain that the moving party will obtain either one or both opportunities. The district court’s decision to deny discovery and an evidentiary hearing is reviewed by a court of appeals under an abuse of discretion standard—that is, only if the taxpayer demonstrates in the summons enforcement hearing that the district court abused its substantial discretion in denying discovery and an evidentiary hearing. Discovery on motivation of an audit is permitted by some circuit courts only when the movant has shown “extraordinary circumstances” that take the movant out of “the class of the ordinary taxpayer, whose efforts at seeking discovery, would if allowed universally, obviously be too burdensome” to the IRS. United States v. Fensterwald, 553 F2d 231, 231–232 (DC Cir. 1977), cited in United States v. Judicial Watch, Inc., 371 F3d 824 (DC Cir. 2004). Another statement of the showing that is required to be entitled to discovery and an evidentiary hearing is that the movant need only establish the possibility of an improper motive before obtaining further discovery. This standard is more rigid than the standard that must be met by a party opposing a motion for summary judgment. Under this standard, the moving party must have evidence sufficient to raise a genuine issue of fact material to whether the audit is an act of political retaliation, or some other improper purpose. Further, requiring a taxpayer to produce records already in the IRS’s possession is arguably an abuse of the court’s process (or a bad faith use of the summons power). However, courts generally have enforced a summons in this situation.

In Clarke, the taxpayer alleged that the IRS had an improper purpose in issuing the summons, and thus was not entitled to enforce its subpoena. Specifically, Clarke asserted that the IRS was retaliating against the Dynamo’s refusal to extend the statute of limitations for a third time and that the IRS was seeking to circumvent the limited discovery rules available to litigants in Tax Court proceedings (The scope of documents and information that can be requested in a summons is generally wider than that which is permitted in a Tax Court Request for Production.)  This allegation was supported by the fact that when the IRS conducted its investigation with regard to a summons that was not challenged, attorneys representing the IRS in the Tax Court proceeding, rather than the agent in charge of the examination of Dynamo, performed the investigation. In essence, Clarke argued that the IRS was attempting to use its summons power in bad faith – as if it was a grand jury proceeding – to be able to obtain information which it would not otherwise obtain under normal Tax Court discovery rules, and thus have the upper hand in the case.

UNITED STATES V. CLARKE

Clarke arises out of an examination conducted by the IRS of a partnership called Dynamo Holdings for tax years 2005-2007.  During the course of the examination, Dynamo agreed to extend the statute of limitations for assessment two times.  Generally, the IRS has three years from the later of the due date for a return or the date the return is actually filed to assess a tax.  A tax is not collectible unless it is first assessed.

When the IRS requested a third extension of time within which to complete the assessment, the partnership refused.  Soon thereafter, the IRS issued five summonses, including one to Michael Clarke, the CFO of two partners of Dynamo.  The focus of the IRS’s summonses was interest deductions of $34 million taken by Dynamo over the course of two of the years subject to the IRS’s examination.

The IRS issued a Final Partnership Administrative Adjustment (FPAA) in December 2010, three days before the expiration of the statute of limitations.  By issuing the FPAA, the IRS tolled the statute of limitations period, formally set forth the amount it claimed the partnership owed, and began the process of assessing the tax deficiency and collecting the tax from the partnership’s partners.  Notably, the FPAA issued by the IRS in December 2010 was dated and signed in August 2010, before the IRS had issued the at-issue summons to Clarke.

In February 2011, Dynamo challenged the FPAA in the Tax Court.  Meanwhile, Clarke had refused to obey the summons, and the IRS began summons enforcement proceedings.  In April 2011, well after commencement of the Tax Court case.

In the typical enforcement proceeding, the IRS submits an affidavit of an agent familiar with the case establishing the Powell factors.  From there, the burden shifts to the taxpayer to allege and prove that one or more of the factors has not been established.  The district court, the forum for summons enforcement litigation, has discretion to determine whether to hold an evidentiary hearing or permit discovery regarding the summons recipient’s allegation that one or more of the Powell factors has not been established.

Before the district court, Clarke argued that the IRS did not have a legitimate purpose in issuing the summonses because, among other reasons, they were (1) issued in retaliation for the partnership’s refusal to extend the statute of limitations period a third time and (2) designed to circumvent the U.S. Tax Court’s limitations on the scope of discovery.  United States v. Clarke, 111 AFTR 2d 2013-1697 (S.D. Fla. Apr. 16, 2012).

Clarke brought forth some evidence supporting the contention that the summon was designed to circumvent the U.S. Tax Court’s limitations on the scope of discovery, including (1) the fact that the IRS sought to continue the Tax Court proceeding on the ground that the summonses were still outstanding and (2) a declaration from the lawyer of the sixth summoned individual (who ultimately complied with the summons request) that her IRS interview was conducted exclusively by the two lawyers representing the IRS in the Tax Court proceeding and that the examining agent was not even in attendance.  Notably, when Powell was decided, lawyers representing the IRS in Tax Court proceedings were not allowed to interview summoned individuals, only examining agents could do that.

