Lesson From The Tax Court: What Makes A NOD Invalid?

When the IRS determines a deficiency of tax, it is then “authorized to send notice of such deficiency to the taxpayer.”  §6212(a).  That’s called a Notice of Deficiency (NOD).  The taxpayer generally has 90 days from the date of the NOD to petition the Tax Court to ask for a “redetermination of the deficiency.” §6213(a).

The procedures outlined in §§6212 and 6213 carry several important consequences.  First, the IRS is prohibited from sending a second NOD for the tax year(s) covered by the NOD. §6212(c)(1).  Second, the IRS is prohibited from assessing the proposed deficiency until after the Tax Court has issued a decision and it has become final. §6213(a).  Third, the statute of limitations for the IRS to make an assessment is suspended for the same period during which the IRS is prohibited from assessing, plus 60 days. §6503(a).

None of those consequences happen if the NOD is invalid.  If a taxpayer convinces the Court that the NOD is not valid, the Tax Court will dismiss the case.  That dismissal hurts the IRS because, almost always, the limitation period for assessment will have expired, barring the IRS from re-doing the NOD.

So what makes an NOD invalid?  It is not what many taxpayers think.  Taxpayers may think that an indecipherable NOD is invalid.  Or taxpayers might think that if the process leading to the NOD was defective, then the NOD is invalid.  Today we learn that is not the case.  The lesson comes from Michael J. Watson and Tracy L. Watson, et al. v. Commissioner, Docket No. 12220-21 plus five others (Aug. 31, 2023) (Judge Weiler). Note that this is an unpublished order, so the link takes you to the Docket Sheet and you have to scroll down to find the Order.

But even though this is just an unpublished order, I think it’s worth attention because it is very well written and can teach us something about how the Tax Court evaluates the validity of an NOD.

Law: The Complexities of Notices of Deficiency
At one level, it’s simple.  When the IRS sends the taxpayer a valid Notice of Deficiency (NOD) and the taxpayer timely petitions the Tax Court, the Tax Court has authority to redetermine the deficiency alleged in the NOD.

But nothing about tax procedure is really ever simple.  For example, the Tax Court has long taken the position that the timing requirement is jurisdictional, meaning the Tax Court has no power to review an NOD if the taxpayer’s petition is even one second late.  Roy A. Nutt and Bonnie W. Nutt v. Commissioner, 160 T.C. No. 10 (May 2, 2023).  However, the Third Circuit has recently decided that the time period to file a Tax Court petition is not jurisdictional.  See Culp v. Commissioner, ___ F.4th ___ (3rd Cir. 2023).  If true, then the seemingly simply timing requirement will become more complex because of the doctrine of equitable tolling.

What constitutes a “valid” NOD is also not so simple.  That is because an NOD serves two important functions, as Prof. Emerita Leandra Lederman so nicely teaches us in her classic article, “Civil'izing Tax Procedure: Applying General Federal Learning to Statutory Notices of Deficiency,” 30 U.C. Davis L. Rev. 183 (1996).

First, the NOD serves an access function.  This is the famous “ticket to the Tax Court” function.  I like to think of the NOD as a key rather than a ticket.  It unlocks the next step in processing the taxpayer’s claim that the IRS’s conclusions are wrong.  For the Tax Court to process this dispute the taxpayer must have the proper key to the courthouse.

To be valid, the key does not have to be fancy.  The IRS can just give the taxpayer a mere skeleton key.  That is, the IRS need not use any particular form or even explain the basis of the determination.  Any document that fairly advises the taxpayer that a deficiency has, in fact, been determined as to a specified year for a specified type of tax will do the trick.  Dees v. Commissioner, 148 T.C. 1, 8 (2017) (“if the notice is sufficient to inform a reasonable taxpayer that the Commissioner has determined a deficiency, our inquiry ends there; the notice is valid.”); Olsen v. Helvering, 88 F.2d 650, 651 (2d Cir. 1937) ("the notice is only to advise the person who is to pay the deficiency that the Commissioner means to assess him; anything that does this unequivocally is good enough.").

