California Journal of Tax Litigation, 2014 4th Quarter

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A Publication of the Tax Procedure & Litigation Committee of theTaxation Section of the State Bar of California

Q4 2014 Edition

In This Edition

Key Dates

Message from the Chair 
Joseph P. Wilson, Wilson Tax Law Group

Photos from the August Meeting

Minutes of the August Tax Procedure & Litigation Committee Meeting 
Courtney A. Hopley, Greenberg Traurig, LLP

YTL Corner (All Readers Welcome):IRS Voluntary Classification Settlement Program (VCSP)
Stuart M. Hurwitz

Practice Pointers: Poker Lessons for Lawyers
Aubrey Hone, Hone Maxwell, LLP

Interview: Richard A. Shaw
Kevan P. McLaughlin


Recent Cases of Interest 
Robert S. Horwitz, Law Offices of A. Lavar Taylor



Key Dates

November 6 – 8, 2014 – Annual Meeting of the California Tax Bar and California Policy Conference
Lowes Coronado Bay Resort, San Diego

November 7, 2014, 12:30 p.m. – 1:15 p.m – Quarterly Meeting of the Tax Procedure & Litigation Committee
Lowes Coronado Bay Resort, San Diego

November 17, 2014 – 2015 Washington D.C. Delegation Paper Proposal Deadline

January 15, 2015 – Q1 2015 California Journal of Tax LitigationSubmission Due Date. Send your submissions to:

Kevan P. McLaughlin 
McLaughlin Legal 
5151 Shoreham Place, Suite 265 
San Diego, California 92122 
Tel: 858-678-0061

California Journal of Tax Litigation Submission Due Date:

Q1 2015 Issue: January 15, 2015

May 3 – 5, 2015 – 2015 Washington D.C. Delegation

Message from the Chair

Joseph P. Wilson, Wilson Tax Law Group

Joseph P. Wilson

I am excited to be the current Chair of the Tax Procedure and Litigation Committee for the 2014-2015 year. I only hope to carry the torch with the same perfection, conviction and passion as my predecessor Chair, LaVonne Lawson. I thank her so much for her leadership and willingness to step forward and chair this Committee, not once, but for a second time. Her dedication and passion is admirable.

As for this year’s team leaders, I am so thankful to have fellow officers: Courtney Hopley, Vice-Chair, Greenberg Traurig (San Francisco); Carolyn Lee, Secretary, Abkin Law LLP (San Francisco); and Kevan McLaughlin, Editor-in-Chief, McLaughlin Legal (San Diego). Joanne Rocks of the Law Office of Joanne Rocks (Anaheim Hills) has graciously agreed to commit her time to help distribute the California Journal of Tax Litigation to interested groups. Our sounding board is Executive Committee-Liaison, Kaelyn J. Romey, Senior Counsel, Office of Chief Counsel, Small Business Self-Employed, San Francisco. Kaelyn is a dynamic trial lawyer with a flair for leadership. We are appreciative to have her guidance.

I want to also thank the officers from last year. LaVonne Lawson did such a terrific job as Chair it will be difficult to match her top-notch performance. I will give it my best shot! Courtney Hopley did a fabulous job as the 2013-14 Secretary. She delivered a stellar presentation on the topic of changes to the IRS’ Voluntary Disclosure Program with Steven Walker and Wendy Abkin at the August TPL meeting in San Francisco. Carolyn Lee edited the California Journal of Tax Litigation, giving it new life, pictures, and updates. Robert Horwitz delivered valued guidance as last year’s Executive Committee-Liaison, and he authored the “Recent Cases of Interest” section of the California Journal of Tax Litigation. Robert will continue as the author of “Recent Cases of Interest” for 2014-15. We are very thankful for his contributions and steady hand.

I next want to welcome Kevan McLaughlin, our newest TPL officer and this year’s Editor-in-Chief of the California Journal of Tax Litigation. I also want to welcome Joanne Rocks who has committed her valuable time to assist this Committee. Welcome aboard Kevan and Joanne. All the ingredients exist for a tremendous year ahead.

My goal this year is to increase participation levels and bridge the gap between experienced and less experienced tax lawyers. I believe the first step is outreach. Talk to the newer tax attorneys and make them feel welcome. Invite them to the meetings. Ask them to author papers with you. Take them to lunch or coffee. Attend a Young Tax Lawyer meeting. Welcome them to the legal tax community. This means so much to the newer tax attorneys and it doesn’t take much to bring them aboard. The second step is active participation in the various legal events. Lead the newer tax attorneys by example. If you cannot personally submit a paper or attend a meeting, reach out to me and share your ideas. We want to know what topics, speakers, and ideas you have so we can bring these to the members. This year we have a wide host of ways to get involved. Take the next step and participate in one of these events. The upcoming events and programs include:

Tax Delegations

The Tax Procedure and Litigation Committee will be sending participatory members to the below delegations. I strongly encourage you to attend and participate in one of these, especially if you have not already done so. If you want to participate, please send me your topic on or before these deadlines:

  • Sacramento Delegation – January 22-23, 2015: Submission Deadline: Now
  • DC Delegation – May 3-5, 2015: Submission Deadline: November 17, 2014.

Tax Conferences

There are numerous conferences and CLE events on the horizon. If you wish to be a speaker or have an interesting topic for any of the upcoming conferences, please send it to me. The Tax Procedure and Litigation Committee is currently accepting nominations for speakers and topics for the following events:

  • Eagle Lodge West, April 24 – 25, 2015
  • Annual Income and Other Seminar, June 2015
  • Solo Firm Summit, June 15, Newport Beach, CA
  • 2015 Annual Meeting of the California Tax Bar & the California Tax
    Policy Conference, Nov 5-7, San Jose or San Francisco
  • Quarterly Tax Procedure and Litigation Meetings (Nov, Feb, May, August)

Tax Publications

If you wish to write an article or something shorter, such as an interesting case update, please send me your proposed article or case update. I can help you get it published in either the California Tax Lawyer or California Journal of Tax Litigation. Also, the California Journal of Tax Litigation will have a new section this year that will feature one tax attorney in each edition who exemplifies achievement and outstanding contributions to the field of tax law. If you would like to nominate someone, please send me your nomination.

Tax Webinars

The Tax Procedure and Litigation Committee is doing at least two webinars this year. The webinars are great because you can do it while sitting at your desk. No travel required. We need speakers and topics. Contact me directly if you have an interesting topic or if you want to host a webinar. This is a great way to get your name out there and give back to the profession.

In summary, there are endless opportunities and ways to be involved. It is the contributions of the members of the Tax Procedure and Litigation Committee that helps make the Tax Section of the State Bar a nationwide force. I encourage the members to participate and connect with the newer tax lawyers. Be kind and impart with the newer attorneys the power to teach and instill in others. Our leadership is not about now, it’s about the next generation.

Best regards,

Joseph P. Wilson, Wilson Tax Law Group
Chair Tax Procedure and Litigation Committee

Photos from the August Meeting

August 29, 2014 TPL Committee Meeting (Front Row: LaVonne Lawson, Courtney Hopley, John Harbin, Wendy Abkin, and Steven Walker. Back Row: Jeff Titus, Joanne Rocks, James Counts, Jeff Prag, Joe Wilson, Barbara Doherty, Edward Beeby, Drew Allen, Carolyn Lee, Fred Crombie, and Marty Schainbaum)
August 29, 2014 TPL Committee Meeting (Left to Right: Barbara Doherty, Steven Walker, and Marty Schainbaum)August 29, 2014 TPL Committee Meeting (Left to Right: LaVonne Lawson, Edward Beeby)
August 29, 2014 TPL Committee Meeting (Left to Right: Jeff Titus, Joanne Rocks)August 29, 2014 TPL Committee Meeting (Left to Right: Drew Allen, Fred Crombie, and Courtney Hopley)
August 29, 2014 TPL Committee Meeting (Left to Right: Carolyn Lee, Edward Beeby)August 29, 2014 TPL Committee Meeting (Left to Right: Wendy Abkins, Joseph Wilson)
August 29, 2014 TPL Committee Meeting Presentation

Minutes of the August Tax Procedure & Litigation Meeting

Courtney A. Hopley, Greenberg Traurig, LLP
Tax Procedure & Litigation Committee Chair-Elect

Courtney A. Hopley represents clients in federal and state tax controversies before the IRS and the California Franchise Tax Board at the audit, collection, appeals and litigation stages. She works on tax controversy matters involving partnerships, corporations, individuals, real estate and penalty disputes. Ms. Hopley currently serves at the Tax Procedure & Litigation Committee’s Chair-Elect.

The Tax Procedure & Litigation Committee convened at Greenberg Traurig, LLP in San Francisco on August 29, 2014. The Chair of the Committee, LaVonne Lawson, called the meeting to order. Ms. Lawson made a motion to approve the minutes and the motion was approved by a vote of the members present.

Speaker Presentation

Wendy Abkin of Abkin Law, LLP, Steven Walker of the Law Offices of Steven L. Walker, APC and Courtney Hopley of Greenberg Traurig, LLP led a panel discussion regarding the recent changes to the Internal Revenue Service’s Offshore Voluntary Disclosure Program. The speakers provided an overview of U.S. income tax and reporting obligations. The speakers then discussed the following options available to U.S. taxpayers: (1) the revised Offshore Voluntary Disclosure Program; (2) Streamlined filing compliance procedures for taxpayers residing inside and outside the United States; (3) delinquent reporting of Foreign Bank and Financial Accounts (FBAR); and (4) delinquent information return submission procedures. The speakers and members discussed practical considerations for advising taxpayers on offshore tax issues.

Committee Business

1. Sacramento Delegation.

There was an August deadline for submitting topics for the 2015 Sacramento Delegation. Each participant will write a paper and meet with representatives of the Board of Equalization, Franchise Tax Board, Employment Development Department and legislative tax committees. One member suggested that the Sacramento Delegation be expanded to include representatives from the Attorney General’s Office. The papers are published in State Tax Notes and the California Tax Lawyer. The 2015 Sacramento Delegation is scheduled for January 22-23, 2015.

2. DC Delegation.

The Executive Committee is currently soliciting topics for the 2015 DC Delegation which will be held on May 3-5, 2015 in Washington D.C. People who are interesting in writing a paper or who have a paper topic should contact Joe Wilson by November 5, 2014.

3. Committee Leadership.

LaVonne Lawson announced the new leadership positions on the TPL Committee. In order to encourage broader participation in the election, the TPL Committee conduct
ed the election via email. Joe Wilson will serve as the Chair; Courtney Hopley will serve as the Vice-Chair; Carolyn Lee will serve as the Secretary and Kevan McLaughlin will serve as the Journal Editor. Because the Journal Editor position requires a significant amount of work, the TPL Committee is creating an informal Associate Editor Position. Joanne Rocks will serve as the Associate Journal Editor to assist Kevan McLaughlin.

4. Tax Litigation Journal.

The TPL Committee has changed the way it distributes the California Journal of Tax Litigation because the State Bar now requires that newsletters be distributed by a link on the website instead of by PDF. Currently, you can access the Journal by password on the State Bar’s website. The TPL Committee is concerned about maintaining a high level of readership, so the TPL Committee will request that the State Bar make the Journal available on the public webpage. The TPL Committee is currently exploring other means to increase the distribution of the California Journal of Tax Litigation. Committee members discussed whether social media tools could be used to inform members of the TPL Committee’s activities.

5. Speaker Presentations.

The TPL Committee is soliciting speaker topics for the upcoming quarterly meetings. We want the TPL Committee meetings to be valuable and informative, so please submit topics of interest to Joe Wilson or Courtney Hopley.

6. Hot Topics.

Committee members discussed hot topics.

Ms. Lawson adjourned the meeting. The next meeting is scheduled during the Annual Tax Section Meeting in Coronado on November 6-8, 2014.

YTL Corner (All Readers Welcome): IRS Voluntary Classification Settlement Program (VCSP)

Stuart M. Hurwitz

Incorrectly classifying workers as independent contractors, rather than employees, can have extreme consequences. But what is a taxpayer to do if they discover an error and want to take remedial steps? The IRS’s Voluntary Classification Settlement Program (“VCSP”) may provide relief for some.i

The IRS unveiled the VCSP on September 21, 2011 (See Announcements 2011-64 and 2011-95) allowing employers to voluntarily reclassify independent contractors as employees and pay significantly reduced employment taxes for prior periods (approximately 1% of one year’s worth of “reclassified wages”), without penalties or interest.

On December 17, 2012, the IRS issued Announcements 2012-45 and 2012- 46, permanently changing the general eligibility requirements of the VCSP and offering a temporary expansion to include employers who did not filed all required Forms 1099. The permanent changes to the VCSP generally: (a) allow employers, under audit for non-employment tax issues, to participate; (b) allow taxpayers previously audited by the IRS or Department of Labor (“DOL”) to participate as long as they are not contesting worker classification in court; (c) bar taxpayers with affiliated group members under employment tax audit; and, (d) remove the requirement that taxpayers agree to extend the statute of limitations in closing agreements.

The VCSP and the Temporary VCSP (which was available through June 30, 2013) allow employers to voluntarily reclassify workers prospectively in exchange for immunity for the past. In exchange for Federal employment tax audit protection for the employer and the reclassified worker, employers pay 10% under the VCSP (25% under the Temporary VCSP) of the employment tax liability for such workers for one year, calculated under the reduced rates of I.R.C. §§ 3509(a) or (b), respectively. The Temporary VCSP was available to employers that failed to file required Form 1099’s for workers it sought to reclassify, but otherwise met the remaining requirements of the VCSP. Employers wanting to participate in the Temporary VCSP were required to submit an application on or before June 30, 2013. The VCSP continues to be available after June 30, 2013, for employers that have timely filed Form 1099’s for workers they seek to reclassify.

A taxpayer must apply to participate in the VCSP by using Form 8952, “Application for Voluntary Classification Settlement Program.” The Form 8952 should be filed at least 60 days prior to the date the taxpayer wants to begin treating its workers as employees.