To further prove their contentions, the Respondents requested an evidentiary hearing to inquire into the government’s purposes for issuing and enforcing the summonses (and also requested pre-hearing discovery).  The district court, however, ordered enforcement of the summonses.  It rejected the first argument as a “naked assertion” unsupported by evidence.  It then dismissed the second contention because it determined that, even if the IRS had used the summons process to sidestep discovery limitations, such a finding was not a valid reason to quash a summons.  Cf. Mary Kay Ash v. Commissioner, 96 T.C. 459, 462, 472-73 (1991) (denying taxpayer’s motion for protective order barring IRS from using evidence obtained through a summons but emphasizing that it was not deciding the enforceability of the summons since that issue was in the district court’s jurisdiction).

The United States District Court for the Southern District of Florida denied Clarke’s request for an evidentiary hearing.  On appeal, the Eleventh Circuit Court of Appeals reversed and held that the district court had abused its discretion in refusing to hold an evidentiary hearing.  The Eleventh Circuit held that an allegation of improper purpose is sufficient to trigger a limited adversary hearing before enforcement is ordered, and that, at the hearing, the taxpayer may challenge the summons on any appropriate ground.  The Eleventh Circuit’s reasoning was based in part on a prior summons enforcement case, Nero Trading.  In that case, the Eleventh Circuit reasoned that requiring the taxpayer to provide support for an allegation of improper purpose without giving the taxpayer the opportunity to obtain such facts “saddles the taxpayer with an unreasonable circular burden.”

Given the clear structure applicable to deciding summons enforcement proceedings, the parties’ arguments before the Supreme Court focused on narrow issues dictated by the facts specific to the case and the standard of review applicable to a district court’s decision to allow, or deny, an evidentiary hearing. The goals of the parties, specifically to persuade the Supreme Court to either affirm or reverse the Eleventh Circuit’s judgment based on the narrow facts of the case, were somewhat at odds with the Supreme Court’s goal of providing instruction to the district courts across the country that regularly face summons enforcement proceedings.

The government argued, and Clarke seemed to concede, that merely alleging bad faith in response to a summons does not necessarily entitle a summons objector to an evidentiary hearing during which IRS personnel can be examined by the objector. The differences arose with regard to what type of showing, beyond a mere allegation, an objector must make before being entitled to an evidentiary hearing.  Clarke argued that the affidavits  he submitted highlighting the questionable actions of the IRS—the close proximity between Dynamo’s refusal to extend the statute of limitations and issuance of the summonses, the issuance of the summonses well after the date the FPAA was signed, and the IRS’s use of its Tax Court attorneys to conduct the summons investigation—were sufficient to require the district court to hold an evidentiary hearing during which he would be permitted to question IRS personnel.  The government countered that the district court’s decision, which took into account all of the reasons for improper purpose raised by Clarke before the Eleventh Circuit and Supreme Court, should be respected because the district court did not abuse its discretion.

The Court’s focus during argument seemed to be on fashioning a rule of more general applicability from the specific and somewhat unique facts of the Clarke case.  What is clear from the Court’s questioning during oral argument is that any type of “automatic hearing” rule, in which a mere allegation of bad faith or impropriety will allow a summons objector the opportunity to participate in an evidentiary hearing, will not be permitted.  What is not as clear is whether the Court will adopt a generally applicable standard, rather than deciding the case before it on narrow grounds, and, if a general standard is adopted, what it will be.

There were hints from some of the Justices that they need to provide guidance to the district courts, and that limiting their decision to the narrow facts presented in Clarke would not be helpful.  Furthermore, there were indications that some of the Justices could seek to adopt more familiar litigation standards for application in the summons enforcement process.  Specifically, Justice Sotomayor raised the question of whether the heightened pleading standards set forth in two fairly recent Supreme Court cases called Twombly and Iqbal is the proper guide or whether the more rigorous standard applicable to summary judgment motions—in which the litigants must set forth specific, admissible evidence to support or oppose a motion for summary judgment—is more appropriate.  Not surprisingly, the government argued that the more rigorous summary judgment standard is more analogous, while Clarke argued that the Court’s rule should more closely follow the scrutiny applied to pleadings facing a motion to dismiss.

CONCLUSION

As with all SCOTUS cases, it is virtually impossible to determine precisely how the Court will rule. If the questions posed by the Justices during oral arguments were any indication of how the Court will rule, it is likely the Justices will side with the IRS.  Further, it is probably safe to assume that the Court will err on the side of requiring some clear, probative evidence before permitting a summons objector to question IRS personnel in Court.  This is because a rule that is too lenient, i.e. one that requires an evidentiary hearing upon the objector’s proffer of any evidence tending to show an improper purpose, would be seen as too damaging to the IRS’s examination process.

