Federal Tax Litigation

I. Introduction

Tax News & Comment — March 2015 View or Print

In general, the statute of limitations for the IRS to assess is three years after the date the return is filed or two years from the date the tax is paid. After audit, the IRS may issue a “30-day letter,” requesting that the taxpayer agree to a proposed assessment. The taxpayer may, but is not required to, request an appeal with the Appeals Office. Under IRC §6161, Appeals is granted considerable authority to settle tax disputes. Appeals may consider the “hazards of litigation” in reaching a settlement. If the taxpayer does not request an administrative appeal, or if an appeal fails to result in settlement, a “ninety-day letter,” or notice of deficiency will issue pursuant to IRC §6212. Appeals will generally not endeavor to find tax issues not identified on audit. Cases resolved in Appeals may be finally settled by the execution of Form 870-AD or 890-AD. A more formal agreement may be evidenced by a closing agreement under IRC §§ 7121 and 7122, utilizing Form 866. Following the issuance of a Notice of Deficiency, the taxpayer must either file a petition with the Tax Court or pay the deficiency within 90 days. The 90-day period is jurisdictional: If a Tax Court petition is not timely, the Tax Court will lose jurisdiction to hear the dispute. If the taxpayer opts to pay the deficiency instead of litigating in Tax Court, the taxpayer may file a refund claim with the IRS. If the IRS denies the refund claim, or fails to act on it within six months, the taxpayer may commence refund litigation in federal district court naming the United States as defendant. While federal district court is a more hospitable forum to resolve a tax dispute, most taxpayers prefer to litigate in Tax Court, since prepayment there is not required.

The expertise of Tax Court judges may be preferable where favorable precedent exists. District Court do not possess the expertise of Tax Court judges, but where equitable issues are prominent, District Court seems a preferable venue, since it appears from decided cases that District Courts exercise greater equitable jurisdiction than does the Tax Court. Jury trials are available in District Court, but not in Tax Court. Where the taxpayer resides affects the law to be applied in the dispute. If the issue has been decided by a Circuit Court of Appeals in the District in which the taxpayer resides, both the Tax Court and District Court must apply the law as decided by that Circuit Court of Appeals. For example, a taxpayer residing in Dallas who litigates in Tax Court will benefit from decisions rendered by the Fifth Circuit Court of Appeals which is notoriously taxpayer-friendly. However, the Tax Court will not be bound by decisions rendered by decisions of a lower District Courts in Texas. It is important to note that although the IRS will be bound by the decision of the Fifth Circuit Court of Appeals when involved in a dispute with a Texas resident, if the same tax issue is litigated by a resident of New York, the Tax Court must apply the relevant law, if any, of the Second Circuit Court of Appeals. If the IRS is unhappy with the decision of the Fifth Circuit, it may not “acquiesce” to the decision, meaning that it may take a position contrary to the Fifth Circuit if the issue is litigated in the Second Circuit.

If the IRS decides that it will accept the decision of the Fifth Circuit in other circuits, it will “acquiesce” to the decision. The result that the Tax Court may render different decisions concerning an identical tax issues depending upon the residence of the taxpayer is known as the Golson rule, the name of a litigant in a case reaching that conclusion. The Golson rule enables a taxpayer to “forum shop” for a hospitable Circuit Court of Appeals. Provided the taxpayer actually acquires legal residence in that hospitable jurisdiction, the taxpayer may well benefit. The result is dictated by the federal system itself. In cases where a conflict among the circuits arises, the Supreme Court may be called upon resolve the conflict. The Supreme Court hears relatively few tax cases. However, the Court will be more inclined to hear a case which involves a conflict among the circuits concerning a tax issue of importance.

