IRS Nonacquiesces in Holding that Uncertainty in Law is Factor in Penalty Defense (1/19/13)

In AOD 2012-05, IRB 2013-7  (2/11/13), here, the IRS announced nonacquiescence as to the holding in Patel v. Commissioner, 138 T.C. No. 23 (2012), here, that "the uncertain state of the law, without a finding regarding a taxpayer's efforts to determine the state of the law, is a factor in determining whether a taxpayer has demonstrated reasonable cause and good faith for purposes of avoiding the accuracy-related penalties."  The AOD Is short, so I quote the discussion section in its entirety:

Taxpayers Upen G. and Avanti D. Patel purchased property in Virginia in 2006 with the intention to demolish the house on the property and construct a new one. Taxpayers' real estate agent informed them that the local fire department had a program through which the fire department acquired houses for purposes of conducting training exercises by burning the houses and extinguishing the fires. Taxpayers completed all of the necessary paperwork to participate in the program, and hired a construction company to remove the remaining debris. In October 2006, the fire department conducted training exercises and destroyed the house on taxpayers' property. Taxpayers claimed a noncash charitable deduction of $339,504 for the claimed contribution of the property to the fire department. The Commissioner disallowed the deduction and determined an income tax deficiency and accuracy-related penalty under section 6662. 

In the Tax Court, the Commissioner filed a motion for partial summary judgment that taxpayers were not entitled to the charitable contribution deduction and were liable for the accuracy-related penalty on the alternative grounds of negligence or substantial understatement of income tax. In response to the motion, taxpayers denied their liability for the tax and penalty, stating that they had complied with the law and, with respect to the penalty, had acted with reasonable cause and good faith by relying on Scharf v. Commissioner, T.C. Memo. 1973-265. In a reviewed opinion, the Tax Court granted the Commissioner's motion on the contribution issue, but did not uphold the penalty, finding that taxpayers fell within the "reasonable cause exception" under section 6664(c). In determining that taxpayers were not entitled to the charitable deduction, the court found that any reliance on Scharf was "unfounded." The court previously held in Rolfs v. Commissioner, 135 T.C. 471, 487 (2010), aff'd, 668 F.3d 888 (7th Cir. 2012) that the Scharf standard was superseded by the quid pro quo standard for charitable deductions articulated by the Supreme Court in United States v. American Bar Endowment, 477 U.S. 105, 118 (1986). Significant also was the fact that Congress amended section 170 to disallow a deduction for contributions of partial interests in property, such as that in Scharf, for contributions made after 1969. Although finding reliance on Scharf was "unfounded," the court held that taxpayers acted with reasonable cause and good faith "given all the facts and circumstances, including the uncertain state of the law" and, accordingly, taxpayers were not liable for the section 6662 penalty. Slip. op. at 39.

We disagree with the court's conclusion that the uncertain state of the law is a factor that supports a finding of reasonable cause and good faith, without any consideration of taxpayers' investigation of the contemporaneous state of the law, including their failure to obtain competent professional advice. Treasury Regulation section 1.6664-4(b) provides for a "facts and circumstances" approach in determining the reasonable cause and good faith exception to the accuracy-related penalties, but a taxpayer's reasonable cause and good faith must be evaluated in the context of the taxpayer's knowledge, efforts and actions. A taxpayer cannot act in good faith and have reasonable cause on the basis of the unsettled state of the law if the taxpayer was unaware of the state of the law and did not make reasonable attempts to become aware. 

Accordingly, the Service will not follow Patel insofar as it holds that the uncertain state of the law, without a finding regarding a taxpayer's efforts to determine the state of the law, is a factor in determining whether a taxpayer has demonstrated reasonable cause and good faith for purposes of avoiding the accuracy-related penalties.

Students and practitioners should anticipate that the IRS will contest this issue in future cases and may be looking for the right case to litigate on appeal.

Students and practitioners should also be aware that this issue arises also in the criminal provisions of the Code.  The ultimate authority in the criminal context is  James v. United States, 366 U.S. 213 (1961), here.  That case takes close reading of both the majority and the dissenting opinions, but it does hold that objective uncertainty in the law is a complete defense to a criminal proceeding whether or not the defendant knew of the uncertainty and whether or not the defendant actually intended to violate the law that he did not realize was uncertain.  I have discussed this issue or facets of it on my Federal Tax Crimes blog,here, but here is my discussion from my Federal Tax Crimes text (I do not indent the text so that I can show the quote from the James case properly indented).