Moreover, the IRS is in the process of implementing more efficient processes relating to information gathering in the process of auditing large businesses.  A rule that takes a permissive approach toward entitling summons objectors to an evidentiary hearing, particularly one in which the agent conducting the exam can be questioned, would contravene the IRS’s stated focus on efficiency in gathering information during exams.

The impact of the Clarke decision will be especially relevant to taxpayers in South Florida.  As we have blogged about previously, South Florida has been a focus of recent IRS summons issuance.  Under the language of Nero Trading, taxpayers residing in the Eleventh Circuit (Alabama, Georgia, and Florida) had seemingly the most accommodating appellate court in the country to hear their appeal when a district court had denied a request for an evidentiary hearing.  If the Supreme Court issues a broad decision, the Eleventh Circuit’s prior decision to taxpayers seeking an evidentiary hearing to support their claims of an improper motive in summons issuance may no longer be precedential.

Notably, on April 28, 2014 – only five days after the Supreme Court heard oral arguments on Clarke – the Tenth Circuit Court of Appeals, in Jewell v. United States, Nos. 13–7038, 13–6069(2014), quashed IRS summonses that were issued after the 23-day period required under IRC §7609(a)(1). IRC §7609(a)(1) requires the IRS to notify summons recipients that it will examine records at least 23 days before the date fixed in the summons as the date upon which such records are to be examined. In deciding whether to quash the summonses, the appeals court examined whether the IRS had complied with the Powell requirements and determined that the 23-day period is an administrative step required by statute. In doing so, the Court acknowledged that it was creating a split between circuits. However, the Tenth Circuit emphasized that the Supreme ruled clearly in Powell when it said that “if the IRS does not comply with the administrative requirements of the Internal Revenue Code, its summonses are unenforceable.” In this battle between taxpayers and the government regarding IRS summons power, the ruling in Jewell and the split that now exists only serve to add fuel to the fire, and make the upcoming Supreme Court’s decision in Clarke all the more significant.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax, tax litigation, administrative law, regulatory compliance, and white collar criminal defense.  They will continue to monitor developments in this and similar cases. If you have any questions, an attorney can be reached by emailing us at contact@fuerstlaw.com or by calling 305.350.5690.

Marijuana Taxation Update: State Sanctioned Marijuana Industry Must Keep the Federal Anti-Drug Trafficking Tax Code in Mind

Monday, March 3rd, 2014

As we have previously reported, despite the growing number of States that have authorized the use of marijuana in various forms, the federal government has continued to crack down on dispensaries. (Our recent articles discussing these efforts can be read here, here, and here.) In addition to direct criminal prosecution for drug trafficking, federal authorities have used various other techniques in an effort to quash the growing marijuana industry. One such technique disallows marijuana dispensaries from taking business deductions on their federal income taxes pursuant to I.R.C. § 280E, and this statute remains in effect in spite of the efforts of numerous states and FinCEN to at least partially legitimize the sale of marijuana.

I.R.C. § 280E states:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

As we have previously explained, because the sale of marijuana remains listed as a controlled substance under the Controlled Substances Act (CSA), state authorized marijuana dispensaries are still deemed by federal authorities to violate federal law. Therefore, pursuant to I.R.C. § 280E, federal income tax deductions for business expenses are not available.  In fact, the United States Supreme Court has concluded that there is no medical necessity defense to the federal law prohibiting cultivation and distribution of marijuana – even in states which have created a medical marijuana exception to a comparable ban under state law. U.S. v. Oakland Cannabis Buyers Co-op., 532 U.S. 483 (2001).

In the District of Columbia and the 20 states that have either decriminalized or legalized marijuana in one form or another, state sanctioned medical marijuana dispensaries have attempted to pay their fair share of taxes to the government – federal, state and local – like any other business. However, because their business primarily involves a product deemed to be criminal under federal law, they are denied deductions for the costs of doing business that any other ordinary business can take.

When it comes to state taxation, an additional problem faced by state sanctioned marijuana dispensaries is that most of the states which have legalized the use of marijuana “piggy-back” their state corporate income tax on the federal income tax. That is, after the federal income tax has been calculated based on federal law, these states will impose a tax of a percentage of the federal corporate income tax (with certain adjustments in most instances). In those cases, not only is the federal government denying the benefits of claiming certain business deductions that any other business would have, but the state governments are equally denying these tax benefits despite the businesses being situated in a state that has legalized the use and sale of marijuana.

As we have previously reported, the effect of I.R.C. § 280E can be drastic on dispensaries. According to a 2013 CNNMoney report, the inability of dispensaries to take business deductions has resulted in dispensaries paying an effective tax rate as high as seventy-five percent (75%). The practical effect of this massive tax burden makes business operations difficult, if not impossible.