For the VCSP applications filed in 2013, the most recently closed tax year was 2012; accordingly, the 2012 rates apply. For 2012, the effective tax rate under I.R.C. § 3509(a) is 10.28% (for compensation up to the Social Security wage base) and 3.24% (for compensation above the Social Security wage base). The rates under I.R.C. § 3509(b) are higher. Interest and penalties are waived (except that under the Temporary VCSP, the employer was required to pay a reduced penalty for unfiled Forms 1099 for the previous three years).

As mentioned in part above, to be eligible to participate in the VCSP, an employer must: (a) have consistently treated the workers that it seeks to voluntarily reclassify as employees as those ‘nonemployees’ in prior periods; (b) have filed all required Form1099’s for each of the workers for the previous three years; (c) apply to participate in the VCSP; and (d) enter into a closing agreement with the IRS. In addition, the employer must not currently be under an employment tax audit by the IRS, current worker classification audit by the DOL or the EDD, or contesting the classification of workers from prior audits with the IRS or DOL in court. A prior audit does not disqualify a taxpayer that complied with the results of the prior audit. Employers are no longer required to extend the period of limitations for employment taxes as part of the VCSP closing agreement with the IRS.

The decision to enroll in the IRS’s VCSP should not be approached without considering other issues. Because the VCSP is limited to Federal employment taxes, a taxpayer may be exposed to a host of other worker and state consequences, not to mention retirement and health care benefits, state taxes, overtime, or other employment law misclassification concerns.

Practice Pointers: Poker Lessons for Lawyers

Aubrey Hone, Hone Maxwell LLP

Aubrey Hone concentrates her practice on all types of tax issues, including tax planning and both civil and criminal tax controversies. Ms. Hone is a frequent lecturer on tax topics. She has also chaired the Bay Area Young Tax Lawyers, and taught as an adjunct professor at the Golden Gate University and Santa Clara University Schools of Law.

Aubrey Hone concentrates her practice on all types of tax issues, including tax planning and both civil and criminal tax controversies. Ms. Hone is a frequent lecturer on tax topics. She has also chaired the Bay Area Young Tax Lawyers, and taught as an adjunct professor at the Golden Gate University and Santa Clara University Schools of Law.

A great poker player and a great lawyer have a lot in common. To be great at poker, a person must be a skilled tactician, calm under pressure and know what strategy to employ when they are dealt a losing hand. The same is certainly true for a great lawyer. A great lawyer must know what strategies and/or tactics are best given the specifics of their case, must be able to remain calm and professional no matter how adversarial a case or matter becomes and know how to make the best of bad facts.

Poker is full of catchy phrases and principles. Below are some of those phrases or principles and their applicability to lawyers and the legal profession.

If You Can’t Spot th
e Sucker at the Table, It’s You

An important element of being a great poker player is being able to read other people. Are they continually bluffing? Do they have some kind of “tell” that tips off other players? A great lawyer, just like a great poker player, is constantly observing others. To be successful at resolving a matter, you must know what is important to the other players. Make sure you listen more than you talk. And, don’t ever underestimate the opposition.

Know When to Hold ‘Em and Know When to Fold ‘Em

Good poker players know when to fold and not lose all their money. They know when to go all in or call an all in. Similarly, a good lawyer knows when to keep pushing, and when to give up and move on. Fighting to the bitter end on every point won’t always get you the best solution. A good lawyer will regularly assess how important any particular point is to their case and adjust accordingly.

Never Count Your Money While You’re Sittin’ at the Table

Actually, a great poker player knows there is nothing wrong with counting your money while you’re at the table – even in the middle of a hand. To be successful, you need to constantly assess how you are doing and from that make meaningful decisions on how to move forward. A great lawyer is always evaluating how they are doing. What strategies have been effective and why? What facts or most helpful or hurtful to my case? What will success look like in this particular case?

Know When to Change Up Your Play

A poker player has to adapt and change, depending on the game. Some tactics and strategies will work, but the player has to adapt and adjust depending on the circumstances.

The same is true in law. A great lawyer is constantly evaluating the best method or strategy for resolving their case. The successful strategy on the last case may not work on the current case. A great lawyer is continually monitoring their cases and adapting their approach to the specifics of that case.

Table Selection Is Important

Before you sit down to play poker, you need to analyze what stakes are best for you and the quality of the competitors (typically with incomplete information). Furthermore, a great poker player, maybe even more importantly, knows when to change tables. Likewise, a lawyer has to make similar calls. A great lawyer carefully evaluates what cases / clients they are taking. A great lawyer, maybe most importantly, knows when to walk away.

Interview: Richard A. Shaw

By Kevan P. McLaughlin

Richard A. Shaw is a California Certified Specialist in Taxation Law, specializing in business and tax planning, estate planning, and tax controversy representation at Higgs Fletcher & Mack. Mr. Shaw is a nationally recognized tax lawyer, and is a past Chair of the ABA Section of Taxation, California Bar Taxation Section, Western Region Tax Bar Association, and the San Diego County Bar Association Business Law Section.

Richard A. Shaw is a California Certified Specialist in Taxation Law, specializing in business and tax planning, estate planning, and tax controversy representation at Higgs Fletcher & Mack. Mr. Shaw is a nationally recognized tax lawyer, and is a past Chair of the ABA Section of Taxation, California Bar Taxation Section, Western Region Tax Bar Association, and the San Diego County Bar Association Business Law Section.

Q. Tell us how you got into tax law and became the tax lawyer you are today.

A. I have always known I was going to be a lawyer. The question was what specialty. My father had been raised in farming, became the first family college graduate and a lawyer in Portland, Oregon. When World War II started, he began a new career as an officer in the Army. Thus, I had a family background in both the law and military. I lived in occupied Japan as a child in 1946 and later graduated from high school in Yokohama in 1955–great growth experiences.

At the University of Oregon Law School I migrated to the business side and applied to NYU as a teaching fellow. Upon acceptance, I taught and obtained my Master of Taxation law degree at NYU in 1963. I had become defined as a tax lawyer.

After ROTC based military deferrals, it was time for the Army. I was first scheduled to teach law at West Point, and then reassigned to practice tax law at the Pentagon during Vietnam. My early military life, as an officer, promoted many of the skills and my view of duties and responsibilities owed to myself, others and my country.

Teaching has been an important avocation throughout my career and a major element in my development as a tax lawyer. The University of San Diego has tolerated me for over thirty-six years as a distinguished adjunct tax professor in its Masters in Taxation Law Program. Each year I must keep current on the new tax issues and must communicate effectively with new lawyers on difficult tax law matters. This bent for education would lead to many articles (e.g., Subchapter S) and lectures.

Your question also encompasses an additional professional tier of involvement. The world of tax law has changed dramatically from when I started in 1962. It is complex and changes constantly for revenue, economic and political reasons. I enjoy working to clarify, modify and simplify our tax system, nationally, through the ABA–I hope with at least some minimal results. Put simply, my military training, my lifetime of teaching, writing, and lecturing, and my participation in efforts to improve our tax laws, have all contributed to making me a better tax practitioner today.

Q. What are some of the habits and techniques you have applied as an expert witness in trial?

A. I believe that success as an expert witness on the stand depends on thorough preparation and due diligence long before trial. It is important that the trial counsel contact the tax attorney early in the case, instead of the last day for the designation for the expert. It is preferable to be consulted even before counsel files or responds to the complaint. An experienced tax expert can provide valuable early assistance in developing the structure and approach to the case on behalf of the client. As an expert, I also need to respect the limits and scope of the engagement and counsel’s expectations on the nature of the opinions required in the case.

Preparation. As the expert witness, I need to have prepared clear succinct written opinions before either deposition or trial. They should be developed with the cooperation of counsel. The preparation for my opinions, and any accompanied report, will require candid dialogue on supporting information, as well as conflicting documentation and expected testimony that will affect the quality of the opinion. At trial I will need to be confined to those opinions and must earlier have guarded against relying on privileged information (unless essential to the case). I do not want to be surprised in the middle of the deposition or in cross-examination. Unfortunately, trial attorneys occasionally try to hide damaging documents or testimony in the hope that they will not surface and damage their case. I would rather know about it and be prepared to deal with it.

During Examination. One of the essential conditions for me as an expert witness is to remain calm, cool and collected. This means being patient, be a careful listener and don’t let any attorney provoke an emotional response during examination. The need to be a careful listener applies both on direct and cross examination. The general plan and approach for handling the expert witness by the examining attorney needs to be developed ahead of time. This should include proposed questions, or at least the es
sence developed so that I can provide desired results. It will be helpful if principal questions are designed broadly, that will open the door for me to best present supporting facts, rely upon reasonable assumptions and representations, if any, and address any negative issues in a manner that will be clearly understood by the judge/jury. Some responses will need to be very short and direct to the point. These should be resolved ahead of time, and not improvised during trial. It is frustrating when I am on the stand and the examiner fails to set up questions that can lead to expert testimony that may/would affect the final disposition of the case.

When it appears that the question is confusing, raises multiple points or contains inconsistent facts, I may ask that the question be restated in order that I will have time to evaluate a proper response, eliminate the confusion, or break down the question into elements, that will add clarity to the response. During trial, I find that the examiner’s questions frequently contain data, assumptions and representations that are mixed, misleading and in some instances intentionally false. In such case, I may need to give a “yes” or “no” response, and as an expert witness, recognize that I have the right to explain away the problems.

Hypothetical Questions. I find that hypothetical questions create a mine field. If used on direct, the details of the question need to be prepared thoroughly ahead of time. Problems frequently arise with hypotheticals presented on cross-examination. On the stand I will be asked to agree to the correctness of the hypothetical based on the facts presented and express an opinion. This may include hearsay permitted for the expert. Again, as an expert, I cannot be required to give an unqualified yes or no to the hypothetical question. Therefore, I need to take the time to evaluate the hypothetical to determine whether it contains elements that are speculative, excludes relevant facts, assumes facts, representations or assumptions that are incorrect, or not relevant, or which are inconsistent with the evidence, or perhaps protected privileged information. In this instance, counsel may be particularly helpful by objecting to the hypothetical promptly, and identifying those areas that in counsel’s judgment rendered the hypothetical improper.

It is my standard practice, if any objection is raised on a question presented, to stop immediately until counsel has resolved the issue. There is a tendency of witnesses to want to explain, without the guidance of counsel.

The use of Exhibits and Charts. I strongly favor the use of exhibits and charts to increase understanding of my testimony. This may include the use of a prepared chart or overhead projector with the expectation that I will be able to use a pointer as appropriate. In this modern world of graphic images, visual support adds greatly to the word. Any such exhibits and charts should be prepared ahead of time and subject to disclosure before trial. I may find it helpful to have a white board on which to design or develop a given set of conditions as they develop during my testimony.

Eye Contact. The judge/jury is looking for expert guidance. I am aware that some may treat the expert as a “hired gun.” This must be avoided. I find it helpful to talk to and have eye contact with the judge/jury, without the appearance of neglecting the examiner. It is sometimes difficult, but important, that a positive relationship be developed where I can present the image of an objective, impartial and trustworthy observer applying the facts upon which I rely for my opinions. In a malpractice case, it must be clear that I am communicating on and opining only on the standard of care compliance, not the rule of law.

Q. What is the most memorable case that you have been involved with and why?

A. Over the course of half a century of litigation and tax controversy, it is difficult to select any particular case. I remember many. One of the very early cases involved a very wealthy Mexican multi-millionaire who was attacked by the IRS, alleging that he was a U.S. resident because of a series of contacts within the United States. This included a small residence in Chula Vista that was then on the market for sale. The IRS considered it irrelevant that his estate in Mexico was so large that he had his own indoor basketball court. The fact that he shopped in the United States was considered relevant. Equally important was the Government’s misunderstanding that a border crossing card was a “green card” making him a resident. In the end, the Government lost the case in District Court and then, I am informed, I received the highest recovery of attorney’s fees then applied in a tax case. The Department of Justice lost again on appeal. A separate criminal case involved a client that maintained a duel set of books which were discovered only after he sold the business and a purchaser decided full disclosure was appropriate on examination. I have had the opportunity to act as an expert witness in numerous tax shelter type cases, and cases both for and against KPMG. It has been an exciting and engrossing tax controversy career.

Q. Any advice for young tax lawyers?

A. Time and space preclude a thorough approach. Perhaps some comments are helpful.

  1. Recognize that the practice of law is an honored profession and is highly respected in the community. While you may represent your client with “warm zeal,” your professional ethics, courtesy, trustfulness, honesty and loyalty to your clients, as well as others, including adversaries, are essential ingredients establishing your reputation in the legal community. It is helpful to a reputation as someone who is reasonable and congenial to work with in resolving tax controversies.
  2. As a “tax lawyer” you are frequently expected to be an expert on every tax issue presented to you. If you know the law, great; if you do not, be prepared to advise the client that you will acquire the necessary knowledge or obtain assistance from another expert who will assist you. Do not get trapped into giving advice when you were not prepared. You need to develop the skill and experience to competently deal with the issues as presented.
  3. In dealing with your clients or your associates, or others, learn to listen before giving premature advice.
  4. In dealing with representatives of the IRS recognize that, in general, each is there as a representative of our United States government, with the goal of determining an accurate tax liability. They are trying to do their job as they see it. As tax attorneys, we need to respect that role even though we may occasionally run into a bad apple whose personal issues go beyond mere accuracy.
  5. One helpful means to develop skill and education is through lecturing, writing articles and participating in other Bar activities. For some, lecturing or teaching are painful experiences at the beginning, but with practice you will find that you will develop into a better skilled lawyer and be recognized in your community for those special skills. Important in this respect, is working with non-tax lawyers in Bar Association activities. You can benefit substantially by developing relationships with peers and mentors within the legal community over the years.
  6. Always remember that you are a team with your legal assistant or secretary. Never underestimate the value of him or her as a second pair of eyes and ears.
  7. You should consider becoming an active participant in your local, state and federal tax bars. There is a wealth to exceptional talent and knowledge that can provide value to you, as well as the opportunity to meet regularly with judges and government officials material to your tax practice.


