Section 7121 authorizes the IRS to enter into “an agreement in writing” with taxpayers “in respect of any internal revenue tax for any taxable period.” Such agreements are called “Closing Agreements.” As implied by that name, the big idea here is that such agreements are meant to “close” a particular tax issue or a particular tax year or years. Accordingly, the general rule is that such agreements are final: they “close” the ability of either the IRS or the taxpayer to later assert a different position with respect to the matters covered in the Closing Agreement.
In Cory H. Smith v. Commissioner, 159 T.C. No. 3 (Aug. 25, 2022) (Judge Toro), the Tax Court teaches a lesson on that finality rule. There, the taxpayer had signed a Closing Agreement for multiple years promising not to claim the §911 exclusion for foreign earned income. He then reneged by filing amended returns (for some years) and original returns (for other years), breaking that promise. Even though the opinion is a 43-page precedential opinion, the lesson is relatively simple: Closing Agreements are final; one must be very careful when signing one because final means final.
What is also interesting (at least to me) is why the Tax Court may have taken extra effort to hammer on the finality rule and issue this opinion as a T.C. opinion. It seems Mr. Smith did not act alone. He appears to have received some dubious advice from his tax return preparer, an Enrolled Agent (EA) who awkwardly styles himself as “Dr.” Castro. Op. at 16, note 20. That EA seems to have also given the same bum advice to a bunch of other taxpayers. The Court notes that “at least 19 other cases pending in our Court involve the same issue as the one presented here.” Op. at 11, note 14. So making this first-out opinion a precedential opinion should help to efficiently dispose of all the rest. The Court makes the effort to note that all 19 of the other cases involve this same EA. This leads to some thoughts about potential §6694 penalties.
Details below the fold.
Law: Closing Agreements
The finality rule is right in the statute. Section 7121(b) provides that, once properly signed, "such agreement shall be final and conclusive, and, except upon a showing of fraud or malfeasance, or misrepresentation of a material fact—(1) the case shall not be reopened as to the matters agreed upon or the agreement modified by any officer, employee, or agent of the United States, and (2) in any suit, action, or proceeding, such agreement, or any determination, assessment, collection, payment, abatement, refund, or credit made in accordance therewith, shall not be annulled, modified, set aside, or disregarded.”
Judge Toro gives a great explanation and background on Closing Agreements. Op. at 17-19. Here, I just want to emphasize two points about them.
First, §7121 authorizes “the Secretary” to enter into Closing Agreements. But, seriously, “the Secretary” has more important matters to occupy her time. Thus, “the Secretary” has issued orders to delegate that authority to the Commissioner who has re-delegated to various subordinates and, sometimes, those orders permit the subordinates to re-delegate the authority down the personnel chain. This happens all the time in tax administration. This delegation process must be done for every Tax Code provision that instructs or authorizes “the Secretary” to take action. You get a sense of the enormity of this process by looking at the IRM, where the various delegation orders are conveniently gathered in Part 1, Chapter 2, Section 2. IRM 1.2.2 (“Servicewide Delegations of Authority”).
This delegation process can be tricky, especially when the IRS changes its organizational structure or changes job titles and descriptions. This part of the IRM gets modified with some frequency. The last modification seems to have been July 22, 2022. I teach my students to always check to see if the proper delegations are in place because an argument that an action was not taken by the proper official can sometimes help a client’s case.
Second, Closing Agreements are not ordinary contracts. They are contracts with the government, authorized by a statute. That has several consequences. One consequence is that while courts use federal common law contract principles to fill in gaps, courts will first look to the statutory text to determine the scope and boundaries of the agreements. That is because they are legislatively authorized agreements. See e.g. United States v. National Steel, 75 F.3d 1146, 1150-51 (7th Cir. 1996). Thus, for example, while Closing Agreements might be used to settle existing disputes, they can also be used to prevent future disputes. Id. (purpose of Closing Agreement was to expedite National Steel’s claim for a refund subject to the government’s ability to later evaluate the company’s return under applicable law).