However, there is currently some hope for marijuana dispensaries in two respects. First, I.R.C. § 280E is limited to the sale of (or “trafficking in”) marijuana. Thus, if a taxpayer is engaged in selling medical marijuana and also in another business, such as care-giving to health patients, the taxpayer may be able to deduct business expenses in connection with the care-giving function. See Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner, 128 T.C. 14 (2007). Note, however, that “the taxpayer’s characterization will not be accepted when it appears that the characterization is artificial and cannot be reasonably supported under the facts and circumstances of the case.”Id. Second, while I.R.C. § 280E disallows any business deduction for a marijuana seller’s ordinary and necessary business expenses, costs of goods sold – that is, the carrying value of goods sold during a particular period – are excluded from this rule. To be sure, while marijuana businesses are disallowed ordinary and necessary business expenses deductions, they are allowed a deduction for the costs incurred for the purchase, conversion, materials, labor, and allocated overhead incurred in bringing the marijuana inventories to their present location and condition. Therefore, marijuana businesses have an incentive to capitalize as inventory all costs associated to the purchase of marijuana and then in future years successfully deduct these costs as costs of goods.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax, tax litigation, administrative law, regulatory compliance, and white collar criminal defense.  They will continue to monitor developments in this and similar cases. If you have any questions, an attorney can be reached by emailing us at contact@fuerstlaw.com or by calling 305.350.5690.

Tax Litigation Update: Eleventh Circuit Reverses Tax Court in Virgin Islands EDP Residency Cases

Monday, February 24th, 2014

Disclosure: Joseph A. DiRuzzo, III of Fuerst Ittleman David & Joseph represents the taxpayers in their Tax Court litigation against the IRS.

We have written extensively about the United States Virgin Islands Economic Development Program (EDP) and the litigation it has spawned between and among the IRS, the Virgin Islands Bureau of Internal Revenue (VIBIR), and the individuals and businesses which have sought to do business in the Virgin Islands and avail themselves of the EDP; see here, here, here and here. Much of this litigation has focused on the issue of whether the various taxpayers have been bona fide residents of the Virgin Islands, which On February 20, 2014, the United States Court of Appeals for the Eleventh Circuit issued its opinion in the consolidated appeals filed by the Government of the United States Virgin Islands (“Virgin Islands”) following the Tax Court’s denial of the Virgin Islands’ motions to intervene in the Tax Court proceedings of three separate taxpayers. The Eleventh Circuit’s precedential decision, Government of the United States Virgin Islands v. Commissioner of IRS, is available here.

The Eleventh Circuit described the background of the Taxpayers’ complex tax proceedings as follows:

The Taxpayers filed returns with the BIR for calendar tax years 2002, 2003, and 2004. The Taxpayers reported their worldwide income, which consisted of income from both United States and Virgin Islands sources, and paid taxes on that income to the Virgin Islands. None of the Taxpayers filed a return with the IRS.  In 2009 and 2010, the IRS issued deficiency notices to the Taxpayers for tax years 2002, 2003, and 2004. The IRS claimed, first, that the Taxpayers were not bona fide Virgin Islands residents during those tax years and, therefore, they should have filed returns with the IRS and paid taxes to the United States on the income they reported from United States sources Second, the IRS claimed that some of the Taxpayers’ income that they classified as Virgin Islands income on their BIR returns was, in fact, United States income and, therefore, the Taxpayers should have paid taxes to the United States on that income too. Rather than crediting the Taxpayers’ federal tax liability with the taxes paid to the Virgin Islands (which the IRS claimed should have been paid to the United States), the IRS issued a deficiency notice for the full amount owed to the United States, plus penalties for failing to file an IRS return and for delinquent payment.

***

The Taxpayers petitioned the Tax Court, challenging the IRS’s deficiency notices as time barred and, in the alternative, as incorrect. The Virgin Islands moved to intervene in the cases, the Tax Court denied its motions, and the Virgin Islands brought these appeals.

Slip op., at 4-5.

The Eleventh Circuit also explained the reasons why the Virgin Islands moved to intervene in the Taxpayers’ Tax Court cases in the first place:

If the Tax Court eventually determines that the Taxpayers were not bona fide residents, one of three things will occur: the IRS may ask the Virgin Islands to transfer over the portion of taxes that should have been paid to the United States; the Virgin Islands may choose to voluntarily refund the “overpaid” taxes as a matter of fairness; or the Virgin Islands may be forced to accept that the Taxpayers paid taxes twice on the same income.9 Thus, the Virgin Islands has an interest in the Tax Court proceedings for the same reason the United States had an interest in the Virgin Islands District Court proceedings in V.I. Derivatives: the court’s findings have practical implications for the Virgin Islands’ taxation of the same individuals.

Slip op., at 16.

In V.I. Derivatives, the IRS moved to intervene in an ongoing tax case proceeding before the District Court of the Virgin Islands. There, the IRS was permitted to intervene, but when the Virgin Islands sought to intervene before the Tax Court on exactly the same grounds, the IRS objected to the intervention. Thus, the Eleventh Circuit slammed the IRS’s position, at one point labeling it “unpersuasive [and] bordering on disingenuous”¦” and at another describing it as a “Monday morning quarterback.”

