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Taxpayer Loses Claim for Research Credit

by Edward L. Froelich | Nov 30, 2023 | Appellate Courts, Court Procedure Matters, Trial Courts

In United States v. Grigsby, Docket No. 22-30764, the US Court of Appeals for the Fifth Circuit held that a refund claim based on claimed Internal Revenue Code (IRC) Section 41 credits was erroneous. Cajun Industries LLC, a subchapter S corporation, filed a refund claim that identified four highly specialized construction projects (two refineries and two flood control systems) as “business components,” which, in turn, gave rise to qualified research expenses (QRE). Cajun fabricated the systems under four separate contracts. The Internal Revenue Service (IRS) granted the claim and issued the refund (ultimately to Cajun’s shareholders who are the taxpayers in this case) but later regretted the decision and filed a suit for recovery of an erroneous refund under IRC Section 7405. The decision turned on two main factors:

A failure to plead
The funded contract exception under IRC Section 41(d)(4)(H)

PLEADING FAILURE

After discovery, the parties prepared for trial and moved for summary judgment. In its motion for summary judgment (and about a month before trial), for the first time in the litigation, the taxpayers identified certain construction processes as additional “business components,” giving rise to the claimed QRE. The Fifth Circuit held that the district court did not abuse its discretion by declining to consider these new processes as “components” in support of the claimed QRE. In short, the taxpayer was too late and paid the price for its delay. One taxpayer faced a similar problem in 2000 when it sought to put into evidence additional QRE beyond the amount described in its detailed refund claim. There, the Federal Circuit cited the doctrine of variance (i.e., a taxpayer must provide adequate notice of the grounds of the refund claim and any substantial variance from those grounds is not permitted in litigation) and declined to put the additional QRE into evidence. Variance may not have been applicable in the Grigsby case because the refund claim was reviewed and issued, but the taxpayers could have improved their position in court by including the construction processes at the beginning of the litigation or at the latest during discovery.

FUNDED EXCEPTION

The Fifth Circuit then analyzed the four contracts and focused particularly on terms pertinent to the ownership of research results and whether payment to Cajun was contingent upon success of its research. (Regulations promulgated under IRC Section 41(d)(4)(h) provide that research is funded and thus not eligible for the credit if the researcher does not retain substantial rights in its research.) The Court held that three of the contracts awarded sole rights in the research to the customer and removed any substantial rights from Cajun. The fourth contract (firm fixed price) was simply considered “funded” because payment was not contingent upon the success of any research performed by the taxpayer. The Court also rejected a Fairchild risk argument negating the funded nature of this fourth contract.

In general, regarding the three contracts, it’s not clear that Cajun retained zero substantial rights in its research. For [...]

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Can the Government Sue for Tax Debts Outside Internal Revenue Code Procedures?

by Kevin Spencer, Edward L. Froelich and Evan Walters | Jul 21, 2023 | Appellate Courts, Court Procedure Matters, Trial Courts

On June 1, 2023, in United States v. Liberty Global, Inc., the US District Court for the District of Colorado held that the US Department of Justice (DOJ) can assert and seek judgment for federal income tax deficiencies using a common law right of action, bypassing the usual statutory tax deficiency procedures outlined in the Internal Revenue Code (IRC). This decision might encourage the DOJ to seek tax collections through court judgments moving forward without following the IRC’s deficiency procedures.

With the IRS, Mail Delivery Counts!

by Kevin Spencer and Evan Walters | Jun 29, 2023 | Appellate Courts, Court Procedure Matters, Tax Refunds, Trial Courts

Over the years, case law has developed around when a mail delivery method is acceptable to prove that a tax filing was made.

The US Court of Appeals for the Fourth Circuit’s recent decision in Pond v. United States[1] addresses how a taxpayer can prove delivery of a filing where the Internal Revenue Service (IRS) disputes physical delivery.

