Procedural Predicates for Setoffs in Refund Suits (7/2/14)

In Lewis v. Reynolds, 284 U.S. 281 (1932), here,modified in 284 U.S. 599 (1932), the Supreme Court held that, in a refund suit, the Government can raise a previously unasserted basis for denying a taxpayer a refund.  The notion is that, in a refund suit, the issue is whether the taxpayer overpaid the tax and therefore is entitled to a refund.  If there is some other basis to conclude that the taxpayer did not overpay the tax, the taxpayer is not entitled to a refund.  The issue usually arises after the IRS has audited an issue and assessed a deficiency.  The taxpayer pays the assessed tax and sues for refund, asserting that the taxpayer does not owe tax with respect to that issue.  Lewis v. Reynolds holds that, in that refund suit, the Government can assert any other basis that shows the taxpayer is not entitled to a refund for that year or is entitled to less than the taxpayer assert.  This is often referred to as a setoff.

The setoff concept is important in tax practice.  One significant issue is what the Government must do to assert the setoff.  This issue arose in a recent case, Lockheed Martin Corp. v. United States, 973 F. Supp. 2d 591 (D. Md. 2013), where the Court addressed the pleading requirements for the Government to raise the setff as a defense.  In Lockheed, the Government pled the following under a caption titled "Second Defense":

Should the Court determine that Plaintiff raised a meritorious argument that would otherwise establish that Plaintiff overpaid its taxes, the United States is entitled to reduce that overpayment based on any additional tax liabilities that the Plaintiff may owe, whether or not previously assessed or alleged. The United States is entitled to such reduction because the redetermination of the Plaintiff's entire federal income tax liability for the litigated tax years is at issue in this refund suit.

Note that the Government pleads nothing except its theoretical right to the setoff.

Of course, the taxpayer in a refund suit does not want the Government to be able to assert the right to a setoff at all.  And, the theoretical assertion of the right may raise concern that the Government will use the refund suit litigation to re-audit in search of something to setoff.  So, in Lockheed, the taxpayer moved to strike that portion of the pleading, alleging that setoff should be pled like an affirmative defense, which, as Lockheed read the cases, would prohibit this type of conclusory pleading without a factual basis for the claim.  The Government argued that, although labeled a defense, it is not an affirmative defense at all, but merely goes to the issue of whether this taxpayer has proved that it is entitled to the refund the taxpayer claims.  The Court does not engage on this theoretical difference between a setoff and an affirmative defense, but treats the setoff as being subject to the affirmative defense pleading requirements.

Focusing on those pleading requirements for affirmative defenses, the Court notes that there is a split of authority over whether any notice of factual predicate for the legal claim is required to be pled.  The Court first identifies the split of authority and then turns to rationale for the majority and minority views as follows:

The opinions holding that the plausibility standard applies to affirmative defenses have relied primarily on two justifications. "First, they reason that it makes neither sense nor is it fair to require a plaintiff to provide the defendant with enough notice that there is a plausible, factual basis for [a] claim under one pleading standard and then permit a defendant under another pleading standard simply to suggest that some defense may possibly apply in the case." Aguilar, 2011 U.S. Dist. LEXIS 122531, 2011 WL 5118325, at *2 (alteration in original) (citation and internal quotation marks omitted). "Second, they cite the importance of litigation efficiency, explaining that boilerplate defenses serve only to clutter the docket and . . . create unnecessary work by requiring opposing counsel to conduct unnecessary discovery." Id. (ellipsis in original) (citation and internal quotation marks omitted). By contrast, "the small minority of courts within [the Fourth Circuit] rejecting the application of the Twombly–Iqbal pleading standard to affirmative defenses have relied on either the absence of an appellate court opinion on the issue or have concluded that Twombly and Iqbal confined themselves to the sufficiency of claims for relief under Rule 8(a)." 2011 U.S. Dist. LEXIS 122531, [WL] at 3 (citations omitted). Furthermore, in concluding that the plausibility standard does not apply to affirmative defenses, courts both inside and outside the Fourth Circuit have reasoned that "defendants ordinarily have a much shorter time to determine and plead affirmative defenses in their answer than plaintiffs have to develop the facts that should be pled to support their complaint." Simple Cell, 2013 U.S. Dist. LEXIS 99580, 2013 WL 3776933, at *9 n.6; accord Tiscareno, 2012 U.S. Dist. LEXIS 55553, 2012 WL 1377886, at *15. 