The Eleventh Circuit also noted that the Third Circuit had already ruled on this issue, reversing the Tax Court and rejecting the same IRS arguments made in the Eleventh Circuit, but recognized that there is a circuit split.  On the one hand, the Third and Eighth Circuits have reversed the Tax Court’s denials of the Virgin Islands’ motions to intervene, but on the other the Fourth Circuit had affirmed. Ultimately, the 11th Circuit held that Federal Rule of Civil Procedure 24(a)(2)applies to the Tax Court and that the Government of the USVI may intervene as a matter of right.

The take away from this decision is that the Government of the USVI may now intervene in cases reviewable by the Third, Eighth and Eleventh Circuits, which includes Florida, Georgia, Alabama, Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, South Dakota, New Jersey, Pennsylvania, Delaware, and the US Virgin Islands.  But the Government of the USVI cannot intervene in the Fourth Circuit which includes Maryland, North Carolina, South Carolina, Virginia, and West Virginia. It remains an open question in other parts of the country where a federal appeals court has not addressed the matter. Additionally, the overtly hostile view the Eleventh Circuit took on the IRS litigation position bodes well for both the taxpayers whom the IRS claims have no protection under the statute of limitations and the Virgin Islands seeking to intervene in further Tax Court disputes arising from the Economic Development Program.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax litigation before the Tax Court, the District Courts, the Court of Claims, and the United States Courts of Appeal.  Additionally, the attorneys at Fuerst Ittleman David & Joseph, PL actively litigate in the United States Virgin Islands and have on-going tax litigation before the District Court of the Virgin Islands against the USVI Bureau of Internal Revenue. For more information about our United States Virgin Islands Tax Law and Litigation practice, click here. If you have any questions, an attorney can be reached by emailing us at contact@fuerstlaw.com or by calling 305.350.5690.

Criminal Tax Litigation Update: Courts are Consistently Ruling that the Act of Production Privilege Will Not Defeat Grand Jury Subpoenas Calling for Foreign Bank Account Statements

Wednesday, January 29th, 2014

On December 13, 2013, the United States Court of Appeals for the Fourth Circuit issued its decision in United States of America v. Under Seal, a copy of which is available here. On December 19, 2013, the U.S. Court of Appeals for the Second Circuit issued its decision in In Re: Grand Jury Subpoena, a copy of which is available here. In both cases, the parties found themselves on the receiving end of grand jury subpoenas demanding the production of, generally, records of his foreign bank accounts, including the names of the account holders, the banks, the account numbers, the type of the account, and the maximum value of the account all information that must by law be reported to the Commissioner of Internal Revenue. In both cases, the parties refused to comply with the subpoenas, and in both cases the government moved to compel production in federal district court.

Before the district court, the recipients of the grand jury subpoenas argued that the Fifth Amendment insulated them from producing the records demanded by the grand jury because, in short, the grand jurys subpoena requires him either to produce documents that might incriminate him or to confirm that he failed to register his foreign bank accounts, which itself could be incriminating. Thus, to the extent that the witnesss simple act of producing the documents could be used against the witness for example, in those cases when the simple fact that the witness possessed the documents would be incriminating the recipients of the subpoenas argued that the Fifth Amendment militated against compelled production. This is commonly referred to as the Fifth Amendment act of production privilege. See Fisher v. United States, 425 U.S. 391 (1976).

The act of production privilege is a serious one, but it is not without its limits. For instance, we have previously discussed the required records exception to the act of production privilege under the 5th Amendment to the U.S. Constitution here and here. As described by the Second Circuit, [t]he required records exception applies only when the Fifth Amendment privilege would otherwise allow a witness to avoid producing incriminating documents. It abrogates the protection of the privilege for a subset of thosedocuments that must be maintained by law. (emphasis added). So, in other words, if a witness receives a subpoena calling for production of documents which must be maintained by law, the witness cannot successfully assert that he is insulated by the act of production privilege. In Grosso v. United States, 390 U.S. 62, 6768 (1968), the Court established a three-factor test to determine whether documents are required records:

First, the purposes of the United States inquiry must be essentially regulatory; second, information is to be obtained by requiring the preservation of records of a kind which the regulated party has customarily kept; and third, the records themselves must have assumed public aspects which render them at least analogous to public documents.

In these two cases, the Second and Fourth Circuits travelled the same analytical course and arrived at virtually identical locations: the regulations under the Bank Secrecy Act require that individuals with foreign bank account maintain those records and produce them to the government upon request.  Consequently, statements received from foreign banks are “required records” and the Fifth Amendment act of production privilege does not apply.

As of today, the Second, Fourth, Fifth, Seventh, Ninth and Eleventh Circuits have address the issue and all have sided with the government.  Given that there is no decision from a Court of Appeals siding with a taxpayer on this issue, the probability that the United States Supreme Court would take up the matter is remote.