Taxation of Medical Marijuana Dispensaries – Part Three of a Three-Part Series

Joseph P. Wilson, Wilson Tax Law Group
Tax Procedure & Litigation Committee Chair

Joseph P. Wilson is a former Federal tax prosecutor, trial attorney for the IRS and trial attorney for the FTB. Mr. Wilson has litigated a wide variety of civil and criminal tax cases in the United States Court of Appeals for the Ninth Circuit, U.S. Tax Court, California Board of Equalization, CUIAB and Property Tax Assessment Appeals Boards. Mr. Wilson currently serves as the Tax Procedure & Litigation Committee Chair.

This is the third article of a three-part series of articles. In the first article I discussed the Federal income tax treatment of medical marijuana dispensaries. In the second article I discussed the California income tax treatment of medical marijuana dispensaries. In this final article I discuss something different than the tax treatment. This article focuses on concerns and issues applicable to the professionals who counsel and provide advice to the organizations, entities and individuals who are engaged in the medical marijuana industry.

Recap of Part One and Two Dealing with Federal and California Tax Treatment

In Part One, I discussed that under the Federal tax regime, the Internal Revenue Service and the United States Tax Court, both take the position that any business that sells marijuana, even if for medical reasons, cannot deduct necessary and ordinary business expenses like a normal business. Because medical marijuana is considered a Schedule I controlled substance within the meaning of the Controlled Substance Act, I.R.C. § 280E does not allow the deduction or credit for any amount paid in carrying on a medical marijuana business activity. In Part Two, I discussed that in California it is not a criminal act to distribute medical marijuana under Proposition 215, the Compassionate Use Act of 1996 (“CUA”). Notwithstanding stark contrast to Federal criminal law, California tax law models the Federal tax law and disallows all business expenses if the medical marijuana dispensary is not being taxed as a corporation under the Revenue and Taxation Code. If the medical marijuana dispensary has been structured in a way as to be taxed as a corporation, it is entitled to deduct all of its necessary and ordinary business expenses. However, if there is a criminal court or other proceeding in which the State of California, county, city or other political subdivision was a party and it was determined that the medical marijuana dispensary engaged in illegal activities, the dispensary will not be allowed to deduct the business expenses or the cost of goods sold under California tax law, regardless of whether the dispensary is structured to be taxed as a corporation, flow through entity, or sole proprietor. Now that we know the tax rules related to these businesses, what are the rules related to the professionals who are providing advice to them?

Concerns for Tax Professionals Who Advise and Counsel Medical Marijuana Dispensaries

In my opinion tax professionals play an important role in society because we help make sure that businesses and individuals adhere to the tax rules. I believe that tax professionals who are dedicated to doing a good job for their clients might not always realize the dangers that exist to them personally in performing these duties as it relates to a client who has a medical marijuana business.

Our tax system is based on a voluntary compliance method in which all businesses are required to file annual tax returns, on which they are required to list the source of their income.1 It is still a Federal crime to distribute marijuana, even for medical purposes. So taxpayers engaged in the medical marijuana business, when stating the actual nature of the underlying business on a filed tax return, are making an admission on a document that is signed under the penalty of perjury, that it has committed a federal crime.2 This is true in spite of the fact that the possession or distribution of marijuana for medicinal purposes is legal under California law. Taxpayers engaged in the medical marijuana business and their tax professionals who are advising them with respect to their tax return can be caught in a pickle because knowingly failing to file a tax return can also be a criminal act.

Lawyers and accountants providing tax advice to, or preparing the tax return of, a medical marijuana business must take into account the possibility that this may subject him or her to criminal liability. Section 2(a) of Title 18 of the United States Code provides, “Whoever commits an offense against the United States or aids, abets, counsels, commands, induces or procures its commission, is punishable as a principal.”3 Given that the medical marijuana business is illegal under Federal law, an attorney or accountant who assists in incorporating a medical marijuana business or arranges a lease of space for a medical marijuana business may face criminal prosecution for aiding or abetting the illegal business.4 Similar charges could possibly be brought against an accountant who handles the bookkeeping for the medical marijuana business. What about presenting a lecture or publishing an article on the tax treatment of medical marijuana businesses? Does this constitute the aiding and abetting to induce or procure the commission of a Federal offense? I would hope not, given the implications to freedom of speech and that such speech advocates compliance with at least one area of the law, not how to violate it, albeit potentially directed at those who have already violated other laws.5

Practitioners could also be considered to be in violation of state licensing and professional responsibility rules. The Model Rules of Professional Conduct state: “A lawyer shall not counsel a client to engage, or assist a client in conduct that the lawyer knows is criminal or fraudulent.” Model Rules of Prof’l Conduct R. 1.2(d) (2011). The California Rules of Professional Conduct have a similar rule that states: “A member shall not advise the violation of any law, rule, or ruling of a tribunal unless the member believes in good faith that such law, rule, or ruling is invalid. A member may take appropriate steps in good faith to test the validity of any law, rule, or ruling of a tribunal.” Cal. Rules of Prof’l Conduct R. 3-210.

I have not discovered a ruling in California on whether an attorney can ethically provide advice to medical marijuana businesses. However, I did discover a few state rulings on whether an attorney can ethically provide advice to medical marijuana businesses under the Model Rules. Two of these state rulings are divided on the subject.

The State Bar of Arizona held a lawyer can ethically perform legal acts necessary to assist a client engage in conduct that is expressly permissible under the Arizona Medical Marijuana Act. State Bar of Ariz. Comm. on the Rules of Prof ‘l Conduct, Op. 11-01 (2011). However, the State Bar of Arizona held that is only the case if the lawyer advises the client with respect to the potential Federal law implications and consequences thereof. Id. I think this
is a very important point and believe that California should follow the same rule.

On the flipside, the State Bar of Maine ruled that a lawyer cannot assist a client to engage in the medical marijuana business. Maine Prof ‘l Ethics Comm’n, Op. 199 (2010). I find this very interesting because in 1999 Maine became the fifth state in the US to provide for dispensaries of medical grade marijuana for persons with debilitating and chronic medical conditions. These not-for-profit dispensaries are even licensed and regulated by the Maine Department of Health and Human Services. Regardless, the State Bar of Maine ruled that it is unethical for a lawyer to assist a client with these activities.

If a state agency disbars or suspends a practitioner as a result of counseling a client in these activities, Circular 230 can sanction that person’s ability to practice before the IRS under section 10.51(a)(10). I think the point is simply to proceed with caution when it comes to the ethical status of providing this type of legal advice in the State of California and be aware that it could lead to other problems.

Another word of caution for tax professionals assisting clients with these activities is that they should check the terms of their malpractice insurance very closely. There is probably a risk of non-coverage due to criminal activity or another intentional act that is not legal.6 In fact, Ann Toney, a Denver lawyer, recently lost her liability insurance coverage over medical-marijuana clients.7 Because part of her practice involves representing medical marijuana businesses, her liability insurance provider, Hanover Insurance Group, did not renew her malpractice insurance coverage. It made no difference that it is legal in Colorado, where she practices law, and it made no difference that she was a former prosecutor who apparently taught classes on medical marijuana law for the Colorado Bar Association.

The bottom line is that the marijuana tax laws are all screwed up and California is the perfect example of how screwed up they can be. In California medical marijuana is legal for criminal distribution purposes but illegal for tax purposes unless of course your are taxed as a corporation, in which case medical marijuana is legal for both purposes unless a criminal court or other proceeding determined that the medical marijuana dispensary engaged in illegal activities. This is the status of the tax law in California.

So if you want to practice law in this area just be mindful of these unsuspecting traps. The last thing you want to happen is to be caught off guard.

Why Stolen Identity Refund Fraud is the IRS’s Biggest Problem, and What Can Be Done About It

Daniel W. Layton, Wilson Tax Law Group

Daniel W. Layton is of-counsel with the Wilson Tax Law Group. Mr. Layton is a former Federal tax prosecutor and trial attorney with the IRS Office of Chief Counsel with at least 30 reported decisions to his name. Today Mr. Layton represents clients in all aspects of tax controversies including audits, collections, international tax, and criminal tax defense.

The IRS’s tax return-related identity theft problem has officially crossed from an item of interest to law enforcement and tax professionals to a disturbing problem worthy of the national primetime news. On September 21, 2014, tax return-related identity theft (also known as “stolen identity refund fraud”) was the focus of a 15-minute segment on CBS’s 60 Minutes, Biggest IRS Scam Around: Identity Tax Refund Fraud.8 Among those interviewed in the segment were IRS Commissioner John Koskinen, Deputy IRS Commissioner Steve Miller, Southern Florida United States Attorney Wilfredo Ferrer, and Miami Field Office FBI Special Agent In Charge George Piro.

The seriousness of the matter certainly came through to anyone watching, with United States Attorney Ferrer using a geographically-appropriate water analogy to describe the situation as “a tsunami of fraud.” Florida has been the hardest hit by these fraud schemes, and Ferrer was also refreshingly blunt on several key points: that the scheme is surprisingly simple and requires no more than a computer, a social security number, and a date of birth; that the IRS was not ready to deal with the large number of fraudulent returns; and that clearing up a victim’s identity theft refund claim with the IRS can be “a nightmarish process.”

A Digital-Age Crime

Stolen identity refund fraud has grown in large part due to the IRS’s, and then criminals’ move into the digital age. Unfortunately for the IRS and many victims of stolen identity refund fraud, the IRS’s acceptance and use of technology has apparently been balanced too far on the side of taxpayer convenience, making it easy for criminals and honest taxpayers alike to receive a refund.

The IRS’s move to online return filing as we know it began in 2002, when the IRS allowed signing of e-file returns using a PIN, making the process entirely paperless. By 2005, more than half of all returns were e-filed.9 The e-filing is only part of the paper-free process, which is completed by the ability to have a refund wired from the Treasury to a bank or even a pre-paid cash card. Those accounts, too, can be opened online using essentially the same personally identifying information (“PII”) appearing on a tax return – a social security number, a name, and a date of birth. One element does typically require a physical presence and access to a mail box, however: a prepaid cash card or a bank account still requires real-world interaction to receive the card and withdraw cash from an ATM. The IRS’s online refund tracking system,10 has also allowed taxpayers and criminals alike to monitor their anticipated payments.

A Tsunami of Fraud

Like a tsunami, the stolen identity fraud has swollen to epic proportions in a very short time. Information from the Federal Trade Commission shows that complaints of tax or wage-related fraud11 grew from 15.6% in 2010 to 24.3% in 2011, 43.4% in 2012, and 30% in 2013.12 Stolen identity refund fraud now sits at the top of the IRS’s “Dirty Dozen” tax scams.13

According to a Government Accountability Office report released on September 23, 2014, the IRS estimates that $29.4 billion in tax return-related identity theft was attempted in the 2013 filing season (which presumably includes mainly 2012 tax year returns).14 Of this amount, the IRS estimates it paid $5.2 billion, just less than 18%.15This is particularly disappointing news given the headway the IRS appeared to be making in battling this type of refund fraud. According to reports by the Treasury Inspector General’s Office (“TIGTA”), for tax year 2010 the IRS issued potentially fraudulent refunds of $5.2 billion as well, but that number diminished to $3.6 billion for the 2011 tax year returns (processed in 2012).16

Perhaps more troubling is that the IRS is doing a better job, at least percentage-wise. TIGTA reported that the IRS prevented approximately $12.1 billion in fraudulent refunds for the 2012 processing year, allowing approximately 23% of the attempted fraudulent refunds (out of a total of $15.7 billion attempted).17 The current increase in fraudulent refunds issued is despite a 5% improvement in detection and prevention by the IRS.18 Assuming the statistics are reasonably accurate from year-to-year, the take-away is that the incidences of stolen identity refund fraud has almost doubled over a single year, completely mitigating any positive effects of the IRS’s improved detection.

The reason for the increase is fairly obvious. Succinctly put by Corey Williams, a convicted perpetrator of stolen identity refund fraud who was interviewed as part of the 60 Minutes piece: “Anybody who knew about it, you’d be a fool to not try to get involved with making some money. I could just wake up in the comfort of my own home, and just get on a laptop, do about 15 returns a day. Fifteen time $3,000 a return, that’s $45,000 a day.”19 In other words, it became popular among criminals (or opportunists-cum-criminals) because it is easy and it works extremely well.

Williams was not exaggerating about how profitable the scheme can be for a criminal. According to TIGTA, 355 undetected fraudulent 2011 tax returns were filed using a single address in Colorado as part of such a scheme, and the IRS issued more than $1 million in refunds to that address before it was detected.20

The $3,000 per return figure was also not randomly picked by Williams. A common component to these schemes is that they rely on small refunds and filing high volumes of returns. To obtain those small refunds, the false returns are accompanied by a fabricated Form W-2 or 1099 showing a small amount of withholding and a small amount of income. The income is typically zeroed-out using the standard deduction, schedule A or dependents, and the return claims the modest refund of the false withholdings. Although the IRS has matching programs that most tax practitioners are familiar with, the matching programs don’t operate in real-time. During filing season, the IRS gives taxpayers the benefit of the doubt, assuming the information returns from the employers weren’t filed or processed yet. Because the amount of the refunds claimed is small, the returns aren’t given much scrutiny before refunds are issued.

The Government’s Response

The government’s response comes from three angles: (1) law enforcement response, designed to effectively prosecute identity thieves; (2) taxpayer-victim response; and (3) preventative measures.

Law Enforcement Response

Perhaps the biggest tool the IRS has used to detect identity theft schemes is the Scheme Development Center. By at least 2013, the IRS developed filtering tools that detect commonalities in returns, like the repeated use of the same address or bank accounts. In February of 2014, the first month of the filing season, the IRS identified and confirmed 28,076 fraudulent tax returns involving ID theft.21 However, because this method of detection involves recognition of patterns, it will only allow the IRS to respond to the scheme after several returns have already been processed.