Second, the NOD serves a pleading function.  That is, the Tax Court will presume the IRS's deficiency determination is correct unless and until the taxpayer persuades the Court otherwise.  Even if the burden of producing facts gets shifted to the IRS, the burden of persuasion remains with the taxpayer to show the deficiency determination is wrong.  See e.g. Rockwell v. Commissioner, 512 F.2d 882 (9th Cir. 1975) (great discussion on burdens).

Thus, an NOD may be valid for the notice function but not for the pleading function.  You can how that works by reading §7522(a).  That statute first says that the NOD must “describe the basis for” the deficiency determination.  However, the statute goes no to say that an “inadequate description...shall not invalidate the notice.”  That is an important qualification.  It means that one might have an NOD that is valid for the first function—a working key—but inadequate as to the second function, the pleading function.

An NOD that inadequately describes the basis for the deficiency makes the NOD invalid for purposes of getting the presumption of correctness, but does not make the NOD an invalid key to judicial review.  The Tax Court has explained it like this: “[if] a notice of deficiency fails to describe the basis on which the Commissioner relies to support a deficiency determination and that basis requires the presentation of evidence that is different than that which would be necessary to resolve the determinations that were described in the notice of deficiency, the Commissioner will bear the burden of proof regarding the new basis.  To hold otherwise would ignore the mandate of section 7522 and Rule 142(a).”  Shea v. Commissioner, 112 T.C. 183 (1999).

Today’s lesson concerns the first function of an NOD, the notice function.  Remember, an NOD is not invalid just because it has an “inadequate” description of the basis for the asserted deficiency.  Nor will the courts generally go behind the NOD to evaluate whether the IRS determination was a thoughtful or careless one.  See Greenberg v. Commissioner, 10 F.4th 1136 (11th Cir. 2021) (collecting cases).

But an NOD will be invalid when it reflects that the IRS did not make a determination regarding the taxpayer to whom the NOD was sent.  Scar v. Commissioner, 814 F.2d 1363 (9th Cir. 1987), is still the leading case for what makes an NOD invalid.  There, the tax year at issue was 1978.  With the 3-year assessment limitation period about to expire, the IRS shot out an NOD asserting a large deficiency in tax based on the taxpayers’ participation in a Nevada mining shelter.

It turns out the taxpayers had been involved in a different tax shelter scheme, one involving videotapes, for which the IRS had dinged them on their 1977 return.  But an IRS employee had entered an incorrect code number into the computer system, thus causing the NOD to spit out based on the Nevada mining shelter instead of the videotape shelter.

On these facts, the 9th Circuit held that the NOD was invalid.  That is because the NOD, on its face, was a determination based on some other taxpayer’s tax shelter.  Key to the 9th Circuit’s decision was the idea that the invalidity of that NOD was able to "be determined solely by references to applicable statutes and review of the notice itself."  814 F.2d at 1368.

After reading the cases applying Scar—or more often refusing to apply Scar—it appears that what is critical to making an NOD valid is whether a reader can tell, from just the documents that make up the NOD, that the IRS goofed up by using only information that related to other taxpayers to assert a deficiency against the taxpayer to whom the NOD is directed.

For example, the 9th Circuit itself has limited Scar’s scope to situations where the NOD on its face shows that the IRS got the wrong taxpayer.  In Clapp v. Commissioner, 875 F.2d 1396 (9th Cir. 1989), the taxpayers were involved in a shelter scheme involving Trust entities.  The IRS issued NODs to both the individual taxpayers (on a theory that the Trusts were shams) and to the Trusts (on the theory that the Trusts were not shams).  The NODs also disallowed deductions to both sets of taxpayers because the taxpayers had refused to give the IRS information during audit to substantiate their deductions.