The Supreme Court addressed this concept in James v. United States, 366 U.S. 213 (1961).  The issue was whether James could be prosecuted under § 7201 for failing to report and pay tax on embezzled income.  James had in fact been convicted, meaning that the jury had determined that he had intentionally violated a legal duty known to him.  The question was whether, because of legal uncertainty as to the duty, he could be convicted even if he had a subjective intent to violate a duty that he “knew.”  In order to resolve that issue the Court had to determine whether embezzled funds were income taxable under the Code and, if so, whether James could be prosecuted for failure to report the embezzled proceeds.  This sets up the issue quite nicely, for the fact that the Court had to resolve the substantive issue -- i.e., whether embezzled funds were taxable -- meant that the issue was not without doubt.  Indeed, the reason that it was in doubt was because the Supreme Court, in an earlier case (Commissioner v. Wilcox, 327 U.S. 404 (1946)), had held that embezzled funds were not income for federal tax purposes.  Between the Court’s decisions in Wilcox and James), the Supreme Court decided in Rutkin v. United States, 343 U.S. 130 (1952) that extorted funds were income.  Although the Court in Rutkin had expressly declined to overrule Wilcox, the Court’s analysis in Rutkin undercut the rational for Wilcox.  Indeed, in James, the Court said that “examination of the reasoning used in Rutkin leads us inescapably to the conclusion that Wilcox was thoroughly devitalized.”  Yet, Wilcox stood unreversed, so the issue was whether James could be criminally prosecuted for failure to report embezzlement proceeds that the unreversed Supreme Court authority squarely on point held was not income.

The Supreme Court started its analysis in James by taking the step it had declined to take in Rutkin – holding that embezzled funds are income, thus overruling Wilcox.  The dissenting opinions take the court to task on that issue, but I do not want you to be concerned about the pro's and con's in the debate over whether embezzled funds are or should be taxable income under the Code.  What I want you to understand is that, at the time of the taxpayer's embezzlement in question James could not have “known” that he had a legal duty to report the embezzled funds as income, for Wilcox had not been overruled even though an intervening Supreme Court case had undercut its theoretical foundations.  James may have thought – indeed, in the case, James actually did think (so the jury found) – he had such a duty and intended to violate the legal duty that he thought existed.  The problem moving the Supreme Court to reverse was that the that duty itself was unknowable in any objective legal sense because of the state of the Supreme Court authority.  After holding that embezzled funds were, after all, income (thus overruling its prior decision), the Court in James addressed the question of whether James could be prosecuted for willfully failing to report that income while Wilcox's holding was still unreversed precedent.  The Court said:

But, we are dealing here with a felony conviction under statutes which apply to any person who “willfully” fails to account for his tax or who “willfully” attempts to evade his obligation.  In Spies v. United States, 317 U.S. 492, 499, the Court said that § 145(b) of the 1939 Code embodied “the gravest of offenses against the revenues,” and stated that willfulness must therefore include an evil motive and want of justification in view of all the circumstances.  Id., at 498. Willfulness “involves a specific intent which must be proven by independent evidence and which cannot be inferred from the mere understatement of income.” Holland v. United States, 348 U.S. 121, 139.   

We believe that the element of willfulness could not be proven in a criminal prosecution for failing to include embezzled funds in gross income in the year of misappropriation so long as the statute contained the gloss placed upon it by Wilcox at the time the alleged crime was committed.  Therefore, we feel that petitioner's conviction may not stand and that the indictment against him must be dismissed.

The bottom line holding is that, given the confusion as to the objective legal duty, James could not be prosecuted.  It did not matter that the jury had determined that James had willfully failed to report the income, a holding which logically meant that James had not placed any reliance on Wilcox n144 and, moreover, had knowingly and intentionally failed to meet the duty implicitly created by Rutkin.  It did not matter if James had the darkest of motives vis-a-vis the federal tax system.  All that mattered was that, as a matter of law regardless of the facts, the legal duty was uncertain and thus could not support a criminal prosecution.
       n144 Justice Clark made this point as follows: “Even if that not be true, in my view the proof shows conclusively that petitioner, in willfully failing to correctly report his income, placed no bona fide reliance on Wilcox.”  Id. at p. 241.  Justice Harlan, with Justice Frankfurter concurring,  reasoned: “But since it does not appear that petitioner's possible reliance on the Wilcox doctrine was considered below, Spies and Holland make it appropriate for us to send the case back for a new trial.  They do not support foreclosing the Government from even undertaking to prove that the petitioner's conduct was willful in this respect.”  Id at . P. 244.  Justices Clark, Harlan and Frankfurter would have permitted conviction based on evil motive or willfulness alone regardless of any uncertainty in the law which was resolved in the case only after the "crime" was committed.  That notion failed to carry the majority in the case.

James thus stands squarely for the proposition that a defendant cannot be prosecuted for a crime of willfulness (at least willfulness in the criminal tax laws) regardless of his actual motive to violate a legal duty that he thought he had when, objectively and as a matter of law, the legal duty was not certain.  One line of defense to tax crimes spawned by this holding in James is that the underlying legal duty is sufficiently uncertain in the James sense.  There are key cases that illustrate this defense.
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