Stephen Pond, the taxpayer, filed two claims for refund in the same envelope. One claim pertained to his 2012 tax year and the other pertained to his 2013 tax year. The government acknowledged receipt of Pond’s 2012 claim. An IRS agent contacted Pond for more information in September 2017, after which Pond faxed a duplicate copy of his 2012 claim for refund but not his 2013 claim. In March 2018, the government issued a refund to Pond for his 2012 claim. However, after receiving no response about his 2013 claim, Pond again contacted the IRS. The IRS could not locate his claim for refund, so he faxed a duplicate copy of the 2013 claim.[2] Pond later received a “Notice of Denial” from the IRS informing him that it denied his 2013 claim for refund because the statute of limitations on claiming a refund or credit had expired.

Pond filed a refund suit in US federal district court, where the court dismissed his claim pursuant to Federal Rule of Civil Procedure 12(b)(6) for failure to allege facts upon which the court’s subject matter jurisdiction could be based. Stated differently, assuming all reasonable inferences in favor of the taxpayer, the district court ruled that the taxpayer’s pleadings did not sufficiently establish that he timely filed his 2013 claim for refund, a statutory requirement for the district court to have jurisdiction.

IRC Section 7502(a) creates a presumption of timeliness if a mailing sent by US Mail is postmarked before the deadline.[3] IRC Section 7502(c) creates a presumption of delivery, but only if the mailing is sent by US Postal Service (USPS) registered or certified mail.[4] Unfortunately, Pond sent his refund claims via USPS first-class mail, rather than registered or certified mail. Thus, he was not entitled to the presumption of delivery under IRC Section 7502. Further, according to the Fourth Circuit (and consistent with case law in the Second and Sixth Circuits), Pond could not rely upon federal common law principles because IRC Section 7502 supplanted the common law rule.[5] Thus, Pond needed more than the postmark alone to establish that he actually filed his 2013 claim for refund. He had to show that the claim for refund was physically delivered.

Nonetheless, Pond was entitled to present evidence to establish physical delivery. The Fourth Circuit cited three factual allegations that could establish a triable issue of fact. First, the envelope he claimed included the claim for a refund was postmarked. Although this fact is not sufficient in the case of mail sent by means other than USPS registered or certified, it was still evidence of [...]

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IRS Proposes New Regulations to Settle Supervisory Approval of Penalties Requirements

by Kevin Spencer and Sarah M. Raben | Apr 14, 2023 | Appellate Courts, Court Procedure Matters, IRS Audits, IRS Guidance, Trial Courts

The Internal Revenue Service (IRS) has proposed regulations to clarify the rules regarding supervisory approval of federal civil tax penalties under IRC Section 6751(b). Since Chai v. Commissioner, there has been a substantial number of cases litigating issues involving supervisory approval of federal civil tax penalties. Back in September, we posted about the US Court of Appeals for the Ninth and Eleventh Circuits split in which both Courts departed from long-standing US Tax Court precedence on the timing requirement of supervisor approval. Those two decisions, along with others, prompted this new guidance “to have clear and uniform regulatory standards.”

The proposed regulations address three timing rules: (1) penalties subject to pre-assessment review in the Tax Court; (2) penalties raised in the Tax Court after a petition and (3) penalties assessed without prior opportunity for Tax Court review.

Specifically, the proposed regulations allow supervisors to approve the initial determination of a penalty up until the time the IRS issues a pre-assessment notice, such as a Statutory Notice of Deficiency, which is the notice that provides taxpayers with a ticket to the Tax Court. The proposed regulations explain that “earlier deadlines created by the Tax Court do not ensure that penalties are only imposed where appropriate” and the “bright-line rule relieves supervisors from having to predict whether approval at a certain point will be too early or too late.” Additionally, penalties raised in the Tax Court after a petition is filed, such as an answer or an amended answer, would need supervisory approval any time prior to the penalty being raised. Supervisory approval for penalties not subject to pre-assessment review in the Tax Court may be obtained at any time prior to the assessment.

The proposed regulations require the approval of “the immediate supervisor,” which is defined as “any individual with responsibility to approve another individual’s proposal of penalties without the proposal being subject to an intermediary’s approval.” The term is also not limited to any particular individual.

Comments and requests for a public hearing must be received by July 10, 2023.

Practice Point: Penalties continue to be a hot topic in the tax controversy arena. The updated guidance promises to clarify and standardize the requirements of supervisory approval of IRS penalties, with the hope and expectation of reducing litigation on the issue. From the taxpayer’s perspective, ideally, the new regulations will enable examiners and managers the opportunity to thoroughly review the facts and circumstances of cases before deciding if penalties are warranted. We will continue to follow and report on any new developments.

