Monday, July 9, 2018
Lesson From The Tax Court: Naked Assessments!
The Notice of Deficiency (NOD) is almost always clothed with a presumption of correctness. Some might say “cloaked” or “shrouded” are a better terms because what the presumption does is shield all that happened prior to the NOD from judicial scrutiny. Courts will generally not go behind the NOD to examine how the IRS came up with its numbers unless and until the taxpayer gives the court a good reason to disbelieve the NOD (or successfully invokes §7491(a), the provision that shifts the burden of production from the taxpayer to the IRS).
It is easy to apply the presumption of correctness in situations where the NOD is simply denying deductions or exclusions. That is because the taxpayer already bears the burden of proving an entitlement to deductions and exclusions. So if the taxpayer cannot come up with the proof, then too bad, so sad.
It is more difficult to apply the presumption in situations where the NOD asserts that the taxpayer failed to report gross income. In that situation, the IRS must have some basis for the assertion of omitted income. That is, the presumption of correctness does not allow the IRS to just make up numbers. In the seminal case of United States v. Janis, 428 U.S. 433 (1976), the Supreme Court said that “where the assessment is shown to be naked and without any foundation” then the burden shifts to the IRS to show facts that link the taxpayer to the alleged omitted income. I really love the delightfully mixed metaphor the Fifth Circuit used in Carson v. Commissioner, 560 F.2d 693, 696 (5th Cir. 1977): "The tax collector's presumption of correctness has a herculean muscularity of Goliath-like reach, but we strike an Achilles' heel when we find no muscles, no tendons, no ligaments of fact."
Two recent Tax Court cases teach a lesson on what “ligaments of fact” suffice to prevent an NOD from being “naked and without any foundation.” In both of these omitted income cases, the IRS was able to produce enough facts to get back the presumption, but in very different ways. The cases are: Gerald Nelson v. Commissioner, T.C. Memo. 2018-95 (June 28, 2018); and Mohammad Najafpir v. Commissioner, T.C. Memo. 2018-103 (July 3, 2018).
The concept of “naked assessment” applies as well to NODs since that is the document where the IRS proposes to make an assessment. If the NOD has no foundation, then the later assessment will be naked. As Prof. Leandra Lederman so nicely teaches us in her article, “’Civil'izing Tax Procedure: Applying General Federal Learning to Statutory Notices of Deficiency,” 30 U.C. Davis L. Rev. 183 (1996), the NOD is not just a “ticket to the Tax Court.” It also functions like a Complaint.
To win in Tax Court taxpayers need to show that the NOD is wrong, wrong, wrong. Yes, that generally involves showing what tax is right, right, right, but not always. In contrast to refund litigation, where the focus is on what is the correct tax, Tax Court litigation focuses on the correctness of the NOD. Start with Helvering v. Taylor, 293 U.S. 507 (1935), and you will see how the burden placed on the taxpayer in Tax Court litigation is importantly different that the burden in refund litigation.
So the presumption of correctness is important. Courts have traditionally given two justifications for it: “the strong need of the government to accomplish swift collection of revenues and ... to encourage recordkeeping by taxpayers.” Carson v. Commissioner, 560 F.2d 693, 696 (5th Cir. 1977). Neither of these reasons, however, excuse the IRS from showing some factual foundation for its proposed assessments.
The leading case is still Portillo v. Commissioner, 932 F.2d 1128 (5th Cir.1991). It is worth pausing and looking at what this case was actually about, because I think it gets a misused.
Mr. Portillo was a painting contractor. He kept a general ledger where he recorded his gross receipts. He timely filed his 1984 returns, reporting income, including $11,000 from one client, Navarro. Mr. Navarro later sent the IRS a Form 1099 showing that he had paid Mr. Portillo some $35,000. On audit, the Revenue Agent contacted Mr. Navarro who produced checks showing only $14,000 in payments to Portillo. Mr. Navarro said all the other payments had been cash, so there was no paper trail. Based on that, the Revenue Agent included the full amount reported on the 1099 and in court the IRS took the position that it was Portillo's burden to prove the negative: that he did not get any cash payments from Mr. Navarro. The Tax Court agreed, but the Fifth Circuit reversed, finding that the IRS' inclusion of the additional income was arbitrary and erroneous because the IRS simply assumed that Navarro was telling the truth and Portillo was lying without engaging in any further investigation or substantiation.