Another consequence of this statutory connection is that courts give Closing Agreements a greater degree of finality than other types of contracts. They are harder to undo. For example, silence in a Closing Agreement can be fatal. You see that in Hopkins v. United States, 146 F.3d 729 (9th Cir. 1998), where the taxpayer had signed a Closing Agreement with her husband. She later asked for Innocent Spouse relief, arguing that the Closing Agreement was simply silent on whether or not she could later claim Innocent Spouse. She argued that therefore nothing in the Closing Agreement precluded her from taking advantage of that statutory remedy. The 9th Circuit said no, the silence was fatal:
“a taxpayer may not avoid tax liabilities arising out of a valid closing agreement by asserting an innocent spouse defense where that defense has not been preserved in the text of the closing agreement. Closing agreements are meant to insure the finality of liability for both the taxpayer and the IRS. This is why courts have strictly enforced closing agreements, finding them binding and conclusive on the parties even if the tax at issue is later declared to be unconstitutional or in conflict with other internal revenue sections.” Id. at 733 (internal citations omitted, emphasis supplied).
Finally, Judge Toro points out yet another consequence: “the validity and enforceability of closing agreements are governed by the Code” and not simply general contract law. Op. at 18. That means that if a taxpayer wants to later claim a Closing Agreement is invalid, the taxpayer may only do so by proving that the Closing Agreement was entered into by “fraud or malfeasance, or misrepresentation of a material fact.” As Judge Toro puts it: “once an agreement under section 7121(a) is approved by the Secretary, it is final and conclusive unless a party can show that it should be set aside on one of the statutory grounds.” Op at 19 (quotes, citations omitted and, yes, emphasis supplied).
Closing Agreements are generally done on Form 906 or Form 866. Form 906 is usually used to dispose of one or more issues rather than to close conclusively a taxpayer's total tax liability for the particular taxable period. And the issues might well relate to future tax periods. In contrast, Form 866 is used to close the total tax liability for tax periods that have already ended before the date of the Agreement. See Treas. Reg. §601.202(b).
Law: The §911 Exclusion
Generally, U.S. citizens are taxed on their worldwide income. Cook v. Tait, 265 U.S. 47, 56 (1924). That sometimes creates a problem of double taxation when a U.S. citizen earns income in a foreign country and that income is also subject to that country’s income tax laws. One solution to the problem are tax treaty provisions that regulate which country should tax and which country should refrain. Another solution is §911, which permits U.S. citizens who have foreign earned income to elect to exclude a certain amount of that income from U.S. taxation, and to also to exclude a certain amount of housing allowances. The cap is adjusted yearly for inflation; the current cap is $112,000. See Rev. Proc. 2022-45 §2.39.
The unstated assumption in §911 seems to be that the U.S. citizen will otherwise be taxed on that income in the foreign country. That is, I do not believe there is any explicit requirement that the income elected to be excluded is otherwise subject to tax. But I am certainly no expert on §911 and it’s complexities. I welcome reader comments and corrections on that.
If I'm right, then if a U.S. citizen is working in, oh let’s say Australia, and the Aussies have a domestic law that excludes the resulting income from Australian taxation, the U.S. citizen could still elect the §911 exclusion and thus receive some amount of income totally tax free....
....unless that U.S. citizen had signed a Closing Agreement with the IRS promising not to elect the §911 exclusion.... Why on earth would someone do that?? Which takes us to....
For the tax years at issue (2016-2018) Mr. Smith worked in Australia for Raytheon. He worked at a location called Pine Gap, a facility created by Australia and the U.S. back in the 1960’s to perform surveillance work. Currently some 400 U.S. citizens work there.
To understand today’s lesson, we need a short background on why Mr. Smith would even contemplate giving up the §911 election. It’s because of a series of Agreements between the U.S. and Australia.
In the 1960’s the U.S. and Australia entered into two Agreements to govern the general operation of Pine Gap. Each was made under the authority of a general Security Treaty between the U.S., Australia, and New Zealand. Part of the Agreements deal with taxation of U.S. citizens working at Pine Gap. Basically, they provide that Australia will not tax any of those citizens’ income so long as the U.S. taxes it. Australia will tax the income if the U.S. excludes that income from U.S. taxation.
The U.S. and Australia later entered into an general income tax Treaty in 1982. Judge Toro explains that the Treaty, standing alone, would subject U.S. Pine Gap workers to Australia taxation. Op. at 7. He also explains, however, that the 1982 Treaty specifically permits “other agreements between the Contracting States” to trump its provisions. So it permits the specific Pine Gap tax provisions to trump its general provisions. Whew.
Thus, the basic idea is that Pine Gap employees get to choose who will tax them: the U.S. Australia. Op. at 5-6. But, at least historically, they will be taxed by someone on their Pine Gap income. It's just a question of which country taxes them. The way employees make that choice is by either signing or refusing to sign a Closing Agreement with the IRS saying that they agree to not claim the §911 exclusion. If they sign, then that’s choosing to be taxed by the U.S. If they don’t sign, that means they are choosing to be taxed by Australia.