What does this mean for taxpayers? At a minimum, it means that when seeking to enforce a grand jury subpoena calling for records of foreign financial accounts, the Government will be able to proceed with virtually no fear that it will be quashed. Taxpayers who have undisclosed foreign accounts should consult with competent counsel so as to become educated about their options, including the IRS Offshore Voluntary Disclosure Program (which we have discussed inter alia herehereherehere and here), and avoid criminal prosecution.

The attorneys at Fuerst Ittleman David & Joseph have extensive experience in civil and criminal tax litigation throughout the United States. You may contact us by calling 305.350.5690 or by emailing us at contact@fuerstlaw.com

Tax Litigation Update: Second Circuit Tweaks its Standard of Review in Tax Cases Involving Mixed Questions of Law and Fact; Decides Complex Tax Controversy Involving “Midco” Transaction

Thursday, January 23rd, 2014

On November 14, 2013, the United States Court of Appeals for the Second Circuit clarified the standard of review for mixed questions of law and fact in a case on review from the Tax Court. The case, Diebold Foundation, Inc. v. Commissioner of Internal Revenue, involved a group of shareholders who wished to dispose of the stock they owned in a corporation which in turned owned appreciated property. Further, the Second Circuit joined the First and Fourth Circuits in concluding that the two prongs of §6901, dealing with transferred assets, are independent, and that the Tax Court did not err by only addressing the second prong of that section. A copy of the decision can be found here.

BACKGROUND

Upon the disposition of appreciated property, taxpayers, including corporate entities, generally owe tax on the property’s built-in gain””that is, the difference between the amount realized from the disposition of the property and its adjusted basis. 26 U.S.C. §§ 1(h), 1001, 1221, 1222. When shareholders who own stock in a C Corp that in turn holds appreciated property wish to dispose of the C Corp, they can do so through one of two transactions: an asset sale or a stock sale. If the shareholders sell the assets, the company is liable for tax on the built-in gain of appreciated property and therefore, there is less money to distribute to the shareholders. If the shareholders sell the stock, they must sell it at a lesser value so that the buyer will be insulated from the property’s built-in gains which will trigger a tax liability when sold. For shareholders to get the benefit of selling stock at a good price and buyers to get the benefit of buying assets without built-in gains, parties engage in “Midco transactions.”

“Midco transactions” or “intermediary transactions” are structured to allow the parties to have it both ways: letting the seller engage in a stock sale and the buyer engage in an asset purchase. In such a transaction, the selling shareholders sell their C Corp stock to an intermediary entity (or “Midco”) at a purchase price that does not discount for the built-in gain tax liability, as a stock sale to the ultimate purchaser would. The Midco then sells the assets of the C Corp to the buyer, who gets a purchase price basis in the assets, as opposed to the lower basis the corporate entity formerly had. The Midco keeps the difference between the asset sale price and the stock purchase price as its fee. The Midco’s willingness to allow both buyer and seller to avoid the tax consequences inherent in holding appreciated assets in a C Corp is based on a claimed tax-exempt status or supposed tax attributes, such as losses, which allow it to absorb the built-in gain tax liability. See I.R.S. Notice 2001-16, 2001-1 C.B. 730. It is important to note that if these tax attributes of the Midco prove to be artificial, then the tax liability created by the built-in gain on the sold assets still needs to be paid. In many instances, the Midco is a newly formed entity created for the sole purpose of facilitating such a transaction, without other income or assets and thus likely judgment-proof. The IRS must then seek payment from the other parties involved in the transaction in order to satisfy the tax liability the transaction was created to avoid.

FACTS

Double D Ranch, Inc., a personal holding company taxed as a C Corp., owned assets worth approximately $319 million, all of which had substantial built-in gain, such that the sale of the assets would have triggered a tax liability of approximately $81 million. The shareholders, Dorothy R. Diebold Marital Trust and Diebold Foundation, Inc., wanted to get rid of the assets of the corporation without triggering this tax liability but also without having to sell their shares at a substantial discount. Therefore, they decided to engage in a Midco transaction.

The parties to this Midco transaction all filed tax returns. On its tax return, the Midco claimed sufficient losses to offset the gain from the sale of assets, resulting in no net tax liability. The IRS issued a notice of deficiency against Double D Ranch, determining a deficiency of income tax, penalties, and interest of approximately $100 million. The deficiency resulted from the IRS’s determination that the Shareholders sale of Double D Ranch stock was, in substance, actually an asset sale followed by a liquidating distribution to the Shareholders. Double D Ranch did not contest this assessment, but the IRS was unable to find any Double D Ranch assets from which to collect the liability, as they had all been sold as part of the “Midco” transaction.

Deciding that any additional efforts to collect from Double D Ranch would be futile, the Commissioner attempted to collect from the Shareholders as transferees of Double D Ranch. Section 6901 of the Internal Revenue Code authorizes the assessment of liability against both (a) transferees of a taxpayer who owes income tax and (b) transferees of transferees. 26 U.S.C. § 6901(a)(1)(A)(I), (c)(2). The IRS issued a notice of transferee liability against Mrs. Diebold, trustee of the Marital Trust and director of Diebold Foundation, as a transferee of Double D Ranch. The Tax Court determined that she was not liable because the Marital Trust was the actual Double D Ranch shareholder, and the court saw no reason to ignore its separate existence. The Tax Court’s decision is available here.