Federal prosecutors now have more tools at their disposal as well. In 2004, Congress enacted 18 U.S.C. § 1028A, which prohibits the knowing use, without authorization, of another’s PII in connection with certain predicate offenses, many of which are now routinely charged in stolen identity refund fraud cases, like mail, wire and bank fraud. Although a similar statute with a wider range of predicate offenses, 18 U.S.C. § 1028(a)(7), had already been in the books in since 1998, the “big A” statute has become the prosecutor’s preferred charge in order to deter would-be identity thieves due to the mandatory minimum 2-year sentence consecutive to the sentence for the underlying offense.

To expedite investigation and prosecution of these cases, Department of Justice Tax Division Directives 144 and 145 were enacted in 2012 and 2014, respectively. These directives allow United States Attorney’s Offices to open stolen identity refund fraud grand jury investigations, to bring charges, and to obtain seizure warrants for forfeiture of criminally derived proceeds arising from such crimes, all without prior authorization from the Tax Division – so long as the United States Attorney’s Office has a designated in-house point of contact who reviews the cases and sends notice to the Tax Division.

In addition to IRS and federal law enforcement, local law enforcement is beginning to prosecute these cases more often. Because these are not particularly sophisticated crimes, many of them are committed by street-level criminals, gangs, or others with histories with local, rather than federal, law enforcement. The stolen identity refund fraud is often discovered as part of a larger criminal investigation or as part of a routine traffic or DUI stop. To allow local law enforcement to keep their momentum and use their resources to prosecute these cases, the IRS has begun a pilot program to enable local law enforcement, with the taxpayer-victim’s consent, to access the tax records necessary to prove the criminal conduct.22

Response to Taxpayer-Victims of Identity Theft Refund Fraud

The IRS’s Identity Protection Program is outlined in section 10.5.3 of the Internal Revenue Manual. Because, as tax practitioners know, talking to the right person and finding the right form are often half the battle, the two most important parts of that program are arguably the use of the Identity Theft Affidavit, IRS Form 14039, and the IRS Identity Protection Specialized Unit, which may be called at (800) 908-4490 for any ID theft related inquiries. Although there have been some instances in the past where identity theft victims have had to wait as much as 18 months to have their tax accounts cleared, the IRS now touts an average processing time of 6 months.23

The IRS divides identity theft issues into two categories: identity
theft that is affecting tax administration, and identity theft theft at risk of (but not yet) affecting tax administration.24 Elsewhere in the Internal Revenue Manual this is referred to as “tax-related” or “non-tax-related” identity theft. The Form 14039 reflects this division, having different boxes to check depending on whether the taxpayer has reason to believe the identity theft has affected his or her return or has no reason to believe his or her returns have been affected yet.25 If the IRS has initiated and made a determination that the taxpayer was a victim of tax-related identity theft, it will systemically issue a notice CP 01A, We Have Assigned You an Identity Protection Personal Identification Number.26

To prove tax-related identity theft alleged by a taxpayer, the IRS will request supporting documentation, including:27

Authentication of Identity – a copy of a valid U.S. federal or state government issued form of identification (examples include a driver’s license, state identification card, social security card, or passport); and Evidence of Identity Theft – a copy of a police report or Form 14039, IRS Identity Theft Affidavit. Fortunately, supporting documentation can be accepted from someone who has power of attorney for the taxpayer (e.g., Form 2848, Power of Attorney and Declaration of Representative). Form 14039 requires a signature of the taxpayer or representative of the taxpayer.

Once a positive identity theft determination is made, the IRS will correct their records based on information submitted and cause issuance of a refund.28 In addition, the IRS will also issue the taxpayer an IRS Identity Protection PIN. The IRS Identity Protection PIN (IP PIN) is a unique six digit number that is assigned annually to victims of identity theft for use when filing their federal tax return that shows that a particular taxpayer is the rightful filer of the return. This is in addition to the e-filing PIN. The IP PIN will allow these individuals to avoid further delays in filing returns and receiving refunds.

Preventative Measures

The IRS has stated that it will continue to expand the filters it uses to recognize schemes prior to processing and issuing refunds.29 In addition, although IP PINs are not ordinarily issued without a tax-related identity theft determination, the IRS began a pilot plan in 2014 to issue IP PINs preemptively to some taxpayers in Florida, Georgia, and Washington DC, in addition to those who received a CP01A. 30

Potential IRS and Legislative Fixes

In its last report, TIGTA suggested that Congress needs to allocate resources to fix the problems associated with these schemes, stating:31

Once the IRS identifies a potential identity theft tax return, it must verify the identity of the individual filing the return. However, verifying whether the returns are fraudulent will require additional resources. Without the necessary resources, it is unlikely that the IRS will be able to work the entire inventory of potentially fraudulent tax returns that it identifies, thus resulting in the issuance of refunds for those returns. The net cost of failing to provide the necessary resources is substantial, given that the potential revenue loss to the Federal Government of these tax fraud-related identity theft cases is billions of dollars annually.

Legislators are now paying attention to the stolen identity refund problem and have proposed some statutory fixes. For example, one gap in the criminal code is that prosecutors have limited predicate charges available if they want to use 18 U.S.C. § 1028A and those charges aren’t always a perfect fit. While 18 U.S.C. §§ 287 and 286 (submission of false claims to the government and conspiracy to defraud the government, respectively) are probably the most apt charges for the false returns themselves, and are the Title 18 charges prosecutors are most familiar with in tax cases, they are not included in the predicate offenses for “big A.”32 To fill this gap, Representative Kenny Marchant introduced a bill to add 18 U.S.C. §§ 286 and 287 to the list of predicate offenses on July 29, 2014. The bill was last referred to subcommittee on September 26, 2014.33

In addition, recognizing that 18 U.S.C §§ 286 and 287 are not tax specific and that 18 U.S.C. § 1028A does not include any tax-specific frauds as predicate offenses, the Joint Committee on Taxation has discussed adding revising I.R.C. § 7206 to include a criminal penalty for misappropriating taxpayer identity in connection with tax fraud. 34

However, while these additions may streamline the law and help prosecutors bring charges that apply more comprehensively to the crimes, prosecutors already charge these cases, juries are convicting on the current law, and courts are ordering substantial sentences. With the submission of patently false returns, adequate means of deterrence is not the problem. Rather, the problems are detection and prevention, which take resources to address. Legislation is popular, of course, without appropriations, because it brings political capital and doesn’t cost the taxpayers anything. However, there is no indication that making the criminal conduct even more criminal will have any net effect. Thus, TIGTA’s suggestion at the start of this section should not be forgotten.

So long as appropriate funding follows, a bill introduced only a few days after Marchant’s stands a better chance of limiting the IRS’s blood loss to identity fraud schemes. The Tax Refund Theft Prevention Act of 2014 was introduced on July 31, 2014, and, as of the date this article was drafted, has been referred to the Committee on Finance.35 That bill includes a fairly comprehensive list of changes to IRS procedures and potential changes to private-party information return filing requirements that would, at least until the schemes evolve again, make it more difficult for the current perpetrators to receive fraudulent refunds. The bill would require the IRS to implement a password system for return filing, require the IRS to set up an online information return filing and distribution system, and requ
ire the Treasury to issue regulations restricting the delivery or deposit of multiple refunds to the same mailing address or bank account. In addition, the Treasury (likely TIGTA) would be required to provide a recommendation to Congress on accelerating the schedule for filing information returns and improving the IRS’s information return matching programs to pick up on the bogus Forms W-2 and 1099 used in the schemes.36

Ultimately, loss prevention and asset protection would be wise investments for the government when it comes to stolen identity refund fraud. If Congress does not act swiftly and give the IRS both the tools and the resources to take swift action, it stands to lose tens of billions of dollars over the next few years given the current trajectory.

Recent Cases of Interest

Robert S. Horwitz, Law Offices of A. Lavar Taylor

Robert S. Horwitz has over 35 years of experience as a tax attorney, having spent years with the Department of Justice Tax Division and in the U.S. Attorney’s Office, where he successfully prosecuted the leading real estate tax shelter promoter in the western United States. Since 1994 Mr. Horwitz has been part of the Law Offices of A. Lavar Taylor, where he represents clients in all types of civil and criminal tax matters.

The Ninth Circuit finally got around to answering the question of the mental state required for a bankruptcy court to determine that taxes should be excepted from discharge under 11 U.S.C. §523(a)(1)(C). That section excepts from discharge a tax liability “with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.” Hawkins v. Franchise Tax Board, 2014 U.S. App. LEXIS 17925 (September 15, 2014).

The taxpayer, William “Trip” Hawkins had an undergraduate degree from Harvard and an MBA from Stanford. He was one of the first employees at Apple, and rose to become director of marketing. He left Apple to become a founder of Electronic Arts, Inc. (“EA”), which became the largest supplier of computer entertainment software. By 1996, his net worth was approximately $100 million. In that year, he divorced his first wife and married his second wife.

In 1990, EA created a wholly-owned subsidiary, 3DO. The taxpayer left EA to run 3DO. 3DO went public in 1993. Between 1994 and 1998, the taxpayer sold much of his EA stock to invest in 3DO. He had millions in capital gains from the sales. His accountant was KPMG. Guess what they advised him to do? To get into FLIP and OPIS transactions to offset his gain with paper losses. The taxpayer continued to sell EA stock in the following years and to use KPMG certified scams to shield his gain from taxation. The IRS eventually audited the taxpayer’s returns for 1997 through 2000 and asserted deficiencies of tax, plus penalties, of $11.6 million.

While the taxpayer was dealing with the IRS, 3DO was going downhill. He loaned the company $12 million, but that didn’t help. The company eventually went into bankruptcy and the taxpayer did not recover the funds he had invested. These losses caused him to file a motion with the family law court to reduce the child support he was paying to his first wife. In the motion, the taxpayer admitted owing the IRS $25 million, that he had limited income, and that he was insolvent. His attorney acknowledged that the taxpayer intended to discharge his taxes in bankruptcy. The family court granted the motion, but required that he put his assets in trust.

In 2005, the IRS assessed $21 million in taxes, penalties and interest against the taxpayer for 1997-2000 and the FTB assessed $15.3 million. The taxpayer’s offer in compromise to the IRS, to pay $8 million, was rejected. The taxpayer and his second wife did little to alter their lavish lifestyle after 2003, when he knew he was insolvent. Their living expenses exceeded their income. In 2006, the taxpayer sold his home and paid the $6.5 million in net proceeds to the IRS. A month later, the FTB seized $6 million from the taxpayer’s financial accounts. He therefore filed a chapter 11 bankruptcy. Shortly after filing chapter 11, he sold his second home. The net proceeds of $3.5 million were paid to the IRS. The bankruptcy court approved a liquidating reorganization plan under which the IRS received $3.4 million. The plan provided that the taxpayer, the IRS and the FTB could bring suit to determine whether the tax liability was excepted from discharge under 11 U.S.C. § 523(a)(1)(C).

The bankruptcy court determined that the taxpayers’ living expenses exceeded their earned income by between $516,000 and $2.35 million in the years preceding bankruptcy. It therefore held that Hawkins’ liability for taxes was excepted from discharge. The bankruptcy court held that his wife’s tax liabilities were discharged.

The Ninth Circuit began its analysis with the words of the statute. It noted that the word “willful” is not free from ambiguity, quoting Spies v United States, 317 U.S. 492, 497 (1943), for the proposition that “willful” “is a word of many meanings, its construction often being influenced by its context.” The Bankruptcy Code was designed to give debtors a “fresh start” and, as a result, exceptions to discharge were to be interpreted narrowly. The Ninth Circuit noted that in Kawaauhau v. Geiger, 523 U.S. 57 (1998), the Court had interpreted the word “willfully” in the context of the exception to discharge of any debt “for willful and malicious injury” to mean a “deliberate and intentional injury” and not just a deliberate and willful act that leads to injury.

Turning again to 11 U.S.C. § 523(a)(1)(C), the Ninth Circuit noted that subsection (A) excepts taxes and customs duties that are priority debts and subsection (B) excepts taxes for which a return was not filed (or was filed late and within two years of the date of the petition). Subsection (C) groups together a willful attempt to evade or defeat tax with a tax for which the taxpayer made a fraudulent return. From this, the Ninth Circuit concluded that “evade or defeat” was more akin to tax fraud than to late filing. The Court also turned to legislative history, which described 11 U.S.C. § 523(a)(1) as a “compromise” between “willfully” attempting to evade and “fraudulently” attempting to evade. Turning to cases, the Ninth Circuit noted that the cases that excepted tax from discharge under 11 U.S.C. § 523(a)(1)(C) all involved affirmative acts to avoid paying tax, such as placing assets in the names of third parties, having hidden bank accounts, and not filing tax returns. With the exception of willful failure to file, all of these acts could satisfy the requirement for criminal evasion.

The Ninth Circuit next turned to I.R.C. § 7201, the criminal tax evasion statute, which makes it a felony to “willfully attempt in any manner to evade or defeat any tax.” As noted by the Ninth Circuit, the courts have interpreted this provision as requiring affirmative acts of fraud or deceit. Merely spending beyond one’s means while owing a tax liability did not meet this standard. Thus, the Ninth Circuit held that to except a tax from discharge under 11 U.S.C. § 523(a)(1)(C) requires the government to “establish that the debtor took the actions with the specific intent of evading taxes.”

The Ninth Circuit noted that several circuit courts have held that all that is required to except a tax from discharge under 11 U.S.C. § 523(a)(1)(C) is to show that the debtor had a legal duty to pay taxes, knew he had that duty, and voluntarily and i
ntentionally violated that duty. In most of these cases, however, there were affirmative acts or omissions specifically designed to evade taxes. Because the Ninth Circuit had not previously ruled on the issue, it was not possible for it to determine whether, absent the lavish spending, the bankruptcy and district courts would have found a “willful” attempt to evade or defeat. It therefore reversed and remanded for the courts below to reanalyze the case under the “specific intent” standard.

