Adequacy of IRS Notices & Variance in Refund Claims (9/15/12)

In Bush v. United States, 2012 U.S. Claims LEXIS 1083 (2012), here, the Court of Federal Claims held in a tax refund suit that a computational adjustment based on a partnership adjustment was subject to the Scar analysis of validity of an IRS determination and that the taxpayer had a fatal variance between an argument first advanced in briefing in the case.  I'll look at both of these issues.

THE SCAR ISSUE

In Scar v. Commissioner, 814 F.2d 1363 (9th Cir. 1987), the Ninth Circuit held that a facially invalid basis for an adjustment in the notice of deficiency meant that the IRS had not made the required determination for a notice of deficiency and thereby invalidated the notice of deficiency.  Bush involves a computational adjustment from a partnership audit rather than a notice of deficiency, but it will be helpful to put Scar in its context.  I offer the  background for the Scar holding (cut and pasted from my Federal Tax Procedure book is (footnotes omitted):

2. The Notice of Deficiency. 

a. The Determination and Explanation. 

The IRS is authorized to issue a deficiency notice “If the Secretary determines that there is a deficiency.”  § 6212(a).  The notice of deficiency should “describe the basis for, and identify the amounts (if any) of, the tax due, interest, additional amounts, additions to the tax, and  assessable penalties included in such notice,” § 7522(a).  Frequently, the notice of deficiency will be somewhat sparse in its explanation, but usually the taxpayer will have been given an agent’s report that explains the IRS position.  And, in any event, the same statute provides: “An inadequate description under the preceding sentence shall not invalidate such notice.”   [Note § 7522(a) was not in the law when Scar was decided; and does not apply to computational adjustments in any event.]

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c. Explanation of the Basis for the Deficiency. 

As noted above, the deficiency notices must describe the basis for the deficiency but failure to do so will not invalidate the deficiency.  Thus, the taxpayer appears to have a statutory right to the information in the notice of deficiency, but no statutory remedy if he does not receive it in the notice of deficiency.  As we shall note, however, there may be some remedies short of invalidity of the notice for failure to meet this requirement of § 7522(a). [Reminder, § 7522(a) was not in the law when Scar was decided and does not apply to computational adjustments in any event.]

Usually, there will be some explanation.  It may be summary or even cryptic because the determination usually follows an audit in which the taxpayer participated and was aware of the issues the IRS was raising.  Indeed, in such cases, usually the taxpayer will have been provided some type of report (often referred to as a Revenue Agent's Report (“RAR”)) that explains the proposed adjustments.  But again, although the Code provides that the taxpayer be notified of the basis for the deficiency, there is no Code remedy if one is not provided. 

Where the IRS satisfies the Code requirement of an explanation, there are some practical pressures to force the IRS to make it a reasonably good explanation.  As noted above, the statute does require that the IRS determine a deficiency.  One court has held that where the notice of deficiency explains the deficiency based on facts that patently do not exist, then the IRS has not met the requirement that it make a deficiency determination. fn1362  In that case, the notice said that it was disallowing a deduction for certain tax shelter partnership items with respect to a named partnership.  The taxpayer was not a partner in the named partnership.  The taxpayer was a partner in a tax shelter partnership with another name, and it is likely that the IRS just plugged in the wrong name on the notice of deficiency.  The Court held that, based on the erroneous explanation on the face of the notice of deficiency, the IRS had made no determination as required by § 6212.  The result was that the notice of deficiency was invalid.  What followed from the invalidity of the notice of deficiency is that the statute of limitations on assessment was not suspended under § 6503 and, by the time the IRS realized the error (i.e., when the Court of Appeals pronounced the notice invalid), the statute of limitations on assessments had likely expired. 

    fn1362 Scar v. Commissioner, 814 F.2d 1363 (9th Cir. 1987); as explained in Kantor v. Commissioner, 998 F.2d 1514, 1521-1522 (9th Cir. 1993) and Clapp v. Commissioner, 875 F.2d 1396, 1402 (9th Cir. 1989).

With that introduction to the Scar holding, let's look next at the notice of the computational adjustment.  Here is the explanation of the computational adjustment from my Federal Tax Procedure book (footnotes omitted):

M. Conclusion of Unified Proceedings. 

1. Partnership Items. 

At the conclusion of the unified proceedings, the IRS takes the determinations of partnership items finally made (either the determinations in the FPAA if there is no unified litigation or the determinations in the litigation) and flows them through to the partners as computational adjustments which do not require a notice of deficiency be issued to the partners.  The opportunity for judicial review has already been provided at the partnership level, so there is no further need for partner judicial review, which is the sole purpose of the notice of deficiency. 

2. Affected Items. 

Adjustment at the partner level may also be made for items that are not “partnership items” but are instead “affected items.”  Affected items are items that are affected by the partnership items.  For any affected item which is a computational or automatic adjustment requiring no further determinations at the partner level, the IRS may assess immediately as a computational adjustment.  An example of an affected item that could be made by computational adjustment is a medical deduction which is automatically affected by percentages of adjusted gross income, so that if all that is at issue is the partnership item adjustment and the automatic affected item adjustment (here the medical deduction), the IRS could assess immediately without a notice of deficiency.  For affected items that may require further partner level determinations, a partner level notice of deficiency may be required. 