Please see the links to our prior commentary on Code Section 6751 below:

Supreme Court Punts on Attorney-Client Privilege Question

by Kevin Spencer, Sarah M. Raben and McDermott Will & Emery | Feb 2, 2023 | Appellate Courts, Court Procedure Matters, IRS Audits, Privilege and Non-Disclosure, Trial Courts

In a surprising move, the Supreme Court of the United States (SCOTUS) dismissed a dispute involving the proper test to apply when determining whether an unnamed law firm’s mixed bag of communications involving both legal advice and discussions of tax preparation was privilege. The dismissal came less than two weeks after oral arguments, with SCOTUS stating that “[t]he writ of certiorari is dismissed as improvidently granted” (commonly known as a “DIG,” which infrequently happens when SCOTUS determines there is no conflict warranting review, one or both parties have changed their position, or no consensus can be reached by the Justices and dismissal is preferable to fractured opinions with no controlling rationale).

BACKGROUND

The law firm and an unnamed company were each served with subpoenas for documents and communication related to a criminal investigation. Both produced some documents but withheld others on the grounds of attorney-client privilege and the work-product doctrine. The government moved to compel production, which the district court granted in part, explaining that the documents were not protected by any privilege, and they were discoverable under the crime-fraud exception. The company and law firm continued to withhold the documents, and the government filed motions to hold them in contempt. The district court ruled that certain dual-purpose communications were not privileged because the “primary purpose” of the documents was to obtain tax advice, not legal advice. On appeal to the US Court of Appeals for the Ninth Circuit, the law firm and the company argued that the court should have relied on a broader, “because of” test, not the “primary purpose” test. The Ninth Circuit disagreed and concluded that the “primary purpose” test governs, and the primary purpose of the communications was tax advice. SCOTUS granted certiorari in October 2022.

SUPREME COURT

In its brief, the law firm asked SCOTUS to adopt a more expansive “significant purpose” test, which was applied by the US Court of Appeals for the District of Columbia Circuit in In re Kellogg Brown & Root, Inc. The law firm argued that the test applied in Kellogg “appropriately protects attorney-client dual purpose communications” and that the test “asks a single question that arises directly from the long-established test for attorney-client privilege: whether a client is seeking or obtaining confidential legal advice from his or her lawyer.”

The government argued that courts consistently emphasize the need to construe the attorney-client privilege narrowly and that the primary or predominant purpose test “thus molds the scope of the privilege to its purpose of encouraging effective legal advice, while avoiding sweeping in communications predominantly about a nonlegal matter.”

During oral argument, the Justices seemed skeptical of a need to change the test and expressed some confusion as to how any privilege analysis would change from a practice perspective. Justice Kagan invoked the saying “if it ain’t broke, don’t fix it.” Shortly thereafter, SCOTUS issued the DIG.

Practice Point: More [...]

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Tax Court Holds That Deficiency Petition 90-Day Time Limit Is Jurisdictional

by Kevin Spencer, Sarah M. Raben and McDermott Will & Emery | Dec 1, 2022 | Appellate Courts, Court Procedure Matters, Trial Courts

Last summer, the Supreme Court of the United States held that the 30-day time limit to file a Collection Due Process (CDP) petition is a non-jurisdictional deadline subject to equitable tolling (Boechler, P.C. v. Commissioner). (Our prior discussion of Boechler can be found here.) The natural follow-up issue was whether this holding extended to the 90-day limit for deficiency petitions.

On November 29, 2022, in a unanimous 17-0 opinion in Hallmark Research Collective v. Commissioner, the US Tax Court held that the 90-day time limit is jurisdictional not subject to equitable tolling. The taxpayer in that case filed its deficiency petition one day late but argued that the 90-day limit is non-jurisdictional under Boechler and that it should be allowed to show cause for equitable tolling of the limitations period.