Circuit Judge Rawlinson dissented, finding that Hawkins deliberately decided to spend money extravagantly rather than paying taxes he owed the IRS and the FTB. Judge Rawlinson would have adopted the Tenth Circuit’s reasoning in Vaughn v. IRS, 2014 U.S. App. LEXIS 16417 (August 26, 2014). The taxpayer in Vaughn v. IRS, 2014 U.S. App. LEXIS 16417 (10th Cir., Aug. 26, 2014), was a businessman who lacked the advantage of degrees from Harvard, Stanford, or any institution above high school. He used his business acumen to become CEO of a start-up cable company that, in 1999, was sold for $2.1 billion. He received $20 million in cash and $11 million in stock. He turned to KPMG for advice. KPMG introduced him to BLIPS, another name for sham.

The Tenth Circuit recognized the essential feature of BLIPS: “Through BLIPS, a desired tax loss could be tailored to offset a participant’s actual economic gain, and thereby shelter that gain from tax.” Vaughn testified that he understood the transaction would be designed to offset his economic gain and that if he withdrew from the transaction after 60 days, and prior to the end of the year, he would generate a tax loss sufficient to offset his capital gains. KPMG advised Vaughn of the risks of an IRS audit and the need for a profit motive. He testified that he “understood the BLIPS program ‘as a choice between paying $9 million of taxes currently or claiming the benefits of [the BLIPS] losses and paying $3 million currently with some risk of paying more taxes later.’” To get into BLIPS, Vaughn paid KPMG $506,000 and paid $2.8 million into the transaction in late 1999. His BLIPS transaction generated a $42 million paper loss.

In April 2000, Vaughn signed a tax return that claimed capital gains of $30.6 million, a capital loss from the BLIPS transaction of $32.6 and an ordinary loss from BLIPS of $3.3 million. Vaughn knew he had not suffered an economic loss equal to the claimed tax losses. By early 2001, KPMG had informed Vaughn that the IRS took the position that losses from transactions like BLIPS could not be recognized for tax purposes. In September 2001, Vaughn divorced his wife. She got the family residence and 5 luxury cars. He got a condo worth $1.4 million and an SUV. They split the investment account evenly. Immediately after the divorce, he got engaged and purchased his fiancé a home for $1.73 million, with title in her name. One month later, he married his fiancé.

In February 2002, KPMG advised Vaughn of the likelihood of an audit and recommended that he enter into the IRS’s voluntary disclosure program for taxpayers who participated in scams similar to BLIPS. After learning of the program, Vaughn set up an irrevocable trust for the benefit of his new wife’s daughter, to which he contributed $1.5 million. He then disclosed to the IRS his participation in a BLIPS transaction. In March 2003, less than 18 months after marriage, he and his second wife divorced. He was not represented by counsel in the divorce. During their brief marriage, he and his wife had spent lavishly. As part of the divorce, the second wife got the home, luxury cars, and $3.5 million from their brokerage account. He got a pick-up truck, the condo and the balance of the brokerage account, which was far less than what his second wife got. Just before the divorce, he learned that his first wife had filed for innocent spouse relief for the 1999 tax year. After his divorce from his second wife, Vaughn filed for innocent spouse relief, claiming that due to the unequal division of assets in the divorce from his first wife, his net worth had dropped to less than $4 million. While noting that he had remarried and divorced again, his request did not mention the trust set up for his second wife’s daughter or the unequal division of assets when he divorced his second wife.

In May 2004, the IRS announced a settlement program for taxpayers who had participated in shelters. Vaughn was ineligible because he could not full pay the tax resulting from participation in BLIPS. In June 2004, the IRS notified Vaughn that he owed an $8.6 million deficiency for 1999 and a $120,000 deficiency for 2000 due to the BLIPS transaction. In November 2006, Vaughn filed a chapter 11 bankruptcy. The IRS filed a proof of claim for $14.35 million in tax. Vaughn initiated an adversary proceeding to determine whether the taxes were dischargeable. After trial, the bankruptcy court determined that the taxes were excepted from discharge under 11 U.S.C. § 523(a)(1)(C) because Vaughn had filed a fraudulent return and had willfully evaded the tax. Based on a “holistic view of the evidence,” the district court affirmed on the ground that Vaughn had willfully evaded tax. It did not address whether the return was fraudulent. Vaughn appealed to the Tenth Circuit, arguing that the district court erred in applying a “holistic view” and in determining that he “willfully” evaded tax when, according to Vaughn, he only acted negligently. The Tenth Circuit affirmed.

The Tenth Circuit held that it did not need to address the first argument, since the bankruptcy court applied the correct approach to determining whether Vaughn “willfully evaded tax,” which required both a conduct component and a mental state component, and supported its determination with detailed factual findings. Whether Vaughn acted willfully was a question of fact that would only be reversed if the trial court’s findings were clearly erroneous, i.e., without factual support in the record. According to the Tenth Circuit:

The bankruptcy court explicitly found that “[Appellant’s] actions meet the state of mind test to show intent to evade tax” under § 523(a)(1)(C). In re Vaughn, 463 B.R. at 548. In making this finding, the bankruptcy court quoted this court’s holding that a “debtor’s actions are willful under § 523(a)(1)(C) if they are done voluntarily, consciously or knowingly, and intentionally.” Dalton, 77 F.3d at 1302. The bankruptcy court also noted that § 523(a)(1)(C)’s mental state requirement is generally satisfied “where the government shows the following three elements: 1) the debtor had a duty under the law; 2) the debtor knew he had the duty; and 3) the debtor voluntarily and intentionally violated the duty.

It then summarized the facts relied on by the bankruptcy court to support its finding of willfulness, including Vaughn’s setting up a trust for his second wife’s daughter, his lavish spending and the uncontested division of assets in the second divorce in light of the pending tax liability.

The Court rejected the first argument advanced by Vaughn, that there can be no finding of willfulness where the tax had not been assessed, since it had previously held that a prior tax assessment is not necessary where the taxpayer’s conduct coupled with knowledge of a potential tax liability suffices to support a finding of evasion. The Court next rejected the argument that since Vaughn relied on KPMG’s advice, he at worst acted negligently, rather than willfully, particularly in light of the bankruptcy court’s explicit finding that Vaughn’s testimony concerning his reliance was not credible.

Vaughn’s third argument was that the Tenth Circuit’s affirmation of a Tax Court decision imposing a negligence penalty on a taxpayer who invested in a KPMG shelter proves that his conduct did not rise to the level of willfulness. The Court quickly disposed of that argument, noting that its prior decision did not compel a determination that the bankruptcy court’s finding of willfulness was clearly erroneous. Vaughn’s fourth argument
was that the bankruptcy court’s finding that he willfully evaded tax was undercut by its use of language implying negligence. The Tenth Circuit held that the bankruptcy court’s use of language such as “knew or should have known” and “reasonably” were just used to buttress its conclusion that, in fact, Vaughn knew that BLIPS was an abusive tax shelter. Finding no error by the bankruptcy court, the Tenth Circuit affirmed the decision that under 11 U.S.C. § 523(a)(1)(C), the taxes were not discharged.

It is important to note that the Tenth Circuit requires both a mental state component and a conduct component to support a finding of willful evasion of tax. It nowhere states that lavish spending alone is sufficient to find willfulness and in its discussion it relied on a number of other facts, specifically that the taxpayer got into the tax scam because he did not want to pay the tax, that he set up a trust for his fiancé’s daughter knowing of the potential tax liability, that he purchased a home in his fiancé’s name as sole owner, that when he divorced her 18 months later he agreed to a division of assets that left her with a disproportionately large percent of his assets and that he failed to disclose the trust or the division of assets to the IRS when he tried to settle his liability. So the Ninth Circuit’s reading of Vaughn was a reasonable one.

Willful evasion is the second part of the discharge exceptions contained in 11 U.S.C. § 523(a)(1)(C). The first is the filing of a fraudulent return. Will the Government in a future case argue (in light of the Tax Court’s decision in Allen v Commissioner) that fraud by the return preparer is sufficient to trigger the exception under the first prong? One major distinction between the language of 11 U.S.C. § 523(a)(1)(C) and the language of 11 U.S.C. § 6501(c)(1) is that the former requires that the “taxpayer made a fraudulent return” while the later requires only that there be a false or fraudulent return.

Prior Recent Cases of Interest discussed cases dealing with the collateral estoppel effect of a criminal conviction on subsequent civil tax cases. The Sixth Circuit recently discussed the application of the doctrine of judicial estoppel as it applies where a criminal tax conviction is followed by civil tax proceedings involving the same taxable years. In Mirando v. United States Dept. of Treasury, 2014 U.S. App. LEXIS 17313 (6th Cir., Sept. 8, 2014), the taxpayer, Michael Mirando, was a two time loser. In 2001, he pled guilty to mail fraud, money laundering and tax evasion for 1995 and 1996. After his release from prison, the IRS assessed taxes, penalties and interest for 1995 and 1996 and for 2000 and 2004. He did not pay these amounts. This led to further trouble.

In 2007 he was charged with conspiracy to defraud the United States and four counts of tax evasion for 1995, 1996, 2000 and 2004. The evasion charge was based on evasion of payment by, among other things, engineering a sham divorce from his wife and understating his income and assets to the IRS. He pled guilty to all counts. In the plea agreement, the taxpayer and the United States stipulated that the total tax liability, including penalties and interest, for these four years was $448,776.13 as of June 29, 2007. The plea agreement also stated that the Government would not prosecute the taxpayer’s wife or children for any crimes and would recommend a three-level downward adjustment for acceptance of responsibility. Prior to entering into the plea agreement, Mirando paid $467,686.04 to the IRS, or $18,909.91 more than the amount owed under the plea agreement. These payments were listed in an attachment to the plea agreement.

In 2008, Mirando and his wife filed amended returns for 1994, 1995 and 2000 claiming refunds of $28,871, $54,112, and $32,332. When the claims were denied, Mirando and his wife filed a refund action in district court seeking to recover $125,315. The Government answered, denying that the Mirandos were entitled to a refund. The answer did not raise any affirmative defenses.

The parties filed cross-motions for summary judgment. In its motion, the Government argued that collateral estoppel barred Mirando from challenging the amount of tax. In reply, Mirando claimed that collateral estoppel did not apply and that the Government could not raise estoppel because it failed to plead it as an affirmative defense. In its reply, the Government conceded that it could not prove that collateral estoppel applied. Instead, it argued that judicial estoppel barred recovery. The Government also moved to amend its answer to assert the defense of estoppel. Mirando moved to file a surreply since judicial estoppel was not raised until the Government’s reply. Mirando’s motion attached the proposed surreply. The district court granted the Government’s motion to amend and its motion for summary judgment. Mirando appealed.

The doctrine of judicial estoppel bars a party who successfully assumed one position in a prior proceeding from assuming a contrary position in a subsequent proceeding. Quoting the Supreme Court’s decision in New Hampshire v. Maine, 532 U.S. 742 (2001), the court set out the three factors used to determine whether judicial estoppel is applicable:

  1. The party’s earlier position must be clearly inconsistent with its later position;
  2. The party must have succeeded in persuading a court to accept its earlier position so that judicial acceptance in a later proceeding would create the perception that the court in either the earlier or the later proceeding was misled; and
  3. The party seeking to assert an inconsistent position would obtain an unfair advantage over or impose an unfair detriment on the opposing party if he is not estopped.

Because the doctrine of judicial estoppel precludes contradictory positions without any examination as to whether either is true, it is to be applied with caution. The first factor is that the positions in the litigation must be inconsistent. In the plea agreement, Mirando took the position that his tax liability as of June 29, 2007, was $448,776.13 and that he had paid $467,686.04. In the refund suit, he took the position that he overpaid his tax for 1995, 1996, and 2000 by $125,315. The position taken in the refund suit was clearly inconsistent with the position taken in the plea agreement. The Court distinguished its decision in United States v. Hammon, 277 F.3rd Appx 560 (6th Cir. 2008), where it held that judicial estoppel did not apply to a refund suit following a guilty plea, where the plea agreement stated that the defendant evaded tax assessed in the approximate amount of $2.39 million. The defendant in Hammondid not “successfully and unequivocally assert” that this amount was accurate. Mirando’s plea, however, clearly and unequivocally agreed to the exact amount owed to the penny and agreed that the amount assessed was accurate. The attachments to the plea that listed the payments Mirando had made did not make the plea ambiguous.

The second factor is that Mirando succeeded in persuading the prior court to accept the numbers in the plea agreement. While the sentencing court did not explicitly state that it accepted the amount owed in the plea agreement, the Sixth Circuit held that it “implicitly” accepted the position because it accepted the plea agreement as a whole. There was no indication of a procedural defect in sentencing that would provide a basis for determining that the prior court did not accept the numbers.

The third factor is whether the party asserting the inconsistent position would gain an unfair advantage if not estopped. The Sixth Circuit held that Mirando would gain an unfair advantage. The plea agreement provided that in exchange for Mirando’s plea the Government would not prosecute his wife or children. This provision was not for the Government’s benefit; the Court therefore concluded that it “must have been a benefit to Mirando, otherwise it
would not have been in the agreement.” As to the three step downward adjustment for acceptance of responsibility, neither party had offered a transcript of the sentencing hearing. As a result, there was no evidence that the sentencing court gave Mirando a three-step downward adjustment. Thus, the court could not determine whether this provision in the plea agreement gave Mirando an unfair advantage.

The lack of a transcript may be the reason why the Government abandoned its collateral estoppel claim in district court. Collateral estoppel, also known as “issue preclusion,” requires a prior court to determine an issue of fact or of law that is necessary to its judgment. To prove collateral estoppel the Government would have been required to show that the sentencing court determined that Mirando owed $448,776.13. Since there was no transcript or other evidence that the district court expressly determined that this was the amount that Mirando owed, the Government probably determined that it would be unable to prove that Mirando was collaterally estopped to argue that he owed less.