In Bush, the facts upon which the taxpayers' Scar claims were presented involved the notice of computational adjustment rather than a notice of deficiency.  In the notice of computational adjustment, , the IRS advised that, for the tax year involved (1983), the IRS did not have a copy of the taxpayers' tax return, "we are making the adjustment without the benefit of your return," and based the computations on other information.

The Court of Federal Claims rejected taxpayers' Scar claims, limiting the Scar holding to notices of deficiency (one footnote omitted).

This case, in contrast to Scar, does not involve a notice of deficiency, and the court declines the plaintiffs' invitation to extend the Scar holding to computational adjustments. fn7 To begin, it is important to note that notices of deficiency and computational adjustments are treated differently under the Code. Under section 6230(a)(1), notices of deficiency are not required in cases where a computational adjustment is issued unless certain individualized tax matters are implicated. I.R.C. § 6230(a)(1) (Subchapter B, I.R.C. §§ 6211-6216, relating to deficiency procedures "shall not apply to the assessment or collection of any computational adjustment."). An exception is provided in section 6230(a)(2), which provides in part for deficiency  [*20] proceedings where a deficiency is "attributable to affected items which require partner level determinations." I.R.C. § 6230(a)(2)(A)(i). 

   n7 The court is not aware of any case in which the Federal Circuit has indicated its agreement with the reasoning in Scar or applied the reasoning in Scar to any tax refund matter, including one arising out of a computational adjustment applying a section 6226(a) decision of the Tax Court imposing section 6221(c) penalty interest for engaging in tax motivated transactions.

* * * * 

The computational adjustment therefore provided plaintiffs with notice of the basis for the IRS tax assessment and the focus of this case must be on the Form CG-4549A issued to plaintiffs. 

This case is therefore wholly distinguishable from Scar. In Scar, the IRS made a tax decision based on a mistake that invalidated the individual notice of deficiency. In this case, the plaintiffs have not identified any mistake in the computational adjustment. The plaintiffs do not dispute that Mr. Strauch [Strauch was the taxpayer rather than Bush, the name under which the case is decided] participated in the subject tax shelter and that the IRS made its calculation of taxes based on information available to the IRS, which plaintiffs did not question in their complaint or before the IRS in their refund claim. In such circumstances, the IRS met its obligation for issuing a computational adjustment. Nothing in the statute or regulations requires the IRS to base its computational adjustment on the taxpayers' specific returns as opposed to "information [before the IRS and] used for prior assessments." Given the trigger for a notice of deficiency in the tax shelter context, the IRS may well need more individualized information for the notice of deficiency than for a computational adjustment. In those cases, the need for the IRS to examine individual returns before issuing a notice of deficiency may well be appropriate. Here, where plaintiffs have not identified in their complaint any specific errors in the computational adjustment and have challenged only the government's failure to reference their tax return, extending Scar to invalidate the adjustment in this case would not be appropriate. In sum, because this case does not involve a notice of deficiency and because plaintiffs have failed to identify any mistake in the content of the computational adjustment, plaintiffs have failed to state a claim for invalidating the computational adjustment based upon the holding in Scar.

JAT Note: Perhaps if the notice of computational adjustment had misidentified the taxa shelter involved, the Court of Federal Claims might have been more receptive to a Scar type argument.]

VARIANCE

Sensing defeat on the Scar issue, the taxpayers raised for the first time in their briefs an issue not yet raised -- i.e., that the IRS should have issued a notice of deficiency rather than made the assessment pursuant to a computational adjustment.  The Court of Federal Claims rejected that new claim because it varied substantially from the claim the taxpayers had presented in their claim for refund.  That was a pretty straight-forward holding on the doctrine of variance which is designed to permit litigation in refund suits of only claims substantially made in the refund claims.  I offer the discussion of variance from my Federal Tax Procedure book for general background (footnotes omitted):

c. Adequacy of the Claim; Variance. 

The claim for refund must state the basis for the refund in such detail as “sufficient to apprise the Commissioner of the exact basis thereof.”  The claim for refund is analogous to a pleading -- it must timely and fairly put the IRS on notice of the factual and legal basis for the refund.  That does not mean that a lengthy brief need be filed -- but the essential facts and summary of the legal position should be provided in the claim.  More detail cannot hurt -- hence detailed statements of the claims are often provided.  But too little detail can mean that the IRS has not been put on fair notice of the claim and that the claim will be defective.  The consequence of a defective claim  – i.e., not fairly putting the IRS on notice of the claim – is that the taxpayer may forfeit any right to a refund through the application of the doctrine of variance unless the defective claim is clarified within the statute of limitations.  

The requirement that a claim be adequately stated in order to give the IRS a fair opportunity to act on the claim has both factual and legal facets.  The claim should fairly put the IRS on notice of the facts.  The claim should also fairly put the IRS on notice of the legal claim asserted on the basis of the facts presented.  But, you may say, the IRS should be presumed to know the law, so that setting forth facts which entitle the taxpayer to a refund should be sufficient.  Wrong, or at least risky. 

The disastrous consequence of the doctrine of variance means that the taxpayer and his practitioner must be very careful in drafting claims for refund.  Taxpayers may be tempted to state claims very generally, thinking that they can later make them more specific, thus merely refining the general claim without varying from it.  The problem, of course, that, if the claim is too generally stated, it may be defective on its face because it does not fairly put the IRS on notice of the specific nature of the claim.

Readers should note that there is a comparable rule of variance in the Tax Court where, if the IRS varies from the grounds for deficiency stated in the notice of deficiency, the IRS will generally bear the burden of proof on the "new issue."