The Fifth Circuit said that the Revenue Agent had to do more than just assume who was telling the truth. “In this case we find that the notice of deficiency lacks any ‘ligaments of fact.’ *** Therefore, before we will give the Commissioner the benefit of the presumption of correctness, he must engage in one final foray for truth in order to provide the court with some indicia that the taxpayer received unreported income. The Commissioner would merely need to attempt to substantiate the charge of unreported income by some other means, such as by showing the taxpayer's net worth, bank deposits, cash expenditures, or source and application of funds.”
Portillo is often mis-cited by taxpayers. It does not require the IRS to automatically disbelieve third party returns; it does require IRS employees to have some reason to believe the third party return over the taxpayer returns. In Parker v. Commissioner, 117 F.3d 785 (5th Cir.1997), taxpayers who had not filed returns argued that the NOD did not get the presumption of correctness when the IRS relied solely on third party returns as the basis for the income adjustment. The Fifth Circuit disagreed, saying: “Portillo did not hold that the IRS must conduct an independent investigation in all tax deficiency cases. In this case, the Commissioner has not arbitrarily found the third-party forms credible: the Parkers never filed a Form 1040 or any other document in which they swore that they did not receive the payments in question. The Commissioner has no duty to investigate a third-party payment report that is not disputed by the taxpayer.” Id. at 787.
In Najafpir, Mr. Najafpir owned and operated a smog inspection station in California. Mr. Najafpir filed untimely returns for 2009 and 2010 reporting business gross receipts of just under $103,000 and $125,000, respectively. It is not clear from the opinion how Mr. Najafpir decided on those numbers because he apparently did not keep a general ledger or a profit and loss statement for his business. He did, however, have two bank accounts, both of which he used for his business. He had no personal bank accounts.
The IRS picked his returns for audit. In addition to disallowing some of his claimed deductions, the Revenue Agent performed a bank deposits analysis to estimate his gross income. When that Revenue Agent retired, a second Revenue Agent repeated the work. Based on that analysis, the NOD proposed to increase Mr. Najafpir’s gross receipts by $38,000 for 2009 and by $22,000 for 2010.
Since this was an unreported income issue, Judge Vasquez properly noted that “the presumption of correctness does not attach...unless the Commissioner first establishes an evidentiary foundation linking the taxpayer to the alleged income-producing activity.” But as you can see, this was very different from the Portillo case. Here, the IRS NOD was far from arbitrary because the Revenue Agents had conducted not one but two bank deposits analyses. So that analysis provided the "ligaments of fact" connecting the asserted unreported income to Mr. Najafpir. And it put the burden on Mr. Najafpir to now disprove the asserted income. He tried. He raised the old “cash hoard” defense and tried to convince Judge Vasquez that $60,000 of the bank deposits had come from cash he had stashed away in his home. Judge Vasquez believed him as to four specific deposits amounting to $14,000 but concluded “the remaining deposits for 2009 and 2010 are taxable income.”
The second case, Nelson v. Commissioner, is more interesting because here the taxpayer looked more like Portillo: he had filed a return for the year in question (2014), albeit late, and the IRS sent an NOD based solely on third party information returns. I think Judge Lauber made the correct ruling, but for the wrong reason. See if you agree with me.
Mr. Nelson had been fired from his first job with MV Transportation Co. that year but had received about $6,000 in unemployment compensation. He grieved his firing and in 2014 was awarded some $18,000 in back pay, reduced by the unemployment compensation he had already received. MV Transportation sent in a W-2 for about $11,000, and New York sent in a Form 1099-G to report the unemployment compensation. However, the IRS also received another W-2, from Empire Films Services, reporting about $1,000 of wages paid to Mr. Nelson. On his 2014 return Mr. Nelson reported only the wages from MV. He reported neither the payments shown on the Empire W-2 nor on the NY State 1099-G, nor did he claim a credit for taxes reported as withheld on those two forms.