Turning to Mirando’s procedural challenge that the district court erred in granting summary judgment based on evidentiary submissions first set out in the Government’s response, the Sixth Circuit noted that normally a court should allow a nonmoving party the right to reply before it relies on new evidentiary submissions in granting a motion. The district court’s alleged failure to do so in the case before it, however, was not an abuse of discretion. The district court relied on the plea agreement, which was before it prior to the Government’s raising the judicial estoppel claim. There was no evidence that the district court did not consider Mirando’s surreply in granting summary judgment for the Government. Even if did not consider the surreply, its failure to do so was harmless since Mirando’s surreply devoted one short paragraph to the judicial estoppel argument and only discussed one of the three factors. The district court therefore was affirmed.

In Yari v. Commissioner, 143 T.C. 7 (2014), the Tax Court was presented with a case of first impression: is the § 6707A penalty calculated with reference to the tax shown due on the return giving rise to the disclosure obligation or the tax shown on a subsequent amended return. The taxpayer had formed a single member LLC that was a disregarded entity. He set up an S corporation to serve as a management company for the LLC. He then opened a Roth IRA to which he contributed $3,000. The Roth IRA acquired all of the stock of the management company. The LLC paid the S corporation a management fee. The net income of the S corporation (over $1.2 million in 6 years) flowed through on a K-1 to the Roth IRA, which was not a taxable entity. In 2004 the IRS issued Notice 2004-8, which identified transactions similar to the one the taxpayer entered into as abusive.

The IRS audited the taxpayer’s 2002, 2003 and 2004 tax returns. While the audit was pending, he filed an amended 2004 income tax return that reported $482,912 in previously unreported management fees. The IRS issued a notice of deficiency. During the pendency of the deficiency cases, the taxpayer filed a second amended 2004 return. The second amended return reported the $482,912 in management fees and claimed a net operating loss carryback. Eventually, the taxpayer and the IRS entered into a closing agreement for all years and the case was resolved.

In 2008, prior to resolution of the deficiency cases, the IRS assessed a $100,000 penalty under I.R.C. § 6707A because the taxpayer had failed to disclose the Roth IRA S corporation transaction on his original return. In 2009, the IRS mailed the taxpayer a CDP notice of intent to levy. The taxpayer protested. While the CDP was pending in appeals, Congress retroactively amended I.R.C. § 6707A to change the method for calculating the penalty. The amendment was retroactive to penalties assessed after December 31, 2006. The taxpayer asserted that under the amendment the penalty was excessive. Appeals issued a notice of determination upholding the penalty. The taxpayer petitioned the Tax Court.

Although neither party challenged jurisdiction, the Tax Court began its discussion with the question of whether it had jurisdiction to consider the underlying liability. The deficiency provisions do not apply to penalties under I.R.C. § 6707A. Under I.R.C. § 6330(c)(2)(B) a taxpayer in a CDP case can challenge the underlying liability if he did not receive a notice of deficiency or “otherwise have an opportunity to challenge the liability.” Since no notice of deficiency was issued prior to assessment, the Tax Court determined that it had jurisdiction.

The Court then turned to the merits. Section 6707A imposes a penalty on “any person who fails to include on any return or statement any information with respect to a reportable transaction which is required under section 6011 to be included with such return or statement.” Prior to amendment, the penalty for failure to disclose a reportable transaction was $10,000 for an individual and $50,000 for an entity. The penalty for failure to disclose a listed transaction was $100,000 for an individual and $200,000 for an entity. In 2010, I.R.C. § 6707A was amended to make the penalty equal to 75% of the “decrease in tax shown on the return as a result of such transaction (or which would have resulted from such transaction if such transaction were respected for Federal tax purposes).” For individuals, the minimum penalty was $5,000 and the maximum was $100,000.

The parties agreed that the taxpayer’s Roth IRA-S corporation transaction was a reportable transaction that was not disclosed on the original return. When the 2004 management fee was included in income, the additional tax was over $100,000. Due to previously unreported deductions and the net operating loss carry back, there was no additional tax owed based on the amended returns. The taxpayer asserted that the penalty should be based on the amended return, which would result in a $5,000 penalty, while the IRS asserted it should be based on the original return, which would result in a $100,000 penalty.

After reciting the oft-repeated canons of statutory construction (“The starting point for interpreting a statute is its plain and ordinary meaning unless such an interpretation ‘would produce absurd or unreasonable result’. … Undefined words take their ‘ordinary, contemporary, common meaning.’” etc.), the Court stated: “We think the statute is clear and unambiguous.” This spelled trouble for the taxpayer. According to the Tax Court, the penalty was meant to punish the failure to disclose a reportable transaction on the return and is based on the tax shown on “the return.” It is not based on the tax shown on “a return,” or some later return. It is not based on the tax required to be shown on a return or on the decrease in tax due to participation in the reportable transaction. According to the Court, the return referred to is the return that gave rise to the reporting requirement, which is the original return.

While the taxpayer relied on legislative history, the Tax Court chided him for failing to point to any actual legislative history, noting that no direct legislative history exists. Citing United States v. Woods, 571 US ___ (2013), it noted that the Blue Book is not legislative history. What was clear to the Court was that in enacting I.R.C. § 6707A Congress meant to penalize the failure to disclose, not the actual tax savings resulting from the transaction. This meant that the penalty resulted from the tax savings claimed on the return that failed to disclose the transaction, “not those that were calculated with the benefit of hindsight.” If Congress intended the penalty to be based on the tax required to be shown, it knew how to do so. The Court concluded that the settlement officer did not err in upholding the IRS’s penalty calculation.

A case that will interest attorneys who are involved in cases with large volumes of electronica
lly stored documents is Dynamo Holdings, LP v. Commissioner, 143 T.C. 9 (2014). The IRS sent formal discovery to the taxpayer, seeking two large computer back-up tape containing millions of pages of information, both privileged and non-privileged. Rather than incur the cost of having its counsel or in-house staff go through all of the documents to segregate irrelevant and privileged documents from relevant non-privileged documents, the taxpayer wanted to use “predictive coding” to determine what electronically stored information (ESI) was privileged. It proposed providing the IRS with the non-privileged documents and a privilege log listing the documents that were being withheld as a result of the predictive coding search. To do a manual review would take many months and cost over $450,000.

The IRS rejected the taxpayer’s proposal and wanted all of the documents, subject to what it referred to as a “clawback agreement,” which the Tax Court assumed meant that the IRS would return all documents it determined were privileged. Because the taxpayer would not agree to turn over all documents subject to a clawback agreement, the IRS filed a motion to compel discovery. The Tax Court was presented with a case of first impression.

The parties agreed that the non-privileged materials requested by the IRS were discoverable. The Court found it inappropriate to require the taxpayer to produce all the ESI subject to the right to get back any information that was later determined not to be discoverable. It also felt it inappropriate to require the taxpayer to incur the costs needed to conduct a manual review of all the documents to segregate irrelevant and privileged documents from relevant non-privileged documents. Thus, the question was whether predictive coding was an appropriate method to cull out privileged documents. The Tax Court described predictive coding as follows:

Predictive coding is an expedited and efficient form of computer-assisted review that allows parties in litigation to avoid the time and costs associated with the traditional, manual review of large volumes of documents. Through the coding of a relatively small sample of documents, computers can predict the relevance of documents to a discovery request and then identify which documents are and are not responsive. The parties (typically through their counsel or experts) select a sample of documents from the universe of those documents to be searched by using search criteria that may, for example, consist of keywords, dates, custodians, and document types, and the selected documents become the primary data used to cause the predictive coding software to recognize patterns of relevance in the universe of documents under review. The software distinguishes what is relevant, and each iteration produces a smaller relevant subset and a larger set of irrelevant documents that can be used to verify the integrity of the results. Through the use of predictive coding, a party responding to discovery is left with a smaller set of documents to review for privileged information, resulting in a savings both in time and in expense. The party responding to the discovery request also is able to give the other party a log detailing the records that were withheld and the reasons they were withheld.

The Tax Court rejected the IRS’s claims that predictive coding was an unproven technique. Not only had it become a preferred method to filter out spam, but several district courts had sanctioned its use in responding to discovery. In addition, the taxpayer had offered credible expert testimony that predictive coding was the most efficient way to eliminate irrelevant and privileged documents. The Court therefore held that the taxpayer could use predictive coding. It ended its opinion as follows: “Our Rules, including our discovery Rules, are to ‘be construed to secure the just, speedy, and inexpensive determination of every case.’ Rule 1(d). Petitioners may use predictive coding in responding to respondent’s discovery request. If, after reviewing the results, respondent believes that the response to the discovery request is incomplete, he may file a motion to compel at that time.”

A single member limited liability company is disregarded for tax purposes unless it elects to be treated as a C corporation. Does that mean that when an LLC is disregarded, its owner is treated as owning the LLC’s assets? In Pierre v. Commissioner, 133 T.C. 24 (2009), the Tax Court held that a gift of a fractional interests in an LLC whose sole asset is real property is a gift of an interest in the LLC, not an interest in the underlying asset. This holding was extended to income tax in RERI Holdings, LLC v. Commissioner, 143 T.C. 3 (2014), which also addressed issues concerning what is a “qualified appraisal” for purposes of charitable contributions under I.R.C. § 170(f)(11).

The underlying property in RERI, LLC, is real property in Hawthorne, California, that was leased to AT&T for a term of 15 years, with three 5-year renewal options. In 2002, RS Hawthorne, LLC, purchased the real property for $42,350,000. To pay for the property, it borrowed $43,671,739 from BB&T, which received a promissory note secured by a deed of trust and assignment of rents. The note is for a term of 14 years, at the end of which a balloon payment of $11.8 million will be due.

RS Hawthorne, LLC (“Hawthorne LLC”) is a single member LLC whose sole member is H.W. Hawthorne Holdings, LLC (“Holdings LLC”). Holdings, LLC, is a single member LLC whose original member was Red Sea Tech I (“Red Sea”). After purchase of the real property, Red Sea split its interest in Holdings LLC into two interests: a term of years (“TOYS”) interest that runs until December 31, 2020, and a future successor member interest (“SMI”) that becomes possessory on January 1, 2021. Red Tech sold the SMI to RJS Realty for $1.61 million. As part of the sale, Red Sea agreed that neither Holdings nor Hawthorne would encumber the real property without RJS’s consent or to transfer any interest or place any lien on the real property that would “materially adversely affect” its value. If these covenants were breached, Red Sea or it successor’s liability was limited to its interest in the TOYS.

In May 2002, RJS sold the SMI to RERI, LLC for $2.95 million. On August 27, 2003, Stephen Ross, who was the principal investor in RERI, pledged to make a $4 million gift to the University of Michigan (“UM”) for the use of its Athletic Department. He later increased the pledge to $5 million. Ross had the SMI transferred to UM on condition that UM would credit $1 toward his pledge, hold the SMI for two years, after which it would sell the SMI and pledge the net sale proceeds to the gift. In 2003, RERI hired an appraiser who valued a “hypothetical remainder interest” in the real property as having an investment value of $55 million on the vesting date of January 1, 2021, and a present value of $32,935,000 using an actuarial factor under Treas. Reg. §§ 20.2031-7(d)(1) and 1.7520-1(a)(1). The appraisal assumed that the real property was free and clear of all liens and encumbrances.

On December 31, 2005, UM sold the SMI for $1.94 million to HRK Realty. Prior to the sale, UM obtained an independent appraisal that valued the SMI at $6.5 million. HRK immediately flipped the SMI and sold it to an unrelated third party for $3 million. Shortly afterwards, the third party donated the SMI to a charity and claimed a charitable contribution deduction of $29.93 million. It used the same appraiser who appraised the SMI for RERI. RERI claimed a charitable contribution deduction of $32,935,000, based on the appraisal it received of the SMI. The IRS audited RERI and issued a FPAA disallowing the deduction. RERI petitioned the Tax Court. The IRS moved for partial summary judgment on the issue of whether the actuarial tables contained in the regulations can be used for valuing the SMI.

A taxpayer is entitled to deduct a charitable contribution under § 170. Under regul
ation, the amount of a contribution of property other than money is its fair market value at the time of the contribution. Treas. Reg. § 1.170A-1(c)(2) defines fair market value as the price that a willing buyer would pay a willing seller. Normally, this definition does not apply to contributions of annuities, terms of years, remainders, reversions or similar partial interests. These are usually valued by determining the fair market value of the underlying property and dividing the value among the interests in the property on the basis of present value.

Section § 7520 and Treas. Reg. §1.7520-1(a)(1) contain special rules for the valuation of remainder interest. Those interests are valued using actuarial tables promulgated by the IRS multiplied by 120% of the midterm Federal rate. The Tax Court’s discussion of the valuation of remainder interests is:

Section 1.7520-1(a)(1), Income Tax Regs., applicable to remainder interests, provides: “Except as otherwise provided in this section and in § 1.7520-3 (relating to exceptions to the use of prescribed tables under certain circumstances), in the case of certain transactions after April 30, 1989, subject to the income tax, the fair market value of * * * remainders * * * is their present value determined under this section.” Section 1.7520-1(c), Income Tax Regs., generally provides that “present value” is to be computed by using tables ( section 7520 tables) reflecting the section 7520 interest rate component and, if necessary, the mortality component described in the section 7520 regulations. See also section 1.7520-2(a)(1), Income Tax Regs., which provides: “Valuation.–Except as otherwise provided in this section and in § 1.7520-3 * * * the fair market value of * * * remainders * * * for which an income tax charitable deduction is allowable is the present value of such interests determined under § 1.7520-1.”