Alternatively, Congress may resolve a conflict, or simply legislatively overrule a tax result with respect to which it disagrees, through legislation. For example, the steadfast refusal of the IRS to acquiesce to Starker v. U.S, 602 F.2d 1341 (9th Cir. 1979), a case involving deferred exchanges in which the Ninth Circuit permitted a deferred exchange to continue five years, led Congress to amend Section 1031(a)(3)(A) of the Code in 1984 to expressly permit deferred exchanges, but to limit the exchange period to 180 days. Tax Court judges sit in Washington, but hear cases in other cities around the country. The IRS is represented by its own counsel in the Tax Court. In District Court, the United States is represented by the Tax Division of the Department of Justice. Attorneys with the Department of Justice may have less institutional loyalty to the IRS than IRS counsel. In difficult cases involving equitable issues, this consideration might sway the taxpayer toward litigating in District Court. In general, but subject to important exceptions, the burden of proof in tax cases is imposed on the taxpayer, who must prove his case by a preponderance of the evidence.

II. Tax Court Litigation

The majority of tax disputes are heard in Tax Court. A decision to litigate before paying results in economic consequences identical to those that would obtain had the taxpayer borrowed the entire disputed amount from the United States at the beginning of the dispute and agreed to pay (nondeductible) interest at the prevailing rate for underpayments if the taxpayer loses, or with the government forgiving the entire amount of principal and interest if the taxpayer prevails. The Tax Court is an Article I Constitutional Court. Its juridical power derives from Congress, and only indirectly from the Constitution. In contrast, an Article III Court derives its power directly from the Constitution. Tax Court jurisdiction is limited to adjudicating only those types of disputes which have been expressly authorized by Congress. Congress has conferred exclusive jurisdiction upon the Tax Court over certain tax disputes. For example, review of an IRS refusal to abate interest may only be heard in Tax Court.

As noted, to commence suit in Tax Court for a redetermination of the deficiency, IRC §6213 requires the taxpayer to file a petition within 90 days of date indicated on the Notice of Deficiency. The 90-day period is calculated without regard to weekends and holidays. Since Tax Court jurisdiction is predicated upon a “deficiency,” the taxpayer may not pay the disputed tax and still file a Tax Court petition. On the other hand, once a Tax Court petition is filed, the taxpayer may remit the disputed tax to avoid the running of interest and penalties. The Tax Court is located in Washington and is staffed by 29 judges, many of whom travel throughout the country and hear cases locally. Within New York, the Tax Court sits in Manhattan, Westbury and Buffalo. It is not usually necessary for the taxpayer to travel to Washington. All cases are decided by the Tax Court judges, as jury trials are unavailable.

A Tax Court petition is filed with the Tax Court and served by the Clerk upon the Commissioner. The Petition states the legal position of the taxpayer with respect to the deficiency asserted, but need not specifically allege every fact. The IRS is required to answer the petition within 60 days. The answer may plead matters with respect to which the IRS has the burden of proof. The taxpayer may, but is not required, to reply to affirmative allegations made by the IRS in the answer. If the taxpayer chooses not to reply, affirmative allegations made by the IRS are deemed denied. Both the taxpayer and the IRS must specifically plead affirmative defenses including res judicata, collateral estoppel, waiver, fraud, and the statute of limitations. Discovery is governed by Rule 70 of the Rules of the Tax Court, and the rules are less complex than in District Court. Rule 91 requires parties to stipulate, to the fullest extent to which complete or qualified agreement can or fairly should be reached, all matters not privileged which are relevant to the pending case.

The failure of parties to so stipulate will not endear the parties to the Court. The parties are encouraged to informally request discovery before making formal requests. Examinations before trial are available in Tax Court, but are not always taken. Although a litigant may serve requests for admissions, it is preferable to serve such requests after an attempt has been made to obtain the desired information informally. The issuance at trial by either the taxpayer or the government of a subpoena duces tecum is available to compel production of documents and testimony from uncooperative third-party witnesses. Rule 147 provides that all subpoenas issued must bear the seal of the Tax Court. The Tax Court generally follows the Federal Rules of Evidence.

Following trial, the Tax Court may require the parties to file briefs within 75 days. The Tax Court issues approximately 40 “Regular” decisions annually involving new issues. “Memorandum” decisions are those which apply existing law. Under Rule 162 and IRC §7483, appeals from the Tax Court must be taken with 30 days after entry of the decision by the Clerk. As noted, final decisions of the Tax Court are appealable to the Court of Appeals for the District in which the taxpayer resides. Cases appealed from the Tax Court must be bonded. The IRS may assess and collect tax following a Tax Court decision pursuant to IRC §7485. The Tax Court also contains a branch that settles small cases, where the amount in controversy is less than $50,000 (including penalties). Such cases are heard in Albany and Syracuse. Small tax cases are not published, and are not considered precedent.