The Tax Court analyzed the relevant statute (Internal Revenue Code (IRC) Section 6213(a)) and found that the statutory text, context and relevant historical treatment all confirmed that the 90-day time limit clearly provided that the deadline was jurisdictional. Its analysis started with the US Constitution and tracked the deficiency procedures from the days of its predecessor (the Board of Tax Appeals) through various statutory changes and the overall framework of the procedures. Based on its analysis of almost 100 years of statutory and judicial precedent, the Tax Court concluded that it and the US Courts of Appeals have expressly and uniformly treated the 90-day time limit as jurisdictional, and the US Congress was presumptively aware of this treatment and had acquiesced in it.

The Tax Court rejected the taxpayer’s arguments to the contrary. It noted that the Supreme Court in Boechler rejected the analogy of the statutory 30-day limit for a CDP petition to the statutory 90-day limit for a deficiency petition. The Court also provided separate reasons why the statutory 30-day time limit was different, both in its text and in prior judicial constructions from the 90-day time limit.

Practice Point: The Tax Court’s opinion in Hallmark will not be the last word on the issue, and we expect further developments in this area. Additionally, there are other types of petitions that can be filed in the Tax Court (e.g., so-called “innocent spouse” petitions filed in non-deficiency cases) that contain language different from the statutes addressed in Boechler and Hallmark. We will continue to follow this area and provide relevant updates as they develop.

Supreme Court Denies Certiorari in Whirlpool

by Kevin Spencer and McDermott Will & Emery | Nov 21, 2022 | Appellate Courts, Court Procedure Matters, IRS Guidance, Trial Courts

On November 21, 2022, the Supreme Court of the United States denied certiorari in Whirlpool Financial Corp., et al., Petitioners v. Commissioner of Internal Revenue, No. 22-9. This means that the US Court of Appeals for the Sixth Circuit’s decision remains in effect and is binding on the taxpayers who reside in that circuit. However, for taxpayers in other circuits, the Sixth Circuit’s decision is only persuasive authority and not binding precedent. Thus, it remains to be seen whether taxpayers in other jurisdictions will challenge the result reached in Whirlpool, and if they do, how appellate courts outside the Sixth Circuit will rule.

Prior coverage of this case can be found below:

Whirlpool Update: New Filings and Distribution for Supreme Court Conference

by Lowell D. Yoder, David G. Noren, Elizabeth C. Lu and Jonathan D. Lockhart | Nov 4, 2022 | Appellate Courts, Court Procedure Matters, Trial Courts

On November 2, 2022, the Supreme Court of the United States announced that the case of Whirlpool Financial Corp., et al., Petitioners v. Commissioner of Internal Revenue, No. 22-9, has been distributed for consideration at its upcoming conference on November 18, 2022. Meaning, we should have an answer in the next few weeks as to whether the Supreme Court will hear the case.

The Supreme Court’s distribution for the conference follows the government’s brief, submitted on October 19, 2022, in opposition to Whirlpool’s petition for a writ of certiorari.

In its brief, the government summarizes its position as follows:

Petitioners contend (Pet. 17) that 26 U.S.C. 954(d)(2) is “conditioned on the promulgation of regulations” by the Treasury Department and thus may not “be enforced without regard to such regulations.” But as the court of appeals correctly held, Section 954(d)(2)’s text itself establishes clear “conditions” and “consequences,” Pet. App. 12a, and when applied to this case, that text “mandate[s]” that the income at issue is FBCSI, id. at 18a. The phrase “‘under regulations prescribed by the Secretary’” delegates to the Treasury Department authority to “implement the statute’s commands,” but not to “vary from them,” ibid., so the court permissibly declined to articulate a separate rationale in this case based on the implementing regulations. Petitioners concede (Pet. 33) that the decision below does not conflict with that of any other court of appeals. Nor does it conflict with this Court’s precedent because petitioners’ cited cases involved meaningfully distinct statutory schemes. And resolving the question presented lacks practical importance because the Treasury Department’s former regulations would dictate the same result as the statutory text, and the revisions that were made to the regulations in 2008 removed any potential doubt about that result. This Court’s review is unwarranted.

The government’s position is an interesting one. It seems to accept that a court is free to ignore regulations relied on by the public if the court determines that the government’s position is supported by the statutory language and the statute is not entirely conditioned on the operation of a regulation. Additionally, the government believes here that US Congress did not entirely condition operation of Internal Revenue Code (Code) Section 954(d)(2) on regulations.