Section 1.7520-3(b)(1)(i)(C), Income Tax Regs., describes an “ordinary remainder or reversionary interest” as “the right to receive an interest in property at the end of one or more measuring lives or some other defined period.” The regulation provides that such an interest may be present-valued using a “standard section 7520 remainder factor” as defined therein. Id.

Section 1.7520-3(b)(1)(ii), Income Tax Regs., describes a “restricted beneficial interest”, in part, as a remainder interest “that is subject to a contingency, power, or other restriction, whether the restriction is provided for by the terms of the * * * governing instrument or is caused by other circumstances.” That regulation further provides: “In general, a standard section 7520 * * * remainder factor may not be used to value a restricted beneficial interest.” Id. It provides, however, that “a special section 7520 * * * remainder factor may be used to value a restricted beneficial interest under some circumstances”, citing an example in section 1.7520-3(b)(4), Income Tax Regs., that is not germane to this case. Id.

If neither the section 7520 tables nor a special section 7520 factor is applicable to determining the value of a remainder interest, then the fair market value of the remainder interest is determined without regard for section 7520 on the basis of all of the facts and circumstances. See sec. 1.7520-3(b)(1)(iii), Income Tax Regs.

Section 1.7520-3(b)(2), Income Tax Regs., is entitled “Provisions of governing instrument and other limitations on source of payment.” Section 1.7520-3(b)(2)(iii), Income Tax Regs., provides with respect to remainder and reversionary interests:

(iii) Remainder and reversionary interests. A standard section 7520 remainder interest factor for an ordinary remainder or reversionary interest may not be used to determine the present value of a remainder or reversionary interest (whether in trust or otherwise) unless, consistent with the preservation and protection that the law of trusts would provide for a person who is unqualifiedly designated as the remainder beneficiary of a trust for a similar duration, the effect of the administrative and dispositive provisions for the interest or interests that precede the remainder or reversionary interest is to assure that the property will be adequately preserved and protected (e.g., from erosion, invasion, depletion, or damage) until the remainder or reversionary interest takes effect in possession and enjoyment. This degree of preservation and protection is provided only if it was the transferor’s intent, as manifested by the provisions of the arrangement and the surrounding circumstances, that the entire disposition provide the remainder or reversionary beneficiary with an undiminished interest in the property transferred at the time of the termination of the prior interest.

See also section 1.7520-3(b)(2)(ii)(A), Income Tax Regs., which, in addressing the requirements of a “governing instrument” with respect to “[i]ncome and similar interests”, provides that the income beneficiary’s interest is adequately protected (i.e., is an ordinary beneficial interest subject to valuation using a “standard section 7520 income factor”) “only if it was the transferor’s intent, as manifested by the provisions of the governing instrument and the surrounding circumstances, that the trust provide an income interest for the income beneficiary during the specified period of time that is consistent with the value of the trust corpus and with its preservation.” (Emphasis added.)

The IRS’s initial argument was that the appraiser improperly appraised a remainder interest in real property rather than the SMI in Holdings LLC and that if the I.R.C. § 7521 tables apply, it is to the SMI and not the real property. RERI argued that Hawthorne and Holdings are disregarded entities and that Pierre v. Commissioner was inapplicable because it dealt with gift tax not charitable contributions for income tax purposes. As the Tax Court noted, both the estate and gift and the income tax use the same “willing buyer-willing seller” standard to determine fair market value of property and both allow a charitable contribution deduction. It thus “sees no reason to identify the property for income tax purposes (and subject to a charitable contribution deduction) differently than from the property to be valued for gift tax purposes (and subject to a charitable contribution deduction).”

RERI also argued that unlike the situation in Pierre, when the SMI became a possessory interest, it would effectively become an interest in the entire real property, through two disregarded LLCs, Hawthorne LLC and Holdings LLC. Thus, the value of its interest in the SMI would be no different than the value of a remainder interest in the real property. The Tax Court stated that if we assume that the Hawthorne property and Holdings LLC are of equal value and that there are no restrictions burdening the SMI, “then nothing may be lost in allowing the Hawthorne property to substitute for the Holdings membership interest in applying the section 7520 tables to determine the value of the SMI.” Slip op. at 25. That raised two questions: first, did the 2-year hold-sell requirement imposed on UM mean that the SMI was a restricted beneficial interest under the regulations to which the I.R.C. § 7520 tables do not apply; second, if not, did the 2-year hold-sell requirement reduce the value of the SMI below that of a “hypothetical remainder interest in the Hawthorne property”? The Court found that there were unresolved issues of fact that made summary judgment on these issues inappropriate.

Addressing the IRS argument that the SMI does not enjoy the protections of a trust interest and RERI’s counter-argument that it is adequately protected by the limitations on the rights of the TOYS holder to encumber the property, the Court stated that under Treas. Reg. § 1.7520-3(b)(2)(iii) the requirements to preserve and protect a remainder interest apply to remainder interests “whether in trust or otherwise.” Because the agreement betw
een RJS and Red Sea for the purchase of 31 the SMI limited the ability of the TOYS holder to sell or encumber the property, the documents did not lack assurances that the SMI would not be adequately preserved and protected. This was especially true where no evidence had been presented of any intention to sell the Hawthorne property so that SMI future interest would not be an interest in the real property. The fact that the property could, in the future, be encumbered would not place any additional risks on the property since presumably any future debt would be used to pay off the balloon note in 2016. At best, the IRS had raised an issue of material fact as to the parties’ intentions.

The Court gave short shrift to the IRS’s argument that the SMI was not adequately protected because of the possibility that Hawthorne LLC would be unable to make the balloon payment in 2016, thus risking foreclosure and sale of the real property. Based on the evidence before it, if AT&T did not renew its lease, Hawthorne LLC would have paid $32 principal on the loan, giving it substantial equity in the property. In addition, it would have accumulated $5.7 million from the lease payments, meaning it only would need to borrow $6.1 to make the balloon payment. The possibility that Hawthorne LLC would not be able to raise the funds needed to make the balloon payment was nothing other than a conventional commercial risk that had little effect upon the safety of the investment. Once again, at best the IRS had raised an issue of material fact as to whether there was a realistic possibility that a default on the balloon payment would jeopardize the value of the SMI.

The Court next faced the question of whether the 2-year hold-sell requirement in the gift to UM made the SMI a restricted beneficial interest. The IRS argued that it did while the taxpayer argued that, based on a line of prior cases, a restriction under Treas. Reg. § 1.7520-3(b)(1)(ii) must jeopardize the beneficiary’s receipt of income, not its ability to dispose of the property. The Tax Court rejected both arguments. The Tax Court found that its prior cases were not relevant, since they dealt with restrictions on the present right to receive income, not on the rights of the holder of a future interest. According to the Tax Court, whether the hold-sell requirement would make the SMI a restricted beneficial interest was a question of state law that neither party addressed. Because the Tax Court views questions of state law as questions of fact, this was another material fact that was unresolved. Additionally, neither party had presented any evidence on the impact (if any) of the hold-sell requirement on the fair market value of the SMI.

The Court then turned to the issue of whether the use of the I.R.C. § 7520 tables would result in an unrealistic and unreasonable fair market value for the SMI. The Tax Court and several Courts of Appeal had held that, where due to various factors use of the tables result in an unreasonable and unrealistic value, the tables are not to be used. In the case before it, between 2002 and 2005, there were four sales of the SMI for prices ranging from $1.61 million (the purchase by RJS) to $3 million (the sale by HKR Realty) and UM’s independent appraiser had valued the SMI at $6.5 million. The appraisal for RERI gave a fair market value of $32,935,000. There was nothing in the record before it to explain this disparity. Thus, there was another issue of material fact that could not be decided.

Finally, the Court addressed the issue of whether the appraisal used by RERI was a “qualified appraisal” for purposes of the charitable contribution deduction. Section 170(a)(1) provides that a charitable contribution deduction is allowable only if it is “verified under regulations promulgated by the Secretary. For charitable contributions in excess of $5,000, Treas. Reg. § 1.170A-13(c)(1)(ii) a contribution of property other than money must be supported by a qualified appraisal. A qualified appraisal is defined in Treas. Reg. § 1.170A-13(c)(3) as an appraisal that:

  1. Relates to an appraisal that is made not earlier than 60 days prior to the date of contribution of the appraised property nor later than the date specified in paragraph (c)(3)(iv)(B) of this section;
  2. Is prepared, signed, and dated by a qualified appraiser (within the meaning of paragraph (c)(5) of this section);
  3. Includes the information required by paragraph (c)(3)(ii) of this section; and
  4. Does not involve an appraisal fee prohibited by paragraph (c)(6) of this section.
  5. Information included in qualified appraisal.–A qualified appraisal shall include the following information:
    1. A description of the property in sufficient detail for a person who is not generally familiar with the type of property to ascertain that the property that was appraised is the property that was (or will be) contributed;
    2. In the case of tangible property, the physical condition of the property;
    3. The date (or expected date) of contribution to the donee;
    4. The terms of any agreement or understanding entered into (or expected to be entered into) by or on behalf of the donor or donee that relates to the use, sale, or other disposition of the property contributed, including, for example, the terms of any agreement or understanding that–
      1. Restricts temporarily or permanently a donee’s right to use or dispose of the donated property,
      2. Reserves to, or confers upon, anyone (other than a donee organization or an organization participating with a donee organization in cooperative fund-raising) any right to the income from the contributed property or to the possession of the property, including the right to vote donated securities, to acquire the property by purchase or otherwise, or to designate the person having such income, possession, or right to acquire, or
      3. Earmarks donated property for a particular use;
    5. The name, address, and (if a taxpayer identification number is otherwise required by section 6109 and the regulations thereunder) the identifying number of the qualified appraiser; and, if the qualified appraiser is acting in his or her capacity as a partner in a partnership, an employee of any person (whether an individual, corporation, or partnerships), or an independent contractor engaged by a person other than the donor, the name, address, and taxpayer identification number (if a number is otherwise required by section 6109 and the regulations thereunder) of the partnership or the person who employs or engages the qualified appraiser;
    6. The qualifications of the qualified appraiser who signs the appraisal, including the appraiser’s background, experience, education, and membership, if any, in professional appraisal associations:
    7. A statement that the appraisal was prepared for income tax purposes;
    8. The date (or dates) on which the property was appraised;
    9. The appraised fair market value (within the meaning of § 1.170A-1(c)(2)) of the property on the date (or expected date) of contribution;
    10. The method of valuation used to determine the fair market value, such as the income approach, the market-data approach, and the replacement-cost-less-depreciation approach; and
    11. The specific basis for the valuation, such as specific comparable sales transactions or statistical sampling, including a justification for using sampling and an explanation of the sampling procedure employed.

The IRS advanced several arguments for why the appraisal done for RERI was not a qualified appraisal: 1) it appraised a remainder interest in the Hawthorne property and not the SMI, it did not appraise the correct property; 2) it failed to consider the hold-sell requirement; 3) it did not consider the mortgage on the property; 3) it did not consider AT&T’s right to remove improv
ements if it did not renew the lease; 4) it did not consider depreciation; and 5) it was a determination of “investment value” and not fair market value.

Consistent with its prior analysis, the Court found that there were questions of material fact as to the effect of the hold-sell requirement and whether the valuation of a remainder interest in the Hawthorne property was the same as valuation of the SMI. It held that AT&T’s right to remove improvements and depreciation were not germane to whether an appraisal was a qualified appraisal. Because “investment value” for purposes of the RERI appraisal was synonymous with fair market value, the use of “investment value” was inconsequential. The Court therefore denied the IRS’s motion for partial summary judgment.

A stolen refund check gave rise to two valid causes of action against the United States in Hill v. United States, 2014 U.S. Claims LEXIS 827 (Cl. Ct. August 20, 2014). Hill timely filed his 2007 income tax return with the IRS. The IRS acknowledged receipt but could not locate the return. In early 2009, it sent Hill a letter asking him to file a signed copy of his return. A month later, he began an 8-year sentence in an Ohio state prison. He sent the IRS a copy of the return. The IRS issued a refund check for $1,182.46. The check was equal to the overpayment plus interest. The check was returned as undeliverable. The IRS then sent him a letter that he was entitled to a refund. It had Hill’s social security number. This letter was forwarded to the prison. Prison authorities gave it to the wrong inmate, also named Hill. This individual, when released, used the information to call the IRS and claim a refund. In July, 2009, the IRS sent the refund check to an address given by this individual, who cashed the check. He endorsed it as “Mark Hill” even though the check was payable to “Mark A. Hill.”

On October 2009, the IRS informed Mr. Hill that his 2007 tax refund check for $1,182.46 had been issued in July. Hill promptly submitted an IRS Form 3911, Taxpayer Statement Regarding Refund. Over the next ten months, the IRS sent letters to Hill that it needed additional time to find the check. Hill sought the assistance of the Taxpayer Advocate Service. After several months, the TAS sent him a copy of the cashed check and the location where it was cashed. A week later, Hill wrote to the Secretary of Treasury asking for assistance in getting his refund. The IRS wrote to Hill in August 2011, that his refund had been misappropriated. In October 2011, he filed “Claims Against the United States for the Proceeds of a Government Check” (FMS Form 3858 and FMS Form 1133), as directed by the Financial Management Service of the Department of the Treasury and an Ohio State investigator.

When the IRS failed to send him his check, he filed an action with the Court of Federal Claims for the check, plus interest and punitive damages. He requested that he be paid without any offset. In its answer, the Government asserted that he was not entitled to the refund check, which had previously been issued. Hill moved for summary judgment.

The Court initially found that it had jurisdiction under the Tucker Act, 28 U.S.C. §1491, for the refund of taxes and “under 31 U.S.C. §3343 to determine whether a taxpayer is entitled to a replacement check from the Check Forgery Insurance Fund, since that statute is money-mandating.”