SECOND CIRCUIT OPINION

  1. Standard of Review

The Second Circuit started its discussion by setting forth that its previous standard of review for mixed questions of law and fact was clear error. See Wright v. Comm’r, 571 F.3d 215, 219 (2d Cir. 2009). However, the Court noted that, according to statutory mandate, all Courts of Appeals are to “review the decisions of the Tax Court ”¦ in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury.” 26 U.S.C. §7482(a)(1). That is, all Courts of Appeal are to review decisions of the Tax Court de novo to the extent that the alleged error is in the misunderstanding of a legal standard and for clear error to the extent the alleged error is in a factual determination. Consequently, the Second Circuit acknowledged that its case law enunciating the standard of review for mixed questions of law and fact in an appeal from the Tax Court was in direct tension with this statutory mandate. Thus, because all Article III courts, with the exception of the Supreme Court, are solely creatures of statute, see U.S. Const. art. III; 28 U.S.C. §§ 1-463, the Second Circuit found that the statute must be determinative. Moreover, the Second Circuit Court held that there is no reason to review the Tax Court under a different standard than a district court, as “its relationship to us [is] that of a district court to a court of appeals.” Scheidelman v. Comm’r, 682 F.3d 189, 193 (2d Cir. 2012) (internal quotation marks omitted). Therefore, the Court held that “the Tax Court’s findings of fact are reviewed for clear error, but that mixed questions of law and fact are reviewed de novo, to the extent that the alleged error is in the misunderstanding of a legal standard.” See 26 U.S.C. § 7482(a)(1).

  1. The Merits of the Tax Controversy

In its discussion of the merits of the case, the Second Circuit Court studied IRC Section 6901, which provides that the IRS may assess tax against the transferee of assets of a taxpayer who owes income tax. The section provides that the tax liability will “be assessed, paid, and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred” and allows for the collection of “[t]he liability, at law or in equity, of a transferee of property…of a taxpayer.” A “transferee” includes a “donee, heir, legatee, devisee, [or] distributee.”

Furthermore, the Second Circuit stated that although the provision with respect to transferees is not expansive in its terms, the IRS may assess transferee liability under § 6901 against a party if two distinct prongs are met: (1) the party must be a transferee under § 6901; and (2) the party must be subject to liability at law or in equity. Rowen v. Comm’r, 215 F.2d 641, 643 (2d Cir. 1954) (discussing predecessor statute, 26 U.S.C. § 311). Under the first prong of § 6901, courts look to federal tax law to determine whether the party in question is a transferee. The second prong, whether the party is liable at law or in equity, is determined by the applicable state law, in this case, the New York Uniform Fraudulent Conveyance Act (“NYUFCA”), N.Y. Debt. & Cred. Law §§ 270-281.

The Second Circuit joined the First and Fourth Circuits in concluding that the two prongs of § 6901 are independent and that the Tax Court did not err by only addressing the liability prong. See Frank Sawyer Trust of May 1992 v. Comm’r, 712 F.3d 597, 605 (1st Cir. 2013);Starnes v. Comm’r, 680 F.3d 417, 428 (4th Cir. 2012). The Court cited Commissioner v. Stern, 357 U.S. 39 (1958) where the Supreme Court recognized that the predecessor statute to § 6901 “neither creates nor defines a substantive liability but provides merely a new procedure by which the Government may collect taxes.” The statute was enacted in order to do away with the procedural differences between collecting taxes from one who was originally liable and from someone who received property from the original tax owner.

As for the second prong, the Second Circuit Court stated that the NYUFCA defines a “conveyance” as “every payment of money, assignment, release, transfer, lease, mortgage or pledge of tangible or intangible property, and also the creation of any lien or encumbrance.” N.Y. Debt. & Cred. Law § 270. Further, the NYUFCA establishes liability for a transferee if the transferor, without regard to his actual intent, (1) makes a conveyance, (2) without fair consideration, (3) that renders the transferor insolvent. See N.Y. Debt. & Cred. Law § 273; McCombs, 30 F.3d at 323. If Double D had sold its assets and liquidated the proceeds to its shareholders without retaining sufficient funds to pay the tax liability on the assets’ built-in gains, this would be a clear case of a fraudulent conveyance under § 273. However, due to the Midco form of this transaction, Double D did not actually make a conveyance to the Shareholders. If the form of the transaction is respected, § 273 is inapplicable.