The Court finds the minority view more persuasive. The Supreme Court's analysis in Twombly and Iqbal centered on Rule 8(a)(2)'s requirement that the plaintiff make a "showing" that he or she is entitled to relief. Ashcroft v. Iqbal, 556 U.S. 662, 667-69, 129 S. Ct. 1937, 173 L. Ed. 2d 868 (2009); Bell Atl. Corp. v. Twombly, 550 U.S. 544, 554-55, 127 S. Ct. 1955, 167 L. Ed. 2d 929 & n.3 (2007). By contrast, Rule 8(b) only requires parties responding to a pleading to "state in short and plain terms its defenses to each claim" and "admit or deny the allegations asserted against it." Fed. R. Civ. P. 8(b)(1). Likewise, it is hard to square the idea that Rule 8 imposes a plausibility standard on affirmative defenses with the language of Rule 8(b)(3), which allows parties in good faith to "deny all the allegations of a pleading . . . by a general denial." Fed. R. Civ. P. 8(b)(3). Although Rule 8(b)(3) does not speak to affirmative defenses directly, it appears in the section of the Rule applicable to defenses, admissions, and denials. See Fed. R. Civ. P. 8(b). It would be anomalous if Rule 8(b) allowed parties to generally deny the allegations in the complaint yet required them to plead facially plausible affirmative defenses. At any rate, the Court deems it unlikely that the Supreme Court "would have ushered in such a radical change in legal landscape sub silentio." See Rosa v. Bd. of Educ. of Charles County, Md., Civil Action No. 8:11–cv–02873–AW, 2012 U.S. Dist. LEXIS 121350, 2012 WL 3715331, at *10 (D. Md. Aug. 27, 2012); see also Davis v. Ind. State Police, 541 F.3d 760, 764 (7th Cir. 2008) (noting that Twombly does not discuss affirmative defenses). 

Generally speaking, the policy considerations that underpin the majority view do not fully persuade the Court. Although the majority believes that not applying the plausibility standard to affirmative defenses creates a double standard, it discounts the fact that defendants usually have considerably less time to develop affirmative defenses than plaintiffs do claims for relief. For instance, in this case, Plaintiff requests a refund for taxes paid in 2004 – 2008. Yet Plaintiff did not file suit until 2013. Once Plaintiff filed suit, Defendant technically had sixty days to respond to the Complaint. See Fed. R. Civ. P. 12(a)(2) ("The United States . . . must serve an answer . . . within 60 days after service . . . ."). Although the Court granted an unopposed motion for extension of time, one cannot presuppose that this avenue will be open in every case. Besides, the Court granted Plaintiff's consent motion to amend its Complaint, and the United States responded to the Amended Complaint two days after its filing. Additionally, while the Court recognizes the majority's concerns about judicial efficiency, one must question whether the majority has overstated them. The discovery rules are written broadly. See, e.g., Fed. R. Civ. P. 26(b) ("Parties may obtain discovery regarding any nonprivileged matter that is relevant to any party's claim or defense . . . ."); Fed. R. Civ. P. 33(a)(1) (allowing parties to serve up to 25 written interrogatories relating to any matter relevant to any party's claim or defense). Thus, the extent to which the pleading of boilerplate affirmative defenses portends to subject parties to added discovery is presumptively unclear. Moreover, parties can always seek a protective order in response to onerous discovery requests. Fed. R. Civ. P. 26(c)(1). And, while the presence of boilerplate affirmative defenses could make more material relevant to a party's claim or defense, courts presumably could consider a defense's conclusory nature when ruling on the discovery request. 

The majority view also disregards the fact that, by filing the complaint, the plaintiff "invokes the jurisdiction of the federal courts in the first instance." Tiscareno, 2012 U.S. Dist. LEXIS 55553, 2012 WL 1377886, at *15 (citation and internal quotation marks omitted). "The primary function of imposing a pleading standard on a plaintiff in the first instance is to ensure that 'largely groundless claims' are not made to 'take up the time of a number of other people.'" Id. (quoting Twombly, 550 U.S. at 558). On the other hand, affirmative defenses do not invoke the jurisdiction of the court and, at least technically, do not expose plaintiffs to liability. See id.; see also United States v. Stevens, 771 F. Supp. 2d 556, 565 (D. Md. 2011) (alteration in original) (quoting Black's Law Dictionary 482 (9th ed. 2009)) ("An affirmative defense is '[a] defendant's assertion of facts and arguments that, if true, will defeat the plaintiff's . . . claim "). Therefore, judicial economy and equity depend on screening complaints more than they do on screening affirmative defenses. Cf. Tiscareno, 2012 U.S. Dist. LEXIS 55553, 2012 WL 1377886, at *15. 

For these reasons, as a general matter, the Court declines to hold that Twombly and Iqbal apply to affirmative defenses. Although the Court is mindful of the cost and efficiency concerns that blithe or shotgun assertions of affirmative defenses may raise, the standards applicable to motions to strike, as well as notice pleading principles, should usually suffice to weed out frivolous, vexatious, and/or unfairly prejudicial affirmative defenses. 