To maintain a refund suit, a taxpayer has to file a claim for refund within the later of three years after the return was filed or two years after the tax was paid. Since Hill filed his 2007 return on April 15, 2008, he had to file a refund claim by April 15, 2011. He did not file a formal claim until October 2011. Under the informal claim doctrine, formal defects in claiming a refund will be ignored if the taxpayer “fairly apprises” the IRS of his claim within the statutory period. The Court determined that several of the letters Hill sent to the IRS within the three-year period constituted informal claims. Thus, his failure to file a formal claim for refund within the three-year period did not bar recovery. The Court also found that his suit was timely. The Court also held that it had jurisdiction under 31 U.S.C. §3343.

Having determined that it had jurisdiction, the court then turned to the merits. It held that Hill was entitled to a refund with interest. Under Treas. Reg. § 301.6611-1(h), a taxpayer is entitled to interest on an overpayment from the date of the overpayment until a date that is 30 days prior to the date on which the refund check is issued. Since in Hill’s case the refund check was issued in July 2009, he was entitled to interest from 45 days after the due date of his timely filed 2007 return (i.e., from May 30, 2008) under Treas. Reg. § 301.6611-1(j), until June 2009. The check that had been misappropriated in July 2009, was equal to the overpayment plus the correct amount of interest.

The court further held that it did not have jurisdiction over claims against the United States for punitive damages or for any alleged torts. Finally, it held that since the United States did not counterclaim against Hill or file a claim against him in any other case, the question of whether the refund could be offset was not ripe. The United States was thus to issue him a check without offset. If the United States offset against the check, Hill could file another action in the appropriate venue to determine the legality of the offset.

The California Second District Court of Appeal once again had to reverse the Los Angeles County Superior Court in Cutler v. Franchise Tax Board, 2014 Cal. App. LEXIS 15789 (Sept. 2, 2014). The taxpayer had sold stock in an internet start-up company in 1998. He invested the sales proceeds in the stock of several other small businesses. He deferred the gain on his return under California Rev. & Tax. Code §§ 18038.5 and 18152.2. The FTB audited the taxpayer’s return for 1999 and determined that he was not entitled to defer gain because neither the business whose stock he sold nor the businesses whose stock he purchased had 80% or more of their assets and 80% or more of their payroll in California, as required by the statutes. He paid the $442,000 in tax, penalty and interest that the FTB asserted was due. After the Board of Equalization upheld the FTB, he filed a refund suit in superior court, alleging that the statute on its face violated the commerce clause of the U.S. Constitution. The superior court granted the FTB’s motion for summary judgment. On appeal, the Second District Court of Appeal reversed, finding that the relevant statutes were discriminatory on their face in violation of the commerce clause. It remanded the case to the superior court to determine whether the taxpayer met the other, non-discriminatory, requirements of the deferral statute. Cutler I, 208 Cal. App. 4th 1247 (2012).

Following issuance of the decision in Cutler I, on December 21, 2012, the FTB issued a notice that for tax years ending before January 1, 2008 (within the four year limitation period for assessments), it would allow deferral for taxpayers who meet the requirements of the statute (other than the discriminatory provisions), but for tax years beginning after that date, it would disallow all deferrals so that all taxpayers would be treated equally.

In February 2013, the taxpayer filed a claim for attorney fees under Cal. Civ. Proc. Code §1021.5. That section provides, in pertinent part:

Upon motion, a court may award attorneys’ fees to a successful party against one or more opposing parties in any action which has resulted in the enforcement of an important right affecting the public interest if: (a) a significant benefit, whether pecuniary or nonpecuniary, has been conferred on the general public or a large class of persons, (b) the necessity and financial burden of private enforcement, or of enforcement by one public entity against another public entity, are such as to make the award appropriate, and (c) such fees should n
ot in the interest of justice be paid out of the recovery, if any.

The taxpayer asserted that he had vindicated a Constitutional right on behalf of a large class of California taxpayers. The FTB argued that the statute was not meant to benefit sophisticated investors who engaged in multi-million dollar stock deals and were seeking refunds of $442,000. It also argued that the taxpayer did not benefit either California or Californians, since the taxpayer’s actions eliminated an incentive to invest in small businesses in California and resulted in the elimination of the deferral for tax years beginning after January 1, 2008. Finally, it asserted that the taxpayer had his own self-interest, since he sought a large refund for 1998 and over $1.4 million in tax was in issue administratively for 1999 and 2000.

The superior court denied attorney fees. Although the taxpayer conferred an important right affecting the public interest, it found that the benefit was not significant because, as a result of the lawsuit, the deferral provisions were eliminated by the FTB. The superior court also held that the taxpayer was not entitled to attorney fees because he had significant assets, was seeking to recover a large sum ($442,000) and the benefit to the public was merely incidental. The taxpayer appealed the denial of attorney fees.

A decision awarding or denying attorney fees will only be reversed if it is clearly wrong and an abuse of discretion. The Court of Appeal reversed the superior court. Under California Supreme Court case law, eligibility for an award of attorney fees under Cal. Civ. Proc. Code § 1021.5 is met if 1) the plaintiff’s actions have resulted in the enforcement of an important right affecting the public interest, 2) a significant pecuniary or nonpecuniary benefit has been bestowed on the general public or a large class of persons, 3) the necessity and financial burden of private enforcement are such as to make an award appropriate and 4) whether in the in interests of justice fees should be paid out of the recovery, if any.

Turning to the case before it, the superior court had correctly determined that the taxpayer had met the first part of the test but had erred in determining that he did not meet the remaining parts. The second part of the test requires that a significant benefit be conferred on a large class of persons. This had occurred in the case before it, since as a result of the taxpayer’s lawsuit, a benefit had been conferred on the class of persons who had sold stock in small businesses and reinvested in other small businesses that did not meet the 80% test. That another class of persons did not benefit was irrelevant. The statute does not require a weighing of benefits conferred on one class against detriments to another class nor does it make a fee award dependent on a net benefit to all classes. It only requires that there be a benefit to a large class of persons, which occurred in this case. Even though the FTB had eliminated the deferral provisions, in late 2013, the Legislature had reinstated them (without the discriminatory features) and the sponsor of the legislation had cited the taxpayer’s lawsuit. The Court concluded its discussion of the second part of the test by stating:

In the end, there is simply no proper basis for the trial court’s conclusion that plaintiff’s lawsuit did not confer a significant benefit on a large class of persons. Certainly the general public benefits by nondiscriminatory tax laws that encourage investment by California taxpayers in start-up companies, whether or not 80 percent of the property and payroll of the start-up companies are in California or elsewhere. The public benefits because those investments create new business and job opportunities. And the proliferation of start-up companies nationwide in recent decades demonstrates there is a large class of persons who wish to invest in such companies and who will benefit by nondiscriminatory tax incentives to do so.

The superior court also erred by looking at the refund sought in the case without considering the attorney fees incurred by plaintiff ($685,000). The superior court assumed that awards are inappropriate where the plaintiff is wealthy when, in fact, they are only inappropriate if the plaintiff’s personal recovery is significantly in excess of the fees incurred. Since the taxpayer’s attorney fees exceeded his expected recovery in the case by more than $200,000, his wealth did not make attorney fees inappropriate. Nor was there any merit to the FTB’s assertion that the taxpayer would substantially benefit because of the proceedings involving his 1999 and 2000 returns, since the FTB asserted that he did not meet the non-discriminatory requirements of the deferral statute for those years. According to the Court of Appeal, the only appropriate consideration is the plaintiff’s personal financial incentive which:

must be discounted by the probability of success at the time plaintiff was considering whether to file this lawsuit. [Citation omitted.] Here, plaintiff faced very long odds of success and undertook the risk of incurring substantial costs and fees. Persuading a court to declare any statute unconstitutional — particularly a tax statute that favors California interests — is always an uphill battle. The difficulty of persuading a court to declare these tax statutes unconstitutional is demonstrated by the trial court’s grant of summary judgment in favor of the Board, rejecting plaintiff’s constitutional challenge.

The superior court had never considered the final factor, whether in the interests of justice there should not be an award of fees. The Court rejected the claim that the taxpayer would have pursued the case regardless of whether he would recover attorney fees. Normally, the interests of justice will not require an award of attorney fees where the litigation creates a common fund out of which fees can be paid while still allowing the plaintiff a net recovery, such as in a large class action suit. This was not the case here. The taxpayer had met all the factors entitling a litigant to recover attorney fees under Cal. Civ. Proc. Code § 1021.5. The superior court’s decision was clearly wrong and an abuse of discretion.


Committee Officers:Chair
Joseph P. Wilson 
Attorney at Law 
Wilson Tax Law Group 
1401 Dove Street, Suite 630
Newport Beach, California 92660
Tel: 714-463-4430Chair-elect 
Courtney A. Hopley 
Attorney at Law 
Greenberg, Traurig LLP 
Four Embarcadero Center, Suite 3000 
San Francisco, California 94111 
Tel: 415-655-1314Secretary
Carolyn M. Lee 
Attorney at Law 
Abkin Law LLP 
150 California Street, Suite 2100 
San Francisco, California 94111 
Tel: 415-956-3280California Journal of Tax Litigation Editor
Kevan P. McLaughlin 
Attorney at Law 
McLaughlin Legal 
5151 Shoreham Place, Suite 265 
San Diego, California 92122
Tel: 858-678-0061
Past Committee Chairpersons:2014 LaVonne D. Lawson
2013 David Warren Klasing 
2012 Michel R. Stein 
2011 Robert Horwitz 
2010 Michael R. E. Sanders 
2009 Kornelia Davidson 
2008 LaVonne D. Lawson 
2007 Cathy Stahler 
2006 Joseph A. Broyles 
2005 David B. Porter 
2004 Steve Blanc 
2003 Edward T. Perry 
2002 Abraham Brown 
2001 Dennis Perez 
2000 Dennis Brager 
1999 Woody Rowland 
1998 Judy Hamilton 
1997 Charlene Woodward 
1996 David Lee Rice 
1995 R. Todd Luoma 
1994 A. Lavar Taylor 
1993 Jennifer Miller Moss 
1992 Evan Smith 
1991 Mark Ericsson 
1990 Jennifer Miller Moss


i This article is an excerpt from a seminar presentation delivered in June 2013 along with Michael Sanders.

See I.R.C. §§ 6011(a), 6012(a)(2), 6071, 6072, 6091. 

See I.R.C. § 6065.

3 18 U.S.C. § 2(a) (2006).

See 21 U.S.C. § 812 sched. 1(c)(10).

5 Furthermore, the crime of aiding and abetting also requires criminal mens rea, which would be lacking in someone merely discussing the state of the law. See U.S. v. Barnett, 667 F.2d 835 (9th Cir. 1982).

6 Annette Nellen, Marijuana and the Tax Law: Issues Faced by Tax Practitioners in Representation of Clients (May 6, 2014)

7 See

8 Currently available at

IRS E-File: A History, available at

10 Where Is My Refund?, available at

11 Where an undocumented worker uses false identity documents to obtain work, identity theft can result in a taxpayer having a Form 1099 or W-2 showing income they didn’t earn filed with the IRS.

12 Consumer Sentinel Network Data Book for January-December 2011, Federal Trade Commission, available at; Consumer Sentinel Network Data Book for January-December 2013, Federal Trade Commission,

13 IRS Releases the “Dirty Dozen” Tax Scams for 2014; Identity Theft, Phone Scams Lead List, IR-2014-16 (February 19, 2014),;-Identity-Theft,-Phone-Scams-Lead-List.

14 Identity Theft – Additional Actions Could Help IRS Combat the Large, Evolving Threat of Refund Fraud, GAO-14-633, p. 10 (released September 22, 2014), available at

15 Id.

16 Detection Has Improved, However Identity Theft Continues to Result in Billions of Dollars in Potentially Fraudulent Tax Refunds, TIGTA Report 2013-40-122 (September 20, 2013), available at

17 Id.

18 Of course, another explanation for the differences in the data could be different methods of identifying the potentially fraudulent returns, e.g., the higher 2012 figures could be the result of better detection and, thus, more accurate inclusion in the data pool.

19 Biggest IRS Scam Around: Identity Tax Refund Fraud, 60 Minutes, CBS (September 21, 2014).

20 Detection Has Improved, However Identity Theft Continues to Result in Billions of Dollars in Potentially Fraudulent Tax Refunds., TIGTA Report 2013-40-122 (September 20, 2013). 

21 Semiannual Report to Congress – October 1, 2013-March31,2014, TIGTA, available at


23 IRS Combats Identity Theft and Refund Fraud on Many Fronts, FS-2014-1 (January 2014),; I.R.M. § (05-29-2013), Identity Theft Time Frame.

24 I.R.M. § (10-01-2013).

25 The process for non-tax related identity theft victims is not discussed here, but more information can be found in I.R.M. § 21.9.2.

26 An example can be found at

27 I.R.M. § (01-16-2014), Identity Theft Case Building

28 I.R.M. § (01-16-2014), Closing Identity Theft Issues.

29 IRS Combats Identity Theft and Refund Fraud on Many Fronts, FS-2014-1 (January 2014),

30 2014 Identity Protection PIN (IP PIN) Pilot, IRS (January 2014),

31 Semiannual Report to Congress – October 1, 2013-March 31,2014, TIGTA, available at

32 Instead, the underlying charges used are typically mail, wire, or bank fraud.

33 Taxpayer Identity Theft Prevention and Enforcement Act of 2014, H.R. 5236 – 113th Cong. (2013-2014), available at

34 Technical Explanation of the Senate Committee on Finance Chairman’s Staff Discussion Draft of Provisions to Reform Tax Administration, Joint Committee on Taxation, (November 20, 2013)

35 S.2736 (July 31, 2014), available at

36 This recommendation is echoed in Identity Theft – Additional Actions Could Help IRS Combat the Large, Evolving Threat of Refund Fraud, GAO-14-633, p. 10 (released Sept. 22, 2014), available at, and the Senate Finance Committee’s own press release on the GAO report, GAO: Action Needed to Combat $5 Billion Tax Refund Fraud, 2014ARD 182-2113th Congress (September 22, 2014).

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