The Second Circuit Court relied on HBE Leasing Corp. v. Frank, 48 F.3d 623, 635 (2d Cir. 1995), where it had previously stated: “[i]t is well established that multilateral transactions may under appropriate circumstances be ”˜collapsed’ and treated as phases of a single transaction for analysis under the UFCA.” HBE Leasing described a “paradigmatic scheme” under this collapsing doctrine as one in which one transferee gives fair value to the debtor in exchange for the debtor’s property, and the debtor then gratuitously transfers the proceeds of the first exchange to a second transferee. The first transferee thereby receives the debtor’s property, and the second transferee receives the consideration, while the debtor retains nothing. Such a transaction can be collapsed if two elements are met. “First, in accordance with the foregoing paradigm, the consideration received from the first transferee must be reconveyed by the [party owing the liability] for less than fair consideration or with an actual intent to defraud creditors ”¦ Second, . . . the transferee in the leg of the transaction sought to be voided must have actual or constructive knowledge of the entire scheme that renders her exchange with the debtor fraudulent.”

The Second Circuit stated that in this case, it was clear that the first element was met. Although the transaction had an additional wrinkle””namely, an additional party serving as the conduit for the transfers””it is still the case that one transferee received Double D’s property, another transferee (the Shareholders) received the consideration for these assets, and Double D was left with neither its assets nor the value of them. Therefore, in order for there to be liability against the selling Shareholders (and their successor entities), the Shareholders “must have actual or constructive knowledge of the entire scheme that renders [the] exchange with [Double D] fraudulent.”

When applying § 273 to a single transaction, the intent of the parties is typically irrelevant; the knowledge and intent of the parties becomes relevant when, as here, a court is urged to treat multiple business deals as a single transaction. Therefore, the Court proceeded to assess whether the Shareholders had actual or constructive knowledge of the entire scheme. The facts in this case demonstrated both a failure of ordinary diligence and active avoidance of the truth. Specifically the Court noted that the Shareholders recognized the “problem” of the tax liability arising from the built-in gains on the assets held by Double D, and sought out parties to help them avoid the tax liability inherent in a C Corp holding appreciated assets. They viewed slideshow and other presentations from three different firms that purported to deal with such problems.

The Court also noted that the Shareholder representatives had a sophisticated understanding of the structure of the entire transaction, a fact that courts frequently consider when determining whether to collapse a transaction and impose liability on an entity. See HBE Leasing, 48 F.3d at 635- 36 (“The case law has been aptly summarized in the following terms: “In deciding whether to collapse the transaction and impose liability on particular defendants, the courts have looked frequently to the knowledge of the defendants of the structure of the entire transaction and to whether its components were part of a single scheme.”) quoting In re Best Products Co., 168 B.R. 35, 57-58 (Bankr. S.D.N.Y. 1994 (emphasis added).

The fact that there had been a delay of the original closing date by one day, and the Shareholders’ representatives’ corresponding intervention between Shap Acquisition Corporation II (“Shap II”), an entity created specifically to carry out the transaction  and Morgan Stanley, the ultimate buyer of Double D securities, made the conclusion of their “active avoidance of the truth” inescapable. By asking Morgan Stanley to “back off” and give Shap II extra time to provide the Double D securities so that the transactions would not be upended, the Shareholders demonstrated not only their knowledge of the structure of the entire transaction, but their understanding that Shap II did not have the assets to meet its obligation to buy equivalent shares on the open market for delivery to Morgan Stanley or pay Morgan Stanley an equivalent sum in cash. This understanding, combined with the Shareholders’ knowledge that Shap II had just come into existence for the purposes of the transaction, was more than sufficient to demonstrate an awareness that Shap II was a shell that did not have legitimate offsetting losses or deductions to cancel out the huge built-in gain it would incur upon the sale of the Double D securities.

The Second Circuit Court concluded that the Shareholders’ conduct evinced constructive knowledge, and therefore collapsed the series of transactions and found that there was a conveyance under the NYUFCA. In collapsing the transactions, the Court stated that, in substance, Double D sold its assets and made a liquidating distribution to its Shareholders, which left Double D insolvent””that is, “the present fair salable value of [its] assets [wa]s less than the amount . . . required to pay [its] probable liability on [its] existing debts as they bec[a]me absolute and matured.” N.Y. Debt. & Cred. Law § 271. With the liquidating distribution, Double D did not receive anything from the Shareholders in exchange, and thus Double D certainly did not receive fair consideration. Consequently, all three prongs of § 273 were met: Double D (1) made a conveyance, (2) without fair consideration, (3) that rendered Double D insolvent. See N.Y. Debt. & Cred. Law § 273; McCombs, 30 F.3d at 323. Because the Court determined that there was state law liability, an issue arose regarding whether Diebold New York was a transferee under I.R.C. § 6901, and subsequently, whether Diebold was a transferee of a transferee under the same statute. To answer these questions, the Second Circuit Court remanded the case to the Tax Court.

The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience in the areas of tax litigation. They will continue to monitor developments in this and similar cases. If you have any questions, an attorney can be reached by emailing us atcontact@fuerstlaw.com or by calling 305.350.5690.