B. Whether to Strike Defendant's Second Defense 

Having concluded that, at least here, the plausibility standard does not apply to affirmative defenses, the resolution of Plaintiff's Motion to Strike is straightforward. Plaintiff has brought an action for a refund under 26 U.S.C. § 7422. The Supreme Court established in 1932 that the United States has implied authority to "reaudit a return whenever repayment is claimed." Lewis v. Reynolds, 284 U.S. 281, 283, 52 S. Ct. 145, 76 L. Ed. 293, 1932 C.B. 130, 1932-1 C.B. 130 (1932). In 2011, the Fourth Circuit reaffirmed the viability of Lewis, holding that "the IRS may recompute tax liabilities in response to a refund claim." R.H. Donnelley Corp. v. United States, 641 F.3d 70, 72 (4th Cir. 2011) (citing Lewis, 284 U.S. 281, 52 S. Ct. 145, 76 L. Ed. 293, 1932 C.B. 130, 1932-1 C.B. 130). Indeed, it would appear that the United States has a statutory right to offset. See 26 U.S.C. § 6402(a) ("In the case of any overpayment, the Secretary . . . may credit the amount of such overpayment . . . against any liability in respect of an internal revenue tax on the part of the person who made the overpayment . . . ."). In keeping with this authority, the United States has asserted that it is entitled to offset any overpayment by any additional tax liabilities Plaintiff may owe, regardless of whether the United States previously assessed or alleged such liabilities. The Court finds no flaw in this approach.

Furthermore, although Plaintiff accuses the United States of using Lewis as a launch pad for a fishing expedition, the record does not reflect that the United States raised this defense in bad faith. Speculation of this sort does not suffice to grant a motion to strike. Indeed, a cynic could just as easily contend that Plaintiff's opposition is a "dilatory tactic" to prevent the United States from discovering whether Plaintiff underpaid its taxes for the years in question. Cf. Waste Mgmt., 252 F.3d at 347. Furthermore, although Plaintiff contends that not striking the Second Defense would prejudice it, "Plaintiff has identified no prejudice that would result from the Court's consideration of [Defendant's affirmative defense], except perhaps the prejudice that litigants faced with meritorious [affirmative defenses] invariably incur." Montage Furniture Servs., LLC v. Regency Furniture, Inc.,     F. Supp. 2d    , Civil Action No. 8:12–cv–03365–AW, 2013 U.S. Dist. LEXIS 125804, 2013 WL 4758056, at *5 n.3 (D. Md. Sep. 4, 2013) (citing Brinkley v. Harbour Recreation Club, 180 F.3d 598, 612 (4th Cir. 1999)). Accordingly, the Court denies Plaintiff's Motion to Strike.

As a result of Lockheed, I revised the relevant portion of my Tax Procedure Book.  Here is the revised version addressing the pleading and other procedural requirements for the setoff.  In this cut and paste, footnotes are omitted:

(2) Procedural Predicates for Setoffs in Refund Cases. 

The Government’s right to setoff means, practically, that, upon the taxpayer filing the refund suit, the Government might do a re-audit in order to avoid having to pay a refund on the basis of the taxpayer’s claims in the claim for refund and resulting suit for refund.  Obviously, should the Government do so, the resulting audit via discovery and trial of new issues could substantially affect and disrupt the orderly progress of litigation.  For that reason, the courts generally require that the Government meet some procedural burdens to assert and pursue the setoff in the litigation.   

First, the Government should assert the right to setoff in its answer in the case.  While technically it might be argued that the right to setoff is not technically an affirmative defense, Courts have treated it as an affirmative defense that must be pled under FRCP Rule 8(b)(1)(A).   There is an issue of the level of factual specificity, if any, required to plead the set off in the answer, but there is no question that the Government has the right to plead the setoff.  The pleading burden is not much of a burden, particularly if, as at least one court has held, all the Government must assert is the general legal proposition that it has the right to assert an offset without identifying any offset or any factual basis for that general legal proposition. 

Second, the Government must then undertake the “re-audit” allowed by the setoff concept approved in Lewis v. Reynolds.  That would be done through discovery in the litigation.  Courts can control the discovery process and prevent fishing expeditions in search of the setoff. 

Finally, if the setoff issue(s) then get to the trial stage, courts that have addressed the issue require that the Government the Government meet some sort of production burden to put the offset issue in play.  If that production burden is met, then, of course, the defendant will have to meets its ultimate burden of persuasion to prove that it has made an overpayment and thus is entitled to a refund.