Let’s start with the easy part: Mr. Nelson’s failure to report the unemployment compensation from NY State. At trial, Mr. Nelson did not dispute that he received those funds, but was apparently confused about why they constituted income. Judge Lauber did a nice job explaining that in the opinion. Lesson point here: if the taxpayer admits to the activity for which the income is alleged, that is a lot more than just a “ligament” of fact. Heck, it’s a major muscle group.
The more difficult and intriguing question in this case is whether Mr. Nelson had unreported income from Empire Films. Judge Lauber’s opinion properly explains that in these type of unreported income cases, the IRS “must establish some evidentiary foundation linking the taxpayer to the income–producing activity.” But Judge Lauber said the IRS satisfied the “evidentiary foundation” by producing: (1) a copy of the W-2; (2) a copy of the NOD (!); and (3) a copy of Mr. Nelson’s Master File computer transcript (!!).
This information seems to fall far short of what Portillo and other cases require. Only one of the items---the information return---is a genuine piece of evidence. The other two items are just bootstraps: recitations of conclusions based on that single W-2. It’s like in the Lemony Snickett books “Series of Unfortunate Events” when the evil Count Olaf “proves” he is a herpetologist just by showing a card he printed up saying he was. Thus my overuse of exclamation points.
So it’s really just one item of information: the Empire W-2. Apparently Judge Lauber had some inkling that he was stretching it because he throws down a footnote invoking §6201(d). Section 6201(d) provides if the taxpayer disputes the accuracy of a third party information form and has cooperated with the IRS’s reasonable requests during audit, then the IRS “shall have the burden of producing reasonable and probative information concerning such deficiency in additional to such information return.” From that language Judge Lauber infers the opposite: if the taxpayer either does not dispute an information return or does not cooperate with the IRS during the examination, then the IRS decision to rely solely on the third party return is the “ligament of fact” necessary to connect the taxpayer to the alleged income. Judge Lauber finds that Mr. Nelson did not cooperate with the audit.
I do not see how §6201(d) allows the IRS to simply skip verification of a dispute third party return. It’s a statute, like §7491, giving cooperating taxpayers a procedural reward for their cooperation, if the IRS still sticks to the disputed position. The more reasonable reading of the statute is that it extends the protections of Portillo to situations where the IRS does something more than just presume the taxpayer is lying and the third party is telling the truth. The statute presumes the IRS is, in fact, making reasonable requests for information to enable it to decide whether to believe the third party or the taxpayer.
What §6201(d) does NOT say is the IRS can just ignore Portillo and its progeny. But Judge Lauber’s reading of §6201 would seem to undo Portillo. That is, the concern of the Fifth Circuit (and other courts) was that applying the presumption of correctness in unreported income cases forced the taxpayer to prove a negative. Judge Lauber’s reading of §6201 seems to allow the IRS to say to the taxpayer during audit: “We believe the W-2. Prove the negative.” I do not think that is the right procedure to establish the presumption of correctness, yet for all I can tell, that is what the IRS did here.
In this case, it is simply not clear that the IRS did anything to verify Mr. Nelson’s employment except ask him (and he did not cooperate, which is the very typical IRS shorthand for “he did not give us information to contradict the W-2”). It needed to have some information other than the W-2 affirmatively linking Mr. Nelson to Empire Film Services. For example, the IRS could have attempted to verify Mr. Nelson’s employment by Empire Film Services, such as by asking the company for its employment records for 2014, or asking if the company had any other record of Mr. Nelson’s employment (here’s the company’s website with phone number). That would be the “ligaments of fact” to support believing the W-2.
The key issue is what did the IRS do to verify Empire’s W-2? The Portillo case says the IRS must use “some other means, such as by showing the taxpayer's net worth, bank deposits, cash expenditures, or source and application of funds” to link the taxpayer to the purported income. Perhaps the IRS did something to make the link. But if it had, surely that is what the IRS Chief Counsel attorney would have produced at trial instead of the NOD and the master file transcript which reflect the W-2 but do nothing to verify it. Again, if there was information verifying the W-2, that is what the IRS should have brought forward to meet the "ligament of fact" standard.