Perhaps sensing the difficulty in prevailing on this argument, the government (similar to what it did in the rehearing proceedings in the US Court of Appeals for the Sixth Circuit) seeks to limit Whirlpool to the specific statute at issue. However, this ignores the fact that the same or substantially the same language is used in other Code provisions, making it difficult to limit the government’s argument to Code Section 954(d)(2).

In another attempt to discourage review, the government essentially argues that the substantive issue is an issue of first-and-last impression because the regulations at issue were amended for tax years subsequent to Whirlpool’s. Again, this ignores the fact that Whirlpool involves important administrative law issues that will remain regardless of the amendment.

Finally, [...]

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The IRS Can Share Your Tax Information with Foreign Governments

by Kevin Spencer and McDermott Will & Emery | Oct 28, 2022 | Appellate Courts, Court Procedure Matters, IRS Audits, IRS Guidance

The recent Zhang v. United States case, Docket No. 21-17093 (9th Cir. Oct. 18, 2022), serves as a reminder that the Internal Revenue Service (IRS) can force you to disclose and share your tax information with foreign governments. The taxpayers in Zhang appealed the decision from the US District Court for the Northern District of California denying their petition to quash an IRS summons for information. The summons was at the request of the Canadian tax authority pursuant to a bilateral tax treaty between the United States and Canada. The US Court of Appeals for the Ninth Circuit reaffirmed that the IRS can seek information for, and on behalf of, a foreign government as long as the request satisfies the accepted guidelines of requesting information in the United States—for example, the “good faith” requirement announced in United States v. Powell, 379 U.S. 48, 57-58 (1964).

So why do we highlight Zhang for you? In this ever-increasing world of tax information transparency, taxpayers need to be mindful of the ability of tax authorities to share information with each other and adjust their taxes accordingly. During a tax audit, it’s a strategic decision as to what tax information to share and what not to share with each tax authority. Telling different stories to different tax authorities could lead to more intrusive audits/scrutiny and higher overall tax bills and could even lead to criminal prosecution. Below are some basic principles to keep in mind:

There are three primary methods as to how countries share tax information with each other:
- Automatic Exchanges
- Spontaneous Exchanges
- Targeted Requests
Automatic exchanges are becoming increasingly used by countries (g., BEPS Action 5 and the Foreign Account Tax Compliance Act) because they are automatic and routine and usually associated with standardized financial/bank transactions.
A spontaneous exchange occurs when one country sees something of interest and alerts another country about a potential tax issue or as part of a joint audit by the countries.
- These exchanges are usually facilitated by provisions in bilateral tax treaties.
- The IRS’s Internal Revenue Manual (g., IRM 4.60.1.3) has detailed instructions for IRS employees on how to handle these treaty exchanges.
Targeted requests (like in Zhang) are typically initiated by one country that is a party to an information exchange treaty to seek information needed by that country in its tax investigation of its resident or citizen.
- In such a case where a foreign government makes a request of the US government through a treaty, the IRS Office of the Competent Authority on the US side handles the request. (See, e.g., IRM 4.60.1.2.2.4.)
- If the US taxpayer does not comply with the IRS request for information made by the foreign government (usually in the form of an “Information Document Request”), the IRS can use its administrative summons power to enforce the summons in court (which is what happened in Zhang).

Practice Point: It is crucial to be strategic [...]

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Recent Tax Developments Concerning Administrative Law Issues

by Kevin Spencer and McDermott Will & Emery | Oct 20, 2022 | Appellate Courts, IRS Guidance, Tax Reform, Trial Courts

We have written extensively on the intersection of tax law and administrative law, specifically on how the Administrative Procedure Act (APA) and the Anti-Injunction Act (AIA) factor into tax cases. In a recent article for the ABA Tax Times, Kristin E. Hickman, a leading authority in the fields of tax administration, administrative law and statutory interpretation, discusses several tax opinions from 2022 concerning APA issues. We think this article is a must-read for taxpayers and practitioners.

For some of our prior posts on tax law and administrative law, see below:

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