The taxpayers first argued the NODs were invalid because the IRS had not made a “determination” that the trusts were shams or not shames but had instead made one assumption in the NOD to the individuals and a contrary assumption in the NOD sent to the Trusts.  The 9th Circuit rejected that argument saying that just because the IRS took inconsistent positions in related NODs did not invalidate them. “Any other approach would reward the tax evader who could come up with a novel scheme and force the Commissioner to take a single, consistent legal interpretation.” Id. at 1401.

The taxpayers next argued the NODs were invalid because the IRS was just making up numbers, as in Scar, because the IRS did not use information it could have used to evaluate the deductions.  Instead the IRS just assumed the worst.  The 9th Circuit rejected this argument as well, agreeing with the Tax Court that “Scar did not even require any affirmative showing by the Commissioner that a determination set forth in an alleged notice of deficiency was made on the basis of the taxpayers' return. Only where the notice of deficiency reveals on its face that the Commissioner failed to make a determination is the Commissioner required to prove that he did in fact make a determination.” Id. at 1402.

Thus, as a general matter, the Courts will not look beyond the face of an NOD to evaluate whether it is valid.  However, the Tax Court has added some nuance to this idea by holding by holding that if an NOD is ambiguous, then the Court can consider evidence from outside the four corners of the purported notice to establish whether the Commissioner made a taxpayer-specific determination.  See U.S. Auto Sales, Inc. v. Commissioner, 153 T.C. 94 (2019) (applying two-step analytical framework to evaluate validity of an ambiguous NOD).

Facts
Today’s case, like Clapp, involves NODs sent to multiple, related, taxpayers and appears to involve a micro-captive insurance company issue.  First, the IRS sent NODs to Mr. and Ms. Watson, asserting deficiencies for the years 2015, 2016, 2017.  Second, the IRS issued NODs to the Watson Family Insurance Company, Ltd. for the same years.  Third, the IRS issued NODs to the Watson Insurance Company, Ltd.  The NODs were all issued close in time.  All taxpayers (the individual Watsons and the two Watson entities) timely petitioned Tax Court.

Lesson: An NOD Is Valid Even If The Audit Was Jicky
The taxpayers here were very unhappy with how the Revenue Agent (RA) conducted the audits.  Their theory was that the audit process was so bad that the NODs could not reflect a valid “determination.”  They filed a 400-page Motion To Dismiss and attached well over 400 pages of supporting Declarations.  Judge Weiler admirably sums it up like this: “Petitioners argue that the RA violated the Internal Revenue Manual’s “basic written audit techniques” by failing to interview relevant parties, misquoting relevant law, citing to interview facts of a wholly separate taxpayer, and engaging in inappropriate interview techniques.”

In this case, the NODs stated the amounts of the asserted deficiencies, penalties, and additions to tax for each year.  That amounted to several millions of dollars. There was nothing in any of the NODs that showed the IRS had mixed up taxpayers like it had in Scar.

That was enough to make them valid.  Here’s Judge Weiler’s bottom line:

“The notices of deficiency issued to petitioners in this case were not ambiguous and clearly set forth the deficiencies in tax, the additions to tax, and the associated penalties. The notices of deficiency would have objectively put a taxpayer on notice that respondent had determined a deficiency in tax for a particular year and for an amount.”

Judge Weiler is careful to note that just because the NOD was valid did not mean the asserted deficiencies were substantively correct.  That’s the whole point of a Tax Court review!

“A proceeding before this Court to redetermine a deficiency is a proceeding de novo, and we generally will not look behind a notice of deficiency to examine the Commissioner’s procedures in making the determination. Our decisions are based on the merits of the record before us, and not on the record developed at the administrative level. Accordingly, our review of petitioners’ tax liabilities is not limited to the administrative record, nor will it be based on the RA’s examination.”

So this case will now move on.  Perhaps its eventual resolution on the merits will give us another Lesson From The Tax Court!

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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