Operationally, the IRS sent Pine Gap employers a blank form Closing Agreement containing the necessary language to present to their employees for signature. If the employee signed the Closing Agreement, the employer sent the signed copy back to the IRS where it would be reviewed and signed by the appropriate IRS official. The IRS would then send the completed Closing Agreement back to the employer and the employer would send a copy to the Australian tax office. That's how the Aussies knew not to tax the income and that's how the employer knew what withholding to do.
Back to Mr. Smith and his employer Raytheon. When he started with Raytheon, he was presented with a Closing Agreement and a lengthy explanation of what it was for. He signed it. The language he agreed to was explicit: "the taxpayer irrevocably waives and foregoes any right that he . . . may have to make any election under Code section 911(a) with respect to income paid or provided to [him] as consideration for services performed for [the employer] in Australia." Op. at 14 (brackets in Opinion).
Mr. Smith initially filed his 2016 and 2017 returns in conformance with the Closing Agreement. However, he later submitted amended returns for those years making the §911 election and he filed his 2018 return making the election. The IRS followed it’s "process-first-audit-later" standard operating procedure and issued refunds to him. It only later opened an examination and issued an NOD for those years. So that’s how he got to Tax Court.
Lesson: The Finality of Closing Agreements
Mr. Smith’s attorney, Ms. Tiffany Hunt, argued that the Closing Agreement was invalid. Facing a pretty desperate situation, she threw three reasons against the wall. None stuck.
First, she argued that the IRS employee who signed the Closing Agreement did not have the proper authority to do so. Great idea, lousy execution. Judge Toro gave a careful review of the relevant delegation orders to conclude that the IRS employee who signed the Closing Agreement indeed had the proper authority to do so. While the playing the “let’s-trace-the-delegation-authority” game is admittedly intricate, it is not ambiguous or especially confusing. Frankly, some of the taxpayer’s argument here bordered on frivolous. For example, the taxpayer's attorney asserted that authority to sign Closing Agreements had to be contained in a single delegation order, and could not be made in different delegation orders contained in different parts of the IRM. It’s difficult to fathom any basis for such an assertion, either as a matter of law or policy. As Judge Toro observes, “mutual delegations of authority are not only permissible, but occur regularly.” Op. at 26.
Second, the taxpayer’s attorney argued the Closing Agreement was created by “malfeasance” within the meaning of the statute because the procedure used to create the Closing Agreement violated the confidentiality provisions of §6103. Judge Toro easily rejected that argument as well. And, again, the argument bordered on nonsensical. For example, the attorney argued in her brief that the IRS violated 6103 “when it obtained the ... Closing Agreement through Raytheon.” Op. at 35 (brackets omitted). As Judge Toro pointed out, a taxpayer can disclose their own tax return information, as Mr. Smith’s attorney herself conceded in oral argument. Id. The other §6103 arguments were equally embarrassing.
Finally, the taxpayer’s attorney argued that the Closing Agreement contained material misrepresentation of fact in its recitals preceding the operational language. The main objection was that the Recitals said that Mr. Smith’s Pine Gap income was generally “subject to taxation” by Australia. Apparently, Mr. Smith’s attorney believed that was not true. It is not clear why. Perhaps there were some provisions in Australian domestic tax law that would permit Mr. Smith to exclude some or all of his Pine Gap income from Australian income tax? Comments welcome on that.
Judge Toro rejects this argument because he decides this was a recitation about applicable law and was not a recitation about a fact. I think there’s a stronger reason for rejecting this argument. The argument misreads the recital. The recital just says Mr. Smith’s Pine Gap wages would ordinarily be “subject to” tax in Australia. Does not say they would be taxed, but just that they were "subject to" taxation. Hard to see how that misrepresents anything.
A fundamental lesson that I try to pound into my students heads starting on Day 1 is that “everything is income.” I actually sing that to the tune “Everything is Awesome”. I want them to absorb in their bones that any accession to wealth, clearly realized, is going to be subject to taxation, unless and until the taxpayer can find either a statutory or common law reason for excluding it. That's the American way!
Australia apparently has a more limited view of what constitutes gross income subject to taxation. See generally Richard Krever, “Analysing Implicit Tax Expenditures,” 35(2) Melbourne University Law Review 426, 430 (2011) (explaining that Australian courts “read down the income concept so it captures only a small slice of receipts that would be considered income by US courts”). But wage income is squarely gross income, even in Australia, as the Australian Taxation Office so kindly explains. So there is nothing misleading in reciting that Mr. Smith’s wages are “subject to" taxation, regardless of whether Australian tax law then operated to exclude some or all of it. That's just the government saying "yeah, mate, we could tax you but we're not going to."
