More on Litigation and IRS Raising Civil Fraud New Matter (7/11/19)

My last post involved the IRS raising the civil fraud penalty as new matter by amended answer and prevailing. IRS Raises Fraud In Tax Court Amended Answer and Prevails (Federal Tax Procedure Blog 7/9/19), here.  The key point of the blog entry was the danger of unspotted issues after an audit and the risks of petitioning the Tax Court for redetermination. 

First, on that issue, I offer the relevant portion of the working draft of my Federal Tax Procedure Book will be published on SSRN in early August 2019 (footnotes omitted):

New Matters [In the Tax Court]. 

The IRS can raise new issues in its answer that seek to increase the amount of the deficiency on a basis not asserted in the notice of deficiency or to justify the deficiency asserted (or part thereof) on some basis not asserted in the notice of deficiency.  Jurisdictionally, the Tax Court case is a case to redetermine the correct amount of tax liability for the year(s) involved, thus permitting it to determine a higher deficiency amount or an overpayment.  § 6214(a) & 6512(b). So the IRS can seek additional taxes and penalties not previously asserted.  The statute of limitations will be open because, to reprise what we learned earlier, the statute is suspended during the period the Tax Court case is pending.  §§ 6213(a) and 6503(a).   This is one of the dangers in proceeding in the Tax Court where the IRS has not previously spotted an issue.  Since the statute of limitations is suspended upon issuance of the notice of deficiency (§ 6503(a)), all new matters may be raised, assuming that the statute of limitations did not bar the notice of deficiency in the first place. 

The IRS's ability to raise new issues after its original answer is, however, limited by rules of fairness.  If the IRS does assert new matters after filing its original answer, it will formally do so by moving to amend the original answer.  The Tax Court rules, like the Federal Rules of Civil Procedure applicable in district courts and the Court of Federal Claims' Rules, permit amended pleadings, usually requiring the approval of the Court which is liberally granted to promote justice on the underlying merits. New issues cannot be inserted too late in the process so as to deny the taxpayer the effective opportunity to respond.  And, as to “new matters,” the IRS bears the burden of persuasion.  (Of course, if the new matter is the civil fraud penalty not asserted in the notice of deficienty, the IRS would have the burden of persuasion anyway to prove civil fraud by clear and convincing evidence, so asserting civil fraud as a new matter has no affect on the burden of persuasion.) 

The IRS is allowed to raise a new theory or ground in support of an issue raised in the notice of deficiency without the theory or ground being a new matter.  Depending upon how much variance the new theory or ground has with the notice of deficiency, the variance might be considered a new matter subject to the foregoing new issues discussion.  Certainly, if it is raised so late that the taxpayer cannot fairly respond with evidence addressing the new issue, the Court should deny the IRS’s attempt to assert the new issue. 

If the IRS asserts an affirmative defense (such as estoppel), it will be deemed denied and the taxpayer need not file a responsive pleading, which is usually called a “reply.”  If, however, the IRS raises “new matter” either in an answer or an amended answer, the taxpayer should file a reply providing the IRS notice as to the taxpayer's position on the new matter.  This is frequently done via a simple denial of the various matters pled with respect to the new matter. 

I think it would be helpful to illustrate the new matter issue.  Recall that § 6662 provides a 20% substantial understatement penalty that is then increased to 40% if the understatement is attributable to a gross valuation misstatement.  If the notice of deficiency asserted the 20% penalty but, in its answer, the IRS asserts the 40% penalty, the IRS will have the burden of proof on the increase in the penalty.  That seems to be the straight-forward reading of the rule shifting the burden of proof to the IRS.  But, let’s focus on one issue raised in this setting.  The taxpayer can avoid the accuracy related penalties if there was reasonable cause for the position on the return.  This is like an affirmative defense to the penalty.  Thus, as to the 20% penalty asserted in the notice and contested in the petition, the taxpayer bears the burden of proving reasonable cause even after the IRS meets its production burden under §7491(c); as to the increased 40% penalty, however, the IRS bears the burden of proof, including establishing absence of reasonable cause. 

Finally, an even worse case for the taxpayer who improvidently petitions for redetermination is that the IRS can raise as new matter a civil fraud penalty.  Say in the above example, the notice of deficiency asserted either the 20% or 40% accuracy related penalty in § 6662 and then in the answer (or amended answer), the IRS asserts the 75% civil fraud penalty in § 6663.  Note in this regard that, if the IRS raises the civil fraud penalty as a new matter, its burden of proof is not affected because, as to civil fraud, the IRS bears the burden of persuasion by clear and convincing evidence anyway, just as it the civil fraud penalty had been asserted in the notice of deficiency.  So,  if the IRS prevails, the taxpayer will be even worse off for having filed a petition for redetermination.  Thus, taxpayers and practitioners should think carefully about unspotted potential issues before filing a petition for redetermination in the Tax Court.

Now let's work this a little more.  This IRS favorable result works because the statute of limitations is still open in Tax Court proceedings.