But Judge Lauber did not need to rely on §6201 to decide the case. Mr. Nelson testified. Courts have held that the IRS can offer the “ligaments of fact” necessary to trigger the presumption of correctness through testimony in court. As the Court for Federal Claims explained in Cook v. United States, "an assessment is not `naked' simply because the administrative file supporting its entry is lost. What is critical, given the de novo nature of the proceedings before this court, is that admissible evidence exists to support the assessment. If such evidence exists, and is admitted by the court, it is irrelevant whether it is the same evidence that the Service relied upon in originally making its assessment." 46 Fed. Cl. 110, 114 (Fed. Cl. 2000)(sorry, but I cannot find a public link - you will have to use LEXIS or Westlaw). So, for example, the IRS could put on witnesses as it did in Blohm v. Commissioner, 994 F.2d at 1549 (11th Cir. 1993).
The common question courts ask in these omitted income cases is "whether there remains competent evidence of the taxpayer’s liability. Barring special circumstances, if the [taxpayer’s] liability can be calculated and enforced, it should be calculated and enforced.” Greco v. United States, 380 F.Supp.2d 598 (M.D. Pa. 2005)(citations and internal quotes omitted).
Mr. Nelson testified at trial and it was his testimony---not the W-2, not the Master File and certainly not the NOD itself (!!)---that met the “ligaments of fact” requirement from Janis and Portillo. Mr. Nelson's testimony was the competent evidence of his liability. According to Judge Lauber: “At trial petitioner did not deny receiving wages of $1,678, but asserted, referring to Empire, that he 'did not know who these guys are.' We did not find petitioner’s testimony credible.” That was enough to link him to the income producing activity and to presume that the IRS’s determination, made in reliance on Empire’s W-2, was correct."
That is all that was needed.
Ligaments are really small. But they are vital. These cases show just how little the IRS needs to do in omitted income cases to connect purported income shown on a third party return to the taxpayer. But the IRS must still do something more than point a finger at the taxpayer and say “prove you did not receive this income.”
Bryan Camp is still the George H. Mahon Professor of Law at Texas Tech University School of Law.
Bryan’s article teaches the valuable lesson that unreported income cases should be distinguished from “regular” deficiency cases. One should never be used as precedent to explain or support the other. In my opinion, in the few cases where the courts have goofed up a holding on the burden of proof in regular cases, it has been caused by citing unreported income cases.
To me, the “burden” cases generally fall into three categories:
1. Section 7491(a) regular burden of proof cases.
2. Section 7491(c) burden of production cases deciding penalties.
3. Unreported income cases.
To digress on the subject of regular 7491(a) cases, the Tax Court has held more than 300 times that the placement of the burden of proof under section 7491(a) does not matter because the cases can be decided based on the preponderance of the evidence, and the placement of the burden makes a difference only in the extremely rare instance of the evidence being tied (evenly weighted). See, for example, Blodgett v. Commissioner, 394 F.3d 1030, 1035, 95 AFTR2d 2005-448, (8th Cir. 2005), affirming T.C. Memo 2003-212.
As a result, I think it can be said that 7491(a) has had almost no impact. Although a 2003 law review article concluded that a study of cases decided after the enactment of 7491 showed that the law had had an impact, the cases included in that empirical study all had their audits initiated before the enactment of the statute, and thus were not affected by the statute, due to the effective date of the legislation (which was effective as to audits initiated after the effective date, not before).
Posted by: Philip N. Jones | Jul 9, 2018 1:33:53 PM
I think Phil makes a great point. I would add that in the omitted income situation, it is particularly useful to remember Leandra’s fine article about how one can view the NOD as functioning as a Complaint. If you think of it that way, then the requirement for the IRS to bring out some “ligament of fact” connecting the taxpayer to the alleged unreported income is akin to the S.Ct.’s decision in Iqbal to require Complaints to actually recite something more than a bare conclusion of law. Cheers, -bryan
Posted by: bryan camp | Jul 9, 2018 1:43:05 PM