The Closing Agreement was thus indeed the final word. Mr. Smith there agreed to forgo the §911 exclusion. He could not later change his mind. And it is not clear why his tax advisor told him he could, which takes us to....
Comment: Let’s Talk Penalties!
Section 6694(a) provides that if a taxpayer’s return contains an understatement of liability that arises from an unreasonable position taken on the return, then tax return preparer may be subject to penalties. I teach this as a three-level test. The default test is “substantial authority.” That is, if a return preparer has substantial authority for a position taken on a return, then they will not be subject to the penalty. §6694(a)(2)(A). However, if “the relevant facts affecting the item’s tax treatment are adequately disclosed in the return or in a statement attached to the return, and...there is a reasonable basis for the tax treatment of such item by the taxpayer,” then the preparer can escape the penalty. §6694(a)(2)(B) (x-ref §6662(d)(2)(B)(ii)). Finally, if the position involves a tax shelter or a reportable transaction, then to avoid the penalty the return preparer must convince the IRS or Court that the preparer reasonably believed the position was more likely than not to be sustained. §6694(a)(2)(C).
I think EA Castro may well have some §6694 exposure. It is difficult to see how anyone who knows anything about Closing Agreements would advise a client to renege, especially based on the flimsy, gauzy arguments offered by the attorney representing Mr. Smith, Ms. Hunt. Ms. Hunt offered little authority for her positions, much less the “substantial authority” needed to avoid penalties. See e.g. Op. at 39, where the Court noted she offered “no authority” for the proposition that misstatements of law were the same as misstatements of facts.
The only escape hatch I see from the admittedly limited information I have is if EA Castro adequately disclosed what he was doing on the amended returns he filed for Mr. Smith or the original return. So, for example, if he included a copy of the Closing Agreement with the amended return I would think that would be an adequate disclosure. On the one hand, I doubt he did. He seems pretty sloppy. Footnote 20 of the Opinion explains that he submitted the amended returns without Mr. Smith’s signature. Instead Ms. Hunt signed them, and did so without attaching a Form 2848 authorizing her to do so. Whoops. On the other hand, perhaps he did disclose, because the IRS hopped on this issue speedy quick. Without disclosure I don’t see how the IRS would have caught the error. If EA Castro did disclose, then all he needs to escape penalties is a “reasonable basis” for the position, which is basically a red-face test. So maybe ... maaaaaybe ... he had that. After all it took Judge Toro many many pages to scrape the arguments off the wall. And I doubt Ms. Hunt's face turned red as she argued the case.
I am guessing that what we have here is signer’s remorse. It may well be that Australian law has changed since the 1960’s when the Pine Gap Agreements were written so that Australian tax law now would not hit Pine Gap employees’ wages as hard as U.S. tax law. So maybe they should not sign a Closing Agreement. I don’t know. But that’s why Pine Gap employees need to get good tax advice before they sign a Closing Agreement. 'Cause once they sign, it's final.
Coda: What is This Firm Castro & Co.?
It appears from this website and this website that attorney Hunt is or was associated with EA Castro, but in what capacity I cannot tell. In fact, when I looked at EA Castro’s business website, Castro & Co, it raised more questions in my mind than it answered. The site describes the company as a “law firm” several times. For example, on its “about” page it claims “Castro & Co. is a digitally global, boutique tax law firm.” But it lists no licensed attorneys at all on the staff profiles page (and no, EA Castro is not a licensed attorney, despite holding two law degrees; another mystery). The Staff profiles include an executive office manager, a marketing director, a client relations manager, even its paralegal. But no lawyers! What kind of “law firm” does not list its lawyers?? I imagine there is some business relationship between Ms. Hunt and this firm, but I’m befuddled by what that might be. I invite comments from those more savvy than I am. Ms. Hunt also represented another Pine Gap taxpayer in the recent case of Brown v. United States, 22 F.4th 1008 (Fed. Cir. 2022). And she may well be counsel of record in some or all of the other 19 Pine Gap cases pending in Tax Court. So we might see her again. Or not, as I would expect all of them to now settle.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech School of Law. He greatly enjoyed two short teaching stints at LaTrobe University in Melbourne many years ago, sadly before he knew about section 911. He invites readers to return to TaxProf Blog each Monday (or Tuesday if Monday is a federal holiday) for another Lesson From The Tax Court.