There is a "standard" gambit that a taxpayer can use to eliminate the possibility of the IRS raising new matter to increase the tax liability.  Basically, the gambit involves foregoing a Tax Court petition in response to a notice of deficiency that misses the unspotted issue.  The IRS assesses the tax, and the taxpayer pays the assessment. Then, the taxpayer (or his practitioner) closely monitors the statute of limitations on refund and files the claim for refund after the statute of limitations has otherwise closed.  And then the taxpayer pursues his refund remedies.

Consider this example, from the Ethics chapter in my Federal Tax Procedure Book (footnotes omitted):

Let's say that the taxpayer is audited and the IRS sets up a single issue that results in a deficiency of $100,000.  You counsel the taxpayer that, in your best judgment as a seasoned tax litigator, you can win that issue in whichever court the taxpayer chooses to litigate it.  However, since you handled that audit, you also know that the auditing agent did not spot an even larger issue that, in your judgment, the taxpayer would lose in any court that the taxpayer chooses to litigate it.  That issue would create a tax liability larger than the dollars that would be saved on the issue that you believe the taxpayer could win.  One of the traditional gambits is to preserve the refund statute of limitations, let the assessment statute expire, and the file the claim for refund.  For example, assume that the Year 01 return was filed on April 15 of Year 02, the audit deficiency was proposed on September 1 of Year 04, your client signs a Form 870 waiver of the restrictions on assessment for Year 01 on September 5 of Year 04, the IRS assesses the tax on February 1 of Year 5, the taxpayer pays on February 10 of Year 05, and the statute of limitations on further assessment expires on April 15 of Year 5.  You will recall that, although the statute of limitations on further assessment has expired, the taxpayer still has 2 years from the date of the February 10 payment to claim a refund. So, on June 1 of Year 05, the taxpayer files a claim for refund alleging that the IRS erred on the one audit issue (the only issue the IRS knows about).  In that claim for refund, the taxpayer does not mention the issue the IRS did not audit and is not otherwise aware of, despite the fact that, in his attorney's judgment, he would lose that issue and his taxes for the year are therefore not overpaid.  Can the taxpayer lawfully sign the amended return (the claim for refund) with the jurat?  Can the attorney counsel or otherwise assist the taxpayer in filing the return?

Now, consider this variation on that fact pattern:  If the notice of deficiency picked up all the issues with respect to the tax liability but missed the potential to assert a civil fraud penalty, the taxpayer would then face the conundrum faced by the taxpayer in deciding whether to file a petition for redetermination of the original notice of deficiency.  I think the ethical issue is not present because the taxpayer cannot self-impose liability for the civil fraud penalty; that requires the IRS to do that, so that the taxpayer could, I think, ethically file an amended return (claims for refund) as to the principal tax liability and related interest. And the lawyer could ethically assist the taxpayer in filing the amended return.  If the taxpayer pursues the refund suit (even after calibrating it so that the normal statute of limitations would have expired), the Government in the refund suit could still assert the fraud penalty by counterclaiming for the civil fraud penalty (remember no statute of limitations) or asking the IRS to issue a notice of deficiency for the civil fraud penalty (again no statute of limitations for fraud).  (I won't get into the detail of war stories, but I had a case exactly like that when I was with DOJ Tax where the taxpayer filed claim and suit for refund after a straight-forward notice of deficiency and I developed a fraud case in discovery that was then assessed and the taxpayer "settled" by paying the entire tax liability and the civil fraud penalty (odd that the taxpayer presented a full concession as a settlement, but I did recommend that settlement).)

There are some complexities here and I'll just mention one.  Consider § 6212(c) which provides:

(c) Further deficiency letters restricted
(1) General rule.  If the Secretary has mailed to the taxpayer a notice of deficiency as provided in subsection (a), and the taxpayer files a petition with the Tax Court within the time prescribed in section 6213(a), the Secretary shall have no right to determine any additional deficiency of income tax for the same taxable year* * * * except in the case of fraud, and except [not relevant].

So, if the taxpayer were to petition for redetermination and the IRS missed an adjustment for additional tax liability plus related civil fraud penalty, the IRS could still even without raising new matter in the Tax Court, even after the Tax Court decision (that would otherwise foreclose new notices of deficiency) assert the new matter principal tax liability and the civil fraud penalty related thereto (or perhaps even as to the whole additional tax liability (even that involved in the Tax Court case).

But, what if the Tax Court case resolved all principal tax matters liability issues (i.e., there is no unspotted issue from the tax liability determined in the Tax Court) and the only issue is civil fraud penalty which was not raised as new matter and resolved in the Tax Court case, can the IRS use § 6212(c)(1) to issue a notice of deficiency for the civil fraud penalty alone?  Interesting issue, but I think not on the statute as it is written.

As an aside, § 6212(c)(1), which is not used that often, is really a magic key to the kingdom on the abusive tax shelter cases if the IRS ultimately prevails on the issue of whether the unlimited statute of limitations in § 6501(c)(1) requires the taxpayer's personal fraudulent conduct.  (I call this the Allen issue (see Allen v. Commissioner, 128 T.C. 37 (2007).) See e.g., Taxpayer Waived Argument that § 6501(c)(1) Requires Taxpayer's Fraud for Unlimited Statute of Limitations (Federal Tax Procedure Blog 6/14/19), here.