III. District Court Litigation

District Courts are Article III courts established under the Constitution and have subject matter jurisdiction over most tax cases. Jury trials are available and are often requested in cases involving responsible person penalties, return preparer penalties, bad business debts, and valuation issues. Rules of discovery in District Courts are governed by the Federal Rules of Civil Procedure. District Courts, like the Tax Court, are bound in their decisions by the law of the Court of Appeals to which appeals from the District Court would lie. District Court judges are tax generalists. In addition to hearing tax cases, District Courts hear many types of civil and criminal cases.

IV. Claims For Refund

Under IRC §§6511, a claim for refund must be filed no later than three years from the date the return was filed or within two years from the time the tax was paid. A claim for refund is made on the appropriate tax return or, if the return with respect to which the refund is claim has already been filed, with an amended return. Following a denial of the refund claim by the IRS, or the passage of six months with no IRS action, the taxpayer may commence refund litigation in District Court.
Payment of the disputed tax will abate the further penalties and interest. If the taxpayer eventually prevails in District Court, interest based upon the statutory overpayment rate will be awarded. Attorneys fees are generally not available to taxpayers who prevail in tax disputes, unless the government’s position is palpably without merit. Under the “variance” doctrine, the taxpayer may not raise issues in District Court that were not raised in the claim for refund. Nevertheless, a claim for refund, once filed, may be amended, provided the amendment falls within the time period during which a claim for refund could originally have been filed.

V. Refund Litigation In District Court

Refund litigation in District Court is commenced by filing a complaint. The clerk will issue a summons. The taxpayer must then serve the summons and complaint upon the local U.S. Attorney and upon the Attorney General. The government must file and serve its answer within 60 days. The government trial attorney will request the IRS administrative file and elicit the view of IRS counsel before serving an answer. Following the government’s service of its answer, the parties will submit a proposed discovery schedule. The parties must confer at least 21 days before a scheduling conference is to be held or a scheduling order is due. At the conference of the parties or within 14 days thereafter, the taxpayer and the government must make initial disclosures containing relevant information the disclosing party may use to support its claims or defenses. In general, the taxpayer has the burden of proving by a preponderance of evidence the existence of an overpayment of tax or entitlement to an additional deduction or other tax benefit. However, the burden of proof may fall upon the government at times. For example, in cases involving a fraud penalty, the government must establish fraud by clear and convincing evidence. Generally, a party may file a motion for summary judgment until 30 days after the close of discovery. One benefit of paying the tax and then commencing refund litigation is that the statute of limitations on assessment of additional tax will likely have expired by the time the IRS and Tax Division examine the grounds for refund.

VI. Tax Litigation Doctrines

Res Judicata.    A judgment on the merits with respect to one tax year is res judicata in a later proceeding involving a claim for the same tax year. Once a decision concerning a particular tax year becomes final, the IRS cannot make additional assessments for that year, nor can the taxpayer challenge the assessment in a refund action.

Collateral Estoppel.   Once a tax issue has been decided, that same issue cannot be relitigated in a subsequent suit between the same taxpayer and the IRS. Collateral estoppel has been applied in tax disputes to questions of fact, questions of law, and mixed questions of law and fact.

Equitable Estoppel.   The government has been successful in defending refund suits by raising the doctrine of equitable estoppel where the taxpayer, having made a representation which is relied upon by the government to its detriment, changes his position at a time when the government would be prejudiced.

Settlement.   Once a tax matter has been referred to the Department of Justice, it retains exclusive settlement authority. The Attorney General has broad and plenary power to settle any tax refund suit. The Attorney General has delegated authority to the Assistant Attorney General. The taxpayer may propose a settlement directly with the trial attorney of the Tax Division, who will communicate the proposal IRS Chief Counsel. Although the IRS is without settlement authority, the opinion of the Chief Counsel nevertheless carries substantial weight with the Justice Department. Only the Attorney General can take action inconsistent with the recommendation of the Chief Counsel.

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